The Many Lives of Tokens

Polygon Labs
September 19, 2022
Case Studies
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Image source: Dribbble

Tokens are the élan vital of Web3 networks, and projects are often perceived through the price at which they trade. But token price, subject to market sentiment and speculation, is not synonymous with token value. To understand the fundamentals, we must first unpack the different ways that value accrues to tokens in the new Internet paradigm.

There are a number of functions performed by tokens that drive value to a protocol, from helping bootstrap a network into existence and providing incentives to keep it secure to acting as the coin of the realm and a governance proxy. While the price discovery is realized by market participants, long-term value accrual engages a much broader ecosystem of players which includes project builders and outside contributors, pioneering early adopters and cautious latecomers, return-minded investors and dyed-in-the-wool believers. 

This is the basics of value accrual for tokens as seen through the eyes of Web3 denizens. As with all things digital assets, none of this article is financial advice.

Cold Start Problem & Network Effects

If you build it, they will come, a Silicon Valley saying goes. The only problem is the saying is wrong. Networks have a chicken and egg problem: users only come when there is enough activity created by … users that came before them. Tokens help solve the cold start problem by giving incentives to early adopters. Once critical mass is reached, network effects take over. More users make the network more valuable to developers, resulting in more dApps, which attract more users in turn and spinning up the growth flywheel.

Let’s say Ash is a (hypothetical) developer who with their small cohort of collaborators just launched a brand new blockchain, xNetwork, and its native $TOKEN. The team makes a few crucial token distribution choices that will have a long-lasting impact on adoption. The project committed a sizable portion of the supply for staking rewards (more on that later), airdropped a smaller percentage to outside contributors to the testnet and set aside a portion of its treasury for a headline-grabbing liquidity mining campaign. When the network effects kick in, the value cascades back to $TOKEN. 

Staking & Network Security

Staking is one of the fundamental functions for a token in Proof of Stake (PoS) systems. Validators lock up (stake) some tokens for a period of time and are tasked with verifying the authenticity and validity of transactions. This way of arriving at consensus keeps the network secure because it makes it difficult for an attacker to subvert the system by creating multiple identities. Validators earn rewards and collect fees in return. Higher adoption leads to more network activity and higher fee revenues, which in turn attracts more validators, making the network more distributed and therefore resilient.

Jesse, an early contributor to Ash’s xNetwork, received a small number of $TOKEN in the airdrop. A believer in the project, he is inclined to hold on to the coins, but as a young father he feels the responsibility to maximize returns on behalf of his newborn son. Luckily, the staking rewards program lets him have the cake and eat it too. Jesse joins as a validator, allowing him to earn while contributing to the project he loves. His success soon prompts more people in the community to join the validator ecosystem, driving demand for tokens and making staking rewards more valuable, up to a point -- a kind of reflexivity that powers value accrual.

Delegating & User Involvement

Jane, a financial analyst who moonlights as crypto-trader, has had her eye on $TOKEN for a while. Without the coding skills needed to contribute, her participation has been limited to talking about the project on Reddit, stalking the founding team on Twitter and lurking in developer Discord chats. Now that the token is live, she has the opportunity to take part in securing the network she already knows well and be rewarded in return.

Becoming a validator and running a node is something only a few can manage because it requires capital and substantial technical know-how. But any holder of a token can contribute as a delegator, or by choosing a validator to stake on their behalf. Having a broad delegator base helps spread the wealth and gives users skin in the game. A high staking ratio, or the proportions of tokens staked relative to total supply, reduces liquidity. Fewer tokens sloshing about the markets makes $TOKEN more rare and, thus, more valuable during the time tokens are staked.

Transaction Fees

With a chain up and running, the token functions as the main touch point through which users interact with xNetwork. Chad was attracted to the network by its low transaction fees, fast processing speeds and a burgeoning decentralized application ecosystem. A manager at a DeFi trading firm, Chad bridged a considerable proportion of his capital to xNetwork setting off a ripple effect that benefitted a broad cross section of stakeholders.

Where whales like Chad go, the dolphins follow and so on down the line of crypto’s aquatic bestiary. Every funds transfer, every DeFi trade or other types of transactions such as NFT mint is paid for in $TOKEN, ratcheting up demand for the tokens. Growing activity also generates more fee income for validators like Jesse and delegators like Jane, giving them and others more incentive to do the good work of keeping xNetwork secure. Behold, a circular economy comes to life. 

Decentralization & Governance

Mina is a digital artist who watched with amazement as her NFT project on xNetwork went from a hobby to full-time job and a once-in-a-life shot at financial freedom. While profoundly grateful to escape the satanic mills of South Korea’s animation industry, Mina has always been uncomfortable with the environmental impact of her new occupation. This led her to the xNetwork DAO and the first act of political activism in her young life: a proposal to offset the chain's carbon footprint.

Network governance and consensus are inextricably linked to tokens, with $TOKEN acting as proxy for votes. The more decentralized the project, the greater the scope of governance, the more demand for token-votes. Quadratic voting and other schemas can help guard against plutocracy, democratize the process and foster an engaged citizenry -- a win-win-win for the network, community and the token. As the price of $TOKEN goes up, so does the economic security of xNetwork. While not always true in the world of nation states and fiat currencies, in Web3, proceeds from a vibrant democracy accrue to the token.

Innovation & Resilience

Mature networks face a number of risks, including but not limited to, entry by new competitors, technological change, geopolitical shifts, and security vulnerabilities and attacks. Teams have to continuously invest in innovation and risk management. A token that can accrue value helps build a warchest that can be the difference between a protocol life and death in emergencies.

Little is known about Hax0r, a white hat hacker (or a team of hackers) whose name consistently appears near the top of bug bounty leaderboards. It was Hax0r who first identified a flaw in xNetwork’s genesis contract that would have allowed an attacker to steal all $TOKEN in existence. But it was no accident that Hax0r was examining the contracts. The protocol’s growing treasury allowed Ash to post a small fortune’s worth in bounties for anyone who discovers and reports vulnerabilities. When properly deployed, accrued value can serve as protection against value-destroying events.

Future Potential

It’s important to keep in mind that whatever value accrual mechanism is in place now, it’s likely just a fraction of its future potential provided the fundamentals are solid. Whether it is multiverse, adoption by financial institutions and governments or something not yet imagined, Web3 is bound to capture more and more of the traditional economy. Each next billion of users is a multiplier and catalyst for the value accrual process.

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