Where is the value of cryptocurrencies reflected?
Yesterday I shared with you whether Bitcoin is a bubble, and today I will discuss with you the purpose and value of Bitcoin and even the cryptocurrency in the currency circle. This article is quite long, so investors should watch it patiently.
Cryptocurrencies and tokens are a new digital asset class never before seen in the financial system. This is why one of the first and most frequently asked questions about crypto assets is what is their purpose and why are they valuable?
Answering these fundamental questions requires a thorough examination of three separate dynamics:
Identify the purpose of the cryptocurrency/token to serve in the underlying blockchain network
Learn why cryptocurrencies/tokens are preferred over traditional monetary instruments
Determining the cumulative value of cryptocurrencies/tokens
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Define cryptocurrencies and tokens
Before diving deeper, it is important for me to define the terms cryptocurrency, token and encrypted asset. Generally, cryptocurrencies are defined as digital assets whose primary purpose is to act as a medium of exchange (MoE) and/or store of value (SoV). Hence why the word "currency" is used in the name, and why cryptocurrencies are generally considered a new form of money. The most obvious examples of cryptocurrencies are Bitcoin and Litecoin, digital currencies intended to be used as goods and services (MoE), and scarce digital commodities similar to gold and silver (SoV).
Tokens, on the other hand, are generally defined as digital assets whose primary purpose is to provide some type of utility other than MoE or SoV. We'll delve into various utilities in later sections, but some of the most common token use cases include exclusive network access, cash flow netting, collateral insurance, protocol management, and more.
It's important to note that the line between cryptocurrencies and tokens isn't always cut and dry, and most digital assets share both attributes. For example, almost all tokens store value and act as a medium of exchange. So while most tokens may never be commonly used as digital currencies or generate a better SoV than digital assets like Bitcoin, they still have primarily cryptographic attributes. Similarly, it can also be said that almost all cryptocurrencies also have token properties, as cryptocurrencies are used as an incentive mechanism for miners to generate and maintain network security. By definition, this is an extended utility that goes beyond MoE and SoV.
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Purpose of Crypto Assets
With the correct definition established, let's infer the purpose of a crypto asset. Doing so requires unbundling multiple layers, specifically the functionality, incentives, and bootstrap of blockchain and smart contract applications, which we collectively refer to as a decentralized computing network.
Defining the capabilities of a decentralized computing network
In order to understand the purpose of a crypto asset, one must first understand the basic functionality of a decentralized computing network. This is most easily understood by comparing decentralized computing networks to traditional businesses.
Businesses are centralized entities that typically own and/or license the intellectual property (IP) of the products and/or services they provide. Legally speaking, businesses maximize profits for their shareholders by extracting as much value as possible from their products and services. So while they may aim to offer the lowest prices to consumers and sometimes even engage in charitable causes, the decision is almost always aimed at generating more profit for shareholders.
Also, a decentralized computing network is not an enterprise. They have free open source IP, and the product/service itself is maintained by a decentralized network of independent operators. Therefore, a decentralized computing network has neither an owner nor a legal mandate to maximize profits. Instead, think of them as public goods that provide services that are equally accessible to all, with no built-in privileges for any one set of users.
These digital public goods operate through the use of the Minimal Extraction Coordinator (MEC) protocol, a self-running logical system that connects buyers and sellers of a particular asset or service, with the goal of allowing those buyers and sellers to retain as much of a share as possible . Maximize value during the transaction by minimizing excessive rental extraction. In many ways, MEC is similar to companies like Amazon and Uber, except that the company is replaced by a decentralized computing network that automatically matches supply and demand based on preset parameters that all parties can verify, but no one can tamper with. .
Centralized business and distributed computing network
The MEC protocol is fundamentally designed to facilitate business processes with minimal cost. For example, users of blockchain networks such as Bitcoin and Ethereum only need to pay transaction fees to use the network; since there is no central coordinator to find rent, there are no additional fees. The cost of using the MEC protocol is usually determined by users themselves through an open auction where supply and demand balance (e.g. users bid for scarce block space).
On the other hand, when a centralized company facilitates business processes, it has the mechanism to simplify and run it as a for-profit organization. This empowers businesses acting as coordinators to act in their own interests, such as raising costs when establishing a monopoly, censoring transactions to favor specific parties, or selling users’ data discretely for additional benefits. profit.
Thus, MEC aims to capture the large network effects that often occur with facilitators (e.g., banking, social media, e-commerce, etc.) "too big to fail". ” By minimizing rent extraction, the MEC protocol brings more value back to users and provides long-term premium service. The next logical question, then, is how do you raise funds and maintain decentralization without a built-in rent extraction mechanism Incentives for Computing Networks?
Incentivize the development of decentralized computing networks
Decentralized computing requires incentives to bring together various infrastructure providers (nodes) to execute shared goals (coordination services) in a highly secure and reliable manner. Incentives must also be sufficiently high, as decentralized computing is purposely inefficient, to lower barriers to entry and generate strong certainty.
For example, the Bitcoin network has approximately 10,000 independent nodes, all of which verify the validity of every block of transactions on the network to ensure that the ledger of those who own Bitcoin is highly trustworthy, tamper-proof, and Individuals can use it. Without incentives, users would have to trust the benevolence and altruism of node operators, which is not a security model that anyone can use to secure anything remotely valuable, let alone a market worth over $900B (at the time Bitcoin market cap at writing).
In business, the incentive to act fairly is driven by profit, legally binding contracts, and brand reputation. The idea is that acting honestly is profitable in the long run and legally necessary. However, large corporations can use their network effects and opaque backend processes to protect themselves in the event of unfair behavior so that they never experience any negative repercussions. Some examples of this motivational misalignment include the 2008 bailout of financial institutions, Facebook’s collection and monetization of personal information, and Apple’s monopoly and rent-seeking app store policies. Therefore, if decentralized computing networks are to provide superior service, they need a better financial profit and loss system that properly rewards positive performance and penalizes negative performance.
For decentralized computing networks, the most obvious starting point at that point is financial incentives, which require a source of funding. In order to even bring a decentralized computing network to life, a chicken-and-egg problem must also be solved: users won't pay to use a network that doesn't exist or be secure, and node operators won't secure or operate the network without paying users or income. Without financial subsidies to start network operations, each side of the market is stuck waiting for the other to make the first move.
Both supply and demand in one public network depend on the existence of the other.
Traditionally, centralized companies receive external funding to fuel their growth by raising funds from venture capitalists (VCs) or other fundraising vehicles. While this model works well to provide initial funding for a development team that provides a minimally mined network, it is nearly impossible to support the ongoing financial incentives needed to subsidize the network to long-term self-sustainability. The bitcoin blockchain, for example, still earns block rewards ten years after its initial launch of 6.25 bitcoins ($306,000), issued roughly every 10 minutes to help fund the mining nodes that secure the network ( ~$44M per day and ≈ $16B (at current rates).
Decentralized computing networks that attempt to rely on venture capital for long-term subsidies need some type of user value extraction mechanism (such as a network fee surcharge) in order to repay the debt they assume. This will eliminate the very valuable proposals that the network is supposed to generate in the first place, as it is the bare minimum extractor coordinator. Doing so also creates misplaced incentives to spend time and resources catering to the needs of the network’s biggest investors instead of better rewards for the long-term success of actual users. As such, the network cannot offer any credible neutrality, as the entity providing the subsidy funding will ultimately have complete control over the future direction of the network.
Furthermore, by extracting value from users, a decentralized computing network will have less of a competitive advantage than a protocol that does not assume VC debt, especially since its competitors can reduce network costs by reducing extraction. It also makes the network less secure by reducing the security budget, as some of the value that would normally go to nodes securing the network is redistributed to investors to pay off debt.
**It's important to note that VCs aren't inherently bad, but that doesn't mean taking risks. They play a key role in providing initial funding to MEC’s development teams, however, VCs as a permanent source of funding for network subsidies may not be profitable for VCs and are contrary to MEC’s ultimate goal.
Instead of long-term reliance on decentralized funds to grow decentralized computing networks, a more beneficial approach is to create debt-free native cryptographic assets (tokens) dedicated to the network. The growth of the network can then be funded by making the native token an integral part of network usage and security. In doing so, the value of the token on the open market can be tied to the value the network provides to users, which rewards projects with high adoption and enables them to grow the network over the long term. It also creates a scenario where network operators have a direct financial interest in tokens specific only to that network, meaning that the performance/security of the network is directly tied to the nodes' own financial health.
Native network tokens benefit all parties in the value chain:
Development teams can raise funds in a debt-free manner to support the growth of the network by allocating the initial portion of the token supply to be sold to users (including VCs) in a token sale (such as an initial coin offering).
The MEC protocol is able to direct its own growth by reserving a significant portion of the token supply that will be paid over time to network operators as a subsidy/block reward for securing the network.
With built-in subsidies and zero rent-seeking, users can obtain the lowest cost of network services.
Nodes that secure the network will earn the highest possible rewards without requiring non-value creators to extract value.
Ultimately, newly created capital in the form of native tokens allows decentralized computing networks to avoid rent-seeking middlemen, preserving their valuable assets with little mining value. However, the only way for these newly minted tokens to actually function to support the growth and security of the network is for them to have financial value on the open market.
Capturing the demand for a decentralized computing network in the value of its native token
While issuing a native token allows teams to raise development funds and create subsidy distributions to bootstrap the network's growth over time, the token will only work if it has value in the open market. The only way for a token to have value on the open market is for it to have some type of way to capture the value generated by its underlying decentralized computing network. If it does not capture any value of the network, then the token has no intrinsic value in speculation or holders' expectation that the token economic design will eventually change to capture value. If the tokens are economically worthless, then the allocations set aside to subsidize the growth of the network will also be worthless, as nodes will have no pocket money for operating profitable network infrastructure rewards.
However, when the token’s value is directly tied to users’ demand for the network, the value of the subsidy distribution increases with network adoption. Increased subsidy distribution results in a larger budget for the network, which can be leveraged as a means to generate additional security/utility for users and encourage greater adoption. This creates a virtuous cycle of growth:
1. Native tokens are issued by the development team. In addition to the original distribution method (mining, public sale, airdrop, crop planting), protocols, development teams or communities create and hold subsidized distributions.
2. A portion of the token subsidy allocation is used to steer the growth of the network by rewarding infrastructure providers (e.g., liquidity providers, miners, validators, etc.) for those new tokens that circulate.
3. Due to network subsidies, the utility of the network increases for users (eg, lower slippage transactions, more secure network, additional services, etc.), leading to increased user adoption and additional fees for infrastructure operators.
4. Increased network usage creates more market demand for the native token (although the following sections describe how), which ultimately leads to a higher valuation of the native token’s market cap.
5. An increase in the value of the tokens in the market directly leads to an increase in the value of the residual subsidy distribution, which expands the unit capacity of these tokens and thus further develops the network. This allows for increased reinvestment into the network as a means of incentivizing additional functionality to the network, increasing user demand and increasing the user fee pool. Accelerate the virtuous cycle again.
Virtuous growth cycle through token subsidy distribution
The main benefit of token subsidies is the ability to bootstrap the supply side of the ecosystem in a debt-free manner before the demand side exists. Once the supply side of the network is sufficient, the demand side will naturally emerge if there is real network utility. As the demand side increases through paying users, the subsidy can be gradually reduced until, eventually, the network becomes fully self-sustaining by aggregating user fees. The remaining subsidies can then be redirected to other network initiatives to generate more adoption, such as expanding services or improving network security. Fundamental to this whole virtuous cycle is driving demand for native tokens, and achieving this has led to a variety of token economic designs. Here are some of the most effective ways today's most decentralized computing networks are generating demand for tokens by creating a token utility that ties the value of tokens to network demand.
Network access via proprietary token payment
The most recognizable way to associate network requirements with native tokens is to require that all payments for network services be made in native tokens. By doing this, all users must be able to acquire the native token itself and be entitled to use it before they can use the web service. Having a standardized payment medium for utilizing the network ensures that demand from users must flow through the token. This also means that nodes have a direct incentive to maintain the value of the token by maintaining the health of the network, since their future income stream depends on users wanting to access a well-functioning network.
The most notable example of native payment design is the usage of the Ethereum blockchain and its native token, ETH. In order for the Ethereum blockchain to verify and complete transactions, users must compensate network service providers (miners) through "gas fees" paid exclusively in Ethereum. This makes the ETH token a "first-class citizen" on the Ethereum network, as all transactions, including interactions with smart contracts and movement of other tokens such as stablecoins, require fees to be paid in ETH.
Since each Ethereum block only contains a finite number of transactions, transaction fees increase as network demand increases, requiring users to buy more ether on secondary markets to pay for gas. Increasing market demand for ETH also increases the value of subsidies already paid to miners through block rewards, further strengthening the security and utility of the network as a global settlement layer for financial assets. Even though per-user transaction fees decrease with layer 2 solutions and batched transactions, the total amount of ETH paid to miners remains the same (or as layer 2 attracts more paying users and increased).
Daily Fees Paid to Ethereum Miners Continue to Grow As Network Demand Increases
The Bitcoin Blockchain also operates on native assets in a similar manner to BTC, which is required to enable transactions on the network. While Bitcoin's primary value comes from its "digital gold" store-of-value narrative rather than smart contract tools, users will need to constantly transact on the network to generate enough fees to support miners in order to keep the network secure. This is due to the fact that Bitcoin's block reward is halved every four years, meaning that user fees must compensate for the drop in block rewards over time if the Bitcoin network is to maintain its high level of security.
An important caveat, however, is that while proprietary native token payments increase market demand on the user side, they do not necessarily increase market demand on the infrastructure provider side. *The reason is that nodes may sell their acquired tokens on the open market. Pay for operating costs, restraining price increases brought about by user demand. Therefore, exclusive payment utilities are most effective when combined with additional forms of value creation that require nodes themselves to acquire and hold There are native tokens. ) or a strong social consensus around a store of value (e.g. Tesla buying $1.5B Bitcoin).
*Many infrastructure operators are also long-time believers in the networks they protect, so they will naturally have an incentive to hold the majority of profits, reducing the pressure to sell. For example, many miners use crypto earnings as collateral for loans used to pay fees, allowing them to maintain greater exposure to cryptocurrencies.
Cash flow generation through dividends and cash burn
Another common way to generate accrued value for native tokens involves redirecting some or all of the fees paid by users to token holders. As a result, increased network demand from paying users directly leads to a proportional increase in the revenue rewarded to token holders. This provides token holders with a form of passive income and allows for the use of more formal valuation models such as discounted cash flow and price-to-earnings ratios.
The method of distributing network revenue to token holders can be achieved in a variety of different ways. One approach is to use some or all of the user fees generated by the protocol to automatically buy and burn native tokens on secondary markets, thereby reducing the total token supply. This approach increases the scarcity of the native token through deflationary pressure, usually in conjunction with a hard fixed total supply (no inflation). The advantage of this approach is that it distributes the revenue equally to all token holders by increasing each person's ownership percentage of the total supply. The most well-known DeFi protocol following this model is MakerDAO, a decentralized stablecoin protocol whose native token is called MKR. All interest paid by borrowers is used to buy MKR tokens from the market and burn them. In return for receiving network cash flow, MKR holders act as lenders of last resort (e.g., minting MKR tokens to re-hypothecate the network, as seen on Black Thursday).
A second variation of token cash flow involves issuing dividends, where some or all of the fees collected by users are rewarded directly to token holders. These fees can also be used to buy native tokens on the open market and then distribute them to token holders, provide price appreciation through market purchases, and provide dividends to token holders (who can sell the proceeds Or let them earn more (dividends). An example of this dividend model is the decentralized exchange protocol SushiSwap and its native token SUSHI. Every transaction made on the SushiSwap exchange incurs a fee of 0.30%, of which 0.25% goes to liquidity providers and 0.05% is used to purchase SUSHI tokens on the open market and distribute them to xSUSHI token holders ( Mortgage form of SUSHI).
Another example of this dividend model is decentralized derivative protocol Synthetix and its native token SNX. Synthetix allows users to stake SNX as collateral and mint the synthetic stablecoin sUSD (500% overcollateralized). sUSD can be sold on the secondary market or converted at zero spread to various other "synthesizers" to track the value of different cryptocurrencies, commodities, fiat currencies, US stocks and indices. Position traders receive dividends from fees generated by synth conversions (0.3% of trade value), and an inflation reward to compensate SNX stakers for having brief exposure to each synth in circulation (similar to at the clearinghouse).
In theory, token burning and issuing dividends should have an equal impact on the market value of tokens, but in practice, market psychology must be considered. Token burning occurs in the background, meaning that accrued value is not always immediately apparent to token holders, and is often indistinguishable from market speculation. With bonuses, users will directly earn additional tokens, making the economic incentive to acquire and hold cashflow tokens even more apparent. However, it is unclear how much this difference in cash flow perception affects the long-term valuation of native tokens.
Security through staking and token locking
Staking is a method of incentivizing token holders to lock their tokens in exchange for the right to provide and/or receive network-specific services. While the purpose and implementation of the staking mechanism varies greatly from one protocol to another, the common denominator involves users/nodes taking native tokens off the market and leaving them illiquid, thereby reducing the A circulating supply of tokens available in the external market. Staking is often combined with dividends and network fee rewards, where users provide token-based capital as a form of cryptoeconomic security and in return users receive some form of network-generated passive income (e.g. Synthetix).
The most recognized form of stakeholder is proof-of-stake consensus, which powers various blockchain networks such as Ethereum 2.0, Polkadot, Tezos, Cosmos, Aavalance, and many others. Any entity that wants to participate in validating transactions and producing blocks on the Ethereum blockchain must lock 32 ETH. If Stakers engage in malicious activity in an attempt to disrupt the network (sign conflicting proofs), their ETH tokens may be slashed, resulting in those tokens being permanently burned and the staker's node kicked off the network. Therefore, staking in this format yields cryptoeconomic security that incentivizes honest performance of web services. In return, ETH 2.0 validators are paid through block reward subsidies and network transaction fees. This has produced a massive token taker with over $5B of ETH locked in the Ethereum 2.0 beacon chain (as of writing).
Another form of staking involves building an insurance pool that can cover any potential losses from the agreement. The most prominent example is decentralized money market protocol Aave, whose security token has locked roughly $2B of its native token AAVE in a security module. 30% of this insurance pool can be used to absorb any black swan shortfall events, such as agreements being undercollateralized. Stakers are incentivized to lock up their AAVE tokens through rewards in the form of an inflation subsidy and the right to any fees incurred by the protocol. This ensures that any user who wants to access the protocol's cash flow must deposit their AAVE tokens as an insurance deposit. Aave's security module covers a very different risk category compared to ETH staking, however, it has the same effect of withdrawing tokens from the market and creating an incentive to hold tokens long-term, thus benefiting the security of the protocol .
Flowchart of Aave's security module, used to protect users from crash events
It should be noted that many tokens have some stake as they can be staked as liquidity in automated market makers such as Uniswap and SushiSwap. This means that users can stake their tokens in an AMM as a liquidity provider, and in return earn a percentage (though impermanent losses and double-sided pools are not taken into account) for executing swaps using the tokens they provided. However, such staking is more of an artifact of AMMs than a built-in mechanism for tying a decentralized computing network to its own token. If a token has no intrinsic value on its own network, it is not worth anything in an AMM.
Protocol governance through voting
With the rise of Decentralized Autonomous Organizations (DAOs), a distributed social coordination structure, we have seen an increase in the number of native tokens including governance aspects. Governance tokens allow holders to directly vote on proposals to change/upgrade the network itself. In most implementations, each vote is weighted by the amount of tokens held by the user, meaning that anyone wishing to gain significant influence over the direction of the network will need to acquire tokens from the market to increase their voting power . However, the ability of token-based governance to influence a network varies widely from one network to another, ranging from simple parameter tweaks to wide-ranging changes to its infrastructure
The most straightforward form of token-based governance is through bonded on-chain voting. For example, in Aave, proposals are encoded as smart contracts and can be executed instantly on-chain if approved by a sufficient number of token-weighted votes. Aave has used this form of on-chain governance to make larger changes, such as the release of protocol v2, and the introduction of new collateral types to the market. A more indirect approach to token management involves off-chain signaling, such as in Synthetix, where token-weighted polls are created to gauge sentiment among token holders and see if changes should be implemented by the DAO. These votes are non-binding, meaning that acquiring a large number of tokens is not guaranteed to affect the direction of the protocol without causing community consensus.
The value of network governance from one holder to another is highly subjective, making formal valuation models for "pure governance tokens" all but impossible. As such, governance is almost always a form of added utility to the token rather than its driving value proposition. However, there will always be exceptions, and this may change as the value of these decentralized computing networks grows. Additionally, it became common for tokens to start out as purely governance tokens and not evolve into revenue tokens until approved by community vote. An example is decentralized exchange protocol Uniswap and its native token UNI. Currently, UNI is only a governance token, but it is widely expected that the community will vote at some point in the future to add a cash flow utility similar to Sushiswap.
On-chain governance allows token holders to vote on binding changes to the protocol
Token Liquidity
Most token designs used in production do not implement only one method of linking network demand to token value. Instead, they combine two or more mechanisms to provide value creation through multiple forms of utility. There is no one-size-fits-all approach to creating value in the smallest pumping network, as everyone tries to serve users differently, leading to the diversity of implementations we see today.
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Conclusion: Through Tokens, Decentralized Computing Networks Become Public Goods
Decentralized computing networks acting as minimum extraction coordinators (MECs) provide humans with an unprecedented set of technological primitives that, if implemented correctly, can completely redefine how humans interact socially and economically. This back-end infrastructure replaces centralized for-profit institutions with decentralized non-profit facilitators, bringing about open markets where buyers and sellers can freely exchange value without warlords having to exercise monopoly control or loot value.
To realize the functions of MEC, it is necessary to use native encrypted assets. Crypto assets allow MEC to require minimal withdrawals, as properly deployed tokens can generate massive network effects without taking on any debt. This enables the network to steer itself to a point of self-sustainability, allowing them to continue to focus on serving users rather than attracting special interests.
The end result is the creation of market facilitators as public goods, where finance, insurance, gaming, social media, and various other as-yet-unimagined markets are run entirely by user input. The benefits of doing so are not yet fully understood or realized, but are bound to restructure the way we create and manage value in social groups and economic markets. If the Internet is any indicator, the changes we will experience will be profound, and it is up to all of us as a collective society to use token-based decentralized computing networks to leverage human input in a way that produces equal output. In other words, the value you put in is the value you get. No unnecessary extractions.
