Crypto ERC20 Token Economics
ERC20 Token Characteristics
In general this ERC20 token summary relates to the tokens that have the most popular characteristics such as:
- Fixed Token Supply or known equitable inflation rate.
- Smart Contract tokens (e.g. ERC20) that can be programmed and updated with more functionality if required.
- Are backed by a public team of verifiable individuals that are openly and actively working on improvements for the system that the token is used for.
- The token has some utility for the assigned project within its designated ecosystem or network.
- The tokens are built on a public decentralised open blockchain platform that has proven security (e.g. ethereum).
- The total distribution of the token has been reasonable, fair, open and has verifiable amounts with even lock-up periods for founders, advisors, partners and developers.
- The tokens should represent some product or service that will build demand for the token ( e.g. represent computing power or decentralised storage space).
- Liquidity – Ideally the tokens should also be liquid ( e.g. actively traded) and available to exchange without the need for a centralised third party service. (ERC20 tokens should always be exchangeable with a decentralised exchange such as etherdelta).
Note: This guide should not be used as investment advice. Read full disclaimer here
ERC20 Token introduction
Cryptographically secured ERC20 tokens are mostly intended to be used as currency within an application or business platform. As there is usually a fixed limited supply of each token the value should appreciate over time if the demand for buying the token is greater than the selling volume. Any potential price appreciation is market pair dependent so it must be considered what currency the token trades against (e.g. BTC or USD ). So if USD or BTC was hypothetically stable and buying demand for a token increased then the price would go up against that other asset (e.g. BTC or USD).
These typical token characteristics do resemble that of national fiat currencies ( e.g. USD or EUR) where the buying or selling against other national currencies determines its price against those other currencies it trades against.
Therefore the main price driver of any given ERC20 token will be the demand for buying or selling the token against its most liquid market (usually BTC). Potential token buyers should also consider the liquidity (e.g. number of tokens traded per minute/hour/day ) and its available token supply . If large companies or many individuals want to use the service that the token is used for, then they will need to buy the token on the open market and that could drive the price higher (If this buying demand exceeds selling pressure and all other factors remain equal).
ERC20 Token Use Cases
- Custom Payment token for an app or business service either exclusive to an ecosystem or multi purpose and useable across many applications.
- Tokens can represent value in any underlying asset. If an asset is digitally native it becomes easier to represent the value and avoid potential fraud.
- Tokens can be used as securities and represent stock, bonds and equity in companies. Dividends and income can be programmed into the token and be completely automated.
- Governance e.g. voting for smart contract upgrades or new features and services.
- Easier to identify and communicate with direct stakeholders in the ecosystem e.g. it is potentially verifiable who the owners are.
- Early adopters and token holders can benefit from promoting the services offered ( e.g. community building).
- Network effect e.g. token holders have a financial interest in the company and are motivated to spread the word and help develop the platform.
- Open source development. If the project and code of a project are open source then anyone could submit proposed improvements to the code and help build the network that they are also a stakeholder in.
- Tokens can represent useage or value in a consumer application or developer platform. Generally the bigger token opportunities could be with useful developer platforms as opposed to application tokens. This is because the potential useage of the token could be far greater on an entire platform with applications built on top of it. If a platform can support multiple application types then it could be a success even if demand for applications built upon it fluctuates. A good example is the Apple App store being far more successful than the applications and games built on it.
Crypto Token Unknowns
ERC20 Crypto Tokens are still very new technology untested at scale. Therefore there are still a number of unknowns and potential outcomes to consider:
- Tokens could be subject to price manipulation (especially with low liquidity on token exchanges when buy/sell order books are thin).
- Wild price fluctuations could mean unfair pricing for consumers. If a user buys a good or service with the token just before a big price increase/decrease then they could be overpaying or underpaying. This volatility could even influence usage of services during token price volatility and potentially hurt the underlying company providing the service as it could result in uncertain demand.
- If a token is the only accepted form of payment in a platform then it can be questioned why other forms of currency are not accepted (e.g. BTC or ETH).
- Additional supply of tokens allocated to the founding team or partners could cause high volatility if the timing of the token release is unknown. Often unsold tokens from an ICO, or initial token distribution event, have been given to founders, partners or advisors and may be available to sell at a set release date. If there is not a pre-programmed open verifiable lockup date then, in theory, the founding team can dump their tokens on the market at anytime.
Crypto Token Long Term Solutions
One solution to the potential emergence of extreme price fluctuations is to manage a pool of tokens as liquidity. These pooled tokens can be used in an attempt to control prices. So if buying demand for the tokens significantly increases or decreases then these liquidity pool tokens can be used to help keep prices stable. This is much like how a central bank tries to control price fluctations in its own national currency. Central banks hold a basket of other national currencies that their country trades with and manages the foreign exchange rate during periods of volatility.
One issue with liquidity pools is that they can be gamed, but it depends on how it is implemented. If the pool is automated with an algorithm then traders could ‘front run’ the algorithm if they know how it functions (e.g. trade before the algorithm buys/sells tokens to profit from it’s activities). Also if certain individuals have insider knowledge of token demand, or are aware of upcoming selling pressure, then they can also look to profit from the activities of the liquidity pool.
The limited supply of tokens could also be an issue as the supply of tokens available to the liquidity pool could eventually run dry. All of this can be tracked in real time as the supply and movement of most tokens are completely open (unless very sophisticated masking or mixing methodologies are used).
Bancor Network Token (BNT) is a platform that can offer liquidity to tokens and appears to be gaining popularity as a potential solution to offer more consistent liquidity to crypto tokens.
Futures and derivatives
Another possible method to ensure price stability for tokens are financial derivatives and futures. This is especially true if you are a big company accepting or using large amounts of tokens. If used sensibly these financial derivative products can be used to hedge and de-risk a particular position. This can minimise losses for large holders during high price volatility. Of course a token would need to have significant demand and scale for any financial services company to even consider offering such products.
Token Economics – Currency Peg
As token systems mature a currency peg could be used to help resolve token price volatility and manipulation in the longer term. Once token adoption has increased they could become pegged (or fixed) to more stable currencies to provide increased price assurance. That said, most large scale historical attempts at currency pegs have ended in failure ( see George Soros breaking the Bank of England or the more recent Swiss Franc to Euro peg).
Could a new programmable smart token peg with a built in liquidity pool be different? It is possible. Tokens could also be programmed to be more stable if the fixed supply was amended in future. Such a change would require consensus and approval from the majority of token holders. It would also require a big event, such as flash crash, for this to even be considered. Nonetheless, the bigger the platform with greater token adoption should mean a more stable currency token.
Token Supply – Fixed?
Any future proposal to fix a token price or increase total token supply would be very difficult for token holders to support. This is especially the case if buyers of tokens are speculating on the token’s price representing value of the network. In this scenario token holders and speculators would need to be given some other sort of value in order to consider such a change.
The token distributors could offer token holders traditional equity or even dividends based on the platform’s profits. Such enticing measures could be used to convince token owners to accept this significant change in token economics. This would certainly result in the token resembling a Security (e.g. stocks/shares). Despite many projects attempting to avoid their token being considered a security, a number of regulated token ‘Security’ exchanges are set to be launched. If a token supply increase is offered in exchange for a dividend then it should be possible to get consensus from active token holders with votes from their smart contract tokens.
For such drastic measures to even be considered there would have to be severe price volatility that would disrupt the platform’s usage. Otherwise it could be a significant reduction in value of the coin to a point where the project leaders would be forced to propose such a solution.
Tokens clearly have a future beyond trading and speculation and Bitcoin will have to live with this new crypto multiverse of tokens. The most popular standard being Ethereum ERC20 tokens. Ethereum based ERC20 tokens have by far the best chance to remain the token of choice that other platforms will have to build compatibility for. It is possible for ERC20 tokens to be transferred to other platforms and EOS.io will be the first large scale attempt at this in June 2018.
For a token to be a success the underlying platform needs to have large adoption and this extra scale will mean more stability and resilience to attack. Therefore it is clear that many tokens will never achieve considerable scale and could eventually find themselves in a download loop where their smaller size becomes the main issue. However these smaller scale volatile tokens could still be interesting for speculative investors with a high risk appetite who wish to gamble for considerable gains (or losses).
Overall big ideas from great teams that deliver useful products within a token ecosystem can become an enormous success. These successful platforms and applications could become large economies in themselves. As with all crypto these tokens don’t recognise borders or friction between participants and are open to anyone.