May 27, 2021
Tokens - Taxonomy of Species
Many crypto protocols have issued interests in the form of freely tradeable tokens. These are roughly the crypto world’s equivalent of public equities, although most carry neither voting rights nor cash flows. Understanding what the tokens do vis a vis their native protocols is critical to evaluating them as potential investments. Tokens fall in a range of categories, some of which overlap.
The man who decamped to the Galapagos on the HMS Beagle, picking up where Carl Linnaeus left off.
(U) Work/Utility Tokens: required to spend or bond to utilize the underlying protocol. Usually, users will spend the token for the right to use the network and contributors will bond the token for the right to contribute to the network. A work token is to a protocol as gasoline is to an engine. Most Proof-of-Stake protocols integrate tokens of this species.
Examples: ETH, SOL (Layer 1), Helium (Bandwidth), Chainlink (Oracle), Arweave (Storage).
Implications: This species of token is particularly robust. Because it must be spent to utilize the underlying protocol, the value of such tokens are tightly linked to the adoption of that protocol. For an investor looking for an investment vehicle with high beta with adoption/usage, a work/utility token is ideal.
(P) Platform Tokens: tokens for decentralized applications built on Layer 1 platforms. These tokens inherit the security of the base layer. Unlike with utility tokens, users may not need to own the token to interact with the protocol.
Examples: DAI (Maker stablecoin), MANA (metaverse/gaming), NexusMutual (Insurance)
Implications: Platform tokens benefit from the “composability” of a base layer blockchain. Composability is the extent to which basic building blocks of code can be recombined into applications. Most platform tokens are built using Ethereum’s smart contract layer, and thus benefit from its broad miner/validator set, but other applications also sit on Solana, Cosmos, Algorand, ThorChain, and other Layer 1s.
(G) Governance Tokens: tokens imbue holders with governance power. Holders use their pro-rata ownership of this token species to guide the underlying protocol by confirming or shooting down propositions.
Examples: UNI (Decentralized Exchange), AAVE (Borrowing and Lending), Maker (Decentralized Autonomous Organization - Backs DAI), Rarible (NFT Marketplace)
Implications: A voting share of a public company is worth more than a non-voting share because holders can, in theory, influence the company’s trajectory to their benefit. The same is true in crypto. Governance tokens can carry additional current and future value via the earnings attached to them.
Tokens like Sushi can be staked today in liquidity pools in return for yield paid by agents seeking leverage. In the future, governance tokens may entitle holders to a portion of the cash flows generated by the native protocol. However, many contemporary governance tokens are already priced with a high implied probability of this cash flow sweep. It remains to be seen whether a governance token with entitlement to revenues from a protocol will be deemed a security by the SEC. (Probably)
(T) Transactional Tokens/Moneys: tokens transfer and hold value. As these tokens mature and as the ranks of their holders grows broader, volatility will fall. These may be a medium of exchange or unit of account in the future.
Examples: BTC, Litecoin, Monero, ZCash, Stellar
Implications: Transactional tokens improve upon existing fiat moneys by incrementally improving upon some combination of decentralization, portability, saleability, trustlessness, security, privacy, supply/demand dynamics (tokenomics), and liquidity. Gresham’s law portends that the most valuable transactional tokens will in fact be held, not transacted with. Bitcoin may thus take on a role as a true digital gold whereas softer moneys will be used to pay for goods and services.
(S)Security Tokens: a token representing a contract or scheme in which a person invests in a common enterprise with the assumption that profit is generated solely through the efforts of others (Howey Test). If tokens are in fact deemed securities by the SEC, they will likely be regulated as such.
Examples: B20 (Fractionalized Art), Sushi (Decentralized Exchange)
Implications: Security tokens remain a nascent species. Many tokens appear to carry the characteristics of traditional securities but are not yet regulated as such. As the regulators catch up, I believe some tokens will be forced into compliance. Although the crypto world bucks at the mention of laws and rules, this may not be a bad thing. Compliance invites mainstream adoption and clarity. For example, if a token for a decentralized exchange or borrowing/lending protocol is regulated as a security, institutions can more freely acquire the asset and use the underlying protocol functions to deliver value to their stakeholders.
Finally, I think it’s worth reconsidering the traditional definition of a security in the context of crypto. Typically we’ve regarded a productive asset and a security as sort of akin. Both imply some sort of dollar cash flow attached. But this return on investment need not come solely from fees, or an explicit cash flow stream. It can take on a different form.
A token implies some interest in a protocol, for example in a decentralized exchange. This DEX protocol often does not explicitly sluice a portion of the trading fees to token holders, at risk of appearing like a security. But networks often incentivize users to provide liquidity by rewarding users with the native token in kind. And users can modify this monetary policy via their governance share. If protocols are catalyzing adoption via inflationary rewards to adopters, as long as the fundamental benefits of a protocol grow faster than the minting rate, users staking tokens in the liquidity pool are receiving a share of those fundamentals at a discount. In an efficient market, the token should rise as the developer community refines the product and distribution. This sounds to me like an investment in a common enterprise, via a smart contract that generates a return, denominated in an alternate currency, driven by the efforts of others. (Howey Test)
Social Tokens (G,P,S): ownership in the productive output of a person or enterprise. Tokens embed certain pecuniary and non-pecuniary privileges for holders. Tokens can enable holders to shape the future creative or commercial direction of the issuer (Artists, Teams, Influencers, etc.)
Non-Fungible Tokens (G,P,S): Digital art, virtual land, loan contracts, staked tokens, and insurance policies.
Sources:
https://blog.makerdao.com/the-different-types-of-cryptocurrency-tokens-explained/
https://www.investopedia.com/terms/h/howey-test.asp