Cryptonetworks and why tokens are fundamental

“Cryptonetworks” can help us build a more competitive, innovative, secure and decentralized Internet.  “Tokens” (also known as cryptocurrencies or cryptoassets) are integral to the operation of cryptonetworks.  As we design new laws and regulations in this emerging space, we should keep these concepts in mind, beyond the financial aspects that are today’s primary focus.


In recent months, there has been untold attention paid to cryptocurrencies, blockchains and the coming of the “decentralized web” or “web3”.  And, given the rise of the cryptocurrency markets (over 1500 coins, with a total market cap of $370B as of today) and the recent boom in token-based fundraising (including a healthy dose of scams and shenanigans) there is increasing regulatory and legal attention being paid to the sector, and rightly so.

This is a profound, and confusing, innovation.  As John Oliver so aptly put it last week, it’s “everything you don’t understand about money combined with everything you don’t understand about computers”.  Basically right.

At USV, we’ve spent the better part of the past five years exploring and investing in this space, and now have roughly a dozen investments touching it in one way or another.  As we have watched the technology and market evolve, alongside the public discourse, we feel its important to reiterate why we think this technology is so powerful and important, and contribute to the ongoing collective learning about how it works.

While much of the focus, especially in the context of regulations, is on the financial and fundraising applications of cryptocurrencies, our interest continues to be on the potential for cryptonetworks to provide digital services, such as computing, file storage, social applications, and more.

You might ask, why is it important to have another way to provide digital services?  We already have lots of websites and apps that do that today.  The reason cryptonetworks are an interesting addition to today’s digital services is their core architecture of decentralization.  Just as the original internet gave us a decentralized layer on top of the telecommuncations network, which resulted in untold innovation, cryptonetworks are a decentralized way to provide digital services.  Chris Dixon has a great post exploring why this is important, including the historical parallels to the original internet.

The decentralized architecture of cryptonetworks has the potential to address many issues in today’s tech and business landscape, including information securitymarket competition, product innovation, and equitable distribution of gains from technology.

Imagine, for instance, if the owners or users of Amazon/Google/Facebook/Reddit/etc. were able to “fork” the product and launch an identical competing copy, if they didn’t agree with the direction of the company?  And imagine if all of the users of & contributors to a web platform also had a direct, monetary interest in the success of that platform, that reflected their own contributions as community members?  This is how cryptonetworks work, since they are essentially open-source, mutually owned & operated web platforms.  Each network’s cryptocurrency or “token” acts as the internal currency, incentive mechanism, and “binding agent” for the other processes that help the platform function.  And further, the internal data structure of cryptonetworks, the distributed ledger or blockchain has unique properties that can improve privacy and data security.  See also, Steven Johnson’s recent NYT piece exploring these ideas.

With that as context, it’s important to walk through how cryptonetworks function, and importantly, how tokens function within them — especially given the growing regulatory scrutiny around how tokens are created and traded.

The deck below (full size / downloadable PDF) is meant to help explain this.  While it does touch on some public policy goals at the end, it does not attempt to make specific, detailed recommendations.  The main takeaways should be (a) cryptonetworks are an important new innovation in how digital services are delivered, (b) tokens are fundamental to their operation, and (c) as we design new laws and regulations in the space, we should keep (a) and (b) in mind as guiding concepts.

   

  • jason wright

    projects (especially wannabe protocol projects) have designed their end state decentralised architectures, but there seems to be a hole in their thinking and planning, the transition from centralised to decentralised. what’s the dynamic process that pulls people away from their comfortable centralised worlds to this web3 utopia?

    • it’s a good question, and honestly we don’t know yet. may begin with things like digital collectibles (like cryptokitties etc), or “real” virtual assets inside of games or social experiences. Or it may have to do with information security and integrity. I suspect it will begin with the uses that are most unique to the medium – places where you can do things decentralized that weren’t possible centralized.

    • Kirtane

      There’s a huge pull for developers because currently every walled garden (GAFA and friends) not only extracts rent and fees from applications and services but also copies, limits, and censors what you can build on top of them. For developers, building on decentralized systems is potentially much more lucrative and enjoyable than the current options.

      For end users, it probably won’t matter much until micro payments allow applications to make money more social and embedded in everything (kind of like we’re seeing with WeChat in China). Otherwise they won’t know (or care) if they’re using a web2 or web3 based application.

      As Nick said, the first use cases will be networks and incentive structures that are unique to blockchain based systems. Over time though I suspect we’ll see a lot of people find crafty ways to exploit the system and extract fees and value from it. It’s just a thing humans do, so while technology helps it doesn’t fundamentally change human biases. With that in mind, I don’t think there will be a web3 utopia, or any utopia for that matter, but it’s still a great vision to work towards and provides direction for further development.

      • jason wright

        GAFA & C0 still have a pulse. They do not go gentle into that good night.

        The present conditions of economic comparison will not remain the same. The apparent competitive attractiveness of upstart crypto token business models may not hold fast.

        • Kirtane

          That’s true.

          I think there’s 2 stories playing out though. There’s an expanding pie that creates new opportunities, and there’s the battle for the existing slices available. As you mentioned the later is a tough battle, but I think the new opportunities afforded by blockchains are where we’ll really see growth and returns.

          That being said, the regulatory environment currently favors incumbents (business and government). It would be so easy for them to move to make decentralized networks illegal due to security risks, as the IMF and this analysis by crypto researches very clearly points out. More progressive blockchains like Ethereum and others with governance mechanisms (Tezos tbd/rip) might be able to adapt, but I’m not feeling too good about bitcoin right now…
          https://blogs.imf.org/2018/03/13/addressing-the-dark-side-of-the-crypto-world/
          https://blog.acolyer.org/2018/03/19/a-quantitive-analysis-of-the-impact-of-arbitrary-blockchain-content-on-bitcoin/

          • jason wright

            make illegal due to security risks – from the perspective of an IMF decentralised networks are by definition a security risk. Beauty is in the eye of the beholder. Such an institution is itself at risk from decentralised networks, ergo a report can conclude nothing else.

            Government would be signing its own death warrant by trying to make illegal decentralised networks. It would reveal in the starkest possible terms the reality of the relationship between it and society. It would signal the beginning of a cyber civil war.

          • Kirtane

            Agreed on all counts. I don’t think it’s out of the question though. Kind of comes full circle to the purpose of the whole slideshow to educate people as to the benefits of crypto economic networks so that they can be integrated into regulatory frameworks in a productive manner. TLDR: Way to go Nick :)

        • As we have watched the technology and market evolve, alongside the public discourse, we feel its important to reiterate why we think this technology is so powerful and important, and contribute to the ongoing collective learning about how it works.

  • Kirtane

    You say in slide 8, “The token is what ties the entire cryptonetwork together. For each cryptonetwork, the token acts both as the internal currency (users spend it to use the service) and the incentive to provide the service (miners and other participants earn tokens in exchange for providing the service), and also plays an integral role in the consensus, security and governance processes of each cryptonetwork. Finally, because users of the network are also holders of the tokens, cryptonetworks have the potential to distribute network value broadly to all stakeholders.”. However, in slide 4 you also mention that decentralized exchanges could allow applications to exchange tokens automatically as part of their services. To build on that… How do you think atomic swaps and decentralized on chain exchanges will affect incentive alignment for networks with “utility tokens”, or even blockchains in general?

    It seems like with decentralized instant onchain exchanges no one actually needs to hold a token to use that token. If so, people would then converge on their preferred token as a store of value, and use instant exchanges as part of any transaction to access services offered by “utility tokens”. For projects who arbitrarily added a token to their web2.0 style app, no one will need to hold the token to use the service, so the incentive alignment (and thus value and security of the network) would drop precipitously. Now of course some blockchains offer incentives to stake like PIVX or Ethereum (tbd), but in general this seems like a huge factor that would affect network effects around adoption, development, and valuation. Curious to hear your thoughts.

    Thinking inspired mainly by these two posts:
    https://vitalik.ca/general/2017/10/17/moe.html
    https://ethresear.ch/t/a-signaling-theory-model-of-cryptocurrency-issuance-and-value/1081

    • that’s a great question and I don’t think anyone knows the answer to that yet. But a lot of folks (chris burniske, christian catalini, lots of others) are doing real analysis on token valuation. The purpose here is not really to propose an answer to that question, but just to explain, mainly for regulatory purposes, how tokens function within networks

      Just on the regulatory front alone, decentralized exchanges will be a new and challenging issue

      on token value, I do think staking is a use case where holding the actual tokens will matter. and for other cases, there will still be some notion of an exchange rate, even if people are swapping in and out of tokens instantaneously for utility purposes. we’ll see!

      • Kirtane

        Thank you for those resources and suggestions. When you say “lots of others” are working on token analysis and valuation, who else comes to mind?

        and yeah it seems like projects with governance or staking built into their tokens will succeed long term, whereas web2 companies or projects that just arbitrarily add a token will not see the same benefits around community engagement and network effects.

        • those are the two that I follow most closely, but if I find other good ones I’ll let you know

          while i generally agree with you on “native” cryptonetworks vs web2 companies adopting tokens, i don’t know that it’s a done deal. we will see what happens with telegram, and the elephant in the room is facebook — they could create a token and launch to massive leverage if they wanted — I suspect they are waiting for the current period of regulatory uncertainty to clear up. Same could go for apple or amazon too.

        • You need to consider that pure blockchain projects can have a native PoS and PoW, while ERC20 and other tokens built on blockchains need to work our on a model that would incentivise their users to stake those tokens, not for gas fee which they don’t get, but for some utility value specifically within that token ecosystem. Examples that come to mind: Numeraire, Cindicator, SpankChain – but there are many others.

          • Kirtane

            That’s a really good point. Derivative tokens built on top of other blockchains don’t aggregate the same platform level benefits. Less work/risk, but also less reward.

            I go back and forth on my thoughts regarding Numeraire, but it’s a great example of a token that does have a very real use. Haven’t heard much of the others you mentioned though so I’ll check them out. Thanks for the recommendations.

          • This rate of dApps vs blockchains will continue to grow exponentially, so we’ll have to think about token economics within these systems, where gas as fuel is out of the question. Do you have a Twitter handle / blog that I can check?

          • Kirtane

            Yeah the cryptoeconomic design of DApps is key to scaling successfully. Jill Carlson has some really great insights regarding convexity in token systems. TLDR: if the system is not designed correctly it will pit the dev team against the users as it scales, which breaks the whole promise of crypto networks to use tokens to align value.
            https://medium.com/@jillcarlson/short-convexity-8793f18629bb

            and I don’t have any social media. I mostly just read papers and blogs. If that changes I’ll circle back and let you know.

          • Thanks for sharing this! I’m building a protocol on the blockchain to fix scams and I need to go deep in the rabbit hole.

          • yep, jill’s stuff is great

  • Julian Erbil

    These tokens remind me of World of Warcraft. I never actually played, but in high school was told the premise in WoW was that as you build your profile out in the game and progress, you gain more money in-game, but you also start have higher incentives to acquire even more resources, and that is where the ability to spend cash to get WoW money comes in, similar to other in-app/game purchases. The difference in WoW if I remember correctly is that when you get to a certain “level,” you essentially have to spend cash to keep your game profile’s positive growth rate of leveling up.

    In comparison to token exchanges on blockchain-based networks, it seems that the token has to be worth acquiring in order for someone to perceive the difference between using their own centralized network and moving over to the decentralized network. Personally, I think my favorite part of this post is about being able to create one’s own network of equally incentivized users that are drawn to a platform based off of individual valuation of what they gain from the platform monetarily.

    This idea of being attracted to a “growth userbase” is an interesting one because the userbase would grows as a network effect does, i.e. the more people the more value potentially. However, will tokens on these networks be limited like ICOs in order to keep an impending rate of atrition away?

    I would love to hear if my thoughts make sense to you @nickgrossman:disqus , as I am trying to understand this space as a student in college.

    • Kirtane

      Interesting that you brought up WoW because supposedly the removal of the warlock spell was a major push for Vitalik to work on decentralized networks. It’s a thing. Check it out lol

      Regarding community driven currency networks: check out Trustlines (https://trustlines.network). It’s one of my favorite projects in the space. It’s essentially a reiteration of the original Ripple idea, but build out by the Brainbot team (same guys who do Raiden on Ethereum).

      Regarding supply/demand and how that influences network effects and growth: there’s a few things that might disrupt that as I mentioned in my comment, but I think it’s also a governance issue. A lot of projects say a lot of things, but we’ll see how they actually play out. Hard and soft forks can change things in an instant, and a lot of future projects are integrating voting into the token models as well so the community can better regulate supply and development. Otherwise it’s just a core dev team making decisions which isn’t very decentralized or community driven. Since with ICOs provide rewards before doing the work, I think many projects will just bail on their original plans when it becomes hard to keep going.

      Ultimately I imagine this will lead to long term success for projects with strong governance and staking, and failures and forks of virtually everything else. Time will tell though.

      • Julian Erbil

        That’s a good point on the governance, seeing as IRS, big banks, etc. are almost being forced to get involved, which means that there are enough projects/citizens being affected by this relatively new network idea to warrant governance activity. Trustlines looks rad; I wonder how they will incentivize people to use their service as opposed to a Venmo?

        • Kirtane

          I don’t think Trustlines is trying to compete with current payment systems, but more provide onramps to crypto assets and capital markets for those that currently have none. Think expanding the pie, not competing to take marketshare from current companies. Also, BrainBot makes all their dough with Raiden and Trustlines is a fun side project that they’re releasing for free (from what I can tell atm)

    • yes, this is the right way to start thinking about

      in addition to the nuances @kirtane:disqus points out below, I think the fundamental difference between WoW assets and crypto assets, is that because of the underlying crypto/consensus/decentralized network, these assets have real, provable value. so they are not at the whims of the creators as with centralized points systems.

      “decentralized” means a lot of things, and there are degrees of it. But one of the most fundamental outcomes is the ability to create provably scarce assets, that can’t be rewritten/taken away by the central controlling party.

    • John Palmer

      Julian, this is spot on. I think for many tokens, social consensus around their value within a given group of people is enough to make them valuable. I think right now, most tokens have their earning + spending mechanisms built into a protocol, but the method for earning and spending a token could also change over time, according to the evolving desires of a community.

      And to answer your question, I don’t think all new tokens will need to be issued via ICO’s. Hexel (www.onhexel.com) lets anyone create their own community token without running an ICO. You can create a token, set a supply, and start sending the coin to anyone right away. They even have a token wallet that lets you send to people for free via email or username. I think the experiments happening there will lead to discovery of lots of new use-cases for tokens, where the thing that really matters is scarcity and a network of people, not necessarily a digitally encoded protocol.

      • i agree — esp w the regulatory scrutiny on token sales, I think we will see a lot more experimentation in launching networks without an up-front sale

  • spolsky

    When you say that cryptonetworks are a hedge against concentrated market power because they are forkable… what exactly do you mean by that? For example if Amazon were a cryptonetwork, with buyers and sellers meeting on a blockchain, wouldn’t one of the participants be Jeff Bezos, with his huge network of warehouses and logistics? So you could fork it till you’re blue in the face but Jeff Bezos would still concentrate all the market power?

    Http and the web are also a decentralized network, but that did not stop one player, Facebook, from participating in that network and concentrating market power. And http and the web are open source and forkable but that doesn’t help if you want to eliminate Facebook’s concentration of market power.

    So, imagine Facebook is a cryptonetwork, and I can fork it… how do I get 2 billion people to move over to my fork? And if they don’t, what have I accomplished? There’s still a concentration of market power only now it’s unclear how it ever evolves or moves forward.

    • correct — the existence of a decentralized network alone does not automatically mean that you can’t build market power with it or on top of it. the open web + google/facebook/amazon/etc demonstrate that

      and so the question is what are the proprietary assets that give a company power on top of an open network

      in the case of amazon, it’s the warehouses, supply chain, data centers, etc. those are hard to replicate no matter what

      cryptonetworks offer promise not just in the “forkability” described in this deck, but in the way data is controlled — on-chain, generally by users, rather than centrally controlled by a company. So, at least in the case of certain networks, it’s more possible to fork a network and take your **data** with you than it’s ever been before.

  • Great write up thanks for sharing – I think we will see this framework applied and projects come out with it, and include models not even yet defined.

    • thanks

      and yes, this primarily described “layer 1” networks, or foundational blockchains, where the idea is to get consensus among nodes. there are lots of other models for producing and allocating tokens that this doesn’t describe. for example, many of the projects that have ICO’d on ethereum pre-generate a set amount of tokens and then just allocate them out, under some kind of centralized or hybrid model.

      one takeaway here is that there is no one model, just a lot of concepts that are being mashed together in different ways

  • jason wright

    Nick, what are these unrelated adverts doing in your blog column? Belly fat reduction?

    • Yeah, disqus has really been amping up the ads

      I either need to pay up or switch off

  • Hunter

    Thanks, Nick. Maybe I’m over simplifying this, but here’s what I still can’t wrap my head around: for the large majority of these projects, why does anyone need the unique token? These tokens (in most cases) seem like they do nothing but bring money to the founders by way of an ICO. Why not just use Ether if your token is already going to be running on top of Ethereum? This would get rid of the issue of having to value an ICO, and people would go back to making money the old fashioned way, by building something valuable and getting people to use it (and getting paid in fractions of Ether).

    • cynical response is that a lot of people are raising $ to tokens because they can. the theoretical response is that the value of a single token rises and falls relative to its own utility and the value of the network. there will be good products built on top of ethereum and bad ones. because tokens can be targeted at sub communities and sub functions, we can isolate the economic impact / upside / downside. this is the theory at least. we will see!

  • Peter Kinev

    Very thoughtful article and the presentation is even better. Allow me to introduce the contrarian point of view to mud our discussion. In my simplistic thinking I see the blockchain component as a separate element in DLT albeit not most important. The notion of decentralization, distributed ledger and to some extent the builtin mechanism for consensual transactions, where it’s granted, are the foundation of the future Internet.

  • ben

    is there any research in cryptonetworks without tokens? or rather without currency based tokens. To me it might seem unnecessary to enable all networks to operate.

    • depends on what you mean by “cryptonetworks” — there are lots of peer-to-peer networks that operate without tokens, like BitTorrent or mesh networks, or open standards that power networks, like HTTP and SSL

      what’s new is the ability to use a token to tie together a large open network

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