The issuance of native tokens within a platform, such as a distributed ledger, is one of the most common ways of financing its maintenance and development. In this note, we discuss how a platform economy works, whether a fixed supply of tokens is optimal and the dynamics between users of a platform and those who govern it.
Most crypto projects based on distributed ledgers issue a native token which can have many possible functions. Tokens can incentivise participants to maintain or further develop the platform, for example when miners earn newly issued bitcoins after writing new blocks of transactions to the ledger. Tokens can also be used to access a particular service, for example to run a smart contract on the Ethereum network. They can also act as speculative instruments on the viability and future success of a project. In this note, we discuss how a platform economy works and whether a fixed supply of tokens is optimal. We argue that the incentives of those who govern the platform and those who use it are not always aligned, as the former face a time inconsistency problem, which can be addressed only when the supply of tokens is fixed.
The Platform Economy
A platform economy is populated by three types of participants: owners, users and contributors.1 Owners govern the platform and issue new tokens, which are then used to pay contributors, who develop and maintain it. Contributors sell the tokens on a cryptoasset exchange, i.e. a token market, for a fiat currency or another cryptoasset, which can more readily be used for commerce. Users demand tokens in order to access the platform’s services and are exposed to the risk of fluctuations in the token’s price. They can decide to enter or exit the platform, depending on how valuable they believe it is and what they think other users will do.
Owners do not necessarily “own” the platform in the traditional sense of the word. For example, a decentralised ledger is not owned by anyone in particular. What is important in this context, is that the owners govern the platform and decide how many new tokens will be issued and how they are going to be used. It is also important to note that a user can also be an owner and contributor. In this note, however, we separate the roles to better understand their incentives and behaviour.
Token Inflows and Outflows
Figure 1 illustrates how tokens flow through the market. The blue arrows represent inflows, whereas the red arrows represent outflows. New tokens are issued by owners and can be used in two ways. First, they can be exchanged to buy resources from contributors, who are crucial for developing and maintaining the platform. This is an investment choice that potentially increases the value of the platform and network. Contributors then sell their tokens in the token market, and the increased supply may reduce the token’s price. Second, owners can supply tokens directly in the token market, exchanging them with fiat currency or other goods. This is a “consumption” choice that increases the owners’ pay-out now but reduces the price of the tokens in the future. A lower price means that newly issued tokens can buy less investment and will result in a reduced pay-out.
On the demand side, users buy tokens to access the services provided by the platform. If the demand is not enough to support the price, the owners may choose to buy back tokens, using external funds, like fiat currency.
Figure 1: Token Economy
Network Effects and the Value of the Platform
The value of the platform is influenced by the owners’ investment decisions and the network effects that arise when more users join in. A decision to invest in the platform increases its value but the rate of return is uncertain, because investments are not always successful and sometimes fail. Moreover, other exogenous factors can influence the outcome, such as the state of the economy or the actions of the competing platforms. If the value of the platform increases, then more users will decide to join, generating positive network effects and resulting in an even more valuable platform.
The Decision Problem of the Owners and the Users
The uncertainty about how valuable the platform will be in the future creates an interesting decision problem for both the owners and users. Users decide how many tokens they want and when to enter or exit the platform. If the platform becomes valuable but they enter too late, they will need to buy the tokens at a high price. In other words, the network effects make the platform more valuable but also increase the price of the tokens for the newcomers. This can create a positive momentum, where users enter early and before the platform proves to be valuable, to avoid buying tokens at a high price. The entry of users generates a positive externality to owners, who can finance investment more cheaply and get larger pay-outs. On the other hand, if the users believe that the platform might fail, they may choose to leave before this happens, precipitating a sharp drop in price, negative network effects and even causing the platform to fail.
In anticipation of these momentum effects, the owners need to regulate the supply of the tokens and support the price, sometimes by buying back existing tokens, or by halting the issuance of new tokens. In practice, the owners care about the ratio of token supply to the value of the platform.1 If the ratio is low, they receive pay-outs by issuing new tokens and selling them, whereas if they ratio is high, they buy back tokens using external funds.
If an investment goes well and increases the value of the platform, then both the users and the owners benefit. If there is a bad shock in the value, however, the probability that the users will start exiting the platform increases. In that case, the incentives of the owners and the users diverge. The owners want to stop a large exodus of users, which might destroy the platform, whereas the users need to decide whether to exit early and before their token holding lose their value, especially if they think other users will do the same.
Under-Investment in the Platform
Owners have three ways of reducing the outflow of users in the event of a bad shock: token buy-backs using external funds, halting the issuance of new tokens, and platform investments. Investing has an uncertain outcome and may fail, but it is the only action that can generate value for the users in the long term. Owners, however, may choose to rely on token buy-backs when there is a bad shock. This is also costly but has a more certain outcome in terms of supporting the price. Halting the issuance of new tokens is costless but requires a platform that allows a discretionary token supply. Both of these measures result in an under-investment in the platform, which in the long term reduces the value of the platform. In summary, the aims of the owners and the users sometimes clash: the users want to enter a valuable platform with many other users, whereas the owners want to maintain a high price for the tokens. Under-investment in the platform reduces the welfare of the users and the equilibrium price of the tokens.
The root of the problem is that the owners behave in a time inconsistent way. Initially, owners want to irrevocably commit to investing in the platform, as this will make more users join the platform, which increases the price of the tokens and makes investment cheaper. This makes it easier for the owners to fulfil their promise to invest and increase the value of the platform, thus completing the virtuous cycle. However, when a bad shock occurs, the owners have an incentive to stop investing, as this increases the supply of tokens and reduces the price of the tokens even further. This may lead to an exodus of users and the destruction of the platform through the negative network effects. Instead, owners have an incentive to buy back tokens, to support the price and reduce the outflow of users. As users anticipate this time inconsistency problem, they are more reluctant to enter the platform in the first place, which results in reduced investment and a less valuable platform.
The Power of Commitment through a Fixed Supply of Tokens
The time inconsistency problem can be solved if owners are able to commit not to decrease the token supply when times are bad. Owners can decrease the token supply with buy-backs, or by halting the issuance of new tokens. The former is costly because it requires owners to pay using external funds. The latter is only possible if the platform allows a discretionary token supply. After removing these avenues of restricting the outflow of users, the only other way of addressing a bad shock is to increase investment, which in the long-term benefits both the users and the owners.
DLT enables such a commitment and it is shown theoretically that its value is positive.1 In Bitcoin, for example, there is an explicit rule that only 21 million tokens will be created. Currently, in every blockchain block, there are 6.25 newly issued Bitcoins and the rate of issuance halves every 210,000 blocks.
However, it is important to note that the power to commit is not perfect, even within a distributed ledger. In principle, those who govern Bitcoin could change the rules and increase the supply of tokens by creating a hard fork. But their incentive is not to do so. The reason is that, since the ledger of transactions is public, any other group can continue to update the original Bitcoin, using the old rules. This increases the danger that the new Bitcoin will not be accepted, hence transactions on the new Bitcoin branch will be worthless.
We have described how a platform economy works and how the incentives of the users and the owners are aligned when there are good shocks in the value of the platform, but diverge when there are bad shocks. Owners face a time inconsistency problem, as they are prone to under-invest in the event of a bad shock, which in turn makes users more reluctant to join the platform in the first place. Network effects can create momentum of users entering or exiting the platform in droves, which also contributes to a high volatility in the price of the token. The benefit of a fixed supply of tokens, or of a predetermined growth rate, is that it allows owners to commit that they will not under-invest, thus precipitating a virtuous cycle of investment, users entering the platform early and prices increasing.
- https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3472481For more details on the economic and the related literature, see “Token-Based Platform Finance”, by L.W. Cong, Y. Li, and N. Wang, at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3472481.