By Noah Jessop
The token mechanisms were simple in crypto 1.0. Tokens were created for new projects in limited supply — they were a store of value, a medium of exchange as well as access to the network. Ethereum may be the poster child here — global compute and money, all intertwined as one. These were ‘simpler’ days.
In blockchain 2.0, this model has started to break down. As the major coins (augmented perhaps by coins offering privacy or low volatility) have grown up to fill the role of store of value, it’s an increasingly harder proposition for each new crypto project. Why will we believe that any player in the increasingly longer tail of utility tokens be selected as a store of value to many token holders?
In the earlier days, it was massively helpful to have a currency for investors and speculators — that the network creators could freely allocate to help bootstrap their network. Dilution (in stock terms) or inflation (in currency terms) in exchange for work on the platform. At the simplest, speculators buy and hold a token, that gives free market value clarity to miners (or other workers) making longer term capital investment decisions in the network.
Flash forward to today: things are a lot harder. The next wave of utility-esque token issuing project have totally different challenges. As I’ve helped some projects design their ecosystems, it’s clear that we are navigating a completely different playing field than just 3 or 6 months prior.
Imagine if your cell provider charged you for your monthly plan in Apple stock — the value will change far more rapidly than the phone company might choose to reprice your contact.
Crypto projects — buying and selling services in their own token — are facing just this problem. A few example challenges I’ve seen:
If we are building a utility-token powered network, designed for actual near-term commercial use, how do we provide our customers access to the network?
Will customers have easy access to our utility tokens on 3rd party exchanges? (Should we run our own exchange to make it easy for customers to buy our tokens for access?)
How can we provide stability of USD or other fiat prices? (Particularly if the network has longer-term transactions.)
Couldn’t we just accept ETH or another reserve currency directly for use of the network? (And will our enterprise customers be able to buy that directly for use here?)
Investment and speculation clearly helps fund and drive adoption of these networks — but just like the phone companies, if your system doesn’t change pricing as rapidly as your new token price might fluctuate, your customers might be the ones who have to suffer the rolling tides of speculation.
The early solutions we’ve seen in market tend to be a lot less than ideal:
1) Provide a mechanism for real utility token users to buy tokens at a stable price relative to fiat or reserve.
This tends to be bad for investors/speculators. And complex. How do you prevent speculators from posing as consumers and playing games with these markets? How do you prevent high adoption of real demand being highly dilutive to the ecosystem?
2) Orient the project around an equity token — e.g. take ETH “rake” or similar from the total use of the network and distribute pro-rata (like a dividend) to regulated equity-token holders.
While this is good for things that look a lot like a typical business, it’s a totally different path to build than the kind of options that were available in blockchain 1.0. How do you create a totally permissionless system when there is direct value extraction built into the network? If all the network parts are open source, what’s to stop a fork with rake being removed?
Perhaps a more nuanced: if the project doesn’t have it’s own currency (just “stock”) to thoughtfully incentivize the right behavior on the network, how will it lock in the network effects that would prevent a fork without any rewards to early backers (or taxes) being imposed?
I propose a better way: the Convertible Security Token (CST)
Here are the five challenges facing crypto projects that this system will address:
- Provide a mechanism for projects to obtain early financing
- Create class of object that team and investors can jointly hold to create alignment
- Enable easy access to the underlying utility network for real usage
- Not conflate real utility buyers and speculators/investors
- Keep simple (as possible)
A convertible security token is as follows:
A security token that converts into an underlying utility (or work) token on a given schedule based on the total size of the underlying network.
For a moment, consider an underlying work token that is designed primarily for access to the network. It could be a single price asset with benefits for earlier holders (like Fragments) or even as crude as a simple contract: issuance of one NoahWork token for every ETH sent to a faucet contract.
For today’s simplicity, let’s just imagine that each work token is approximates around $1 in value and is not designed to for pure speculation, but rather for work.
Convertible security tokens would be the path for (accredited) investors to finance the growth of the network. These could be percentage-based or dollar-cost based.
%-based CSTs
Let’s look at percent first, in a simple example.
Project sells a total of 10 CSTs — each redeemable for 1% of total market cap of the work tokens outstanding.
Network users realize that they will suffer inflation (dilution) at some point when these CSTs are eventually converted to the work token.
Early buyers of CSTs can freely trade with other accredited investors (perhaps on a Harbor compliant security token exchange or direct secondary transactions). Each CST represents a call option on the future value of the network — more measured in total market cap, vs appreciation of the value of each work token.
Thus, work tokens can be fixed (again, for simplicity’s sake, say at $1), with heavy creation, via mining, price stabilization or otherwise — yet investors can choose when they want to exercise their option, or find liquidity on the secondary markets.
$-based CSTs
CST issuers can further design the rewards curve — there’s nothing stopping us from explicitly shaping the curve, v.s. yielding a consistent percentage ownership.
Consider the following example:
Project issues $10M worth of CSTs to fund network development. Again, for simplicity’s sake, imagine work tokens are still set at par ~$1 USD.
Project sets the following redemption table:
Example 1: Capped Upside at 15X
In this example, the project has incentivized the CSTs be converted later in the growth of the ecosystem — and capped the total upside to 15X.
Instead of capping upside, we could create a reward curve that instead greatly incentivizes long-term holding before conversion:
Example 2: Long-term Rewards
This has a dramatically different payout curve (and incentives for all parties) — all powered by convertible security token design.
There’s a lot more to build on here — for instance, imaging adding the variable of how the market cap of the work token has been performing as an ingredient of dollar value of CSTs. This could be as simple as rewarding redemption when the market cap has been growing for at least the past 3 months (or punishing redemption during a time of downfall).
Regardless of what flavor Convertible Security Token is selected, all the rules of the system can be made public to other network participants — building a pathway to enable fair and transparent rewards to early ecosystem backers. And give makers the ability to have their own tokens, fundraise for their projects, and build the mechanism design of their ecosystem.
Let me know what you think — or if you see of other variants of the CST: @njess
Thanks to Evan Kuo, Chris McCann, and Hart Lambur for reading drafts of this post.