How can we understand and classify value creation in the web3.0 economy?
An abstract from A Hitchhiker’s Guide to Token Engineering. Chapter 3: Cryptoeconomic Patterns & Application domains
Web3.0 protocols are good examples of value networks, a concept developed on top of Porter's value chain. Networks can produce value in different, sometimes completely bizarre, and inconspicuous ways. The efficiency of value production in networks could greatly outperform traditional organizations due to network effects, low operation costs, resource pooling, and trustless automation.
A major question for understanding web3.0 is “what is the value generated by networks and how can it be measured or assessed?”. However, what is value in a particular case is a highly subjective matter. Considering a particular protocol, value created for a specific type of users, service providers, token holders, DAO members, and other categories can be entirely different. For example, the main metric for traditional companies such as “profitability” is meaningless in the majority of cases. Since decentralized protocols are mainly non-profit organizations, currently, network fees and proceeds are distributed to the DAO/community members using different approaches.
Value capturing mechanisms for digital tokens
One approach for understanding value produced in the network is to understand the value behind its native token. With some exceptions, operation of web3 protocols is based on a “token model” - a mechanism design/set of economic incentives built around the native digital asset (token). In traditional public companies stock is considered as the main product for market participants, integrating different sources of value into its price - future cash flows, growth expectations, speculative components, and even brand value:
Jack Barker: Pied Piper's product is its stock (Silicon Valley series)
When it comes to web3.0 decentralized protocols a clear analogy can be made. First of all, decentralized protocols are “public projects” by design, taking into account the permissionless nature of the web3.0. Since a token is used for ensuring correct protocol operation and sustainability, its value should be bonded somehow to the actual value and size of the network to prevent attacks that can result in taking ownership over network resources. Based on that analogy, token value* should somehow integrate value produced by the network, for example protocol fees, value of access to the network resources, leverage community trust, etc.
*It’s important: here we discuss token value, not token price. Token value is “what kind of utility can I receive as a token owner and how can I value this utility?”. In its turn, the token price is determined on the open market and is an answer to a question, “how much do I need to pay to buy/ will I receive for selling this token?”
Using a token-centric approach for understanding the value of web3.0 protocols is critically important to answer different questions: how exactly does the token accrue value? What mechanisms are behind it? One of the strategies for analyzing complex objects is decomposition into simple patterns and working with them. Natural sciences, for example Chemistry and Physics were developed on top of this approach, decomposing complex objects (such as molecules) into simple ones (atoms). They, in turn could be decomposed into elementary particles (electrons, protons, and neutrons).
Applying the idea of decomposition to understanding token design and value created on top of it leads us to two entities: Value Capturing Mechanism (VCM) and Value Creation Pattern (VCP). The Mechanisms (VCMs) explain how value is created and how the token accrues value (describes origins of value capturing), while the Patterns (VCPs) describe how VCM should be implemented. In addition to the two mentioned mechanisms, it is logical to emphasize that value is not only captured, but also distributed to the token holders. Sometimes value capturing and distribution co-exists in one mechanism, but there are also examples of pure Value Distribution Mechanisms (VDM).
Understanding value capturing mechanisms for tokens comes down to answering the following questions:
(1) what value does the token holder receive by using this token (its utility)?
(2) why is this utility valuable/what is the origin of value based on this utility function?
Let’s discuss an example - Compound (COMP) token. Utility of a token is a protocol governance right (which also can be delegated), proportional to the quantity of the tokens owned or delegated to a specific address. This token offers only one type of utility - internal protocol governance, which is valuable since it allows managing limited resources of the protocol: such as future development, liquidity mining policy, usage of DAO treasury holdings, etc. The value of such utility depends on (1) actual amount of protocol resources to be managed (2) size of token holders stake according to Banzaf power index. Read more about the connection between governance value, power, and a size of a stake for a specific stakeholder,.
But, the origins of value include not only (1),(2) - both come down to managing limited resources which are quite valuable, but also to the value of coordination. The value creation pattern (VСP) could be defined as the technical implementation of Compound protocol governance, which is used by other projects, for example Uniswap. Monetary value accrued by the protocol (fees, spread on lending markets) is accumulated in a DAO treasury and there is no automated value distribution mechanism since treasury usage is a subject of community governance decisions.
Fig. 1. Compound token decomposition based on the proposed approach.
Of course, the logic behind every value capturing mechanism, for example the aforementioned Internal product governance is a very generalized one. It’s true. However, its particular implementation is different - examples are Compound governance and MakerDAO governance systems. Popular Snapshot governance approach implementation is an additional example.
So, the general idea is that origins of value for a particular VCM are identical regardless of its technical implementation. Policies and mechanism design defining token functions are predictors for the origins of its value. For example, a set of governance mechanism designs leads to (1),(2) origins of value mentioned for Compound token.
Using the proposed approach, nine different-by-design value capturing mechanisms were identified: value transfer*(1), work “staking” token(2), protocol consensus token(3), dividend(4), backing by another asset(s)(5), discount token(6), internal product governance(7), meta-governance(8)**, and hedonic value(9). Every mentioned value capturing mechanism has unique [from economic and logic point of view] origins of value based on implemented policies. Particular implementations of each mechanism may differ.
*In my opinion every “store of value” asset can be used for transferring value, and vice versa (considering deflationary currencies). So, it is not necessary to distinguish these two functions into two different VCMs.
**The meta-governance VCM concept was created by PowerPool protocol which first offered to combine the voting power of several tokens into a single proxy token. However, meta-governance could be the first representation of a more generalized meta-pattern. It requires additional research.
The mentioned value capturing mechanisms can be considered as building blocks for token models. The simple mind map describing progression from principal system goals of a protocol to mechanism design and particular implementation of token model is presented below. It starts with the initial system, its goals, and policies/mechanism design applied to a native token in order to ensure the achievement of these goals.
It is important to point out that Token, integrated into a system is considered as a key tool for achieving system goals. For example, the system goal can be security of operation (blockchains, oracle networks), decentralized governance (Defi protocols), etc.
So, the first steps include system itself and applied mechanism design/policies:
Initial system (with “raw” value of coordination), system goals, and issues that need to be solved for achieving these goals
Policies/Mechanism design for a token as a part of network design ensuring achieving system goals
The overall mindmap is presented below:
Initial system -> Policies and mechanism design for a token -> Origins of value -> Value capturing mechanism -> Value creation patterns (set of implementations) -> Combination of composable VCPs as a particular token model
Strictly speaking, the majority of existing token models can be described as “value transfer” plus other VCMs. Technical features of blockchain protocols lead to almost every asset being used for transferring value between two counterparties. Understanding this feature, I suggest excluding value transfer while decomposing all tokens for which it is not a core function. From another angle, hedonic value can be not only an attribute of NFTs such as digital art, but in some cases it can be a VCM for almost any other digital asset depending on context and circumstances.
Decomposition of tokens into VCMs and application domains
The proposed value capture mechanisms can be used for describing token models developed for entirely different application domains. The most obvious example is internal product governance - it can be used in Defi protocols, NFT projects, green energy blockchain startups, and many others. Examples of decomposition of tokens into VCMs are presented below:
Tokens that could be described using one VCM: COMP(7), BAT(1), REN(3), NMR(2), ETH1.0(1), ETH2.0(3), LPT(2), LINK1.0(1), cDAI(5), YLA(5), DPI(5)
Tokens that are designed as a combination of two VCMs: MKR(4)(7), 1INCH(4)(7), SUSHI(4)(7), SNX(1)(7), FIL(1)(2), DAI(1)(5), BNB(3)(6), SOCKS(5)(9)*, OXT(1)(2)
*formally, the famous UniSocks token can be described by these two VCMs
Three-VCM tokens are quite rare since there aren’t many combinations of VCMs that can complement each other. The main examples of such tokens are in the Defi sector, combining internal product governance(7), dividends(4) in different forms, and work token(2) or meta-governance(8).
Value capturing mechanisms and patterns approach can be applied to digital tokens related to different sectors of the economy - starting from native field of L1/L2 protocols, DeFi, Data (NMR, Ocean), decentralized web services (dVPN - Orchid Protocol, dVideo streaming - Livepeer, dFile hosting - Filecoin), energy(in energy sector VCM #5 is mainly used), and many others including tokenized physical goods and property, and digital art.
Talking about famous cryptoeconomic primitives such as Bonding Curves or Token Curated Registries (TCRs) - not in all cases there is a token representing the value captured by the implementation of a primitive. For example, tokens issued through Bonding Curve in most cases have their own utility and VCM composition, while Bonding Curve itself serves just as a sort of automated market maker. Therefore, there is no “token model based on a Bonding Curve” - it is a market maker mechanism. TCRs, in contrast, always have native tokens exclusively related to a particular TCR, and this token is composed of VCMs #1,2.
With the development of the space, token models tend to be more complex. First of all, it is related to explosive growth of mainnet protocols on the market and therefore new composability opportunities. For example, tokens can not only serve their primary purpose, but also can be lent or used as a collateral for securing loans or issuing synthetic assets. At the same time, the space is moving to wide adoption of decentralized governance, as well as different value distribution patterns such as dividends of different kinds. I expect that in the near future almost every token will have at least two VCMs in a basic model and some additional utility attributes based on listing in DeFi protocols.
As an author of Chapter 3 of A Hitchhiker's Guide to Token Engineering: Cryptoeconomic Patterns & Application domains I invite all interested token engineering enthusiasts to discuss this concept during a webinar that will take place on the 17th of June, 7PM CET, zoom link.
Disclaimer: The author is familiar with various approaches for token taxonomy proposed by individuals, institutions, and government agencies. This list includes , , , , and some other references. The main difference of the presented approach with ones mentioned in the literature is that it describes assets from the view of value capturing mechanisms and economic functions based on mechanism design. It is not considering legal status/structure, process of issuance, features of underlying technology (besides cases when it directly influences implementation of VCP).