Capturing Value & Identity
Do tokens even make sense?
Hello!
Welcome to issue two of our paid newsletter. This is still in beta so any feedback would be appreciated.
Blockchain transactions are interesting because of the anonymity they offer. Or, well, pseudonymity. Be it Silkroad (in 2013) or the alleged insider traders at OpenSea and Coinbase - users presuming their transactions cannot be traced have led to their eventual downfall.
ZachXBT has built his entire personality on Twitter around revealing hacks & rug-pulls that occur in the industry. Coffeezilla on YouTube does a similar job of surfacing the stories of scammers. They are a much-needed force for self-regulation in the industry. But when taken to the extreme, it can cause more harm than good. This week, a token proposed in the crypto world made many of us wonder if that’s just the case.
Arkham, a blockchain data platform with a motive to “deanonymise the blockchain”, launched its product in August 2022. This week, they announced the Arkham Intelligence Platform- a data marketplace that connects people who want to buy and sell data. They introduced a token (ARKM) to help “decentralise” the marketplace and a new meme – Dox-to-earn.
The token’s ecosystem has four major actors
Bounty posters, who stake ARKM tokens to seek information/data
Bounty hunters who provide information/intelligence to claim bounties. Anybody can compete for the bounty by submitting the required information.
Intel merchants put intel they have for auctions.
Intel collectors bid for auctions by intel merchants instead of targeted bounties.
Arkham takes a 2.5% maker fee on all the bounties and auctions; and a 5% taker fee whenever bounty payouts and successful auction bids. ARKM token holders get platform fee discounts depending on the holding period and the number of tokens.
Arkham has raised over $10 million at a valuation of $150 million from backers, including folks from OpenAI and Palantir. They will soon conduct a Binance launchpad sale of 5% of the total supply to raise $2.5 million, setting the new valuation at $50 million. It seems Binance is now guaranteeing the retail participants that acquire tokens through their exchange have a lower entry point than VCs. Talk about ensuring your users consistently win!
There are multiple ways to interpret this. You have a micro-gig-economy around data emerging. In Arkham’s case, they incentivise users to data on a particular niche for token rewards. It just happens so that this niche is the identity of wallet users. The challenge is that there are very few mechanisms to ensure the data provided is accurate. A user could falsify documents to claim a fund owns a certain wallet if the incentives are large enough and they can remain anonymous. A version of this happens with users registering ENS handles of funds or users (like the one here) and making trades to push behaviour.
The flip side to the argument is that a marketplace for identity helps identify bad actors too. Say a hack occurred. Or you want to know where the flow of capital has been after a transaction. Offering dollar or token incentives in a free marketplace can be a mechanism that helps identify bad actors better. One way this is used in the investment world is through identifying funds selling tokens. Labels offered by Nansen and Arkham are routinely used to track when tokens are dumped right after vesting by funds.
Arkham just released market incentives for a frequent occurrence in digital assets. Much of the uproar is likely caused by the fact that there are now clear monetary incentives for giving up the identities of other actors. It seems like tying monetary rewards to certain functions feels gross. Much like how we don’t have a market for blood donations or organs. (Good book on the matter).
The broader implication is how the model can expand to other data sets. Can token incentives be used to get people to feed their health data? This could occur in the context of constant glucose monitors and food. Joel is diabetic - and a portion of managing diabetes is knowing the impact different food items have on blood glucose.
Over time, people recognise foods that cause a crash and develop behaviours that deter it. Eggs and bacon are fine. Toast and jam - could likely cause a crash at noon. A neural network designed through crowd-sourcing glucose monitor data and associated foods could be powerful in generating better insights into what different foods could do to blood sugar. Imagine picking up an apple, scanning it with your phone and seeing the average blood sugar spikes it caused in people of similar demographics. (Ping us if you can build this).
Surely, healthcare data is highly sensitive, and we are far from having the regulations to enable it. A version of it may come to market with zero knowledge proofs. But if you take this model to the extreme, you have an open data market with incentives. (We are tinkering with questions around it and will have a long-form on it soon).
The question then becomes, why do you even need tokens for incentives? Can’t dollars be given out as incentives? Paypal did fine giving out dollars as referral rewards in the early 2000s. Surely they weren’t giving out stock in the firm to acquire users. This has been the other theme we have been exploring at length internally.
Are tokens needed if they capture no value?
Protocols Good, Tokens Bad?
Let’s start with a chart we have been looking at internally. It looks at how prominent DeFi and L1 tokens have performed over the past few years.
SOL is the only asset outperforming ETH (Aug 2020 to Jul 2023). Jan to July of 2022 was the only time some tokens in our sample space outperformed ETH. A simple way to put this is most of the tickets are “down only” when measured against ETH. (This should explain why we sent out a long form on ETH alone yesterday)
Tokens are high beta on ETH- when ETH goes up, they go up a little more and when ETH goes down, they go down a lot. So far, tokens have behaved like tools to speculate how much value they will capture in the future (just like every investment on the planet). Naturally, we overestimate how much value can be captured when a narrative is strong and completely underestimate how well an asset can perform when the tide turns.
Why have tokens not captured value?
We are entering deeply philosophical territory. And the subtitle here may as well be, what is the meaning of life? But the fundamental reasons why they don’t capture value boils down to regulations (or the lack of them), poorly designed token economics entailing either the absence of precise value capture mechanisms, bad token distribution mechanisms, or both. A well-designed token often flirts with the possibility of being a security- a line most founders don’t want to cross. (And likely should not).
But what even is value capture? We’ll keep it simple and only look at tangible value. We define it as how much value the protocol or application accrues in fees (aka the revenue). And if tokens are pseudo-equity, how much value goes to the token holders why mechanisms like direct fee sharing with stakers or buybacks? Uniswap is a good example here. The fees amount to over $300 million yearly.
If the fee switch is flicked and we assume that 50% of the value goes to token holders, it generates a cash flow of roughly $300 million annually for the token holders.
Because the laws are unclear and Uniswap is registered in the US (where the regulatory scenario is rather gloomy), no value currently goes to token holders. So one could argue that regulation keeps tokens from accruing value. Uniswap could have launched as an equity company, but how do you get people to put tickets into your liquidity pools by offering equity? There is no precedent to it so far in the financial world.
That’s not the story everywhere. Yearn Finance borrows from equity buybacks and runs a YFI buyback program. But the program has not helped YFI outperform ETH over the long term either. An even better instance of this is evident in the NFT markets. LooksRare and Blur changed how we think of royalties over the last year.
LooksRare’s token has a clear-cut value capture mechanism. A major chunk of the fee earned by the protocol goes to users who stake LOOKS - their native token. Despite this, LOOKS has embarrassingly underperformed ETH. In terms of the product, Blur achieved what Looksrare set out to do. It disrupted OpenSea and proved that leaders may not always remain leaders.
Blur’s strategy was twofold – product innovation (aggregation, lending) and regulatory arbitrage. OpenSea being in the US, refrains from launching a token, allowing a competing product to snatch volume using token incentives. Although the BLUR token doesn’t have a defined value capture mechanism like Looksrare, one can anticipate the token will be more than just the governance token at some point.
Apart from regulations and value capture mechanisms, tokens don’t accrue value because applications are starved for users. No “mechanism” will help accrue value if there are no users. Much like governance tokens are not useful, if there’s not much to govern.
The complexities around value capture and the lack of examples of tokens capturing value force us to wonder - why do we even go down the token road? Can a great firm be built in Web3 without all the token nonsense?
Should applications have tokens that are only governance tokens or utility tokens? Despite the flaws, we are inclined towards yes. Here are a few reasons why we think so
First, they offer much better infrastructure for settlement than markets for trading equities of early-stage companies.
Second, they free up investor capital sooner than traditional routes.
Let me unpack. Private investors are arguably better capital allocators than governments. But unlike governments, investors cannot create money with a few keystrokes. So, for investors to keep funding new ideas, the sooner their initial capital frees up, the better it is. This means more ideas (also good ideas) will get funded if they get to churn their capital quicker. And tokens offer one of the fastest ways to churn money. Not all early-stage investors are god-sent angels. (Yes, that’s a pun).
There are a few obvious arguments against early-stage investors in crypto.
They sell tokens quite quickly and don’t add value. Investors sell tokens partly because they want to free up capital to see new deals. This is common in the equity investing world too. Quite recently, Tiger Global opened parts of its portfolio for external bids to shore up liquidity.
Investors have two forms of customers. First is the founder raising money from them. And the second is the LP they have raised from. Selling tokens in a timely fashion is required to protect the limited partner's interests. Suppose you hold on to tokens while other investors on a cap-table sell; you may underperform your peers. And end up looking bad to your source of money (LPs).
Desire to avert loss compels investors to sell when they can. A nerdy game-theoretic way of saying this is that the Nash equilibrium is to sell the token while you are sitting on some gains. Whether early investors add value is subjective and depends on the team raising the money. But the possibility a token opens up is twofold.
Incentive alignment. They allow participants of all kinds to be rewarded with a new asset that a founding team does not need to pay for. The market pays for tokens like Blur or Uniswap when there’s an airdrop. So the cost of capital to bootstrap products like those are a fraction of what it would have taken if they were giving dollar rewards.
Global scale settlement. Tokens are likely the first truly global market that allows anyone from any walk of life to participate with little to no restrictions. This quality may extend to traditional equities with CBDCs coming of age, but that claim sticks with tokens for now.
So it is not that tokens on their own are bad. It is just that we are within a decade of a new primitive coming of age. Equities have been around for four hundred years. Debt has been around for over 5000 years. For all their novelty, tokens are a new primitive compared to the grand scale of human existence. Add to that the chaos of short-term incentives, anonymity and cultural clashes from the first truly global market. And you have what we have today with digital assets.
We are digging deeper into this question over the coming days and aim to have a long form in your inbox by mid-next week. Until then, enjoy the rally in the market and touch grass over the weekend.
Signing out,
Saurabh Deshpande