The law of tokenomics, revisited - cousinos-firearms.com

Did you miss a session from the Future of Work Summit? Head over to our Future of Work Summit on-demand library to stream.

This article was contributed by Louis Lehot, partner and business lawyer and Patrick Daugherty, partner with Foley & Lardner LLP

As the web further decentralizes based on blockchains, we are seeing new technology business models, particularly in the ecommerce sector, incorporate digital tokens into transaction flows by using digitally native tokens as a medium of payment for transacting on the platform. The boom in financial markets is also a cause-and-effect situation of decentralized financial applications as well as the tokenization of unique, or nonfungible tokens and assets, colloquially referred to as “NFTs,” whether tangible (like your house) or intangible (like a digital photo).

Increasingly, we are seeing these business models emerge as decentralized, autonomous organizations that will govern a business from the bottom up rather than top down in the classical capitalist style. Entrepreneurs build financial assets in the form of fungible cryptographic tokens for platform users to receive and pay as currency without bank or government involvement. The economical design of the token, the allocation of tokens among stakeholders in the business, on what terms the token commences trading, as well as how that trading evolves over time, are referred to as “tokenomics,” or the economics of a token.

What is driving tokenomics and tokenization? The wave of tokenization has gone from forms of payment, or currency tokens, to hard assets, to debt and equity securities, to utility tokens such as pay for a specified service or a reward for participation on the platform. Extended periods of pandemic-induced confinement accelerated the growth of virtually everything, not least of which have been crypto assets. According to one reliable source, more than 9,000 different crypto assets are trading in public markets today. Tokenization of assets allows the holder to trade the whole or a fraction of owned property. While currency tokens and tokens underlying commodities like gold and silver are “fungible,” monetization of a holder’s ownership of unique assets such as art, music, and even real estate has spawned a boom in non-fungible tokens, or NFTs. The governance of companies, virtual worlds, and games has also become tokenized.

Benefits of tokenization to entrepreneurs and token users can include broader distribution and increased customer engagement, improved liquidity, enhanced accessibility, transparency, and, ultimately, transaction efficiency. Challenges include data security and privacy, technological reliability, and, importantly, legal and regulatory uncertainty — particularly in the United States.

Whether you are a content creator looking to monetize the value of non-fungible assets, or a token buyer looking to transact in a fungible digital asset, tokenomics practices will factor into the success or disappointment of your experience.

The status of a token as currency, security, commodity, or property — or all of them — has considerable legal significance. The status of a token can facilitate its use as a form of payment, or impede its usage to the extent regulated, especially if regulated as a security:

A token that is generated by and for use as a form of payment is by definition a currency under banking laws. The exchange of currencies can be regulated by national governments and central banks.
Entities that facilitate the exchange of currencies are typically regulated as “money transmitters” under national, state and local regulations, which triggers a complex hodgepodge of registration and licensure requirements.
A token in the flow of interstate commerce in the United States that fails the “Howey” test will be a security, most likely because it will have been sold to raise capital with which to build the platform. Thus, rendering it an investment contract as to which token buyers primarily expect to earn profits based on the efforts of the founders.
Futures contracts, “swaps” and other derivatives can also be subject to extensive, prohibitive, regulation depending on the facts and circumstances. The Commodity Futures Trading Commission (CFTC) takes the view, with which the Securities and Exchange Commission (SEC) has acquiesced, that common cryptocurrencies such as Bitcoin and Ether are commodities, with the result that the CFTC, but not the SEC, has jurisdiction over them to some extent.

The chicken or the egg?

Where crypto assets are tokenized as NFTs, the market for the NFT is typically denominated in one or more of the prominent Layer-1 coins, and they are purchased, sold and traded as some fraction of a “coin.”

In the creation of any new workflow, the question arises as to what comes first, the chicken or the egg? Or, in this case, the commercial utility or the investment value? Similarly, the creation of a new token and its commercial utility do not occur at the same moment. On the flip side, the creation of a new token can have immediate investment value as a security or commodity.

There is a paradox here: If the token is currently useful in commerce, then it’s not an investment contract security and can be sold and resold freely. But to become useful in commerce, it might need to be broadly distributed, and broad distribution of the token before it is useful might be an unlawful securities offering if conducted in the United States. At the core of a token’s value is its utility in contracting in the flow of the web3 ecommerce ecosystem. But the traction achieved in the underlying business and the velocity of use of the token in the flow impacts its intrinsic value as a digital asset, which attracts investors.

While initially, this was the province of highly specialized “DeFi” investors, investment platforms like Coinbase, Binance, FTX and even Robinhood democratized crypto asset investing for retail, and it is now ubiquitous in the retail world. The acceleration of digital transformation, combined with extended confinement at home and global government stimulus, has made crypto assets a matter of common parlance in American households.

If the summer of 1968 was the summer of love, then 2017 was the summer of coin. Initially, the Securities and Exchange Commission and state “blue sky” regulators vacillated between creating safe regulatory sandboxes (e.g., Wyoming statutes and SEC Commissioner Peirce’s safe harbor) on the one hand, and enforcement actions on the other (the infamous DAO Section 21A report, Munchee, and other cases). The markets began to respond by moving offshore, as then-SEC Chairman Jay Clayton, encouraged them to do by citing private placements and offshore offerings as two lawful means of selling investment contract tokens.

If cholera and “Spanish flu” made the 1920s both the time of cholera and the “roaring 20s,” then COVID-19 has turned the 2020s into the pandemic age and a crypto-boom (with even party-going moving to the metaverse). While stocks went mainstream in the 1920s, digital assets (and not only Bitcoin) are becoming a ubiquitous portfolio allocation for main street retail investors in the 2020s. Investment advisers no longer talk about “whether” investors should hold crypto assets, but instead “how much.” One percent of a person’s portfolio is not an unusual suggestion.

So, how does one navigate the murky waters of tokenomics? It can be challenging to discern which crypto asset project to adopt or invest in and what gives it value (its commercial use or its potential for appreciation). Tokenomics can help to determine whether you should invest or not. Tokenomics is often discussed in a project’s whitepaper and helps clarify the token’s objective, functionality, allocation policy, and more.

Tokenomics, the combination of token and economics, refers to a crypto asset’s qualities that make it appealing to both users and investors. It refers to the supply and demand characteristics of the asset.

What should you look for to understand the tokenomics of a digital asset? First, look to understand how the token will be used in the flow of commerce. Is it the medium of payment? Does the accomplishment of a task result in the delivery of a new token? Does an exchange of goods or services result in an exchange of the token? How many tokens exist now? How many tokens can exist in the future? Is there a hard cap or a soft cap? Can the token be forked and, if so, by what vote? To whom and in what amounts were the tokens initially issued in the stream of commerce?

Evaluating a token’s worth 101

Tokenomics is also helpful when assessing the likely future value of a token. This is important not only when judging a token in isolation, but also and especially when considering versus alternative tokens. When considering tokenomics, any factor that even remotely concerns the value of a token should be identified and weighed. Below are some key metrics to consider when deciding a token’s worth.

Allocation of Tokens: Check to see how the token is being distributed. There are two main ways of generating crypto tokens at present – either by pre-sales leading to a public tokenization event or else by a so-called “fair launch.”

Pre-sales compares with the traditional private financing model according to which crypto tokens are generated and distributed to early investors such as the founders, friends and family, key employees, and venture capitalists before later being sold to the public in a public tokenization event, sometimes called an ICO. In this model, the pre-sales (which might occur in more than one round) are best viewed as additional rounds of financing preceding a public offering. Pre-sale proceeds are generally used to build out the functionality of the network on which the tokens will be used. The fair launch model, in contrast, does not automatically result in preferred terms being offered to these categories of stakeholders, but it does depend upon the creation and operation of a DAO.

Supply: A primary component of a crypto asset’s tokenomics is supply. There are different types of supply to check when it comes to crypto assets. The number of tokens issued and currently in circulation is called the “circulating supply” of a token. The “total token supply” refers to the number of tokens in existence, excluding ones that might have been burned (i.e., destroyed). And the maximum supply is exactly that — the maximum number of tokens that can ever be generated. Think of the circulating supply as being equivalent to the “outstanding” amount of a company’s debt or equity securities, and the maximum supply as being the limitation on issuance built into the company’s charter documents or debt indentures.

Market Cap: The market capitalization of a token shows the amount of fiat currency, usually expressed in US dollars, that’s been invested in the crypto project so far. In the context of cryptocurrencies, the market capitalization or market cap is a metric used to determine how widely and deeply held the token is at a point in time. It is calculated by multiplying the current market price of a token, expressed in US dollars, with the circulating supply. It helps to strive to understand a project’s fully diluted market cap. This provides some insight into how to value a token. The higher a token’s market cap and the lower its circulating supply, the more valuable it could become in the future.

Token Model: Every crypto token has a model which factors into its value. Is the token inflationary or deflationary? Do you know? An inflationary token doesn’t have a maximum supply and will continue to be produced over time. Fiat currencies are inflationary by design, which can be abused by governments, leading to devaluation and wealth destruction. The deflationary token model is the opposite. A deflationary token has either a maximum supply, like Bitcoin’s 21 million, or even a decreasing supply. A deflationary token is perhaps more likely to increase in value over time, everything else being equal.

Allocation: Leaving aside the fair launch model, a key question is how the token in question will be allocated, among whom, and in what amounts. The many stakeholders or constituencies of a token and its related protocol can be classed into these groups: founders and other insiders; private investors; a foundation; and the community. Each token is allocated differently from all others. There is no one-size-fits-all model. In general, however, an investor will prefer a token in which the insiders retain less, rather than more, of the maximum supply of the token upon public launch. Twenty percent or so is typical. Private investors in the aggregate might be allocated a similar portion. These percentages should decline over time as the foundation distributes tokens, and will decline further if and to the extent that the token is inflationary. The public tokenization event might account for as little as five or ten percent of the maximum supply. The remainder is typically owned by a foundation whose purpose is to assure the smooth functioning of the protocol and the token in line with directions received from the community. The community is or becomes a DAO, ultimately determining the future direction of the business.

Lock-ups: Tokens are not freely trading from date of issuance by an early-stage crypto business. Pre-sold tokens, like privately placed bonds or shares, will be locked up for a year or more if sold in the US or to US persons because U.S. federal securities laws impose that requirement. Tokens sold offshore, whether in a pre-sale or in the public tokenization event, will be subject to lock-up restrictions as well, at least for a while. If and when the protocol and the tokens are sufficiently decentralized, or if and when the protocol is fully functional and other conditions are satisfied, the tokens (whenever and however issued) will not be investment contract securities, and will at that point be freely tradable in the United States. That judgment is best made in close collaboration with experienced counsel. Many tokens are subject to lock-up restrictions that exceed legal requirements in duration and geographic scope. Lengthy lock-ups are viewed as a positive for token value because less supply to the market implies a higher price to the extent that a trading market exists or later develops. Under current law, founders are well-advised not to assist in the development of a U.S. trading market for their tokens, so long as they are securities.

To succeed in creating new technology business models in 2022 that leverage web3, much like successful investment in DeFi, you will need to articulate and understand the tokenomics of a project, and the transaction flows contemplated should be created, and in the quantum anticipated.

Louis Lehot and Patrick Daugherty are partners and business lawyers with Foley & Lardner LLP

DataDecisionMakers

Welcome to the VentureBeat community!

DataDecisionMakers is where experts, including the technical people doing data work, can share data-related insights and innovation.

If you want to read about cutting-edge ideas and up-to-date information, best practices, and the future of data and data tech, join us at DataDecisionMakers.

You might even consider contributing an article of your own!