Tokens Not As Profit Engines, But as Coordination Mechanisms

Let’s talk about tokens.

Tokens are the foundation and denominators of the web3 economy.

Although tokens share a common name for the category of assets they belong to, not all tokens are the same.

Tokens are designed with different intents, different utility, and different tokenomics.

While most tokens are oriented towards profit-seeking incentives, there might be a more interesting framework for thinking about them:

not as monetary instruments, but as coordination mechanisms.

First a step back: Where Profit Incentives Go Wrong

I may be over-generalising, but here is the picture: Teams are issuing tokens out of thin air, with little basic economic system design, and short-term intents.

The last point is the most important: short term intents.

Short-term intents include value accrual and hype — both of which, without fundamentals, can harm projects on the long term, or amount to short-lived experiments at best.

Common example: DeFi liquidity incentives.

In DeFi, protocols leverage token rewards or token airdrops from their treasury as marketing tools to attract more capital into their protocols.

In business KPI terms, there are a few problems here:

• high CAC (customer acquisition cost)

• low LTV (customer lifetime value)

On CAC: the protocol has to either pay from the treasury, or dilute the value of their tokens to acquire new users — both of which have negative effects on their balance sheets.

But is it worth it? Perhaps for future growth?

This is where LTV comes in. This metric focuses on retention of the users. When incentives are short-term oriented, so are the users. What does this result in? Churn. (and the death spiral of high turnover, value leaving the network, and more users exiting begins…)

So let’s do the math:

high CAC + low LTV = really bad ROI.

The Founder’s Dilemma

This becomes increasingly problematic in the current DeFi ecosystem that competes on increasing CAC instead of focusing on fundamentals.

When rewards inevitably start to decrease due to rising costs as the DeFi protocol network scales, the users that were motivated by those rewards are no longer served, and leave for the same reason they came in: for more profit.

At this stage, the DeFi protocol is left with few options: either pay more for their users to stay, or accept the sunk cost of misdirected growth efforts.

The issue is: the token incentive mechanism used was wrong for the type of user and behaviour that the protocol would actually benefit from in the long term.

In this case, tokens used as profit incentives to drive growth fails at basic product-market-fit.

This is where shifting from thinking about tokens only as a profit vehicle to thinking about tokens as a broader coordination mechanism becomes more interesting as a business strategy.

Tokens as Coordination Mechanisms

Coordination mechanisms can be driven by incentives, and the idea of using tokens as incentives is a good one.

The problem is that the current primary framing of tokens only as a “number go up” technology does not coordinate the right users or behaviours.

It is a failure of first principles thinking.

The first questions to ask when designing a coordination mechanism for a network or protocol are:

• what kinds of users to your want to attract?

• what is the user intent that aligns with the problem you are solving?

• what kind of behaviours do you want to promote?

To put it differently, the higher level question is: what are the variables the token coordination mechanism is optimising for?

The strategy is to align the incentives with these variables, and the answers to these questions will inform the coordination mechanism design of the system you want to coordinate.

An Analogy for Coordination Tokens

A first analogy for tokens as coordination mechanisms is loyalty points. When a customer performs a certain action (i.e. purchase or participation), he or she accumulates points, that amount to rewards, benefits, or status within the brand’s ecosystem. (examples: Starbucks loyalty program, Sephora Insiders, Fitness studios, etc.)

Another analogy is in-game currencies. As a player plays or progresses in a game, he or she might earn rewards or recognition denominated in the game’s currency or assets, which he or she can use to unlock new features, trade for in-game assets, or display as performance credentials.

The aim of these loyalty points or in-game assets is to move the users to adopt specific habits or take specific actions that both benefit the user and drive business outcomes.

Important note: in both of these examples, the points do not possess any value outside of their ecosystems. As a result, the value remains captured in the brand’s or in the game’s micro-economy.

The Case for Leaving People Out

Coordination tokens operate best in closed micro-economies, with prescribed utility that promotes the actions and behaviours required to drive the intended feedback loops within that system.

That being said, most of the realised value of the current tokens relies on value outside of their networks, coming from public markets.

This exposes the discrepancy between reality and the common narrative that tokens associated with a network generally represent the value in that network.

If the intent is to align incentives and coordinate behaviour, then external token holders are detracting from these goals. An external holder is a speculator by default, since it does not contribute or benefit from the network itself.

In this way, an external holder is motivated by extracting value out of the system, rather than bringing it in.

The question then becomes: why distribute and circulate a token outside of the system is aims to coordinate?

The answer: maybe we shouldn’t.

Although access to public market liquidity can benefit the growth of the project or community, the cost of attracting detractors and disrupting your coordination mechanism can be much greater — and the purpose of your token gets lost in the noise.

Detaching Monetisation from Coordination

This leads to the next point: tokens as equity or treasury assets should be differentiated from tokens as coordinating mechanisms.

The token coordination should not be successful because of the token valuation, but in spite of it.

A dual-token model could be an option if token financing is a part of your plan, or opting for a traditional equity structure and treasury that is decoupled from the token that coordinates your network.

While monetisation and instant liquidity are not the primary goals of a coordination token, the benefits of a well-designed and well-functioning system can indirectly contribute to the business model.

Proper coordination creates logic for proper function, structured interactions, and better experiences — all of which feed back into the revenue streams by making user funnels more efficient.

Leaving Room for New Use Cases

When greed and external holders are taken out of the equation, the token allocation can reflect more accurately the true value of contribution and participation of holders in the network. Consequently, the token has more room to breathe into other use cases that were not possible with a disproportionately low signal-to-noise ratio.

Think: denominating governance power, attributing verifiable credentials, or allocating rewards from the treasury in proportion to their token holdings that actually reflects the holder’s value in the network.

(Needless to say — we might need another article for that.:))

Last Thought

Programming coordination through smart contracts via tokens issued and recorded on an immutable public ledger is a powerful concept.

While tokens as profit engines or public value accrual devices are attractive in the short-term, tokens as coordination mechanisms in a closed system introduce an alternative way to leverage the same technology for more valuable outcomes in the long-term.