Decentralisation and public distributed ledgers — the role of utility tokens

This is the second article in the series on Public Distributed Ledgers — The Case for Tokenisation. In the previous article, we concluded that public distributed ledgers (DLs) are important because it:
(1) enables permissionless innovation
(2) fosters incentivised coordination cooperation
(3) empowers us as creators and not only as consumers.

In this article, we dive into why decentralisation is a necessity for public distributed ledgers (DLs) and how tokenisation and especially utility tokens support this decentralisation.

1. What is decentralisation and why is it important?

With centralised networks (such as the networks we use for social media, taxi rides and vacation rentals) the control and decision-making functions are concentrated at the centre. Centralised networks have the disadvantage of a (1) central point of failure and a (2) central point of control.

A central point of failure means that the whole system is vulnerable to the malfunction of that central point. This leaves users open to damages as well as a loss of property or privacy. With a central point of control, the rules of the network can be changed without consulting participants. This has the effect of innovative developers not participating in such systems for long which negatively affects the level of innovation of the network. Incremental rule changes also make practices possible that make users uncomfortable.

Decentralised networks have their actions and functions spread across the network. The advantage of decentralised networks is that they have no central point of failure nor point of control. From this perspective, decentralised networks are more robust and trustworthy than centralised networks. According to Metcalfe’s Law, the value of a network is measured by the number of active users. By being more robust and trustworthy decentralised networks will, in the long run, attract more active users and innovators and become more valuable.

2. What is tokenisation and why is it important?

In the first article of this series, we mentioned that DLs make digital scarcity (think digital gold) possible. Tokenisation is the use of digital scarcity — not just in value transfer — but also in the area of agreements. In the physical world, we rely on contracts to seal agreements on the future use of services or rights to profits of a business.

In the digital world, it is now possible to use tokenisation instead of contracts by making the token represent a claim. By holding this token you then become a party to the agreement. Smart contracts make these tokens — and by extension the claims of the agreement — transferable from one person to another.

Based on the nature of the claim the token can be classified as a utility or security token. Utility tokens represent a claim to the future use of the product while security tokens represent an equity or profit-share claim.

If you want to (1) monetize a technological innovation, (2) create partial ownership of a property or (3) fund a conventional business a security token makes the most sense. If one wants to build a network and activate network effects utility tokens are the best strategic option. Not only does it make the direct monetization of the network possible (more on this in the following article) it also makes it possible for participants to share in the success of the network. These attributes make utility tokens ideally suited to public DLs. In the rush to sing the virtues of Security Token Offerings (STOs) this important distinction is getting lost — this is why the rest of the article series also focusses on public DLs and utility tokens.

3. What is the role utility tokens play in decentralisation?

Utility tokens support decentralisation in the following three ways:

3.1 Replacing centralised fundraising with international community-based fundraising

By means of distributing utility tokens in an offering, fundraising can be achieved at an international level to a broad audience. By raising funds in this way co-ownership of the network of the DL is — under ideal circumstances — distributed under a knowledgeable community who believe in the goal of the project. This community can still hold the project accountable but it does give the project a certain measure of independence to achieve its original vision. This is, in contrast, bowing to concentrated investor power. All the while the project could still enjoy the community’s expertise.

3.2 Financial incentive mechanism for broad participation

Financial incentives are all around us. In getting up in the morning for work or contemplating the purchase of an electric car all involves financial incentives. Public DLs are no exception to this. By offering incentives in the form of distributing utility tokens support a public DLs decentralisation by attracting miners/stakers to deliver distributed processing power to the system.

The initial wide distribution of utility tokens also contributes to commercial robustness through developing a broad potential customer base. Bounties in the form of utility tokens for improving the codebase also adds to the technical robustness of the network.

3.3 Anti-spam mechanism for public networks

Anybody can take part in a public DL. So the system should be protected against bad actors or vandals. By acting as the only means to take part in the network and by having a monetary value there is a limit to the number of actions one participant can do on the DL. Utility tokens, therefore, act as an anti-spam mechanism and support the decentralised nature of public DLs.

4. Things don’t have to be the way they are

Since an ever-increasing part of our lives is spent on networks and platforms it becomes important to questions their practices. It becomes even more important to bust the myth that things just have to be the way they are. Utility tokens in combination with public DLs can provide the decentralisation needed to make our networks and platforms better.

In the next article, we will look into how utility tokens help public DLs to generate sustainable network effects — another root cause of bad practices from networks/platforms.