Discover more from Public Keys
Decentralizing $Billions in Utility Tokens
How subnetworks can level up utility tokens with real decentralization and authentic value.
To date, most native blockchain tokens have been able to deliver financial upside to purchasers because they have demonstrated that they are sufficiently decentralized and operate without human intervention. There are, of course, very large exceptions and differing perspectives on what constitutes sufficient decentralization when you look outside the lens of Bitcoin, Ethereum, and other established Layer-1 blockchain networks.
Recently, some US regulators have even gone as far as to state that only Bitcoin demonstrates true decentralization and that BTC should not be classified as a security. So, where does that leave the seemingly countless tokenized applications, projects, and businesses that also strive for decentralization, living atop blockchains?
For now, it would appear that unevolved regulations will continue to constrain and limit a utility token's ability to deliver value and innovation to users in truly meaningful ways.
What I will lay out in this article:
That the mechanics of a blockchain and their protocol tokens provide the most genuine framework and playbook for creating decentralized networks
That replicating blockchain-level decentralization might be the golden ticket for how tokenized products and their utility tokens will deliver truly transformative financial innovation to their users–legal, non-security classified, earnings and upside. Just like Bitcoin.
To prime our token vocabulary and define what I am calling utility tokens and protocol tokens, we can use the sensible token classification system where:
Protocol Token = “Natively DLT” assets and are tokens that are created, maintained and utilized on a specific distributed ledger or blockchain
Utility Token = “Tokens” that are created or maintained on DLTs (blockchains), often referred to as cryptoassets, cryptocurrencies, virtual assets, virtual currencies, digital assets, convertible virtual currencies, etc.
To define “decentralization” and what is decentralized, we can say that it has (1) no single and central point of failure, (2) no single and central point of trust or truth, and (3) no central point or party from which changes can be made.
Now that we’re primed, we can explore how protocols are evolving to elevate the utility token to the same level of ability, value delivery, and decentralization. First, it’s important to understand utility tokens, their purpose, and their promise.
What is a utility token, really?
Depending on the timing within a market cycle, the term utility token can be almost uncouth.
Use it in a bear market and it becomes cheapened, and almost exhausting to say. Audiences will require a breakdown of exactly why the product needs its own utility token to operate. Most of the time, the conclusion is that the product or application does not truly need the utility token—at least, not right now.
Conversely, use the term in a bull market and its purpose somehow becomes more ubiquitous and obvious. Audiences vie to hear about this new cryptocurrency, and how it can uniquely serve the product and its users. Users and purchasers also seem to be keenly concerned with when the utility token will launch, how to become an early adopter, and how it will grow in value.
It’s fair to say that the widely accepted syntax utility token, generally speaking, has pushed the crypto-thesis and blockchain technologies forward—adapting to meet the market’s demand, however forced it may be at times.
Consider utility tokens from seven perspectives…
From a blockchain network and hierarchy perspective, utility tokens operate on top of blockchain networks. They are assets that are assigned attributes, traded between users, and usually have their own value independent of the underlying blockchain. They cannot be used to directly pay the network transaction fees of the blockchain.
From a functional and programmable perspective, One utility token can interact with a blockchain-based application or product in a way that other utility tokens may not. Utility tokens can be designed to have limited or unlimited supplies and programmed with associated metadata like names and symbols to make them distinguished.
From a marketing and community coordination perspective, projects use the utility token to engage users in a variety of ways, e.g., through distributing tokens directly into user wallets—like an advertisement appearing on a website you’ve just visited—and incentivizing them to actively use and partake in the token’s native application and community.
From an ownership and control perspective, a utility token can represent decision-making or governance rights related to the underlying product or application. Utility tokens, held in a user’s wallet, can be used to vote on a variety of decisions, including, for example, how the organization’s treasury should be allocated; which new application-specific features or initiatives should be approved, whether certain OKRs or risk metrics should be accepted, etc.
From an economic and value accrual perspective, utility token holders believe that the tangible value each token unlocks will outsize the circulating supply, causing the utility token to appreciate in value and result in a potential profit-making opportunity for the token holder. Importantly, a utility token must be sufficiently decentralized (have no central/single; point of failure, source of truth, ability to modify data or consensus mechanism).
From a legal and financial instrument perspective, a utility token is theoretically not a security token—in that it does not in any way promise financial returns or dividends to the purchaser. Instead, a decentralized application, as governed by members of a DAO and other governance token holders, strives to translate the application’s financial earnings into new and enhanced functionality and capabilities for the users of the utility token.
From a social and societal perspective, a utility token may strive to birth an entirely new, purely digital, nation-state–one where online communities can become societies and agree to transact in the currency of the token regardless of how the rest of the online world values it. Pretty exciting stuff and not entirely far-fetched when you think back to the unique coins and currencies of kingdoms.
Pulling these perspectives together, and looking at the history of utility tokens, dating back to 2015 and the launch of Ethereum’s ERC-20 utility token standard, the number of actual utility token launches that have proven to be successful is quite small. In most cases, requiring the use of utility tokens in many applications has introduced unnecessary friction when protocol tokens and Stablecoins can often perform these actions easier and with less risk (have you read our team’s Super Token Thesis?). That all said, utility tokens and the abilities they represent are necessary experiments for how we will distribute ownership and control to token-holding communities.
Still, the most interesting and undeniably valuable utility of any token is also the most necessary one. Some tokens—protocol tokens—persist the decentralized nature of blockchains themselves, creating a virtuous loop of value exchange that includes all participants.
Okay then. What is a protocol token?
Let’s break down protocol tokens and why they are so valuable.
Protocol tokens—for example, ETH (Ethereum), AVAX (Avalanche), MATIC (Polygon), SOL (Solana)—are the currency of the base network themselves. Think of these networks as nations with their own base currency that citizens, businesses, and governments use to transact. In this system, there are two critical roles—the user and the network provider.
All users of the network must pay a fee when using it to send money or messages, use existing applications, launch entirely new on-chain products and applications, and so forth. Because blockchain networks are decentralized, the fees collected are used to incentivize and reward those who contribute the energy (electricity) and stake (protocol tokens) required to power the network. These network miners and validators, in most cases, keep a full copy of all past network transactions (blocks) and work to secure new transactions to the blockchain—forever. Importantly, the rewards to miners and validators are always denominated in the native token of that protocol and rewarded according to a preset rewards program.
Protocol tokens become more valuable as they gain popularity from both sides of this harmonious relationship. As more application builders and token users develop a preference for one blockchain network over another, the more that blockchain’s value grows. As blockchain adoption grows, more miners and validators expend energy to receive the network rewards of the blockchain. And so the flywheel spins.
In addition to the growing decentralization challenges that utility tokens face, they must also compete the astoundingly authentic utility and value that protocol tokens like ETH and BTC already demonstrate so well:
Decentralization of the network and programmatic (non-discretionary) release of its protocol tokens
Equal and open access for anyone to choose, use, and work for the blockchain network
No single entity or person is responsible for the financial upside that gets delivered to token holders
If you’ve ever wanted a great example of the network effect, this one is perhaps the best.
So how can the utility tokens on a blockchain act (and be valued) more like the protocol tokens of a blockchain?
In the near term, the answer to that question may be for tokenized projects and applications to become protocols themselves. Some established blockchains have realized this and are quickly racing to offer this ability to projects.
Protocol tokens, subnetworks, and the future of utility
In 2017/18, COSMOS brought us the modern multi-blockchain framework and the driving thesis for a world that consists of many blockchains 2021 brought us Polkadot’s parachains, followed by the first Avalanche subnetworks (or subnets), and the announcement of soon-to-come Polygon supernets. Think of parachains, subnets, and supernets as branches of blockchains that are attached to the trunk of the base blockchain protocol. As proof-of-stake blockchain networks, subnetworks incentivize validators to work for their blockchain and maintain its state. Some subnetworks, like those on Avalanche, provide a way for projects and their utility tokens to evolve from states of centralization to decentralization—where anyone can participate in the validation of that subnetwork. What’s more, is that subnetwork designers can choose to use their own utility token to pay the network fees on that subnetwork.
What you now have is a utility token that can leverage the same primitive abilities of a protocol token—that same supply and demand network dynamic and progressive decentralization.
So what do subnetworks mean for the future of decentralized applications, products, and the utility tokens that exist to power them?
Firstly, utilizing a subnet that is powered by its own utility token means that founders will focus far more energy on building a valuable and useful product and less on coordinating disparate community members (DAOs) to demonstrate decentralization. This would be a dramatic innovation around the tireless and often unsuccessful task of achieving decentralization through governance.
Next, there is the risky line that project founders straddle when alluding to a utility token's value—or, dare I say price. Value captured and delivered on a subnet will become far more rationalized when, like the protocol, it is required for powering the network on which the product resides. If the product is good, people will want to use it and, importantly, require the utility token to do so. If users require the utility token to transact on the subnetwork, it will incentivize more and more validators to invest in securing the subnetwork transactions, earning rewards for doing so, and selling them back to the demanding subnet user base.
Combine the subnetwork with the correct governing controls (DAO tooling, permissionless validators, network fees, economics design, etc.) and you’ll have a very compelling argument that the utility token is decentralized from day one.
Perhaps most compelling and an area that we at Republic Crypto are eager to discover—will this particular subnet-based utility token evolve entirely beyond the classification of the “modern-day” security asset?
One thing is for certain: the utility token will never look the same after it becomes a subnetwork utility token. The race is on, and I am front row center.