A primer on blockchain and token concepts for beginners.
I see these questions asked all the time by novice investors entering the space, either for specific projects, or as a general question. So I thought I’d attempt to write a detailed yet basic explanation on the utility of tokens, and what justifies the use of a blockchain.
Basically, blockchain embodies a lot of game theory and incentive models. In order for a blockchain network to be valuable or useful, it has to have participants in a network, it would be worthless if Bitcoin only had me and you using it, there’s not much value there in a barren network with not much utility.
In order to secure participants, there needs to be some sort of incentive to attract them, the most common method is via issuance or reward of the token used in the network, the more participants, the more decentralized it is.
So why not just a database, why do these projects need a blockchain?
There are a few key benefits to decentralizing things instead of keeping it in a centralized server/database:
- Immutability
- Security
- Redundancy
- Overhead/cost reduction
- Accountability/transparency
Immutability
Having records and data decentralized, and deployed on a blockchain makes it virtually impossible for any one party to tamper with data or records. Versus how it is now, if you host your data on let’s say, your computer, you can easily edit that file, before you send it to someone else, how can I ensure I can trust you?
Security
Traditional servers or data are generally centralized, making it a likely target for malicious attacks. Just look at the Equifax’s security breaches and other cybersecurity concerns arising in recent times. Instead of having a single or limited # of servers hackers can attack, decentralization via the blockchain greatly increases the difficulty. The more participants/nodes in a network, the more copies of the data there is. Therefore, if you want to tamper with the data, you will need to attack every single node on the network and alter all of their data simultaneously. Not only does blockchain make data tamper proof, it is also hard to breach. Every “block” on a chain contains a certain amount of data, and when that block gets filled, much like a USB drive, it is encrypted and sealed forever. To get the full picture, hackers will need to hack not just the current block, but also every block before it. This is not only technically almost impossible, but it is costly, thereby reducing the incentive for malicious activities. Different blockchains have different security measures and algorithms, this is a generalization of the concepts.
Redundancy
You basically have the same set of data distributed across the world, you don’t need to worry if you lose your copy. This provides data resilience to corporations which gives peace of mind from any data corruption, server downtimes, etc
Overhead/cost reduction
Having a decentralized network of nodes to maintain this ledger allows companies to offset and offload hosting, security, and maintenance costs. It removes a lot of the costs of IT staffing, Dev Ops, and infrastructural overhead. For example: Apple’s servers are literally under attack constantly. They have teams, and teams of people monitoring their servers 24/7/365.
Accountability
With all of the above in place, you can be sure that everything that is logged or deployed on the blockchain, is accurate, and true.
All of this results in the ease of trust, and ease of the ability to do business in a transparent manner, without needing to trust the counter-party. You can simply leverage blockchain technology to let the data and facts speak for themselves.
Do currently systems and data infrastructures work? Sure, but they are not perfect. They only exist the way they do because there hasn’t been technology that could come along and offer a vast improvement until the introduction of Blockchain.
Ok but what gives token value? Why are they needed?
Well, it really depends on the project. 90% of the projects out there are pure bullshit, but for sake of argument, I’ll simply address it for the ones that have actual utility and use cases.
As mentioned above, tokens are often used as a method of incentivizing participating in a network, therefore, a successful network means there are a plethora of participants, contributing to the decentralization and securitization of a network. The more participants, the more consensus there is that the network has utility, like Bitcoin. It was worth nothing when Satoshi first introduced it to the world, and it was only him on the network. But as it gained adoption, there is increasing consensus now that Bitcoin the token, has utility as a currency, and therefore intrinsic value between participants in the network.
There are generally a few classes of tokens and each class derives value differently:
- Currency tokens — Tokens like Bitcoin, Monero, Raiblocks, etc
- Utility tokens — Tokens that allow you to essentially use or perform an activity on a network, such as ETH or ZRX. On the Ethereum network you would need to spend Ether (aka gas), to run a smart contract, etc
- Asset tokens — Tokens that represent an actual asset or product
- Equity tokens — Tokens that basically act like a share, and gives you some kind of voting right or consensus participation
For a currency token like Bitcoin, it’s value is derived primarily on the use case of it being a currency/store of value.
For utility tokens, value could come from the adoption and usage of the network, for example, the amount of data that gets put on the blockchain, and the amount of information that it’s processing, as there are parties willing to pay transaction fees to nodes to process, validate, exchange, and secure that data. This could be decentralized exchanges, or businesses putting supply chain data on the blockchain, etc.
For an asset token, this could be tied to the valuation of the assets (ie: Cryptokitties could be considered an asset, yet the underlying network powering it is Ethereum, thereby giving ETH value because it is a method of trade, and it now has utility to trade this asset) that it’s tied to or represents. If a CryptoKitty is traded and its value is tied to a KittyCoin, then that would make KittyCoin an asset token.
Equity tokens, this could be valued closer to the investor sentiment and the progress of the project itself. Are they getting business and real world adoption? What kind of voting power will token holders have? What is the future potential and direction of the company?
So now that we know where value is derived from, what affects their price?
Every project and token may have different stimuli or economic models that affect price. Speculation aside, here’s a few technical factors that affect it regardless of investor sentiment:
- Supply & demand — This is likely the largest factor in the valuation of a token, especially today, where the market is purely speculative
- Adoption/utility — Is there any activity on the network? What’s the usage like?
- Burn rates — Do tokens get burned over time or upon usage? What’s the rate?
- Circulation & lockups — How much is in circulation? Is there any lockups?
- Generation of secondary token — (like NEO/GAS), etc
- Staking — Do you earn additional tokens by locking up and “staking” your holdings to secure the network?
- Mined/premined — How much of the coins are released and what’s the schedule? Or is it all mined already?
So as you can see there are a large number of factors that can affect the valuation and price of a token, and “why is a token even worth anything?” is quite a broad question and requires an in-depth answer.
I hope I’ve explained the concepts of why a blockchain is needed and the incentive structure around decentralization and its benefits, as well as why tokens are needed and what drives value. With the cryptocurrency market increasingly saturated, it’s important to understand the underlying technology and principles, so you can make discerning investments, and separate the signal from the noise.
If anything’s unclear or if I’ve made any mistakes, please make a suggestion to improve this article!
Good luck, and invest wisely!
About the Author
Mathew Chan is an entrepreneur, designer, and crypto-enthusiast. He’s also the creator of MatrixPortfolio.com, a mobile app for crypto investors to track their investments effortlessly, with automatic trade syncing, and other time saving features.
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