One of the major themes in Decentralized Financed ("DeFi") is that everything can be tokenized. This article discusses what tokens are, how they are created and what's involved in managing them, using Solana as an example.
What is a Token
A token is the fractional representation of a digital whole on a blockchain ledger. Any fraction of a token's total supply can be held by an account and transferred to another account by the holder, who signs a transfer transaction with their private key.
Tokens are akin to equity or debt instruments in traditional, centralized finance ("CeFi"). Owning shares of stock means owning a fraction of a company, which comes with voting rights. Owning a bond means you have loaned money to a company, government or other entity. In both cases, there is an expectation of future cash flows in the form of dividends, interest or nominal appreciation in value. The business or government issuing stock or debt is governed by established intermediaries including regulators, exchanges, clearing houses, etc. In DeFi, tokens are the medium for any of these functions allowing investors to hold, exchange, borrow or lend tokens without any intermediary.
Tokens are also akin to currency, and just as a central bank must manage the monetary policy of their currency, the authority that issues a token must manage the supply of tokens available.
Blockchain technology provides the infrastructure for the immediate and final exchange of tokens. Tokens have been established as a fundamental building block of DeFi applications and there are a growing number of blockchain networks competing in this space.
The Bitcoin network was purpose built for the token that bears its namesake. However, the Ethereum network made it easy and popular to create myriad tokens on its blockchain with the introduction of the ERC-20 token standard. Solana's made it even easier still, and more scalable too.
How to Create a Token
Perk Labs recently engaged Jonah Group to help them create a utility (non-security) token for tracking balances of their crypto loyalty reward program. I had the opportunity to work with Benny Cheung, a Technical Architect at Jonah Group, to evaluate several blockchain networks and identify which was most suitable for Perk Lab's needs.
Solana won us over with its performance and use of the general purpose programming language; "Rust" for smart contract development. While Rust remains attractive when smart contract development is required, we soon realized that creating a token on Solana did not require any custom smart contract development; which highlights another benefit of Solana - its composability. A single instance of a Solana's core Token Program can be used to compose any token by specifying just these few properties.
- Private key of an account containing a small amount of Solana's native token ("SOL") to pay for creating the new token
- Private key of an authority account used to manage the minting or burning of tokens
- Private key of a freeze account to manage freezing or thawing token accounts that hold the token
- Decimal places a token can be quoted in (i.e. 9)
Creating a token establishes a public key representing the address to which tokens can be deposited or queried by other accounts. Once the token is created, distributed apps can use Solana's version of Web3 APIs to mint token supply, burn token supply, transfer tokens between accounts, and freeze or thaw the balance of tokens associated with accounts.
Initially, only those who know the public address of the token can find it, and no supply of the token has been minted.
Minting Token Supply
Minting creates token supply while burning tokens removes them from the total supply. The private key of the token authority account can be used to mint or burn token supply across one or more accounts.
The above properties of a token can be adjusted to allow for multiple tokenomic scenarios. To create a deflationary token like BTC, set the maximum supply and remove the authority key so no more can be created. To create an inflationary token like ETH set the maximum supply but leave the authority in place so more tokens can be minted or burned. One can also create more complex scenarios such as the disinflationary inflation model of the native Solana token, SOL which has an inflation rate of 8% that decreases by 15% each year.
A non-fungible token ("NFT") is simply a token that has a minted supply of 1 and an authority account set to null. Without an authority account, the supply is fixed so additional tokens cannot be minted and the existing token cannot be burned.
Register a Token
To make a Solana token accessible to others it must be registered on the solana-token-registry; which really is a GitHub repository with automated merging of pull requests as long as they meet a criteria.
Registering a token will populate the Solana registry with details about the token. The Uniswap token-list schema standard is used to specify details about the token such as the public address, symbol, name, logo, social media accounts and other metadata related to the token address.
Once a Token is registered, wallets and other Distributed Applications ("DApps") use APIs to resolve the details about the token.
A word of caution. Unlike the world of finance which manages CUSIP, SEDOL and other standards for unique identification of securities, the token registries associated with blockchain networks do not enforce unique symbols. In fact, the same token symbols may appear on the same blockchain networks, each representing different projects or assets. Further, the same token symbol across blockchain networks may represent the same project; or not.
Tokenomics describe the purpose of the token, how its supply will be distributed and how the tokens will be managed.
Reputable token projects will publish their tokenomics online to provide transparency for potential holders and regulators. Further, additional smart contracts may be developed to govern the supply model and make it less susceptible to arbitrary human intervention.
Purpose of Tokens
While blockchain networks are making it easy to create tokens, the challenge remaining is for a business to give a token purpose in the context of their business model. Traditional businesses trying to introduce a token are often stuck balancing reality with virtual worlds.
The Initial Coin Offering ("ICO") phase is over, since attempts to raise funds by issuing a token means regulators will view the token as a security and expect a proper prospectus be filed. There must be a purpose beyond simply raising funds.
The purpose of native tokens such as BTC, ETH and SOL are to pay fees to those contributing to the network's consensus model either as miners or stakers, who are contributing the physical infrastructure to process transactions. Meme tokens such as Dogecoin and Shiba Inu came into existence as a joke (or counter-joke) and the subsequent network effects, with free advertising from big social media names like Elon Musk, saw them take on a life of their own.
Some of the more tangible business cases for tokens are, in fact virtual, as social media sites and game makers attempt to leverage blockchain infrastructure so individuals can purchase avatars as NFTs or track a ledger of points or achievements in a digital world.
Supply of Tokens
Managing the supply of tokens available is the responsibility of the one(s) that hold the private key(s) of the authority account(s). When a token is meant to represent the value of a real world asset, holders will question its legitimacy if the token authority mints more tokens, effectively diluting the value of existing holders.
Holders of Bitcoin trust the total supply is capped at 21M and changes to that supply could break that trust. Conversely, as the Ethereum team prepares for the move from a Proof-of-Work to a Proof-of-Stake consensus model, they introduced EIP-1559 and began burning some of the ETH previously used to pay fees to miners. Existing miners were not happy to see their fees slashed, but burning tokens meant upward pressure on the price of ETH for all existing holders. Through transparent communications about why, how and when they are evolving the governance of the network, the Ethereum team has been able to maintain the trust of their community.
A token authority will need to define how the initial supply of tokens will be distributed. Some tokens may be held in reserve accounts for subsequent distributions. Other tokens may be airdropped to user accounts to establish a network of holders incentivized to participate in the token's underlying purpose. Tokens may also be allocated to liquidity pools to create trading pairs so users can swap to or from other tokens on the network.
Once tokens have been distributed across accounts, the individual account holders are free to transfer some or all of their balance to others, or use them on any DeFi or CeFi exchanges where a market exists, or to create their own market.
Operating a Token
For any business looking to incorporate a token into their business model, they will need to be prepared to disclose material updates about the token. Once live, holders of the token will expect updates on the social media sites that were listed when then token was registered.
With the myriad tokens available prospective holders need to know the token is being managed in line with its purpose.
Benny Cheung and I have each been working with blockchain technology since 2017, with a focus on Hyperledger Fabric, Ethereum and now Solana. Working with the Perk Labs team on their token project was an excellent opportunity to modernize our blockchain skills and explore some of the more modern blockchain networks.
In addition to having currencies by geographical regions, the world now has cryptos across different blockchain networks. Within each blockchain network, there is established DeFi infrastructure that supports listing, swapping, borrowing and lending of tokens. DeFi now has all the infrastructure, risks and reward structures of CeFi, but it redistributes the governance away from traditional parties, to a new network of businesses and individuals.
Originally published on https://www.linkedin.com/pulse/tokenomics-david-evans-cfa