Why DOT's token design is sustainable and maximizes community benefits

Recent research by the Web3 Foundation research team on utility tokens shows that unlike centralized web2 platforms that focus on platform benefits, decentralized utility token ecosystems are generally more efficient, thereby providing optimal services to all ecosystem participants. The study also highlighted the conflict of the “utility token impossible triangle” and proved that Boca's utility token model is sustainable, thereby optimising the entire community of online participants.

As defined by FINMA in a guide published in February 2018, a utility token is “a token designed to provide digital access to an application or service through blockchain-based infrastructure.”

The service provided by Polkadot consists of parachain slots, which have shared security and technical means of communicating with other parachains in the network. To get one of these slots, users (teams built on Boca) need to stake DOT to participate in recurring auctions.

For many utility token-based projects, the most common practice is to have each utility token native to its own blockchain. This means that these tokens are needed not only when consuming services, but also when motivating network nodes to provide consensus services. This dual role raises delicate design issues, which I also discussed in my recent research paper “Utility Token Design”: https://ssrn.com/abstract=3954773.

In this paper, I analyzed the dynamic general equilibrium model of the proof-of-of-stake blockchain's native utility token. In the past, the dynamic general equilibrium model was used to explain supply and demand relationships in an overall economy. The utility token market and the economy as a whole share some characteristics because they all have their own users, producers (mainly network nodes that “produce” blockchain security), and incentives.

I have mainly observed the dynamic principles of utility tokens from two aspects. First, I found that the utility token system usually works because it leads to the optimal distribution of services in society. Second, I discovered a conflict between the dynamic principles of the value of utility tokens, the evolution of the services provided, and the motivational details of users.

This section describes the theoretical framework for a general utility token ecosystem. Readers who aren't interested in technical details can skip ahead and go directly to the next section where the conclusions are discussed.

I built a dynamic model of utility tokens on a bilateral platform. A platform is a special kind of marketplace that aims to bring together different types of market participants to enable them to realize online benefits. Traditional platforms include UBER (matching drivers and passengers) and Amazon Marketplace (matching sellers and buyers).

In my model, the platform is responsible for developing and maintaining software (commonly known as a runtime in blockchain terminology), which is required to provide services, and is run by validators. To cover the cost of doing so, the platform needed to repeatedly sell utility tokens on the market.

One aspect I'm considering is that the platform has a fixed number of users who reuse tokens to spend some services. Consumption is competitive, and the share of consumption benefits obtained by one user in the total tokens provided by all users is constantly increasing. Basically, the throughput of any blockchain network is limited, but the more tokens you hold, the higher your chances of getting a service result, such as a parachain slot on Polkadot.

On the other hand, there are a fixed number of validators who are rewarded for providing security and need to sell part of the rewards over and over to cover the costs. However, validators never want to give up all of their tokens. They faced a trade-off as their share of rewards increased their share of the total token holdings of all validators. This reflects the proof-of-stake nature of the blockchain: the rewards you get as a validator are directly proportional to your share of the network.

The model assumes that the token ecosystem is in long-term equilibrium. This means that the number of participants on the network remains the same over time, and there is no speculative use of tokens. In other words, the token is only used to consume the platform's services.

The resulting utility token value plays an important role in this scenario because it requires balancing user and validator incentives. If today's price is too high compared to tomorrow's, then users will only buy a few tokens to enjoy the service, validators can't cover their infrastructure costs, and the network will crash. On the other hand, if today's price is too low compared to tomorrow's price, then validators may not be able to make enough money from selling the tokens. As users expect the value of blockchain services to grow rapidly over time, the value is likely to increase. When blockchain platforms need to sell too many tokens due to the high cost of maintaining the blockchain in the future, the value may drop.

The platform has several options to influence the supply and demand for tokens. First, it can set staking rewards to be distributed each round. Second, it can set the quality of services, thereby regulating users' consumption efficiency. Third, the platform can decide whether the tokens proposed by the user are bound (that is, returned after each round, such as Polkadot) or spent (deducted from the tokens held by the user, such as many smart contract chains).

The balance in this setup is token value and the mutually optimized strategies of users, validators, and platforms. Any balance must have a constant staking rate, which is a requirement of the Proof-of-Stake blockchain for security reasons.

The most important finding is that even if blockchain platforms are modeled as monopolists on both the user side and validator side (that is, they do not face competition from other platforms), there is still a balance point to select the best service level in society. In other words, by choosing the level of service that is optimal for everyone, the platform chooses the level of quality that is also the best for everyone.

Given what we know about classic bilateral platforms, such findings might come as a surprise. Typical two-sided platforms include UBER, Amazon, and the iOS App Store. All of these platforms match both sides of the market (drivers and passengers, merchants and consumers, app developers and users) to achieve revenue through network effects. However, we note that it is generally not in the interest of the platform to realize all the benefits. Conversely, platforms are known to distort the price and/or quantity of their services, thereby reducing the benefits for platform participants while maximizing the benefits of the platform.

However, if we are aware of the effects of decentralization, then the discovery that the utility token ecosystem produces effective results is less surprising. One characteristic of utility token platforms is that the price of the service is not fixed by agreement, but is determined competitively by users. In Boca, the number of tokens required to obtain a parachain slot is determined in an auction; in Ethereum, the user's additional tip to the transaction determines the processing speed of the transaction in the block.

If the platform has no influence on the price of its services, then it will seek to make the best choices in terms of the quality of services offered. The paper's main contribution was to show that there is an effective competitive balance. Technically speaking, this is achieved by formulating balanced strategies for validators and users. Under these strategies, validators and users adjust their token usage decisions, so that their utility remains unchanged in terms of service quality, leading the platform to choose service quality that maximizes overall benefits.

The paper's second main conclusion, “Utility tokens are impossible triangles,” describes a possible equilibrium set. The impossible triangle indicates that only two of the following three characteristics can be balanced: (i) user token binding, (ii) constant token value, and (iii) constant value of services provided.

Intuitively, if characteristics (ii) and (iii) hold, then the optimal amount of tokens a user can hold today is the same number of tokens they want to hold tomorrow. Now, if on top of that, users also retrieve their tokens after spending (this is a result of characteristic (i)), then users won't need tokens. But this in turn means that neither validators nor blockchain platforms are profitable.

This result means that, in fact, we can only expect at most two of these three characteristics to be present in a practical design. A design with all three features won't work. However, from a realistic token design perspective, each of these three features may have its own value.

First, consider value stability. The reduced value can be offset to some extent by improving the quality of service over time, or by removing some users' tokens from circulation in each round. Either way, from a psychological point of view, a business model built on value stability definitely has some appeal — certainly more appealing than well-known platforms that constantly dilute the value of their tokens.

Second, consider token binding. Under the binding plan, the user's tokens for purchasing services are locked at the time of purchase and then returned. As a result, their holdings won't decrease over time, which in turn may give users a better idea of what they can do with the tokens. Furthermore, bundling can be used as an alternative to pledging; similar to a pledged token, a bound token represents the direct participation of its holder in the ecosystem and reduces liquidity in circulation, so it is valuable from a security perspective.

Finally, consider the constant quality of service. Having a constant blockchain value is a natural requirement for many projects: business models that rely on declining value propositions may raise questions, while business models that rely on growing blockchain value may also raise sustainability issues. In particular, people may worry that the cost of providing an ever-improving quality of service may grow too fast to be sustainable.

The main conclusion of the above results is that Boca's general setup is sustainable. The token value reflects the share of services DOT can buy. Token requirements generated by parachain auctions will be met by the supply of validators to maintain the normal operation of the system.

Another general conclusion is that there is no need to worry about decentralized platforms like Boca abusing their power. The reason is as follows: since such platforms do not set clear prices for their services, but rather allow their users to compete, anti-competitive pricing behavior cannot be specified in design. As a result, the question becomes whether the platform will provide an inefficient quality of service. The analysis in the paper suggests the answer is no. Specifically, the paper shows that there is a state of equilibrium. In this state, choosing the best service quality in society conforms to the platform's maximum interests.

It is now clear that Boca does not have a single platform designer, but is led by the community and has clear governance processes. Although this part is abstracted in the model, the conclusion is still valid. We can think of platform designers as a third group of stakeholders, software developers, who work with users and validators to decide on the further development of the service and then implement these community decisions. The analysis showed that the developer's overall goal is in line with that of users and validators: maximizing community output. Of course, how the generated surpluses are distributed among the various stakeholders depends on governance.

One indication that Boca does provide users and validators with more incentives than is needed to keep the system self-sufficient is that it uses a binding scheme to bid in parachain auctions. The analysis in the paper shows that the optimal balance of platforms (that is, the balance that maximizes platform profits) does not involve binding user tokens. (The reason is that if a user's tokens are tied rather than spent, then the demand for tokens on the user side will be reduced, which is bad news for platforms that need to sell tokens.) Therefore, Boca must be in an equilibrium different from the platform's optimal balance. But that meant that Boca added value and went to the right place: with the community.

Practical Token Design Paper Link: https://ssrn.com/abstract=3954773.

To learn more about the Polkadot Native Token DOT, visit Polkadot Wiki: https://wiki.polkadot.network/docs/learn-DOT

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