Token Economy: Money, NFTs & DEFI

By Shermin Voshmgir

Token Economy that has been a bestseller since its first edition in 2019. The first two editions were published as one book. This third edition has expanded in scope and depth and has been published as three separate books. Money, NFTs and DeFi is the first of three books in the Token Economy Series. Tokens that

• Language: English
• Publisher: Token Kitchen
• Release date: Apr 14, 2023
• ISBN: 9789899157064

Book preview

Imprint

Token Economy: Money, NFTs & DeFi

Third edition, 2023

The first edition was published in June 2019 under the title Token Economy: How Blockchain & Smart Contracts revolutionize the Economy and had two amended editions. A second revised edition with four additional chapters was published in June 2020 with a modified subtitle Token Economy: How the Web3 reinvents the Internet. This third edition has expanded in scope and depth compared to previous editions and is being published as three separate books that constitute the Token Economy Series. The other books in this series are titled DAOs & Purpose-Driven Tokens and Web3 Infrastructure.

Author: Shermin Voshmgir

Publisher: Token Kitchen, operated by Labirinto Eclético Unipessoal, Lda. Estrada do Garro 1649 Varche, 7350-123 Elvas, Portugal

https://token.kitchen

Design: Justyna Zubrycka

Production: Caroline Helbing

Copy edit: Constanze Huther

Cover & layout: Carmen Fuchs

eBook ISBN: 978-989-9157-06-4

Paperback ISBN: 978-989-9157-04-0

Hardcover ISBN: 978-989-9157-05-7

Audiobook ISBN: 978-989-9157-07-1

An open access version is available on Github: https://github.com/Token-Economy-Book/

Copyleft 2023, Shermin Voshmgir: Creative Commons - CC BY-NC-SA: This license allows reusers to distribute, remix, adapt, and build upon the material in any medium or format for noncommercial purposes only, and only so long as attribution is given to the creator. If you remix, adapt, or build upon the material, you must license the modified material under identical terms. For commercial permissions contact: [e-mail]

Table of Contents

Imprint

Table of Contents

About the Author

Acknowledgements

Other Books in the Token Economy Series

Preface

Tokens

History of Tokens

Web3 Tokens

Properties of Tokens

Non-Fungible Tokens

Chapter Summary

References & Further Reading

Money & Credit

Separation of Money and State

History of Money & Types of Currencies

Properties of Money

Fractional-Reserve Banking: Money as Debt

Redefining the Concept of Money and Value Creation

Chapter Summary

References & Further Reading

Stable Tokens: Money with a Stable Value

Inflation & Exchange Rates

Fiat-Collateralized & Commodity-Collateralized Stable Tokens

Crypto-Collateralized Stable Tokens

Algorithmic Stable Tokens

Central Bank Digital Currency

Interdependencies & Building Blocks

Impossible Trinity

Challenges & Outlook

Chapter Summary

References & Further Reading

Asset Tokens & NFTs: Money with Attributes

Use Case 1: Security Tokens

Use Case 2: Real Estate NFTs & Fractional Ownership

Use Case 3: Art NFTs

Use Case 4: Collective Ownership & Micro-Investments

Use case 5: Energy Tokens

Use case 6: Data Tokens

Use Case 7: Attention Tokens

Use Case 8: CO2 Tokens

Chapter Summary

References & Further Reading

Decentralized Finance (DeFi)

History of Finance & Potentials of DeFi

DeFi vs. CeFi

Composability & Money Legos

Challenges of DeFi

ReFi, MachineFi & DeSci

Bankable Funds & the Future of Finance

Chapter Summary

References & Further Reading

Token Sales

History of Token Sales

Initial Exchange Offerings (IEOs)

Airdrops

DAICOs, SAFTs & SAFEs

Issuance Mechanics & Clauses

Chapter Summary

References & Further Reading

Token Exchanges & NFT Marketplaces

History of Exchanges – The Wild West Times

Centralized Exchanges (CEX)

Decentralized Exchanges (DEXs) aka Automated Market Makers (AMMs)

Challenges of Decentralized Exchanges

The Interoperability Challenge

NFT Marketplaces

Chapter Summary

References & Further Reading

Tokenized Credit & Lending

Tokenized Lending

Tokenized Borrowing

Over-Collateralization

History of P2P Lending Protocols

Flash Loans & Flash Attacks

Staking

Challenges & Outlook

Chapter Summary

References & Further Reading

Tokenized Derivatives, Synthetics & Insurances

Types of Derivatives & Perpetual Contracts

Purpose of Derivatives

Synthetics

Challenges & Outlook

Chapter Summary

References & Further Reading

How to Design a Token System

Technical Engineering

Economic Engineering

Ethical Engineering

Legal Engineering

Conclusion

Chapter Summary

References & Further Reading

About the Author

~

Shermin is the founder of Token Kitchen and BlockchainHub Berlin. In the past, she was the director of the Research Institute for Cryptoeconomics at Vienna University of Economics, which she also co-founded, and a curator of the infamous project  TheDAO back in 2016. She is currently setting up a data driven farm in Portugal with her partner where they investigate how to tokenize agricultural assets and sustainable ecosystem services such as soil quality or CO2 capture with the support of hardware wallets and sensor technology. Shermin studied Information Systems Management at Vienna University of Economics and film-making in Madrid. Under her pseudonym KAMIKAT.SE she has also created a series of audiovisual works. She is Austrian, with Iranian roots, and now lives in Portugal where she works at the intersection of technology, agriculture, art & social science.

Acknowledgements

~

I would like to express my deepest gratitude to my partner Tom Fuerstner for encouraging me from the very first edition to write this book, and also for his continuous input and feedback along the various iterations of this book.

For this specific volume I would furthermore like to thank Jakob Hackel, Quentin Botha, Peter Kaas, Valentin Kalinov and Agustina Perez Comenale for all the input and feedback – without them, this book would not have the same level of quality and depth. Both Valentin and Peter merit special gratitude for their ongoing contributions since the first edition and all previous activities that influenced this book.

I would also like to mention the people who have inspired or supported me from the very beginning of the crypto journey and who have contributed with input and feedback to previous iterations of what has now become the Token Economy Series: Peter Kaas, Valentin Kalinov, Jakob Hackel, Alfred Taudes, Michael Zargham, Justyna Zubrycka, Caroline Helbing, Kris Paruch, Susanne Guth, Guido Schäfer, Sofie Schock, Katja Nettesheim, Nina Siedler, Robert Krimmer, Markus Sabadello and all the advisors and collaborators of BlockchainHub, including my dear friends from Lunar Ventures. I am also grateful for all the people who supported the creation of the Cryptoeconomics Research Lab at the Vienna University of Economics, and who believed in the necessity of dedicated interdisciplinary research on this topic.

I am especially grateful for the hospitality and open environment of the Ethereum Office in Berlin, who offered us shelter in their co-working space when setting up the BlockchainHub, and the open mind of all the people involved in post- TheDAO hack activities, working 24/7 to find a solution to recover depleted funds, which taught me a great deal about open-source software development and bug fixing in decentralized networks.

Last but not least I would like to thank all those voluntary contributors who – over the scope of 2021 – collectively translated the book into nine languages, all of which are accessible for free on Github.

~

Shermin Voshmgir

March 2023

Other Books in the Token Economy Series

~

Token Economy: Web3 Infrastructure

The purpose of this book is to explain the paradigm shift between Web2 and Web3 on an infrastructure level of the Web and how this will affect the application landscape that builds on it. It gives an introduction to the basic principles of Web3, explains why the emergence of the Bitcoin network was a game changer, and outlines the fundamental building blocks of Web3 from a technical, economic and political perspective. The book caters to a general audience with a non-tech background and aims to give an overview over the topic without going into all the technical details. The chapters in this book cover the following topics:

* Tokenized Networks: Web3, the Stateful Web

* Token Management: Bitcoin & Its Origins

* Token Management: Other Blockchain Networks

* Token Security: Cryptography & Wallets

* Token Privacy: Privacy by Design for Web3

* Who Controls The Tokens? User-Centric Identity-Systems

* Token Contracts & Token Types

~

Token Economy: DAOs & Purpose-Driven Tokens

The aim of this book is to conduct an in-depth analysis of how purpose-driven tokens can be designed to steer the individual actions of participants of a decentralized network towards a collective goal. The first part of this book will explain how smart contracts can encode and algorithmically enforce the governance rules of complex agreements to create a Decentralized Autonomous Organization (DAOs), and why DAOs are a new form of institution over the Internet. The second part introduces an analysis framework for the design of purpose-driven tokens that steer DAOs - by analyzing the stakeholder types, stakeholder structures, as well as all relevant token types and their properties of a variety of use cases. The chapters in this volume cover the following topics:

* Institutional Economics of Web3 Networks & Other DAOs

* Governance of Web3 Networks & Other DAOs

* Use Case: Bitcoin - The P2P Payment Network

* Use Case: Helium - P2P Telecommunication Network

* Use Case: MakerDAO - The Dai Stable Token System

* Use Case: Biodiversity Tokens: Rebalance Earth

* Use Case: Data Tokens: Ocean Protocol

* Use Case: Social Media Tokens: Steemit, Hive & Reddit

* Other Use Cases

* How to Design a Token System

Preface

When writing the first and second edition of Token Economy, my focus was on getting the scope of all related topics right. When I started working on the third edition, I expected that updating the book would be a lot of work – but not as big a task as writing the first edition. However, as soon as I started working on the third edition I got overwhelmed by the scope and depth of the amendments that I thought were necessary. As a result, the book was getting thicker and thicker and I was way off of my self-imposed schedule. Updating the schedule did not seem to help: the more I pushed deadlines, the more topics I thought were necessary to cover. Eventually I came to realize that my task was quite different this time – I would not only need to widen the scope, but also go deeper. The book grew to such an extent that I had to divide it into three separate volumes. All three volumes stand independently from each other and cater to the individual needs of a reader: "Web3 Infrastructure, Money, NFTs & DeFi, and DAOs & Purpose-Driven Tokens."

Criticism can be hard to take, and this is certainly also true for me. But still, it was the feedback from my most critical readers which turned out to be the most useful in identifying where my analysis was missing depth, especially regarding this book in the Token Economy Series. I realized that if I replace the term criticism with feedback in my head, then I might actually get some valuable insight, no matter the tone of the feedback. It was not a smooth learning curve – when I first read the negative review that motivated me to rewrite the Money chapter, I doubted myself and wanted to throw in the towel. At that point I was exhausted. More than two years had passed since I had finalized the previous edition of the book, which was slightly before the first DeFi boom and bust cycle, so there was much new territory to cover about the rapidly emerging DeFi space. Blockchain years seemed to pass like dog years. While objectively the book is just two years old, to industry insiders it might feel like 14 years, and who in their right mind wants to read a 14-year-old book about an emerging technology?

At this point in my writing process, reading a relatively extensive and critical review on the previous edition of the book blocked me even more. After a while however, I realized that the review was not so negative after all. I was just thrown off by the tone of the review, which I perceived as angry. Then it occurred to me that this anger might also be rooted in disappointment – maybe my book had just failed to give that particular reader the information they had been looking for. This realization gave me the renewed perspective and stamina to deal with the challenge of making the extensive changes and amendments which were necessary for this third edition. I also realized that I needed to start by rewriting one of the most important chapters in the whole book – the chapter on money. This one particular critical reviewer helped me understand that I was conveying a very narrow perspective of money, even though my intention in writing the book was quite the opposite. I further realized that the history of money and the history of credit are deeply intertwined and cannot be told separately from one another, which is why I changed the chapter title to Money & Credit.

As money has become an increasingly native feature of the Internet, easily programmable with a few lines of code, the chapter on money and credit is a cornerstone to understanding the scope of tokenization and the different shapes in which money can potentially be deployed and used, including the financial applications that build on top on these new forms of money. The general question that this volume of the Token Economy Series tries to answer is: How will tokenization impact not only our monetary systems, but also our financial systems and the real economy and can so-called cryptocurrencies and other tokenized assets replace money as we know it? In public debate, these questions usually lead to highly contentious discussions and the arguments very often depend on one’s definition of what actually constitutes money. Discussions about what real money is often seem to have an almost religious dimension, where arguments are based on ideology or semi-knowledge.

One of the greatest challenges for understanding the impact of Web3 and tokenization is that financial literacy is not taught in most schools across the globe. Most students who finish high school and even college have little to no idea what money is, where it comes from, and how financial markets work. The lack of financial literacy creates considerable information asymmetries when it comes to making sound financial decisions, and might be one of the reasons why retail investors with little financial experience are more prone to being scammed by malicious actors. Unfortunately, the history of financial markets is full of such examples, and it is no different in crypto. How can people make wise investment decisions if financial literacy is so often insufficient or even non-existent, even among those who work in the banking sector? While I believe that financial market regulation plays an important role in customer protection, the first step should be breaking the cycle of ignorance and introducing financial literacy classes for children from a relatively young age, and making sure that even those who do not finish high school have access to this information.

Having studied business administration at Vienna University of Economics, I graduated from college in 1998 without really understanding what money is or where it comes from. While we were taught certain aspects of money in some economics classes, such as the different classifications of government issued money (M1, M2, M3, etc.), I was clueless about the history of money, the different types of money, or the fact that modern fiat money is in fact not printed or coined, but predominantly created by private banks via the issuance of credit. International friends and acquaintances, who also graduated from business and economics schools across the globe, seem to have had similar experiences. The level of financial literacy I have today is almost entirely based on personal research and everything I learned over the last two decades, and only marginally based on what I studied at university 30 years ago. My self-taught financial literacy has grown exponentially ever since I had to wrap my head around Bitcoin, Web3 and tokenization.

The overall lack of financial literacy in the general population also impacts how media outlets cover the topic of Bitcoin, Web3 and its applications. Over the scope of my career I have given hundreds of interviews to journalists, often from traditional media outlets. The experience was mostly frustrating, because in order to be able to explain Web3 and its tokenized applications, I not only have to explain how the Internet works before I can explain Web3, I also have to explain what money is before I can get into the actual questions around cryptocurrencies. There is usually not enough time to do this, and even when there is, only a negligible part of what I say gets printed or quoted by traditional media outlets. The intention of this book is, therefore, to give an overview of the concept of money and credit, including the history, types and functions of money before we deep-dive into different use cases of tokenized currencies, tokenized commodities, and a range of tokenized assets of the digital and real economy – that may or may not include inbuilt stability mechanisms, and may or may not be fungible.

This book will first introduce core concepts of tokenization, before delving into the question of what constitutes money and credit. Both chapters provide an important foundation from which we can then analyze various use cases for fungible and non-fungible tokens that represent different types of assets. Later chapters will introduce the concepts of financial markets and analyze how asset tokens can be used as collateral in a growing ecosystem of tokenized financial applications – ranging from DeFi (Decentralized Finance) to CeFi (Centralized Finance).

The technical and political aspects of blockchain networks and core Web3 infrastructure will be discussed in another book of the Token Economy Series titled Web3 Infrastructure. Tokens that are designed to incentivize an autonomous group of people to individually contribute to a collective goal, and are minted upon proof of a certain behavior, will be the subject of the third book titled: DAOs & Purpose-Driven Tokens.

Tokens

Tokens are cryptographically secured digital certificates that are collectively managed by all nodes of a blockchain network or similar distributed ledger, and in their simplest form just require a few lines of code. They can be seen as the atomic unit of Web3. They are publicly verifiable and globally valid digital certificates – they transcend the established certification authorities that often only operate in a single jurisdiction. Tokens are rights management tools that can represent anything from a store of value to a set of permissions in the physical, digital, and legal world. Their effect on the financial world might ultimately be similar to the effect the Internet had on the postal system.

~

While the existence of tokens in general and digital tokens in particular is not new, the speed with which these Web3 tokens are being deployed and issued is an indicator that these tokens might be the main application of blockchain networks and Web3. As of February 2023, an ecosystem of over 8810 publicly traded fungible tokens are listed on "Coinmarketcap, and a total of over 762,014 different fungible token contracts and around 150,000 non-fungible token contracts have been issued on the Ethereum main network which – at the time of writing – still seems to be the blockchain network upon which most Web3 tokens are being issued. Web3 tokens are cryptographically secured digital certificates which are collectively managed by the participants of a blockchain network or similar distributed ledger. As such, they are the atomic unit of Web3. All nodes in the network have the same core information¹ about who owns which tokens, and the transfer of all tokens – also referred to as state changes" – are collectively managed. Depending on the type of network, different nodes might have different permissions and tasks in a blockchain, but they all contribute to the collective management of tokens in one form or another.

On the Ethereum network and similar smart contract-based networks, tokens can be issued with just a few lines of code via a token contract. A token contract is a special type of smart contract that serves as a design template. The predefined token properties can be adjusted depending on what type of token one wants to create. Token contracts are rights management tools that can represent the ownership rights to any existing digital or physical asset. Tokens can also be programmed to include access rights, usage rights, voting rights or management rights. Simple tokens represent just one set of rights. More complex tokens can come with several rights attached to them – such as a token that represents the property rights of an asset and also includes voting rights and/or management rights that are attached to that asset. Tokens can, therefore, represent a set of permissions in the physical, digital, and legal world that facilitate social and economic collaboration across various jurisdictions over the Internet.

While digital assets and access rights are not a new thing, they have traditionally been managed and controlled by centralized entities on private Internet infrastructure. Web3 tokens are digital certificates that can be easily issued, transferred and verified on a public Web3 infrastructure without the need for traditional intermediaries or escrow services. The ability to deploy tokens relatively effortlessly and at a low cost on public infrastructure is a game changer, because it makes it economically feasible to represent many types of property rights, access rights, voting rights or management rights in a digital way which might not have been feasible before. Due to the publicly verifiable nature of token transactions, it is now possible to guarantee accountability for social and economic interactions between market participants.

While more and more people are starting to issue or invest in cryptographic tokens, the general understanding of different token types is still limited. To add to the confusion, terms like cryptocurrency, crypto assets, and tokens are very often used synonymously. The media tends to refer to these new assets as cryptocurrencies, which is often used to describe a diverse range of crypto assets or tokens that could represent anything from a physical good, a digital good, a security, a collectible, a royalty, a reward, a concert ticket or a driver's license. Of course a lack of clear, agreed-upon terminology and definitions is quite common in emerging domains such as Web3 – but for informed decision-making and a robust public discussion of the subject matter, we require precise language and terminology. It is important to understand that, at the time of writing this book, different people are using a set of overlapping terms to refer to more or less the same thing, which generates much confusion in the public discourse.

The term cryptocurrency is not ideal as a general term, since many of these new assets were never issued with the intention to be used as money in the first place. Crypto asset would be a more generic term, but it only works for tokens that stand for some form of property right. The term token has become more widespread, seems to be more generic and can be used to describe all forms of rights, not only property rights. This chapter will, therefore, try to clarify the nuances between these terms by giving a brief overview of the history and different properties of Web3 tokens.

History of Tokens

Tokens are not a new thing and have existed long before the emergence of blockchain networks. They have represented a range of economic values or access rights over history. Shells and beads were probably one of the earliest types of tokens used, and the list of tokens we have come to use on a daily basis is long. Casino chips, vouchers, gift cards, bonus points in a loyalty program, coat-check tokens, stock certificates, bonds, club-entry tokens represented by a stamp on your hand, ID cards, club memberships, and airline tickets are all examples of modern types of tokens. Most of these tokens come with some form of inbuilt anti-counterfeiting measure, which may be more or less secure, in order to prevent people from cheating the systems the tokens are being used in. Paper money or coins are also examples of analogue tokens. Tokens are furthermore used in computing, where they can represent a right to perform an operation or manage access rights. A web browser, for example, sends tokens to websites when we surf the web, and our phone sends tokens to the telecommunications system every time we use it. A more tangible form of a computer token would be a tracking code of a parcel, or QR codes that represent access rights to trains or planes. Tokens have also been used as a reward mechanism in cognitive psychology, as a positive reinforcement method of incentivizing desirable behavior in patients in a hospital setting, or potential consumers by companies through loyalty programs. Airline bonus points that reward consumers for each flight mile and that can then be redeemed for other goods or services are the best example for incentive tokens in the real world.

Real life objects can also represent tokens, for example in the context of recycling. In some countries, such as Germany, any bottle you buy in the supermarket is issued with a recycling value of usually a few cents, which is printed on the bottle. When you return the bottle, the recycling value is reimbursed by collecting institutions such as supermarkets. Losing the bottle is, therefore, equivalent to losing money. This recycling value is paid on top of the initial price of the product and has become a method for governments to encourage the recycling of materials and subsequent reduction of litter in public places. A garbage bag could also be a token. In the Netherlands or some parts of Switzerland, for example, you can’t just throw out your trash using random bags. Instead, you have to buy special-purpose plastic bags that include a dumpster fee, issued by local authorities, and you can only use those bags to dispose of your trash. As opposed to most other countries, where you pay your garbage bill monthly as part of your utilities bill tied to the rent of your apartment or house, this system requires you to purchase a special-purpose tokenized bag.

Whether analogue or digital, tokens always need a substrate that ensures their validity, including inbuilt anti-counterfeiting measures to prevent double spending and other forms of counterfeit. Historically, tokens have been issued and managed by centralized entities to ensure validity, and have had security mechanisms built into their substrate. Central banks issuing coins and bills, for example, need to make sure that the currency they issue is difficult to replicate so that counterfeited money is easily detected by its recipients. The same is true for an institution issuing tickets to a concert, other type of event or public transit.

Web3 Tokens

Web3 tokens can be used in all of the above-mentioned cases. They are publicly verifiable and globally valid digital certificates that transcend the boundaries of established certification authorities, which often only operate in a single jurisdiction. The rights attached to a Web3 token are encoded into the token contract and can be enforced by the holder of that token using a wallet software. The validity of a Web3 token is secured by the consensus mechanisms of the blockchain network upon which a token has been issued. In fact, consensus mechanisms of blockchain networks are designed to provide an anti-counterfeiting mechanism for token transfer over the Internet. Bitcoin’s Proof-of-Work was the game-changing innovation because – for the first time in the history of the Web – it introduced a reliable native anti-counterfeiting mechanism for digital values over the Internet, and subsequently paved the way for other blockchain networks and Web3 networks to emerge.

Web3 tokens don’t manifest as digital files; instead, they show up as an entry in the ledger and are mapped to a blockchain address which represents the blockchain identity of the token holder. Tokens are therefore only accessible with a dedicated wallet software that communicates with the blockchain network and manages the public-private key pair related to the blockchain address. A Web3 wallet or crypto wallet is a blockchain client that runs on your device. It contains your private key with which you can authenticate yourself as the owner or custodian² of the token. The private key is necessary for successful authentication of being the rights owner, before one can access the respective tokens and exercise the rights attached to the token. If the token represents an asset, the owner can initiate transfer of the token by signing with their private key. If the token represents an access right to somebody else’s property, the owner of that token can initiate their access right by signing with their private key. The same applies to tokens that represent voting rights or management rights. (The technical aspects of Web3 wallets and their cryptographic mechanisms are discussed in depth in another volume of the Token Economy Series titled Web3 Infrastructure.)

The first blockchain tokens were the native tokens of public and permissionless blockchain networks such as the Bitcoin network – these are also referred to as protocol tokens. In the very early days of crypto, each blockchain network only had one token, and