A Model of Cryptocurrencies.pdf

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A Model of Cryptocurrencies

Michael Sockin

Wei Xiong

January 2021

Abstract

This paper develops a model to examine decentralization of online platforms through

tokenization as an innovation to resolve the con‡ between platforms and users. By

ict

delegating control to a collection of preprogrammed smart contracts, tokenization cre-

ates commitment devices that prevent a platform from abusing its users. This commit-

ment comes at the cost of not having an owner with an equity stake who, in conventional

platforms, would subsidize user participation to maximize the platform’ network e¤ect.

This trade-o¤ makes utility tokens a more appealing funding scheme than equity for

platforms with weak fundamentals. Our analysis further highlights that token prices

are determined by the marginal user’ convenience yield, in contrast to equity, whose

payo¤ is determined by the average user.

We thank An Yan for a comment that led to this paper, and Franklin Allen, Bruno Biais, Will Cong, Cam

Harvey, Emiliano Pagnotta, Aleh Tsyvinski, Haoxiang Zhu, and seminar participants at Alberta, Imperial,

ITAM, Michigan, Minnesota, NBER Asset Pricing Meeting, NBER Summer Institute, Tsinghua, UBC, UNC,

and Yale for helpful comments.

University of Texas, Austin. Email: Michael.Sockin@mccombs.utexas.edu.

Princeton University and NBER. Email: wxiong@princeton.edu.

The proliferation of the digital economy and the recent rise of the …ntech industry have

led to two important trends. The …rst is that a sizable number of digital platforms have

funded their development and operations through the issuance of cryptocurrencies or to-

kens. According to Allen, Gu and Jagtiani (2020), for instance, as of May 2020 there exist

4,136 cryptocurrencies, not including many that have failed. While rampant speculation

and volatility are often observed in this asset class, its growing popularity raises important

conceptual questions about the bene…ts and costs associated with the tokenization process

and the determinants of token prices. The second trend is the growing tension between dig-

ital platforms and their users as online platforms, such as Amazon, Google, and Facebook,

become pervasive in our everyday lives. Their large networks of users not only facilitate

monopoly power in pricing but also extensive access to users’ private data for advertise-

ment targeting and sale to third-party vendors.

These privileges are subject to abuse, as

re‡

ected by ongoing antitrust investigations into big-tech companies and the enactment of

data privacy regulations in the European Union, the United States, and Japan. Such con‡

ict

between online platforms and their users represents a unique challenge to their design and

raises questions about whether they could be disintermediated to protect consumers.

In this paper, we link these trends by arguing that tokenization represents an innovative

e¤ort to resolve the tension between platforms and users, similar to how corporate …nance

has developed governance tools to manage the classic tension between …rm managers, who

control the …rm’ operations, and …rm owners, who own the …rm’ assets. Indeed, the success

of Bitcoin, the …rst cryptocurrency to achieve unprecedented popularity across the world,

was largely built upon the notion that delegating the issuance of the cryptocurrency to pre-

coded computer algorithms would free its users from potential abuses by central bankers,

who control the supply of traditional …at currencies and may increase the supply for their

own interest but at the expense of current holders of the currency. The success of Bitcoin

has further stimulated strong interests in using cryptographical technologies to design de-

centralized platforms that delegate issues of governance and enforcement to users through a

collection of preprogrammed smart contracts, thereby preventing platform owners from abus-

ing their users. Harvey et al. (2020), for instance, provide a roadmap for how crypto-based

technologies can decentralize various aspects of the …nancial industry.

There is extensive literature exploring how online platforms’ extensive access to user data may allow

them to price discriminate users, e.g., Taylor (2004), and take advantage of users’ personal vulnerabilities

such as weak self-control, e.g., Liu, Sockin and Xiong (2020).

Decentralization through tokenization divests initial equity holders of their ownership

and control of a platform. Allocating the control to users makes it possible to prevent user

abuse. This bene…t, however, comes at the expense of removing any owner who would

subsidize user participation to maximize the platform’ network e¤ect. As network e¤ects

are essential for the success of online platforms, conventional platforms typically devote

substantial resources to subsidize user participation to amass a large user base. For example,

Google and Facebook o¤er free search and social networking services to attract users. The

equity holders of these platforms bear the initial costs of subsidizing user participation to

maximize future advertising revenue, which increases with the size of the user base.

In this paper, we develop a model to investigate the trade-o¤ induced by decentralization

between safeguarding users and subsidizing their participation in the presence of network

e¤ects. We also use this framework to address the determinants and properties of utility

token prices, which represent the most common form of tokenization in practice.

Our baseline model features an online platform that facilitates bilateral transactions

among a pool of users. There are three dates. At time

the developer of the platform

chooses to fund the platform by issuing either conventional equity or a cryptocurrency. The

choice of the funding scheme also determines the control and ownership of the platform in

the subsequent periods. At time

potential users choose whether to join the platform,

subject to a personal cost of downloading the necessary software and becoming familiar

with the platform’ rules and user interface. After joining the platform, a user can bene…t

from matching with other users to make bilateral transactions at both times

and

model a user’ transaction need by his endowment in a consumption good and his preference

of consuming his own good together with the goods of other users. As a result of this

preference, users need to trade goods with each other, which can occur only on the platform.

Consequently, there is a key network e¤ect— each user’ desire to join the platform grows

with the number of other users on the platform and the size of their goods endowments.

To provide a sharp characterization of the key conceptual issues, we focus on two archetypal

funding schemes for the platform. One is the conventional equity-based scheme in which eq-

uity conveys both control and (residual) cash ‡ rights. If the developer issues equity, it

leads to a group of equity holders that is represented by an owner who takes ownership and

control of the platform. The owner would choose to provide a subsidy at time

to attract

the marginal user, whose own transaction need is relatively low and who is otherwise not

incentivized to participate on the platform without the subsidy. The participation of the

marginal user, however, makes it easier for other users to …nd transaction partners and con-

sequently maximizes the network e¤ect. As the owner can pro…t from charging transaction

fees that increase with the transaction surplus on the platform, he would internalize the

participation cost of the marginal user by providing a subsidy to all users. Control of the

platform, however, also allows the owner to abuse users at time

after the platform collects

extensive user data at time

We consider a particular form of user abuse— the owner may choose a subversive action

(such as pursuing aggressive advertising strategies or selling user data to third parties, as is

sometimes observed in practice), which bene…ts the owner at the expense of all users. Intu-

itively, the owner would choose this action only when the transaction fees from the platform

fall below the gains from abusing its users. Interestingly, while choosing this subversive ac-

tion may bene…t the owner ex post at time

the owner is strictly better o¤ ex ante at time

if he can precommit to not taking such an action, because anticipation of the owner’ taking

the subversive action discourages potential users from joining the platform initially, and this

abandonment is magni…ed by the network e¤ect. It is impossible to precommit under the

equity-based scheme, as the owner can always choose to reverse any previous commitment

at time

This demand for precommitment motivates tokenization.

Alternatively, the developer may adopt a token-based scheme by issuing utility tokens,

which are widely used in practice and considered the canonical crypto-based tool for de-

centralization. While utility tokens also confer voting rights to holders, similar to equity,

they are a claim to the platform’ services and not to its (residual) cash ‡

ows. Under this

token-based scheme, the owner sells tokens to users to participate on the platform instead

of charging fees. By cashing out from issuing tokens to users who join the platform at time

the developer leaves control of the platform at times

and

to users through precoded

algorithms, which can conveniently foster a precommitment not to abusing users by requir-

ing their consent. Although users, as the holders of the tokens, can vote on changes to the

platform and these algorithms, they would not agree to adopt any action that would hurt

themselves. This captures the key appeal of tokenization— giving ultimate control of the

platform to users through decentralization. This bene…t, however, comes at the cost of not

having an owner with an equity stake who would subsidize user participation to maximize

the platform’ network e¤ect.

A comparison of these two schemes leads to several key insights: First, the token-based

scheme with utility tokens is more appealing for platforms with relatively weak demand fun-

damentals (i.e., aggregate transaction needs by users). Under the equity-based scheme, users’

concerns about the owner subverting the platform are particularly high when transaction fees

to the owner are low, which makes the precommitment created by tokenization particularly

valuable. Consistent with this observation, we show that for a given level of concern about

user abuse, user participation, developer pro…t, and social surplus are all higher under the

equity-based scheme when the platform fundamental is su¢ ciently high; for a given level of

platform fundamental, in contrast, user participation, developer pro…t, and social surplus are

all higher under the token-based scheme when the concern about user abuse is su¢ ciently

high. This dichotomy leads the developer to choose the token-based scheme when his prior

belief about the platform fundamental is relatively low. Such a stark implication is con-

sistent with casual observations of the high failure rates of tokenized platforms and can be

systematically tested by future empirical studies. More generally, our analysis suggests that

decentralization is desirable on platforms for which the tension between owners and users is

su¢ ciently severe.

We acknowledge that tokenization requires implementing a certain consensus protocol to

accomplish the intended decentralization, which is challenging in practice and may intro-

duce con‡

icts between users and record keepers, who record and validate transactions on

blockchains, and even con‡

icts among record keepers. As such con‡

icts are not our focus,

we take as given the frictionless implementation of a consensus protocol to focus on how

the resulting decentralization from tokenization a¤ects user participation and welfare. Al-

though we abstract from these important issues, our analysis highlights a key trade-o¤ that

decentralization introduces between empowering users with control of digital platforms and

subsidization of their participation. More sophisticated token arrangements may be able to

better balance this trade-o¤ than utility tokens. We nevertheless note that this key trade-o¤

can reemerge in new forms under alternative token arrangements,

as well as through the im-

plementation of the consensus protocol.

As digital decentralization represents a promising

For example, by conveying both control and cash ‡ rights, equity-like tokens may incentivize some

holders who may not be major users of the platform to amass enough tokens to collect rents from e¤ectively

becoming owners, which would reintroduce the con‡ between owners and users.

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See Section 1.4 for a review of the burgeoning literature that analyzes the e¢ ciency and economic

consequences of alternative consensus protocols. A particular concern is that record keepers may gain

concentrated control of the platform under certain consensus protocols, thereby e¤ectively becoming owners

and reintroducing the con‡ between owners and users.

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