The common threads that unite successful protocols is that they have limited restrictions on participating, are open and interoperable and are impartial to who uses them. Once protocols are successful, they generate network effects that sustain them and encourage their growth.
Participants in blockchain networks also essentially have to make an investment, however small, in the network in order to participate. This stake may include, but isn’t limited to downloading and running the blockchain network software to validate transactions (which requires a resource investment of processing power/energy); buying the protocol’s native cryptocurrency (which requires monetary expenditure); or spending time in assisting with community governance, code contribution or marketing and promotion.
These factors reinforce lock-in, making it extremely challenging to switch to competing ones, regardless of their relative performance.
As blockchain protocols solidify themselves as industry standards and become increasingly difficult to challenge as standard protocols, they make possible new ways for businesses to create value by innovating at the application layer of a blockchain network, using tokens.
Tokens on blockchain networks provide a new way to bootstrap networks and to bolster and intensify positive network effects. As denominators of value — whatever that value is, from monetary equivalent to voting rights — they can be used to incentivize participation, both in the early days of a network and, if structured properly, over the long-term life of a network as well.
In addition to serving as “stakes” in the network, tokens can be used to coordinate network activity, through instructions programmed into their code. These can include rewards for loyalty, staking requirements for participation or access, as well as disincentives (penalties for bad acting) and more.
Token network effects occur when the value of a network’s tokens appreciates as the network grows, in turn reinforcing network value and accelerating that growth. Successful tokens also compound the network effects of the protocol a blockchain network is built on, and vice versa. More people will be attracted to build on a blockchain protocol if it has other successful tokens; the more successful tokens that are built on top of a blockchain protocol, the more value the blockchain protocol accrues. When blockchain networks are able to align incentives for all participants, from the protocol layer up to the application layer, they have a significant competitive advantage over traditional centralized applications.
However, not all circumstances require, or even benefit from, the use of tokens. So, when should a token be introduced into a network? In our view, tokens should only be adopted if they:
- Enhance the network effects of the network
- Increase benefits to participants
- Encapsulate value in the network
- Drive alignment between different network participants
- Help network self-correct when there are imbalances
While these principles sound straightforward, deciding to introduce a token on a network is only the very beginning. After determining whether adding a token makes sense, the significant challenge of designing how it works remains. Still, weighing these principles ensures that the design process at least starts off on the right foundations.
Want to learn more about the underlying network effect principles in EPNs? Read our in-depth article here.