Tokenization

Summarised by Alireza Aghaee.

Introduction

This is a summary of “Decentralization through Tokenization” published in the Journal of Finance in February 2023. This study investigates the decentralization of digital platforms through tokenization as a novel approach to resolving the tension that exists between platforms and users. Tokenization via utility tokens functions as a commitment mechanism that stops a platform from abusing its users by transferring control to them. This commitment comes at the expense of not having an owner with an equity investment who, in traditional platforms, would subsidize participation to increase the platform’s network effect. Because of this trade-off, utility tokens are a more enticing funding strategy than equity for platforms with bad fundamentals. The conflict resurfaces when non-users, such as investors and validators, participate on the platform.

Model

The model has three dates and a developer who wants to develop a generic platform that supports bilateral transactions among a group of users. At t = 0, the platform developer chooses a funding scheme based on a prior belief about the platform’s fundamentals. Each potential user decides whether to join the platform at t = 1. After joining the platform, a user can randomly match with another user to execute mutually beneficial transactions at t = 1 and t = 2. There are multiple funding schemes to consider. The equity-based platform owner can commercialize customers’ private data at t = 2. Potential users’ decisions to join the platform may be influenced by their expectations of the owner’s lack of commitment. The setting of the model are as follows:

• At t = 1, there is a continuum of prospective users with a measure of one unit, indexed by ${\textstyle i\in [0,1]}$. These potential users can trade products in two rounds at t = 1, 2 on the platform.
• To join the platform, each user incurs a personal cost of ${\textstyle \kappa >0}$.
• There is an entry fee ${\textstyle c}$ to the platform that users pay. This fee can also be negative if owners subsidize entry.
• If the platform is funded by a token-based scheme, a user must pay the cost of acquiring a token to join. If the platform is funded by an equity-based scheme, the owner may subsidize each user’s initial involvement.
• ${\textstyle X_{i}=1}$ if user ${\textstyle i}$ joins the platform, and ${\textstyle X_{i}=0}$ otherwise.
• User i has a unique good and a randomly matched trading partner, user j. Both i and j must be on the platform to trade products at t = 1 and t = 2.
• User i has a Cobb-Douglas utility function ${\textstyle U_{i}\left(C_{i},C_{j}\right)=\left({\frac {C_{i}}{1-\eta _{c}}}\right)^{1-\eta _{c}}\left({\frac {C_{j}}{\eta _{c}}}\right)^{\eta _{c}}}$. Both goods are needed for a user to derive utility from consumption. If one of them is not on the platform, there is no transaction and each of them gets zero utility.
• User ${\textstyle i}$ has a goods endowment of ${\textstyle e^{A_{i}}}$, which is equally divided across ${\textstyle t=1}$ and ${\textstyle t=2}$. User ${\textstyle i}$ ’s fundamental, ${\textstyle A_{i}}$, comprises a component ${\textstyle A}$ common to all users and an idiosyncratic component,${\textstyle A_{i}=A+\tau _{\varepsilon }^{-1/2}\varepsilon _{i}.}$ with niid ${\textstyle \varepsilon _{i}}$ such that ${\textstyle \varepsilon _{i}\sim {\mathcal {N}}(0,1)}$.
• The common component ${\textstyle A}$ represents the platform’s demand fundamental, which is publicly observed by all users and the developer only at ${\textstyle t=1}$. At ${\textstyle t=0}$, the developer has a prior over ${\textstyle A,A\sim G\left({\bar {A}},\tau _{A}^{-1}\right)}$, and chooses the platform’s funding scheme based on this prior belief.

Solving the consumer transaction problem yields that when user ${\textstyle i}$ is paired with another user ${\textstyle j}$ on the platform, they simply swap their goods, with user ${\textstyle i}$ using ${\textstyle \eta _{c}e^{A_{i}}}$ units of good ${\textstyle i}$ to exchange for ${\textstyle \eta _{c}e^{A_{j}}}$ units of good ${\textstyle j}$. Consequently, both users are able to consume both goods, with user ${\textstyle i}$ consuming

$$C_{i}(i)=\left(1-\eta _{c}\right)e^{A_{i}},C_{j}(i)=\eta _{c}e^{A_{j}},$$

and user ${\textstyle j}$ consuming

$$C_{i}(j)=\eta _{c}e^{A_{i}},C_{j}(j)=\left(1-\eta _{c}\right)e^{A_{j}}$$

First Best The paper shows that in the first best equilibrium, there exists a threshold ${\textstyle A_{*}^{FB}}$, that if ${\textstyle A\geq A_{*}^{FB}}$, then all users participate on the platform and a social planner can implement this outcome by imposing transaction fees proportional to users’ transaction gain at a sufficiently high rate and redistributing the fees equally back to all users. If ${\textstyle A<A_{*}^{FB}}$, then the platform shuts down because the social surplus is negative.

Discussion First best equilibrium shows a network impact in which all users join the platform when the social surplus is positive, even when individuals with low endowments cannot cover their participation costs from their transaction gains because their involvement boosts the transaction gains of other users. Given that users with high endowments earn more profits from transactions and pay higher fees, the redistribution of fees offers a cross-subsidy from users with high endowments to those with low endowments. A high transaction cost ensures full user participation.

Equity-Financed platform

Assume at t = 0 the developer chooses to set up a conventional equity-based scheme to fund the platform. Therefore, the developer issues equity, fully or partially sold to outside investors. All equity holders together comprise the owners of the platform. Owners can provide an entry subsidy (i.e., a negative ${\textstyle c}$) at ${\textstyle t=1}$ and then charge each user a fraction ${\textstyle \delta }$ of his utility surplus ${\textstyle U_{i,t}}$ from the transaction in each period ${\textstyle t=1,2}$. The subsidy has a cap to prevent opportunistic individuals from joining the platform:

$$c\geq -\alpha \kappa .$$

This cap ensures the total cost of participation for users, that is ${\textstyle \kappa +c}$, remains positive. The owners can take a subverting action ${\textstyle s\in \{0,1\}}$ at ${\textstyle t=2}$. If the owner chooses ${\textstyle s=1}$, this action benefits the owner by an amount proportional to the number of users on the platform, ${\textstyle \gamma \int _{0}^{1}X_{i}di}$, at the expense of the users. This action prevents any transaction on the platform and imposes a utility cost of ${\textstyle \gamma >\alpha \kappa }$ on each user. The owner, therefore, sets fees at ${\textstyle t=1}$ to maximize their total expected profit

$$\Pi ^{E}=\sup _{\{c,\delta ,s\}}E\left[\int _{0}^{1}\left(c+\delta U_{i,1}\right)X_{i}di+\int _{0}^{1}\left((1-s)\delta U_{i,2}+s\gamma \right)X_{i}di\mid {\mathcal {I}}_{1}\right],$$

where ${\textstyle {\mathcal {I}}_{1}=\{A\}}$ is the owners’ information set at t=1. The owner chooses subversive action ${\textstyle s\in \{0,1\}}$ at ${\textstyle t=2}$ to maximize its profit

$$s=\arg \max \int _{0}^{1}\left(\delta U_{i,1}(1-s)+\gamma s\right)X_{i}di$$

Noteworthy, the owner may prefer to commit to not subverting at t = 1 to maximize user participation, but such commitment is not credible under the equity-based scheme.

User ${\textstyle i}$ decides on participation based on her expected utility as follows:

$$\max _{X_{i}\in \{0,1\}}E\left[(1-\delta )\left(U_{i,1}+(1-s)U_{i,2}\right)-\kappa -c-\gamma s\mid {\mathcal {I}}_{i}\right]X_{i},$$

where ${\textstyle {\mathcal {I}}_{i}=\left\{A,A_{i}\right\}}$ is the information set of user ${\textstyle i}$ at t=1. Solving the user problem will result in a cutoff equilibrium, in which only users with endowments above a critical level, ${\textstyle {\hat {A}}^{E}}$, participate in the platform.

Equilibrium: Under the equity-based funding scheme, there is a unique cutoff equilibrium with the following properties:

• If ${\textstyle A>A_{*}^{E}}$, the owner does not subvert the platform at ${\textstyle t=2}$, which leads to the following outcomes at ${\textstyle t=1}$ :
  • The owner provides the maximum entry subsidy, ${\textstyle c=-\alpha \kappa }$.
  • The owner sets a positive transaction fee.
  • Each user ${\textstyle i}$ adopts a cutoff strategy to join the platform if ${\textstyle A_{i}}$ is higher than ${\textstyle {\hat {A}}_{NS}^{E}}$, where ${\textstyle {\hat {A}}_{NS}^{E}}$ is decreasing in ${\textstyle A}$.
• If ${\textstyle A\in \left[A_{**}^{E},A_{*}^{E}\right]}$, the owner subverts the platform at ${\textstyle t=2}$, which leads to the following outcomes at ${\textstyle t=1}$ :
  • The owner provides the maximum entry subsidy, ${\textstyle c=-\alpha \kappa }$.
  • The owner sets a positive transaction fee.
  • Each user ${\textstyle i}$ follows a cutoff strategy to join the platform with the cutoff ${\textstyle {\hat {A}}_{SV}^{E}}$, which is decreasing in ${\textstyle A}$.
• If ${\textstyle A<A_{**}^{E}}$, the platform breaks down with no user participation at ${\textstyle t=1}$.

Values of ${\textstyle A_{**}^{E}}$, ${\textstyle A_{*}^{E}}$, ${\textstyle {\hat {A}}_{NS}^{E}}$ and ${\textstyle {\hat {A}}_{SV}^{E}}$ are pined down in the paper.

Discussion: The equity cash flows incentivize the owner to internalize the network effect and subsidize the entry fee to maximize user participation. Therefore, the owner always chooses the maximum entry subsidy, ${\textstyle c=-\alpha \kappa }$, to attract the marginal user. Nevertheless, the cap on the entry subsidy constraints user participation from reaching the first-best level. Furthermore, Anticipating the subversion and the resulting damage to users, potential users are reluctant to join the platform at t = 1. Their reluctance forces the owner to reduce the transaction fee, and, despite the reduced fee, platform participation by users remains lower than the level in the absence of the subversion. The paper also shows that under the equity-based scheme, when the subversion equilibrium occurs, that is, when ${\textstyle A\in \left[A_{**}^{E},A_{*}^{E}\right]}$, user participation, owner profit, and social surplus all decrease with the degree of user abuse ${\textstyle \gamma }$, while the boundary of platform breakdown ${\textstyle A_{**}^{E}}$ increases with ${\textstyle \gamma }$.

Token-Financed platform

When the platform is funded through tokenization, by giving control to users, users can protect themselves from nonusers who would take subversive actions. Under this scheme, a user must purchase a token to join the platform. Buying a token also entitles users to vote on issues related to the platform at t = 1, 2. A utility token, therefore, conveys control rights to holders. The main tradeoff between token-funded and equity-funded platforms is that decentralization leads to a commitment not to exploit users at the expense of not having an owner with a stake in the platform’s profit which has the incentive to subsidize user participation. The lack of entry subsidy implies that the token-based scheme cannot accomplish the full user participation required by the first-best equilibrium.

Under the token-based scheme, the developer has a simple choice at ${\textstyle t=1}$ of setting the token price ${\textstyle P}$ to maximize his revenue from token issuance,

$$\Pi ^{T}=\max _{P}\int _{0}^{1}PX_{i}\left({\mathcal {I}}_{i}\right)di,$$

The developer faces a trade-off between a higher token price and a smaller user base. Similar to the equity-based scheme, at ${\textstyle t=1}$, each user chooses whether to join the platform by evaluating whether his expected transaction surplus with another matched user on the platform is sufficient to cover the costs of participation, which is now the fixed cost and the purchase of a token,

$$\max _{X_{i}\in \{0,1\}}E\left[U_{i,1}+U_{i,2}-\kappa -P\mid {\mathcal {I}}_{i}\right]X_{i}$$

Equilibrium Under the utility token-based funding scheme, the platform breaks down with no user participation if ${\textstyle A<A_{**}^{T}}$, and there is a cutoff equilibrium with the following properties if ${\textstyle A\geq A_{**}^{T}}$ :

• Each user ${\textstyle i}$ adopts a cutoff strategy in purchasing the token to join the platform
  $$X_{i}={\begin{cases}1&{\text{ if }}A_{i}\geq {\hat {A}}^{T}\\0&{\text{ if }}A_{i}<{\hat {A}}^{T}\end{cases}}$$
• The token price ${\textstyle P}$ is given by
  $$P=e^{\left(1-\eta _{c}\right)_{\varepsilon }^{-1/2}z^{T}+A+{\frac {1}{2}}\eta _{\varepsilon }^{2}\tau _{\varepsilon }^{-1}}\Phi \left(\eta _{c}\tau _{\varepsilon }^{-1/2}-z^{T}\right)-\kappa ,$$
  where ${\textstyle {\boldsymbol {z}}^{T}={\sqrt {\tau _{\varepsilon }}}\left({\hat {A}}^{T}-A\right)}$.

Values of ${\textstyle A_{**}^{T}}$ and ${\textstyle {\hat {A}}^{T}}$ are pinned down in the paper.

Discussion: The token price P depends on the marginal user’s platform participation. The equity price under the equity-based scheme is set by the transaction fee collected from the average user, who gains more from participation in the platform than the marginal user due to the network effect. This disparity has numerous major ramifications. First, an equity offering is superior to token issuance for fundraising since marginal users have lower transaction surpluses due to the network effect than average users. Second, token values are more volatile than equity prices due to the platform’s network effect.

Comparison: Token-based scheme vs. equity-based scheme:

• For a given level of ${\textstyle \gamma }$, the utility token-based scheme leads to lower user participation, developer profit, and social surplus if the platform fundamental A is sufficiently high.
• For a given level of ${\textstyle A}$, the utility token-based scheme leads to higher user participation, developer profit, and social surplus if the degree of user abuse ${\textstyle \gamma }$ is sufficiently high.
• Given his prior belief distribution about A, the developer chooses the utility token-based scheme when his prior is that A is weak.

Mixed platform

The additional cost of decentralization motivates hybrid schemes that combine features of equity and utility tokens. The cash flows from the equity tokens provide a channel to subsidize marginal users. Such cash flows, however, may also incentivize nonusers to acquire equity tokens as a financial investment. The paper separates the two cases relating to whether non-user investors can hold the tokens.

In the case without investors, since the decision makers are the users, they never choose the subversive action. The paper shows that this hybrid equity token-based scheme can achieve the first-best equilibrium. If the platform fundamental is higher than ${\textstyle A_{*}^{FB}}$, there is full user participation, and the developer can extract the entire transaction surplus through the token sale. If the platform fundamental is below the threshold, it breaks down as it does not lead to any social surplus. Therefore, without investors, equity tokens improve traditional equity financing and can achieve the first-best outcome on the platform.

In the case with investors, however, the presence of nonusers who can acquire a sufficient quantity of equity tokens may reintroduce the commitment problem, albeit through a modified form. For instance, the investor can alter the platform’s terms of service and use privileged information about users to harvest blockchain transactions for ad targeting.

The paper shows that under the equity token-based funding scheme with a large investor, there is an equilibrium in which the investor acquires a majority share of tokens and subverts the platform when the platform fundamental, A, is sufficiently weak. Moreover, the developer’s profit, the token price, and user participation are lower than in the absence of the investor. The key shortcoming of equity tokens is that the platform’s developer and precoded governance algorithms cannot distinguish which token holders are users or investors.

Conclusion

This study examines how tokenization can decentralize online platforms to alleviate conflicts of interest between platforms and users. Tokenization prevents platforms from abusing consumers by giving them authority over preprogrammed smart contracts. The research indicates that this commitment comes at the cost of not having an equity-stake owner who is encouraged to subsidize user involvement to optimize the platform’s network impact. Utility tokens may not always be better than equity for funding platforms. Utility tokens appeal to platforms with weak fundamentals because they worry more about user exploitation.

This analysis reveals a high-level trade-off that can guide platform design in general and platform financing, in particular, using traditional control and cash flow rights allocations. It shows that token values are based on the marginal user’s convenience yield, while equity prices are based on the average user’s transaction fees. Moreover, although users will never undermine the platform, they have no motive to subsidize platform participation, even when it is socially optimal. Lastly, if tokens contain cash flow and control rights, users or outsiders may have the motive to centralize the platform by amassing tokens, which would reintroduce the commitment problem, especially if the token price is low and the platform is open to subversion.