Dr. Avtar Singh Sehra, CEO and Chief Product Architect at Nivaura Ltd.
Richard Cohen, Senior Associate at Allen and Overy LLP.
Dr. Vic Arulchandran, CPO at Nivaura Ltd.
In this article we review the technical, economic and legal aspects underlying cryptocurrencies – the native digital assets that form the basis of an open public blockchain infrastructure. This structure is then extended to discuss secondary tokens, where blockchains can be leveraged to issue, register and settle digital assets that may represent securities, private forms of money or other property rights. The viability, complexities and limitations of such models are reviewed with the purpose of providing the reader with a strong foundation for deeper exploration of this complex and emerging field.
Throughout history money has taken various forms. One of the earliest forms of money consisted of Cowry Shells, emerging over three thousand years ago across multiple continents . As civilisation progressed other forms of money developed, which included precious metals and consumable items such as sugar, coffee, salt and tea. During World War II cigarettes also came to be used as a form of money in prisoner of war camps, where markets developed that leveraged cigarettes as a means to pay for goods and services . These are all cases of commodity money, which has intrinsic value derived from the materials they are made from and their scarcity. On the other hand Fiat money, or currency, is money without intrinsic value, and is issued by central and commercial banks, and in its cash form, is declared by the government to be legal tender. Such fiat money has value because governments leverage their powers to enforce and stabilise the value of a currency or because the exchanging parties agree to its value. The first recorded use of Fiat money was in China in about 1,000 AD, and since then it started to be used concurrently with commodity money. It was not until the 20th century that Fiat money became the dominant form of money .
Whether money is considered to be paper, shells, precious metals or even cigarettes, it has three primary functions in any economy: as a Medium of Exchange (MoE), a Unit of Account (UoA), and a Store of Value (SoV). In market transactions, money as a MoE is used to pay for goods and services and fulfill contractual obligations. The use of money as a MoE enables economic efficiency by eliminating the time and effort spent on executing a transaction, known as a transaction cost. From this point of view money can be seen as essential in lubricating trade in a complex economy by lowering transaction costs and encouraging specialisation and division of labour. Money also provides a measure of value, or UoA, for goods and services in the economy, which can further minimise transaction costs and facilitate exchange.
While money as a MoE and UoA minimises transaction costs as an economy increases in size and complexity, no one would want to use money if they thought others wouldn’t consider it as having or retaining value. Therefore, one of the key functions of money is to be a repository of purchasing power i.e. money can be used as a SoV to defer transactions to a later time. This is a fundamental function of money as people normally do not want to spend money immediately upon receiving it but would rather wait until they either have the time, need or sufficient amount.
There are many assets that can be considered a SoV, such as stocks, bonds, land, real estate, art, collectible cars and jewellery. In some cases they may not only store value but also pay owners an interest rate return, experience price appreciation, and deliver additional utility such as accommodation from owning a house or pleasure from signaling wealth from owning luxury goods. So while scarcity and demand for these assets makes them a useful SoV compared to money, it may diminish their benefits as a MoE and UoA, which requires properties such as stability, standardisation, liquidity, divisibility and portability. Therefore, while many assets may provide the foundations to act as a SoV, only a subset of these would provide the basis for a MoE, and in turn a smaller subset of that can be considered a UoA, as shown in Figure 1.
In this context of varying forms of assets and money, classifying and understanding cryptocurrencies and other forms of digital assets can be challenging. Not only is the technology underpinning these digital assets still highly novel, it also suffers from significant technical limitations that impact how these assets may evolve from being a SoV to an adequate form of money or digital cash that fulfills all three functions of money.
One of the critical aspects to consider when it comes to digital assets and other forms of electronic money, and one that is often ignored from the context of the traditional functions of money, is that of Privacy. As noted by Kahn et al, in Money is Privacy , electronic transactions on the internet and in store card payments are becoming increasingly prominent, even for small value transactions. However, such electronic transactions differ fundamentally from ordinary cash transactions because there is currently no widely accepted form of electronic money that enables purely anonymous electronic transactions as can be done with cash.
While money minimises transaction costs and facilitates trade and economic growth, Money is Privacy highlights that additional value of money may be derived from its use in anonymous exchanges that enables the facilitation of certain types of infeasible transactions i.e. privacy minimises transaction costs for a particular subset of trade. While this property may often be associated with illegal activity, such anonymity can also facilitate potential social value in economic situations where parties to a transaction cannot trust each other not to take subsequent opportunistic actions if identities are known.
So just as traditional functions of money are critical in understanding and classifying potential forms of money and their abilities in minimising transaction costs and facilitating trade, the function facilitating transaction privacy, or Provision of Privacy (PoP), also needs to be considered as a vital (fourth) function of money. The PoP function of money may become increasingly relevant as the economy moves towards becoming a cashless society and a greater spotlight is placed on individual freedoms and rights. As such when assessing cryptocurrencies and digital assets, the function of privacy, or the lack thereof in current blockchain infrastructure, also needs to be considered.
The introduction of Bitcoin  in 2009 provided the tools and infrastructure to transact primitive native digital assets (bitcoin in the case of the Bitcoin blockchain) over the open public Internet without trusted intermediaries. However, in order to create new tokens one either needed to deploy and scale a new blockchain network (likely forked from Bitcoin), or issue tokens on top of an existing blockchain network such as Bitcoin (through metadata encoded into raw transactions). The former was an uphill struggle due to challenges of scaling and achieving network effects for a new blockchain, and the latter was challenging due to the complexities of trying to encode sufficient information related to new tokens into raw Bitcoin transactions. Neither model was ideal.
However, with the introduction of Ethereum  in 2015 came the concept of decentralized smart contracts. The Ethereum blockchain not only provided the infrastructure for transacting primitive digital assets (ether in this case), but also provided the capability for easily creating and autonomously managing other secondary digital tokens of value over the open public Internet without trusted intermediaries.
Using this concept of smart contracts, which are effectively applications running atop a decentralised network, tokens can be created and allocated to users, and made to be easily tradable. This process of creating tokens and distributing them to users in return for a network’s primitive digital assets such as bitcoin and ether (in general cryptocurrencies) is called an Initial Coin Offering (ICO), and can be seen as a novel distribution channel for the issuance of new digital assets.
This work is not meant to be an introduction to the technically rich world of cryptography, blockchains and consensus mechanisms, for which there are numerous excellent entry level resources . However, the key point to keep in mind is that secondary tokens are not like primitive assets (cryptocurrencies such as bitcoin and ether) that are intrinsic to the “structural integrity” of a blockchain network.
Open public peer-to-peer value transfer networks, such as Bitcoin or Ethereum, need to survive complex attack vectors in an open hostile environment where all parties (hosting, maintaining or accessing the network) are assumed to be self interested and focused on maximising their own value. In this scenario the key question is how can all parties be incentivised to work for the greater good of securing the network while fulfilling their self-interest.
The answer to this question lies in the key innovation of the blockchain network: the native digital asset or cryptocurrency. As well as being the subject of transactions between parties on the network (the users), the cryptocurrency also provides incentive for key parties (e.g. miners) to compete and reach consensus as quickly and securely as possible on the state of the blockchain ledger. The state of the ledger can simply be who owns what token or from a smart contract perspective the output state of an executable code that most likely involves moving tokens based on some form of payout logic. The reward for securing the network and reaching consensus on the final state is either a new supply, or transaction fees paid, in the native cryptocurrency of the network.
In this model, trust is created from mistrust through a consensus mechanism, such as expending energy in the proof of work (PoW) mining process, which makes the violation of the “sanctity of the blockchain ledger” expensive and economically unfavourable to the alternative of securing the network and being rewarded in the native store of value for the effort of doing so.
While PoW is deemed to be wasteful in terms of energy expenditure it is currently the only viable consensus mechanism that is shown to be effective at scale. A number of research efforts are underway that involve other more novel means of achieving consensus, such as proof of stake (PoS), where users stake their native digital assets in order to participate in the consensus processes and any violations of the rules may result in loss of the stake. In addition there are other more sophisticated hybrid models that consist of a combination of PoW and PoS.
From this perspective, whichever consensus mechanism is used, an open public blockchain is a self-contained system that is simple in its implementation and requires no more rules and controls than are necessary. The core purpose and unique nature of a cryptocurrency, and why it is fundamental to a blockchain network, can be summarised as:
Cryptocurrency is the atomic element from which the open public blockchain network is forged.
For a cryptocurrency to be leveraged as an incentive to drive consensus and enable security it must first be perceived as a store of value i.e. it may be stored and retrieved at a later date with the expectation that it will still have value. One way to achieve this is to implement artificial scarcity into the supply release, so the total supply of native digital tokens is capped or the release of new tokens becomes negligible relative to the total supply in circulation.
A cryptocurrency’s Monetary Policy refers to the model for supply release and the cap or controls on total supply i.e how many native digital tokens are issued, how often, and what the total number of issued tokens will be. A capped and well-controlled supply release increases the chances of a small increase in demand driving the tokens’ value. Normally the monetary policy would be predefined as part of the issuance strategy, where a fixed number of tokens are created and issued to reward users of the network for securing the network and to incentivise them to continue doing so.
In the case of Bitcoin the total supply will be twenty one million, and new bitcoins are released as mining rewards approximately every 10 minutes, with the supply release reducing every four years. In the case of Ethereum there is currently no supply cap, however the release of new ether through the mining process is claimed to be sufficiently small that eventually the impact of new supply relative to the large supply in circulation combined with lost supply will lead to a steady state i.e. the supply release can be considered to have a “quasi-static release model” so new supply will eventually have negligible impact on value. The current supply structure for both Bitcoin and Ethereum is shown in Figure 2.
As the supply of bitcoin and ether is effectively inelastic and inflexible, there are no viable modes of managing their value and ensuring price stability. So, while the fixed (or quasi-static) supply and strong speculatory demand may drive cryptocurrencies to perform as a SoV i.e. prices may tend to increase but have high volatility, similar to risky investment assets, this feature would also potentially limit their function as good forms of MoE and UoA. The reason for this is that if deflationary and volatile cryptocurrencies replace Fiat currencies it would have a number of impacts on transaction costs, and trade and economic growth. One key impact would be on the price index of goods and service. In the best case scenario, if prices continuously fall people would likely delay purchasing, and in the worst case scenario highly volatile prices could make simple trade much more risky, thus increasing transaction costs and hindering economic growth. In addition, if debt contracts denominated in cryptocurrencies rise in real value over time they could cause debt deflation, which in turn could contribute to economic instability. On the other hand, the desire to invest in R&D and other enterprising ventures may also decrease as rational holders of cryptocurrency would feel their expected returns from holding cryptocurrency are higher than investing in other risky ventures. All of this could be further aggravated as nominal wages in a cryptocurrency increase forever in real terms, regardless of productivity growth . These are just some examples of the controversies and challenges surrounding the economic viability of cryptocurrencies acting as a form of money however they may have a more viable future as a form of commodity or raw material that can be leveraged in digital infrastructure.
As explained earlier, a primitive native digital asset, or a network’s cryptocurrency, is a fundamental component of a blockchain. It is a network’s store of value, medium of exchange and unit of account, that is transacted and tracked on a distributed ledger, but also drives the incentivisation model to achieve consensus on the state of the ledger amongst the network’s participants.
On the other hand a secondary token, created on top of a blockchain network, is merely a representation of some “property rights” i.e. the blockchain network acts as an independent “custody or notarisation” layer to securely record one’s ownership/access rights to some product, service or asset that may be intrinsic or extrinsic to the network itself.
When leveraging an open public blockchain infrastructure to create and distribute secondary tokens, the blockchain’s native cryptocurrency is the optimal unit of denomination for on-chain clearing and settlement of the secondary tokens. In this manner the secondary tokens issued and registered on the blockchain can be cleared and settled in a delivery versus payment model i.e. secondary tokens are only assigned to owners when their payment in cryptocurrency is executed – so either both transactions take place or neither do. This distribution model is essentially the mechanism that underpins an ICO process. While the native cryptocurrency may be the optimal unit of value, many ICOs sell tokens in return for fiat currency as well as cryptocurrency.
The network effects of the underlying open public blockchain and its cryptocurrency can be leveraged to securely and transparently create and issue secondary tokens through an ICO process. However, the value of the secondary tokens will need to be judged on the rights they offer, and the enforceability of such rights.
One of the most obvious and natural use cases for an ICO based secondary token issuance is to represent some form of traditional security e.g. equity, debt, participation in profit sharing, etc. When using a smart contract infrastructure one can also predefine a set of events such as cash flow rules that can be triggered either at set times or by specific external events. There are a number of reasons why a blockchain infrastructure makes sense for the issuance and registration of financial securities, which are mostly related to the ease with which holders can be given ownership of the assets and that ownership can be recorded.
However, since the “offer and sale” of securities is in and of itself highly regulated, several models have been devised by startups to enable the issuance of tokens through an ICO distribution model that complies with securities regulations. As well as the question around whether a token is a security or not and, if it is, where and how it can be distributed, there are also a number of other unanswered questions related to tax of capital gains and KYC/AML rules. These are some of the regulatory and statutory financial considerations that are currently an ongoing area of scrutiny and development  .
The SEC investigative report  highlighted that classifications of digital tokens as a security will depend on a case by case basis and will relate to the facts and circumstances, including the economic realities of the transaction. This reflects the Howey test which sets out how to define a security under U.S. law. In addition, while the SEC has highlighted that ICOs similar to the The DAO (i.e. decentralised investment funds) are securities, it is still not entirely clear what the boundaries are for token issuances in general. To add to the complexity it is also unclear how regulators around the world uniformly view tokens issued through an ICO process, and what factors would trigger their oversight, to say nothing of how tax authorities approach the category. The trend among regulators though is to classify ICOs as securities. It is clear that as they are becoming more mainstream regulators are taking an increasing interest in them. Because of the nature of the open public blockchain, the default position on any token issuance is that it is open to everyone globally. This has fast become a problem as issuances may be compliant with the securities rules of one state but not another. This is of particular concern given that U.S. securities laws apply globally, and people and businesses are rightly anxious not to fall afoul of the U.S. regulatory authorities. Issuers therefore should ensure they have taken appropriate measures to structure their ICO and be careful not to engage in inappropriate activity when issuing and marketing their ICOs in markets where such instruments may be regulated. As far as the U.S. is concerned this increasingly requires positive action to show compliance.
Going even further, structuring of more complex secondary tokens that represent property rights in other real world assets are also often touted as being a strong use case for secondary tokens e.g. issuing fungible units of ownership in a physical asset or a number of pooled assets. When secondary tokens refer to off-chain “extrinsic asset” ownership/access rights there is added complexity related to asset servicing (managing ongoing performance of real world assets on behalf of investors) and trustee services (acting on behalf of investors to enforce their rights if things go wrong) and such complexities are often neglected.
In the case of financial instruments there is a complex legal framework in place to manage structures of contractual agreements referring to extrinsic assets i.e. where a financial instrument provides rights to some other asset e.g. loans, mortgages or even physical property.
Such structures can range from a secured financial instruments e.g. bonds, where the extrinsic assets such as property remains on the bond issuer’s balance sheet but investors may have recourse against an issuer to the value of the secured assets if something goes wrong with performance of the financial instrument, to structured products, covered bonds and full scale securitisations. Such transactions typically involve complex legal and economic structuring and documentation to provide assurances on enforceability. and in the case of statutory covered bonds can involve compliance with specific primary legislation.
Based on this it can be seen that forming such a contract is not just about creating a secondary token that simply evidences ownership/access rights, enables management of cash flows and other basic features such as transferability, there is a depth of legal, economic and potentially political complexity that goes beyond basic technical features related to independent asset registration and custody.
While talking about the valuation of a cryptocurrency is a much more complex and nuanced problem beyond the scope of this article, the discussion of the value of secondary tokens is significantly more straightforward.
When the secondary token is a representation of ownership rights its value stems directly from the value of the underlying asset. In this case pricing is no more complex than the traditional models of valuation for the underlying. The only real impact of using a blockchain infrastructure to register, clear and settle the tokens and potentially enable some autonomous administration functionality (if using smart contracts) is on operational and compliance costs, which may or may not be a huge saving depending on the efficiencies and economies of scale available through incumbent infrastructure for a particular asset class.
Logical features of a contractual agreements, such as cash flow payments dependent upon meeting certain conditions (e.g. payment of a coupon at a certain date) can be programmed into a smart contracts, however the smart contract would first need to have access to the money for it to be repaid. In most financial instruments money is never left sitting in an account waiting to be paid – it is likely being invested to generate returns that can then be used to meet the contracts cash flow obligations.
In the example of a coupon payment, the issuer would need to fund their blockchain account and trigger the smart contract for repayment of cash flows to the registered investors. While the interactions between the issuer’s money account and an instrument smart contract may be automated, this does not answer the question of what would happen if the issuer does not fund their account when the payment date arrives. In such a scenario, if the issuer’s account is empty on the payment date, then the “automated” cash flow would fail and the system would need to revert to the need for a trusted third party such as an Asset Servicing firm that can facilitate the collections process i.e. making sure the money is collected. If an issuer is unable to pay even after chased by the asset servicer, then there may be a default event, which can be significantly more complex, especially if an issuer does not have sufficient assets to cover their liabilities. In this case a Trustee would step in to act on behalf of investors for the recovery process, and if successful relevant assets may need to be liquidated to repay investors.
In addition, apart from simple asset servicing for collections and trustee services for contingent events, there are numerous other covenants and conditions that are part of the formation of a legal contract underpinning a financial instrument, which require management and monitoring as the contract performs over its life, and potentially enforcement if there are violations in expected performance. Management of such complexity would not be technically viable using current blockchain infrastructure – except in the simplest of cases which may not be useful for any real world application. However, this is likely to change as blockchain infrastructure improves and its interactions and interfaces with the current legal, economic and political frameworks becomes well understood and established.
So while proving ownership and enabling ease of payment and asset transfers are important aspect of a secondary token that may be effectively managed using an open public blockchain infrastructure, there needs to be an underlying legal contract to ensure enforceability of what is agreed. Also, such legal agreements are even more important if the secondary tokens have additional complexity that depends on real world events that cannot be easily automated or can be subject to fraud. The underlying legal agreement and enforceability of the contractual terms is what supports and assures the realisation of the value of a financial instrument.
On the other hand, many secondary token issuances are not a record of ownership of some complex legal contract but are merely a combined form of product/service access right and a payment mechanism i.e. they are a form of Private Money accepted only by the issuer of a product/service. These are best considered as “vouchers” that entitles the holder access to a product/service for a commercially beneficial price relative to another payment mechanism e.g. the network’s underlying cryptocurrency. In this case the value of such secondary tokens can only be referenced by the demand for the product/service and the supply of the tokens available to fulfill the demand. When combining a product/services access rights with a payment mechanism in this manner further complexity and friction may be added that makes such token models unviable for most use cases.
The complexity of private money can be viewed through a thought experiment . Imagine that a laundry expert publicly announces a plan to open a new chain of laundry shops, where the development will be funded through an ICO process. The tokens would be issued at a price of 1 Laundry Token (LTX) for $1 and will enable holders to gain access to laundry services in all laundry shops that are a part of the new chain. However, only 1 million LTX will ever be issued, thereby creating artificial scarcity. In addition, this will be done through an independent third party to ensure that the laundry expert is unable to defraud the system i.e. the independent third party will ensure that: a) no more LTX can be issued; b) no LTX already issued can be recalled and c) the LTX already issued will be honored for their intended purpose. Furthermore, imagine that the LTX price can go up and down based on supply and demand, and that they are easily transferable between users at the fair market rate. Under the efficient market hypothesis, the value at which the tokens are exchanged in a sufficiently liquid market will capture all the market information relating to the underlying project. The theory is that as the LTX tokens are issued and the funds are used to build the laundry business, the value of the LTX will go up (on anticipation of a successful launch) and LTX holders will enjoy the benefits of capital gains. On the other hand, if the project begins to struggle and bad news enters the media, the value of the LTX will begin to decrease and LTX holders will suffer capital loss.
In order to ensure that the LTX are a viable means of private money the issued tokens need to be convertible for their intended purpose of receiving laundry services i.e. holders should be able to take their LTX to any of the shops in the laundry chain and pay for required services. LTX can be divisible into subunits, but for simplicity in this example when a single LTX token is redeemed in a shop it is converted to laundry credits equivalent to the market rate in USD. Therefore, if 1LTX is now being traded for $50, then on redemption at the shop the holders can gain access to $50 of cleaning credits e.g. they can clean five jackets where the cost of cleaning is $10 per jacket. As the value of the tokens goes up, on the open market, holders can gain more laundry credits “for free” on redemption i.e. more jackets cleaned for the same units of tokens. This example may sound convoluted, but bear in mind it is simple compared to how some ICO token issuances have operated.
However, the economics of the ICO and digital token model needs to be viable to ensure sustainability i.e. a token skyrocketing in value may be damaging in subtle ways to the issuing business compared to the obvious issues of a token plummeting to zero.
If the laundry LTX ICO supply was capped at 1 million tokens, the issuer may only distribute 500k LTX tokens and keep the remaining in an escrow account, which can be used to cover the costs of running the business and or expanding laundry shops in the future. The escrow account would likely have some form of access/usage controls to provide comfort to investors that the tokens held will not be dumped (sold in one go), in turn causing a price crash; or they may be locked for a fixed period to allow sale in a controlled manner over a “sufficiently long” period of time. All of these aspects fall under the monetary policy of a token as they are related to directly managing the supply of tokens in circulation, and is a relatively well-understood concept in cryptocurrency.
It is also important to understand and define the commercial benefits the ICO participants gain from holding the Laundry tokens, beyond just the capital gains related to scarcity. This point is a key one, and one that is least talked about and or understood, but is just as important as a token’s monetary policy. In the case of the laundry ICO, the laundry business could maximise the value of its tokens by potentially offering laundry services not only in the issued LTX but also in USD fiat currency (and even in other cryptocurrencies BTC and ETH). Linking a commercial benefit (e.g. discounts) with token usage means customers would be more likely to access the laundry services through LTX rather than other forms of payment, this is especially true if there is a large supply of tokens in circulation (resulting in less scarcity).
To drive continued customer interest in buying LTX, the issuer can ensure that LTX holders always gain some benefits/discounts on the services offered e.g. rather than cleaning costs for a jacket being $10 the LTX holders may only pay $8. This discount may be adjustable so as to manage commercial benefits based on levels of external competition, changes in operational costs and other unknown factors. This becomes a way of managing the flow of the issued token without taking drastic actions related to monetary policy e.g. increasing/decreasing supply from circulation or even hoarding/dumping tokens. This control of flow of tokens and impacts on aggregate supply and demand can be considered a form of “Fiscal Policy”. The fiscal policy actions highlighted here are not directly connected to managing the supply of tokens in circulation but rather connected to managing the flow of tokens through indirect economic incentives and interventions. Such flow management strategies could also lead to possibilities of market abuse, therefore their setup and execution would need to be a key issuance consideration – similar to the controlled release of excess tokens held in an escrow as part of the monetary policy.
One example of the benefit of a fiscal policy mechanism is that an issuer can propose to increase the commercial benefit (e.g. cleaning discount in LTX), which will increase aggregate demand of the tokens (from D1 to D2 in Figure 3). Such an action can then be combined with monetary policy decisions, for example as the aggregate demand of the tokens increases through the fiscal policy decisions, the issuing company could then also release further tokens, that may be held in escrow, increasing the total supply in circulation (from S1 to S2 in Figure 3). This combined increase of supply in circulation and the demand due to increased commercial benefits may have a minimal impact on the current market price.
Taking into account Monetary and Fiscal policies (fundamental in macroeconomics), and applying a framework which allows them to interact and affect the aggregate supply and demand, the model above shows that these policies are critical to understanding secondary token issuance structures that provide access to a product or service. The balance of Commercial Benefit and Supply Scarcity factors is critical in planning the issuance of any form of Private Money and its impacts on the local economy that consists of the product/service, business owners, investors and the users.
The economic analysis for such a balance can be modeled through assessing the supply and demand surfaces based on these explanatory factors. Assuming that highly scarce tokens with very high commercial benefit (e.g. offering steep product discounts) may result in hyper deflation of their value, leading to a hoarding mentality, as there will be a view of “falling prices” or being able to purchase more with the same tokens if token holders delay redemption. While this may seem like a positive effect, as a higher purchasing capability of a token implies higher returns for a company when they sell a redeemed token back into the market, such a scenario also has the potential to detrimentally impact a business and its cash flow. One of the most obvious impacts is that whilst a hoarding mentality will result in people delaying the use of their tokens, accordingly customer perceptions of using fiat currency to pay for services could cause them to feel like they are getting a worse deal compared to buying with a token, hence driving them to also delay their purchase, or use substitutes and or competitive products/services. This business slow-down will, in turn (assuming an efficient market), lower the value of the token until an equilibrium point is reached. However, the equilibrium point may not be what makes this a highly profitable business. On the other hand, tokens with low scarcity and minimal commercial benefit may be of little interest to users either as “investments” or for access to services. Evidently there is a level of complexity here that is very challenging to assess without some historic and forecast sales revenue/cost data related to a company’s core product or service and its customer profiles.
From an issuer perspective, as the secondary tokens are redeemed by holders for their relevant commercial purposes, for which they may receive company credit (e.g. coat cleaning in the laundry example) the issuer can then resell the token in the market at the current market rate. Using this approach the issuer can recover operational costs and generate profits. This cycle of token purchase and redemption by customers and resale into the market by issuer can continue, meaning the tokens would become a form of private money that is only locally accepted by the issuing company. From this context it becomes apparent why the above framework considering Monetary and Fiscal policies and their interactions makes sense, as “a long line of research emphasises that separating monetary and fiscal policies overlooks policy interactions that are important for determining equilibrium” .
In addition, issuers must account for the time it takes to sell the token in the open market after being redeemed by a token holder for its intended commercial purpose. In a sufficiently liquid market this may be “instantaneous”, thereby minimising the risks associated with price volatility. From a commercial perspective these risks could be severe because hoarding tokens to control market supply may backfire if the tokens value falls. In this scenario the issuing business may not be able to sell the tokens it holds to recover costs incurred delivering the services in return for redeemed tokens. While risks can be hedged if appropriate instruments/services are available, the optimal model would see smaller companies refrain from hoarding, instead preferring to sell in sufficient quantities to at least recoup costs. This is also the model used by blockchain miners.
Leading on from this is the challenge of “retiring” secondary tokens, for example if an issuing organisation at some point in the future decides to discontinue a particular product/service, or move away from a token model. In this scenario the token holders can effectively be seen to have some form of right or vote on the future of the product or service offered by the company! This challenge becomes greater than just a simple vote because as the value and or usage of these tokens increases, the holders will be seen to have more influence over company decisions. The optimal and simplest approach would be for the issuing company to buy back the tokens from holders at the market rate; a process which must be managed appropriately so that any announcements and buyback processes will not result in liabilities for the company. In this context, it must be noted that retiring any form of “money or security” from circulation (if these tokens are thought of as such) is a huge challenge. On a much larger scale this is evident in the issues that occurred in India with the heavy-handed banknote demonetization strategy in 2016 . In the case of a digital token the scale would be much smaller, but as a company grows and token values and or usage increases the challenges could be similar, especially when the tokens represent some form of access to a product or service that people have become attached to, or is critical to operations for which they still require some form of support from the issuing company (think Windows XP). A prudent way to manage this would be to have a buyback/demonetisation strategy as part of a secondary token issuance, and even some functionality to manage this autonomously in a controlled manner.
As can be seen here, the issuance of a secondary token that acts as a form of private money and managing the ongoing micro/macro-economic impacts on the business, key stakeholders and the market will mean issuing companies may not only need a CFO but likely also a Chief Economist, as running such a firm will be akin to running a small country! The above example assumes though that it is one business that issues the token which is then spent with that business. On certain platforms the tokens issued by the platform may be spent by many users of the platform rather than one specific business. Here some of the challenges described may be pluralised and not so acute.
From this perspective it can be intuitively deduced that having private money could add significant complexity and risk for a business. As any major global business will testify to, having multiple currencies is not a desired feature but a risk that needs to be managed, and as such good business management relies on hedging such risks. All things being equal minimal friction drives flow of capital and the most optimal structure may be one of a global unit of account that spans across jurisdiction, markets and social networks
Looking at this another way, the use of secondary tokens specific to a product/service can be compared across a wider economy, leading to a form of bartering economy. Money was “invented” because bartering isn’t a particularly efficient means of paying for goods and services. While this should be obvious it hasn’t stopped idealists and opportunists trying to bring back the concept through “new and revolutionary” business models — some of which scarily resemble the current secondary token issuance models. With the growth of the internet in the 1990s and 2000s there was a sporadic resurgence in the concept of bartering. But many platforms that attempted such models disappeared as quickly as they emerged. An example of one that launched in 2005 and persevered for a number of years was PeerFlix, which was a platform that enabled users to exchange DVDs. A notable summary by CNET read :
“Essentially, it’s Netflix with no centralized processing center. Actually, that’s not true. It’s more like an open-source version of Netflix, with users sending their own DVDs to other members instead of everyone borrowing from the company’s massive library of movies. The idea is that collectively, users have the movies that everyone wants. So, if one user has a copy of “Pulp Fiction” and another member wants to borrow it, the first sends it off to the second. ”
Peerflix tried to overcome the limitations of bartering. One of the key issues was associated with the “Coincidence of Wants” i.e. users not having exactly what their bartering counterpart wants . Peerflix attempted to solve this problem by introducing their own token called “Peerbux”, with which users could pay for DVDs rather than doing an outright exchange. This native token was used as a medium of exchange on the platform and could be bought for fiat currency or earned by sending DVDs to other users. By early 2008 Peerflix shut down, apparently as people realised that :
“when you have to trade DVDs straight up, there are going to be a lot of crappy DVDs available, and not many good ones. It doesn’t take an advanced economics degree to figure out why”.
An important lesson that can be learned from this is that having a secondary token is senseless when the economic structure of the underlying market is fundamentally flawed. In the case of Peerflix the flaw is simple, and is one Ebay knew very well. Ebay realised it could not fulfil user demand with the highly limited supply of used goods. The inelastic supply of used goods meant that as demand for a product increased the auction prices increased to a new equilibrium, however there is a limit to how much a user is willing to pay for a used item i.e. there is a point where a user would rather buy a new item than pay above a certain threshold for a used item. Ebay’s original model works well for antiques, where there is no more supply of new items, but it does not work well for generic mass market items. Ebay knew it needed to expand into a wider marketplace model that also offered new goods; this way it could fulfil user demand and compete effectively with the likes of Amazon . Peerflix did not fulfill its market’s fundamental needs, instead it focussed on simplistic ideas of solving problems that people really didn’t care about. Which resulted in Peerflix being eaten alive by Netflix!
So while native digital infrastructure assets, such as bitcoin or ether, are fundamental innovations as a decentralised store of value, medium of exchange and potentially a unit of account, their value can also be seen to stem from the frictionless markets they enable to be developed atop of their decentralised networks. Leveraging the core benefits of these native digital assets means that developers and entrepreneurs can focus on solving the real problems of inefficient markets they are trying to tackle.
Adding secondary tokens merely for the purposes of fundraising through regulatory arbitrage is a potential sign that the market model being deployed may be contrived and of no extra value at best, and potentially ineffective and value destroying at worst, due to frictions introduced in the market. This view of a contrived market can be further reinforced when looking at the complexities/risks being added to a startup’s operations with the introduction of secondary tokens. In cross border businesses hedging FX risk is a common practice, and introduction of a “global currency” such as bitcoin/ether can be considered as one of the key aspects of eliminating/mitigating such risk. However, then adding secondary tokens, and introducing FX risk again between a network’s native digital token and the secondary token local to a product/service, means businesses that either offer or use such tokens will need to hedge such exposure to run a successful company. Without hedging running a sustainable/successful business will be like running a trading book!
What then, if any, are the benefits of secondary tokens that behave like private money and are subject to price uncertainty, hedging complexity and costs? This is a question that, in the view of the authors, is not effectively answered by any current secondary token ICO issuance to date, and the chances are it may never be answered or the answer would be there are no benefits, in which case the market will revert to secondary tokens that are primarily regulated securities acting more like traditional equity or debt, where there is a valuable use case and where blockchain infrastructure offers efficiencies.
There are a number of limitations that make current open public blockchain networks unfeasible for wider commercial use. Some of the key ones, that are part of ongoing research and development efforts, include network latency (time taken to include blocks into the blockchain) and throughput (number of transactions that can be included in a block at any one time). For example, Bitcoin latency is ~10 minutes and has an average throughput of ~5 transactions per second (tps), while Ethereum has latency of ~15 seconds and an average throughput of~20tps. However, latency can be even longer during peak times, as new transactions are queued and prioritised based on size and fees. As a benchmark, these throughput numbers pale in comparison to Visa’s ~2,000 tps.
Apart from processing capability limitations there are other operational aspects that require further research. For example, the energy required to secure a blockchain through PoW  and the storage requirements for every full node participant in the network to keep a copy of all the transactions that were ever processed, which currently stands at ~180gigabytes for Bitcoin and ~325gigabytes for Ethereum .
While these limitations have a significant impact on cryptocurrencies being a good MoE and UoA, this work does not go into further details on these technical challenges, however one area that will be discussed is that of privacy on open public blockchains. As was alluded to earlier, one of the key aspects of an open public blockchain is that cryptocurrency payments and any associated secondary token transfers are recorded transparently in the blockchain ledger. Which means one’s economic activity can be tracked by any third party who knows that persons public address. Thus, if an open public blockchain is used for financial transactions, such as issuing a bond, the flow of funds and ownership of securities would be publicly available information! So while blockchain based tokens may potentially fulfill the traditional functions of money as a SoV, MoE and UoA, the issues related to Provision of Privacy (PoP) may be a key function that limits the uptake of a blockchain infrastructure as a system for issuing electronic cash and other forms of dematerialised digital assets.
In its current form the consensus mechanism used in Bitcoin and Ethereum requires extreme transparency to ensure any network participant can access all the required data to validate and record transaction and enable the network to converge to the true state of the system. Transparency is so important to reach consensus that, to some degree, individual privacy is sacrificed. However, as long as users keep their public addresses confidential they are able to manage a certain level of privacy, known as pseudo-anonymity, but this is challenging over an extended period and makes current public blockchains unviable for most commercial financial services applications.
One of the key aspects that makes the concept of a decentralised ledger technically viable is that all transactions are open for everyone to see on the network. This transparency means that anyone can validate if a particular transaction and the encompassing blocks follow the network’s protocol rules. The three key aspects for validation are as follows:
The network consensus model leverages the transparency of the transmitted transactions so they can be collated, reviewed, validated and “mined” into the blockchain ledger, in addition every mined block that is shared across the network can be validated and included to the end of the chain (Figure 4). This means that every transaction that is ever sent, and the value being sent is available for all to see, and more importantly anyone can use this information to participate in the use of the network or the process of securing the network i.e. validating new transactions and forming new blocks.
The issues with such transparency is that it can easily be used to infringe on an individual’s privacy, both in terms of tracking payments made in the network’s cryptocurrency and also tracking ownership of secondary tokens that are used to represent rights to other issued assets such as securities.
This extreme level of transparency would be equivalent to one having their bank account number and all historical transactions available for everyone to see – their entire financial history could be tracked just by knowing a person’s account number This leads to the point of privacy. As long as the account number, or blockchain address in the case of bitcoin/ether, is kept secret, attempts can be made to abstract the flow of funds i.e. as noted above achieve a level of pseudo-anonymity. However, doing so would be troublesome, and over a period of time it not very effective.
One could ask the natural but complex question: is the need for transparency to drive the consensus mechanism, and the right to privacy for individuals, incompatible in a decentralised world? Does one need to be sacrificed to enforce the other?
Moving away from a centralised system, it is difficult to pinpoint where accountability should sit as there is no single authority that could be responsible to maintain the system correctly/honestly and be accountable for privacy of users data. In particular, in an open public blockchain infrastructure, new nodes, or those maintaining the network through validation and mining, can come and go dynamically, and anyone is able to participate in the mining process to secure the network just by adding computing power (or potentially staking their cryptocurrency in a PoS model). In such a decentralised setup the accountability lies with all the participants, hence the need for a consensus mechanism to coordinate and converge to the truth.
This is where the extreme transparency of transactions on the blockchain are required to ensure that all the participants can see exactly what was transacted, how it was transacted, and what the current state of the ledger is. This way all the participants of the network can compete to converge to the “true” state of the ledger of transactions – using the same rules and with equal access to data. To enable this system to function all participants need to not only have equal access to information but also see all the details of every transaction and the history of the blockchain to be able to validate and mine new transactions into the chain.
As long as users are ok with sharing all their economic history and future activity over an open public peer-to-peer network such a model works well. However, when the information is financially sensitive e.g. a user’s bank account and investment portfolio, the lack of privacy can be an issue and point of friction for wider commercial uptake.
There is much debate, both legally and socially, around the correct balance to strike between an individual’s, organisation’s or state’s need for privacy and the need for transparency. Data protection laws typically assure a certain amount of privacy with the need for transparency being assured by freedom of information laws which are, increasingly, a part of national laws for developed democratic countries as a means of holding governments to account and tackling the imbalance of power between states and citizens.
While using transparency as a means to hold power accountable is a fundamental tool against corruption and exploitation, its balance against the loss of individual’s privacy is an important consideration.
As shown in Figure 5, while a balance between privacy and transparency is challenging it can be managed in centralized systems through the use of regulations and national/international laws. However, these do leave room for abuse by self interested organisations and governments. While decentralized systems may mitigate the risks of concentration and abuse of power, this currently comes at the loss of privacy for the individual.
While such loss of privacy is concerning, and it can be considered that current blockchain infrastructure does not adequately fulfil the PoP function of money, it can be argued that there may be some advantages to such extreme transparency beyond enabling distributed consensus. One of the key advantages is that it can potentially help overcome some of the inherent tensions between the need for good regulation and security on the one hand and the need for free flow of capital to fuel economic growth on the other.
One of the key outcomes of the geo-political and economic events that have shaped the first two decades of the twenty first century has been an enormous increase in regulation and scrutiny. The global financial crisis has led to a substantial amount of financial regulation; and various terrorist atrocities, together with actions by various states, has led to much greater and stringently enforced sanctions, anti-corruption and anti-money laundering regimes. While these regulations may strive for consumer safety they are also a substantial cost for businesses and a restriction to the flow of capital.
In a world where open public blockchain technology is widely used in finance and commerce, people and organisations will likely use endpoint payment solutions that can leverage the blockchain and execute transactions. In such a model, the allocation and safekeeping (or custody) of private keys may become a fundamental business potentially offered by regulated entities that have accountability, and thus provide certain assurances of security and privacy through various centralised modes of operation. These safekeepers of private keys, or Key Custodians, can then use the transparency of the blockchain infrastructure to comply with regulation while minimising transaction costs and not inhibiting the flow of capital. This is one of the promises of public blockchain technology. However, while key custody may provide a replacement for the current electronic payment services, chain of custody and asset clearing/settlement systems, it does not provide an adequate replacement for cash i.e. an electronic equivalent of bearer assets such as central bank issued notes. This electronic form of cash may be vital for particular scenarios where privacy is fundamental to minimise transaction costs, an example could be where people want to protect their wealth from corrupt/dictatorial states. Therefore, the PoP function of money needs to be a core element of a blockchain or cryptocurrency, or at least be part of its delivery roadmap, for it to have a sustainable global future.
The current lack of privacy is not a complete deadend. As noted earlier open public blockchain technology is in its infancy. While tried and tested cryptographic tools underpin current frameworks, such as public key cryptography and hash functions, there are a number of novel concepts and tools undergoing industry experimentation that may well be the holy grail for balancing the need for transparency with a desire for privacy. One of these promising cryptographic concepts is Zero Knowledge Proofs, and a specific implementation of this is known as zk-SNARKs, which is used by the privacy focused cryptocurrency Zcash .
In general zero-knowledge proofs allow one entity, the prover, to prove to another entity, the verifier, that a statement is true, without revealing any information beyond the validity of the statement itself. Traditional zero-knowledge proofs may require interaction and sharing of information back and forth between a prover and verifier for multiple rounds. However, non-interactive zero-knowledge proofs (i.e. zk-SNARKs) are a variant in which only a single message, or “proof”, needs to be shared between the prover and verifier.
For example, imagine a prover wants to prove to a verifier that they have hashed a number, and they know what the number is, without actually revealing the number to the verifier. The prover could use a zero-knowledge proof to convince the verifier that there is indeed a number that only the prover knows which generates the hash that the verifier can see. Such privacy tools can be leveraged to prove certain steps have been taken in a transaction without revealing what those steps actually are i.e. only reveal part of the process without showing the whole process itself and prove that the verifier being honest about their claims.
Such zero-knowledge proofs can provide assurances that users are only spending money that they have without revealing their identity, holdings and transactions on the public ledger. In Bitcoin, transactions are validated by linking the sender address, receiver address, and bitcoin input and output values on the public blockchain, which can be openly seen by all parties i.e. are transparent. In the case for Zcash, it uses ZK-SNARKs to prove that the conditions for a valid transaction have been satisfied without revealing any crucial information about the addresses or values involved. The sender can construct a “shielded” transaction proof to show that the economic, security and structural consensus rules (discussed above) have been followed.
Thus, using such cryptographic tools, one can maintain the required transparency to ensure the network consensus rules have been followed, but the underlying information of who sent how much to whom would remain private.
However, it is important to note that such Zero Knowledge cryptographic privacy tools are highly novel and there are many challenges related to the current setup, processes, performance and even future consequences when the tools are compromised and immutable private transactions can become visible.
This work highlights some of the technical, legal, economic and political complexities that underpin the use and wider adoption of cryptocurrencies, digital assets and private forms of electronic money. However, an important point to note is that open public blockchain technology is still in the very early stages of use, testing and development. While the industry will likely experience significant issues due to inflated cryptocurrency prices and legal/regulatory challenges, the chances are that some variant of this technology will likely form the basis of future payments and asset clearing and settlement systems.
Dismissing cryptocurrencies and the technological and economic innovations that underpin them merely due to the current challenges and limitations would be akin to dismissing the internet in the early 90s just because Netflix could not be deployed on the infrastructure at that time.
Thanks to the contributions of Philip Smith, Partner at Allen & Overy.
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