In the world of public blockchains and cryptocurrencies, projects need to bootstrap network effects before becoming useful. As per Metcalfe’s Law, the value that a network provides scales non-linearly with the number of people; a network with \(n\) people participating has a total of \(\binom{n}{2}\) possible connections between people. The more people join, the more it makes sense for others to join. Given this dynamic, the question for the founding teams of crypto projects becomes, how do we get tokens into the hands of potential users and grow the network?
Bitcoin, the first cryptocurrency, came into existence when in early 2009, Satoshi Nakamoto published the code to the open source software platform SourceForge, and announced the release through a cryptography mailing list, with little fanfare. Anyone was free to download the code and start mining Bitcoin on their computer, but few knew about it, and the community participating in the network was small. However, knowledge of Bitcoin spread over time, resulting in more miners joining and people sending the cryptocurrency to each other. Its adoption was purely organic, and every Bitcoin in existence has been the result of mining.
The rise in Bitcoin prompted technologists to expand upon the idea, and many projects popped up. One early such project of note is described in “The Second Bitcoin Whitepaper” by J.R. Willett, published on the Bitcointalk forum in early 2012. The paper describes a token built on top of the Bitcoin protocol meant for the creation of stablecoins and other tokens, a precursor of the ERC-20 abstraction later developed by Ethereum. The significance of this paper is that it perhaps contains the first description of an initial coin offering, or ICO. Willett describes an initial fundraising that “will provide initial funds to hire developers to build software which implements the new protocol layers, and ongoing funds to pay for maintenance of this software” and “will richly reward early adopters of the new protocol, in proportion to how successful it is.”
As opposed to the development of Bitcoin, for which Satoshi hacked on the project presumably without being paid before releasing the code, ICOs serve as a way for a founding team to raise initial capital through a public sale of a portion of their token supply, before a final product is released, allowing the team to plan for more capital-intensive strategies. This was the route Ethereum took in their 2014 uncapped public fundraising that ended up raising the founding team Collected $18.4 million Bitcoin over the course of the 42-day ICO period.
As the early waves of ICOs played out and proved to be successful, with token values of ICOs and the broader array of cryptocurrencies skyrocketing, more teams became interested in conducting an ICO to raise money, and many investors looked towards ICOs as an opportunity with extremely high upside. This dynamic ultimately created a positive feedback loop, culminating in the ICO boom around 2017 late to early 2018, where many projects decided to raise large uncapped ICO rounds despite having barely fleshed out an idea through a whitepaper, and written zero lines of code, and investors were blindly throwing money into ICOs as a get-rich-quick scheme. As with any bubble, this one eventually popped, and both founders and investors had to deal with the consequences.
Although the early vision for ICOs had good intentions, ICOs as a token distribution mechanism have numerous drawbacks. The people investing in ICOs are mainly interested in the token as an investment or speculative asset. The incentives are not aligned to make people use the tokens later on to interact with the network in any way. In many cases, tokens that were distributed through an ICO saw widespread dumping by speculators who were looking to scalp the rise in price of the token due to hype. Furthermore, ICOs are generally not a great way to distribute tokens uniformly throughout the user ecosystem. In the case of Ethereum, over 40% of the ether sold went to the top 100 buyers. This poses a risk as large token holders are able to use their large stakes to influence the network and would potentially defeat the purpose of decentralization.
Regulation also plays a major role in ICOs; in the early days, there was little regulatory clarity on ICOs, but over time, the United States government has come to view ICO tokens as being securities through the Howey Test. As a result, the SEC had to subpoena numerous projects for violating securities regulations, and many of the later ICOs had limited distribution in the United States due to strict standards from the SEC.
Related to the ICO is the Initial Exchange Offering (IEO), which is essentially an ICO conducted through a crypto exchange as an intermediary, where investors would purchase the token through an exchange rather than from the project’s team directly. Binance pioneered this mechanism when they held an IEO for the Gifto token in late 2017, and has since gone to conduct more, with other exchanges following suit. From the point of view of the team launching the token, IEOs are expensive due to the exchange often taking a cut of the token sales and also charging fees, but in many ways, it may be a worthy investment. When conducted through a large, reputable exchange, IEOs are a way to reach a broader audience. Projects don’t have to worry as much about KYC/AML regulation, marketing, and distribution, which are handled by the exchange. Given that teams generally seek to get their token listed on the major crypto exchanges anyways, performing an IEO is a natural way to spread the word about a token.
One model of token distribution that became popular circa the 2017 crypto bubble was the airdrop. Essentially, projects would deposit some amount of their token to Ethereum wallet addresses over some Ether threshold, in the hope that users would be curious about a new token that popped up in their wallets. Some airdrops were slightly more refined, such as in Dfinity’s case, where the project airdropped tokens to those subscribed to their mailing list before a certain date.
However, airdrops as a whole generally were ineffective as most users fail to take the next step in using the tokens to interact with the network. Users would see the airdrop as free money and sell their tokens for a quick profit, or the tokens would end up sitting in a wallet address, unused. Furthermore, there was a cost to the airdrop issuer in having to pay transaction fees on sending the tokens to thousands of addresses. In general, the incentives were highly skewed and the effort ended up not being worth the cost to most projects, but from these experiments, there was one positive: as opposed to the ICO, a derivative of the initial public offering on Wall Street, airdrops were a novel, blockchain-native mechanism and are a testament to the power of smart contracts and the ERC-20 abstraction.
Since the mania of ICOs and airdrops, founders have taken a step back to think about how to fully use the power of smart contracting to their advantage when it comes to token distribution. Livepeer and Edgeware are two early projects that found a way to hack traditional distribution mechanisms.
Livepeer, a decentralized video streaming protocol over Ethereum, introduced a novel token distribution mechanism known as Merkle Mining when they were looking to grow their network in 2018. The Livepeer team took a snapshot of the Ethereum network and wrote a smart contract that allows users to claim Livepeer tokens by submitting a transaction including a Merkle proof that their address was above a certain Ether threshold during the time of the snapshot. Over time, the contract would also allow for users to submit proofs for other addresses that have not claimed tokens. The Livepeer Merkle Mine flipped the mechanic of airdrops on its head, requiring users to incur the gas cost of obtaining the token. The mechanism also filters users in the sense that submitting an on-chain smart contract transaction requires some level of technical ability, and it is this group of people savvy enough to engage with contracts on-chain who would be more likely to participate in the Livepeer network and use their tokens for the intended on-chain mechanisms rather than holding them purely as an investment. One unforeseen consequence of the Merkle Mine was that Merkle Mining was computationally expensive and as many transactions were being sent in the Ethereum network to participate, the Ethereum network became fairly overloaded during this period, resulting in high gas fees, foreshadowing what was to come a few years later through decentralized finance.
Edgeware, a WASM smart contracting platform for the Polkadot ecosystem, had their token distribution through a mechanism they called the Lockdrop, in which users had to lock up Ether tokens in a smart contract for some specified length of time, 3, 6, or 12 months, before they could withdraw their Ether. The amount of Edgeware tokens that one would receive scaled with the amount of Ether locked, and also increased if the lock period was longer. The team also added a mechanism called signaling, in which no locking period was required, but resulted in a severe penalty in Edgeware token that could be acquired. The Lockdrop ended up being extremely popular for the Ethereum community, with over $200 million in Ether being locked up in the contract. Overall, the mechanism served as an interesting experiment in introducing additional costs to acquire the token, in particular the opportunity cost of using Ether to do something else, and the market risk of not being able to sell Ether while it is locked, making those who participate likely to be more aligned with the project and viewing it as a worthy investment.
The Compound lending protocol, though having been around for a few years, launched the distribution of their governance token, COMP, in May of 2020. Compound allocated a portion of COMP to be distributed to borrowers and lenders using the protocol, initially as an even split between the two groups. As the COMP token quickly gained in price after launch, users realized that participating in the protocol by lending or borrowing was a way to make a good return from the COMP token earned alone. Although the Compound protocol charges interest on borrowing tokens, the amount of COMP distributed greatly outweighed this cost, making both lending and borrowing profitable. It was common practice for users to leverage up their position multiple times by lending tokens as collateral repeatedly using the lent tokens as collateral to borrow and re-lend the borrowed tokens. Eventually, the unforeseen mania-inducing token mechanism was fixed through an on-chain governance proposal conducted through COMP voting, but ultimately served as an important lesson in showing how proper token mechanics are able to hack distribution and network adoption. The success of the COMP token distribution was a seminal moment in the Ethereum ecosystem, as it prompted the launch of many other projects with novel token mechanics, starting the decentralized finance and yield farming craze.
Dozens, if not hundreds of new projects were developed of varying levels of success and credibility experimenting with different ways to reward users with governance tokens. To name a few projects, Yearn, a yield maximizing decentralized finance protocol launched their YFI governance token by requiring users to provide liquidity on the separate Curve.fi protocol, and staking tokens from Curve.fi to obtain the token, and the decentralized exchange Uniswap launched their UNI governance token as an airdrop to all users who had traded on the exchange, and currently gives UNI token to those participating in market making.
As a final point, a current hotly debated topic is the idea of a fair launch. To give an example, in the case of Compound, the team had obtained funding through venture capital, and as a result had a large portion of the COMP token pre-allocated to these firms. Furthermore, the team had allocated a portion of their tokens to the founding team, a practice very common in the crypto space. This resulted in a highly skewed token distribution, mimicking some of the behavior of ICOs, made for single addresses that had a disproportionate amount of influence over protocol governance. Seeking to prevent this dynamic, many of the newer projects, such as YFI, are conducting fair launches where no pre-allocation is made; the only way to obtain the token is through some staking or locking mechanism. This practice has received praise from the community and is the roadmap to greater decentralization and effective governance in the future.
From the recent advances in decentralized finance, it is evident that the design space for token distribution mechanisms is extremely wide. New projects seem to be springing up every week, each with a unique spin on token behavior, and it is exciting to see what comes next.
Written on September 1st , 2020 by Alex Miao