Network tokens vs. company-backed tokens

Distinguishing network tokens from company-backed tokens can be difficult, because both types of tokens may have utility and derive some value from both onchain functioning of a blockchain and offchain efforts of a company. But it’s important to distinguish between them: Network tokens and company-backed tokens pose very different risks to holders and should therefore be treated differently under applicable laws. So, where’s the line?

The unique feature of network tokens that distinguishes them from company-backed tokens is that network tokens primarily accrue their value from a blockchain or smart contract protocol. This is key because these systems are capable of autonomous and decentralized operation — operation without human intervention or control. Because of this, blockchain-based networks can be truly open: The network effects of the system are captured onchain and accrue to tokenholders, and those network effects can in principle be accessed and built upon by anyone.

Conversely, company-backed tokens primarily accrue their value from offchain systems or sources that are not capable of autonomous operations — centralized systems that require human intervention and control. This relationship is most often explicit — for instance, when the token’s price is tied to the profits of an offchain application, product, or service, or when the token has utility in such systems. But it can also be implicit — for instance, a token without purpose or utility that uses a company’s brand may imply the company will drive value to the token. In either case, if a token is intrinsically linked to a system that is not capable of autonomy and it primarily derives — or is expected to derive — its value from that system, then the token is a company-backed token. The lack of autonomy means that any related network, even though it may appear to be public, is in practice closed — just like in a web2 social network controlled by a single company — and thus the token’s network effects accrue to the company that controls the system and not its users. 

These differences in network design (closed vs. open) have real economic and regulatory consequences. Because network tokens relate to open networks that are not controlled by anyone, they are more similar to commodities — they are capable of operating in a manner that precludes any party from unilaterally affecting or structuring the risk associated with the network’s token. The elimination of this trust dependency distinguishes network tokens from securities, and the elimination of trust is bolstered if the network drives value to the network token through its functioning, such as through a programmatic buy-and-burn.

Conversely, company-backed tokens have trust dependencies that are similar to securities: If a token derives its value from a closed network controlled by a single entity, that entity can unilaterally alter the expected value of the token. For instance, the controlling entity could alter the utility of the token or inflate the supply of the token — or even turn off the entire system — at will. This strongly suggests that securities laws should apply where people are investing in company-backed tokens.

Two examples help further highlight the distinction:

• ETH is a clear example of a network token. It enables holders to transact on the Ethereum Network and provides holders with an economic interest in the network. The network is decentralized and functions autonomously (with no one person or management team in control of it). As a result, the SEC itself has concluded that securities laws don’t apply to it.
• FTT, meanwhile, is a clear example of a company-backed token. Its value was entirely dependent on the ongoing operation of the FTX exchange, which itself was a centralized exchange operated and controlled by a company. FTX, the company, took a portion of company profits from operating the exchange and used them to buy back FTT, thereby driving its economic value. As a result, FTT was essentially a profits interest in FTX — its utility and value were controlled by FTX — and should have been subject to securities laws.

Between these extremes things can get murky. But whether a token is a network token or a company-backed token can typically be determined by answering three questions: 

1. Is the system’s network design open?
2. Do the network effects of the system accrue to the protocol and tokenholders?
3. Does the system enable independent value accrue to the protocol and tokenholders?

If the answer to all of the above questions is yes, then theoretically the system should be able to continue to function, even if in a diminished form, without the initial development team. This is critical, as it means the system is capable of functioning without being controlled.  

Additional examples help illustrate these concepts:

The tokens associated with most decentralized exchange smart contract protocols (DEXs) are network tokens even though the initial development teams often operate frontend websites and offchain routing software for such protocols. Why? 

DEX protocols are typically open networks, meaning that anyone, not just the initial development team, can operate a frontend website and their own routing software on top of the protocol. That means the network effects of most DEXs accrue to the protocol and tokenholders, not to the companies that built them. Specifically, the liquidity critical to the DEX’s functioning is controlled by the protocol itself, not the initial development team. 

Value accrual can happen at multiple places, but the key question is: Can it accrue to the protocol and tokenholders independently of the initial development team? DEXs typically have their own programmatic economic mechanisms embedded in the protocol (typically called a “fee switch”), and frontend website operators also regularly collect fees from users. Critically, the presence of this fee collection at the interface level is not disqualifying if the economic mechanisms that underlie the value of the network token function independently of and do not depend upon the offchain products and services of the initial development team. In other words, if the protocol fee switch is turned on, then value of the network token will accrue independently to tokenholders regardless of any single company’s operation of an interface (including the initial development team’s interface). That means the network token is economically independent from and not controlled by the initial development team. 

As a result, even if an initial development team were to abandon a DEX that meets all of the above criteria, that DEX would still be capable of continuing to function. So, the system’s token should be properly classified as a network token.  

Or consider gaming. While there are many instances of fully onchain games, most web3 games depend on offchain services (e.g., servers) to function. But just because a game isn’t fully onchain doesn’t mean that games can’t have network tokens. If the core assets — items, characters, and so on — are issued and recorded onchain and not controlled by any single party, then the system can be said to function like an onchain network. As a result, the network could be open, and enable anyone to build with the core assets of the network (i.e., if that privilege is not reserved for the initial development team), which means the network effects of the game could accrue to tokenholders rather than to the original game developer. Programmatic economic mechanisms designed to accrue value to the game’s token would then support a finding that the token is a network token — the system would be capable of continuing to function and create value without the initial development team. 

Or consider decentralized social media protocols. Many such protocols make use of a combination of onchain and offchain components. For a social network to be open and for its network effects to accrue to tokenholders rather than a centralized company, users must be able to find each other and communicate, even if the rest of the network wants to prevent it. One way of accomplishing this is to maintain user account registrations and the associated authentication keys for posting social media messages onchain, and to enable any developer to build their own clients on top of the network — meanwhile, storing posts and other user interactions through a network of offchain “hubs,” each of which replicates the network’s data and state. As a result of these features, the network can be said to be open — anyone can create an account using openly accessible blockchain smart contracts, and then use that account to post. And the network has robust protection against centralized control because the hubs are maintained by a wide range of parties. Such a network would be capable of having a network token, despite the presence of centrally controlled user-applications that provide access to the network. The system could be strengthened further by adding programmatic economic mechanisms that accrue value to the network’s token, making them economically independent. 

In contrast, consider what would happen if Apple launched an App Store token. Holding the token could entitle users to discounts in the App Store, or it could be used for payments for apps, and a percentage of all blockchain-based payments for apps in the app store could be directed through a smart contract that then distributed value back to tokenholders. Despite this use of blockchain technology, Apple’s token would be company-backed:  The system is closed, and nothing about the use of blockchain rails would enable third parties to capitalize on Apple’s network effects and build competing app stores in such a system. Furthermore, value would be derived from proprietary offchain products and services controlled by Apple (the app store). Even with onchain programmatic economic mechanisms, if Apple simply shut down the app store, all value accrual would cease. As a result, the risk profile of the token would look much closer to a share of APPL and very different from a network token, and securities laws would likely apply.

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Before you believe someone that their token is decentralized, think through whether its value chain can really operate without human control or intervention. If its value depends on the offchain operation of an application, product, or service that’s not capable of being autonomous, it’s not a network token. 

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Acknowledgements: We’d like to thank Chris Dixon, Tim Roughgarden, Bill Hinman for their helpful comments; and Tim Sullivan for his editing. 

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Miles Jennings is General Counsel of a16z crypto, where he advises the firm and its portfolio companies on decentralization, DAOs, governance, NFTs, and state and federal securities laws.

Scott Duke Kominers is the Sarofim-Rock Professor of Business Administration at Harvard Business School, a Faculty Affiliate of the Harvard Department of Economics, and a Research Partner at a16z crypto. He also advises a number of companies on web3 strategy, as well as marketplace and incentive design; for further disclosures, see his website. He’s also the coauthor of The Everything Token: How NFTs and Web3 Will Transform the Way We Buy, Sell, and Create.

Eddy Lazzarin is the chief technology officer for a16z crypto. He oversees the engineering, research, and security teams, which support the investing process and collaborate with portfolio companies to build the future of the internet.

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