Since the dawn of mankind, scarcity has been bound to suffering. Until recently in history, most of us simply didn't have enough to get by. In the words of Eric Jorgenson, “Not enough food, not enough shelter, not enough time.”
The internet flipped this on its head. Suddenly, we could make copies of anything digital and distribute them infinitely at no cost. The abundance our new digital tools gave us provided unprecedented leverage over the analog world.
Unfortunately, this came at the cost of ownership.
Ownership and collection are deeply human traits. Our ancestors collected rocks, beads and animal teeth as a means of self-expression and identity. In a time before central banking, collectibles evolved into money, and we relied on cultural consensus that what we chose was easy to exchange and hard to counterfeit. Soon enough we had trade, and economies were born.
Although we've long since passed the time where collectibles and money were one in the same, we still find ourselves collecting— baseball cards, cars, action figures, vinyl— practically anything you can think of. In a way, the internet threatened this practice: while anything physical is inherently unique, until recently, we didn't have any universal way of ensuring uniqueness for anything digital.
To replicate scarcity online, we built highly centralized platforms that gave the illusion of ownership— of followers, of game items, of images, of media— on a small subset of servers owned by a small subset of corporations.
That's changing very quickly.
In the same way digital abundance was a big idea made possible through the advent of the internet, digital scarcity will follow suit through the advent of blockchains. Making copies of everything will prove to be just be as important as ensuring something digital is unique.
To understand digital scarcity, we need to understand fungibility.
For something to be fungible, it is mutually interchangeable. A classic example of this is the dollar bill. A dollar bill is fungible because $1 is $1 is $1— you don't care what particular bill you have. An airplane seat, on the other hand, is non-fungible. They're both plane seats, but I'd prefer 3A over 48F on my transatlantic flight because 3A comes with champagne and 48F comes with someone's screaming kid.
Let's go a bit deeper on each of these.
When we say fungible token, we basically mean money. Gold, US Dollars and Bitcoin are all fungible. As it turns out, most things are non-fungible, and fungibility is just a good way of ensuring two things are equivalent. Remember, $1 is $1.
Economically speaking, money has 3 functions: a medium of exchange, a store of value, and a unit of account. These allow us to facilitate trade, preserve wealth, and standardize how we measure value, respectively.
Making money programmable expands on this considerably. We can take Ethereum, for example, which uses the ERC20 standard for fungible tokens. Here, we can expand our use-cases to equity, utility, and governance.
Equity tokens are a good place to start because they provide the strongest analog to traditional finance. Stocks can be thought of as an ownership incentive to provide a company with capital. Like a stock, equity tokens represent ownership in an asset. Unlike a stock, equity tokens are used as incentive for people to provide a network with a scarce resource. In addition to contribution of capital, they can also pull for computing power, customers, talent, and more.
A good example of equity tokens used as incentive is Uniswap, a decentralized exchange for swapping Ethereum-based tokens.
Public markets traditionally use a central limit order book exchange. Under this model, orders are organized by price and filled as demand shifts, but the underlying matching algorithm for buyers and sellers is actually pretty opaque.
Uniswap changes this by using an Automated Market Maker (AMM) instead of that order book. The AMM replaces buy and sell orders in an order book with a liquidity pool of two assets valued relative to one another. A buyer and seller trade directly with that liquidity pool and a new market rate is determined as the prices of both assets shift.
The exchange is powered by transparent smart contracts, which allow anyone to see exactly how their order is fulfilled. The goal of the exchange is to give a user the best execution price for a pair of tokens, and does that by incentivizing liquidity providers (LPs) to deposit their tokens into liquidity pools. It accomplishes this by giving LPs a share of trading fees through issuance of pool tokens. These tokens track an LP's share of total reserves and can be redeemed at any time.
To return to our fundamentals, we find that Uniswap incentives LPs to contribute a scarce resource, capital, to their network through issuance of equity (pool) tokens.
Governance tokens represent ownership of fractional voting rights in an asset. By definition, a crypto protocol is meant to be governed by a decentralized network of stakeholders and their delegates to ensure the permanence and immutability of a protocol should anyone choose to build on top of it.
As Jeff Amico puts it, "[the] primary objective in governance is to create the conditions necessary for protocols to achieve long-term adoption and self-sustainability."
At a base level, cryptonetworks function through use of smart contracts. Smart contracts are basically logic gates that are executed when predetermined conditions are met on the blockchain. Though simple in theory, smart contracts power transactions otherwise impossible or desperately slow in legacy systems. For example, it might take weeks of time and a mind-numbing amount of paperwork for a bank to verify someone's assets and issue them a loan. A smart contract can execute this instantly based on a user's provided collateral.
The early days of an Ethereum smart contract are actually quite plastic. In order to limit vulnerabilities, after it's deployed to the blockchain, a smart contract can be edited with administrator privileges until it's been thoroughly tested, at which point it's locked down for good. Although this means the smart contract can't be abused and edited at will by an administrator, a protocol still needs to be upgraded over time.
This is done through governance tokens which are issued to network participants and made useful with tools like Snapshot, which allows holders of governance tokens to vote on proposals or delegate their governance power to another individual. This can cover everything from more familiar concepts, like electing committee members to specific policy domains, to more complex ones like voting on the collateral ratio for tokens or changing protocol fees for liquidity providers.
Utility tokens, lastly, are a just a kind of fungible token that unlocks functionality on-chain via a smart contract, and sometimes off-chain, in the real world. Let's start with the former. A good example of an on-chain utility token is in Compound, an on-chain lending protocol built on Ethereum.
On Compound, loans are made through collateral tokens, which are voted on by $COMP holders. Tokens used as collateral, like stablecoins such as USDC and Tether are great examples of utility tokens because they unlock functionality in a smart contract for a user— in this case, decentralized lending.
There's a bit of a problem with some utility tokens, as Ryan Selkis wrote in 2018: "almost all utility tokens will trend towards zero because there is no need to actually hold them for any length of time." Given the purely supply-and-demand driven value of utility tokens, no incentive to hold poses an issue. Some fixes have been pegging utility tokens to another asset, like stablecoins are pegged to the US Dollar. Still, it's difficult to unpack completely.
Predominantly off-chain systems, on the other hand, are more difficult to enforce, but arguably more valuable for that same argument Selkis made earlier. A great example of this is gating access to a community with utility tokens. In this case, network (and thus community) participants are economically and interestedly incentivized to invest time and resources into cultivating that community.
Friends With Benefits is an example of a social token-gated community that focuses, in their words, on "where crypto meets culture." They put on events and foster community among creatives in major cities across the US and abroad. To join, you need to apply and hold 75 $FWB, which equates to about $8000 USD today. If you're like many people, this price seems absurd, and by all respects it probably is. Earlier on in its life, the price for entry into FWB was in the lower hundreds of dollars, which seemed like a reasonable price to pay for inclusion in a quality, spam-free, mutually aligned community.
The problem with gated admittance is the fact that as a community gains notoriety and the price of its token appreciates, the price of admittance does too. For a technology so focused on inclusion and lowering barriers for participation, this is a major hurdle that needs to be surmounted.
Fungible tokens are gaining more traction as tools in equity, governance and utility, but there's another half to this technology that digs even deeper into traits that make us fundamentally human.
Non-fungible tokens, or NFTs, are just tokens that prove the authenticity, scarcity and ownership of a digital asset. If fungible tokens are productive assets, non-fungible tokens (NFTs) are non-productive assets— but that doesn't make them non-valuable. On the Ethereum blockchain, we use the ERC721 standard for non-fungible tokens.
For some context, we'll return to the example of our cavemen ancestors we discussed earlier. In the same way fungible tokens tackled money and mediums of exchange, non-fungible tokens map to collectibles for the same means of self-expression and identity.
We can break NFTs down in the same way we broke fungibles down. For simplicity's sake, we'll continue working with 3 categories: status, identity, and community.
Status is central to human behavior, whether we'd like to admit it or not. But how does a digital asset signal prestige or social standing? I'd point at something more tangible in our daily lives: luxury brands. People don't buy Lamborghinis and wear flashy watches because they're explicitly better at performing a function. A Toyota will still get you from A to B and a Casio tells the same time as a Rolex. What's more is that people will go out of their way to pay a significant premium for the authenticity of a luxury good, which is effectively what you're paying for with an NFT: proof of ownership. Packy McCormick illustrates this well:
"An authentic Birkin bag is able to fetch prices hundreds of times higher than the exact same bag in knock-off form because owning the real thing says something about the person who owns it. The same is true for digital items, fashion-related and otherwise."
We see this in the digital world today as well. Follower counts on Instagram often act as an analog for social status and clout, driving further ostentatious behavior online. Importantly though, you don't own your followers or those images you used to accrue them in the first place.
The ultimate NFT equivalent here might be CryptoPunks, which have become something of a cult as of late. They were created in 2017 well-pre NFT craze and launched as a set of 10,000 8-bit style portraits with randomly generated traits and were given away for free. Today, the cheapest one you can buy goes for upwards of $400,000 USD. In a way, they're the ultimate status symbol because holding one inherently passes up the opportunity cost of some very serious money.
Identity is also key to the utility of NFTs. The Ethereum Name Service, or ENS for short, is a great example of this. In their words, they're "a distributed, open, and extensible naming system based on the Ethereum blockchain." Their job is to map human readable names like John.eth to machine readable names like Ethereum and other crypto addresses.
On the web, DNS translates domain names of a web address like Facebook.com into an Internet Protocol (IP) address, something like 69.63. 176.13. ENS does the same but domains are mapped into Ethereum addresses. Instead of 0xAFA087... we can just use labossiere.eth, for example, which I own.
The point here is that ENS domains act as identifiers and are in themselves non-fungible tokens. If you hold the labossiere.eth NFT in your Ethereum wallet, that domain will resolve to your wallet address.
Community is the last use-case we'll cover here, and functions for NFTs very similarly to community-based utility tokens covered earlier. The only real difference is instead of holding a certain number of fungible tokens for admittance, you just need to hold an NFT.
Projects like Bored Ape Yacht Club, CreatureWorld, SquiggleDAO, and others are notable for their tight-knit communities and events in major cities across the world. For admittance, of course, you need to hold their token, which can run you a pretty penny.
Other organizations like CityDAO are taking a more literal approach, minting NFTs that act as proof of citizenship to their nascent crypto-state, which, yes, is an actual thing. CityDAO was among first crypto-organizations to purchase physical land, which they did recently in Wyoming— the state recently recognized decentralized governance of LLC corporations, which made this possible.
Okay, that was a lot. To sum this all up, the fundamental units of value in the crypto-economy are tokens. Though the technology is new, tokens aim at practices as old as mankind itself. Fungible tokens are most functionally similar to money, and facilitate use-cases in equity, utility, and governance. Non-fungible tokens, on the other hand, are more analogous to collectibles, and serve as tools for status, identity, and community.
While challenges still exist in scaling this technology, it's come to its current state unbelievably quickly. Bitcoin hit $1T market cap faster than Apple, Amazon and Google. If past velocity is any hint of future potential, this technology is going to change many more things, much more quickly than we think possible.
Thanks for reading,
Composability is Innovation by Linda Xie
Designing Internet-Native Economies: A Guide to Crypto Tokens by Patrick Rivera
Digital Scarcity in web3: types of scarcity, applications, and how the world might change by Eric Jorgenson
NFTs and A Thousand True Fans by Chris Dixon
The Value Chain of the Open Metaverse by Packy McCormick
Crypto fundamentals and NFTs by Patrick Rivera
Life is Non-fungible: The Evolution of Ownership, Assets, and Us by Roham Gharegozlou
Stories, Scarcity and Mimetic Desire by Nick Tomaino