Tokenomics and the Social Forces Driving Crypto Markets | Shimon Kogan

Itay Goldstein: Welcome everyone. This is the Future of Finance series. This is our second season, and we are talking about digital assets, cryptocurrencies, tokens, decentralized finance, and everything related to that space. I am Itay Goldstein, professor of finance here at Wharton, and I’m currently the chair of the finance department.

We are going to devote this episode to thinking about the economics of tokenization. This is a term that is now known as tokenomics. We’re going to try to understand what are the fundamental forces that are driving the market for tokens and coins, and how these forces are different from some of the other markets, financial assets that we are used to and that we have been thinking about in the past.

I have the perfect guest today to think about those issues. Shimon Kogan has been with us at Wharton for the last 10 years or so, teaching the fintech course. He was one of the first movers into the area of fintech when few places had fintech courses. He already designed one and came to teach it for us, and has been doing it since then with great success. He also worked on related issues in his own research, and we are going to talk about that as well. Welcome Shimon. It’s great to have you.

Let’s dive right in and try to understand some of the terms that we are talking about. Can you help us understand, what do we think about when we think about tokens and coins? What are the common uses for them? How are they potentially going to change the financial system? A lot of it is maybe just a pipe dream, things that we are aspiring to but have not been realized yet. How much is real and how much is still just a fantasy?

Shimon Kogan: I’ll try to deliver on that, at least at a high level, because I’m sure that we’re going to dive into some of the more specifics during the conversation. But the top is a good place to start because there are lots of terms in this field and it gets quite confusing. In the world of crypto, I think it’s important to distinguish between different class of assets, because it tells you something about the underlying technology and the underlying structure.

At the core level, we have cryptocurrencies. And each of these cryptocurrencies is associated with a particular blockchain. [For example,] bitcoin is the blockchain protocol. BTC is the native currency for that. Here as well, I think it’s helpful to distinguish between transactional only blockchains like bitcoin or litecoin, where the primary use case of the coin, aside for paying for the security, but the primary use case in these kinds of blockchains is payments.

We want to separate that from the second generation, if you will, of blockchains, and those are programmable blockchains like ethereum, solana, and many other competitors where the primary use case of the native digital coin is to pay for the execution of smart contracts. So, we have cryptocurrencies as the main type of asset. Now, notice that when we talk about cryptocurrencies, because each of them is native to its own blockchain, you cannot take bitcoin and transact in ethereum and vice versa without some third-party offering, kind of like bridge services. We can talk about that if you’re interested.

Now, on programmable blockchains, there are lots of things you can do. As it turns out, you can create tokens. We want to distinguish between, again, the cryptocurrency like ethereum and tokens that live on ethereum. These are assets that are created by applications around various use cases. Some of them could be payments for services, could be voting, could be control. We’ll come back to when we talk about tokenomics. The fact that this sort of Turing complete programming language means that you can create lots and lots of different varieties of contracts, and we see that in practice.

That also introduces vulnerability. Many of my examples are going to be from ethereum because it’s simply the largest programmable blockchain. They created templates of types of tokens just to make developer’s life easier, so you don’t have to figure out from scratch all the features and open yourself up to security vulnerabilities. You may be familiar with ERC-20, which is the fungible token standard that was behind the ICO boom, or heavily used during the ICO boom. We have ERC-721 tokens. That’s the template oftentimes used in nonfungible tokens. More recently, we have ERC-1400, which now advances as a format to offer tokenization of off-chain assets.

Again, we have cryptocurrencies and we have tokens. Now, those tokens inherent the security of the blockchain on which they were developed. So as a developer, you have to ask yourself where you want to develop your application and where these tokens are going to live. Because, again, they don’t port from one protocol to another. Naturally, there’s a lot of competition around kind of eyeballs and attention of developers by these, what we call layer ones, by these programmable blockchains.

Goldstein: But if you want to think about the main economic uses for them, how would you classify that?

Kogan: The first is, and that’s a very specific type of token, but it’s so specific that has its own name, and those are stablecoins, right? Stablecoins are tokens that are designed to keep a peg to, typically, the U.S. dollar, but could be, in principle, anything. It’s a big business. Circle went public, went from like $30 to $200 overnight. It’s a real big business.

There’s another big business around and some real traction around tokenization, because that’s the idea of representing non-crypto native assets on crypto infrastructure, blockchain infrastructure. BlackRock, for example, partnered with Securitize to offer its money market fund, Biddle. That was the relative success.

Goldstein: What you’re saying is taking financial assets and putting them on token. What is the advantage of doing that?

Kogan: There could be few advantages. First of all, what you get is instantaneous settlement. Even if you’re an institutional player, once you have stablecoins and you have these crypto-native securities, or representation of them, then you have 24/7 instantaneous settlement, which we still don’t have even if you’re a large sort of corporation. If you’re moving money about a settlement, it takes time, depending on what kind of asset you’re looking at. But obviously, the ambition is much bigger than that.

RobinHood announced that they’re going to offer tokens associated with private equity. So, they’re going to take, I don’t know, SpaceX, and OpenAI, etc., and represent them as tokens. People are talking about what’s called tokenizing real-world assets. Those are not securities at all. This could be anything from collectibles to real estate.

Goldstein: It allows us to trade on things that otherwise we wouldn’t be able to trade. And things that we could trade, it allows us to do it more efficiently?

Kogan: That’s right. Look, this is not a [panacea]. I have a lot of conversations with people in the industry about this. I think [there are] the parts of it that makes sense, [and] the parts of it that people are not thinking carefully through. Like, for example, there are fundamental reasons why some of these assets are illiquid. That illiquidity I don’t think is going to go away by creating a digital representation and offering people to trade it 24/7. That’s not a solution to the fundamental problem that causes these assets to be non-tradable. I’ll take the other side of this, but you can take assets that have a fairly infrequent price discovery, and you’re still not going to solve the problem of that price being stale. Again, this is not a fiction, this is happening.

You can allow owners of these assets to pledge them as collateral, and that could be a partial solution for the liquidity problem. I have an asset that you have a hard time valuing, and you’re saying, “Look, I don’t know if it’s worth $80 or $90 or $100, but the probability that it’s worth less than $20 is very low. If you lock this asset in a smart contract, I’ll lend you $20 against this, with appropriate interest.” I think it’s an interesting solution of — kind of indirect way of giving some liquidity and by making these assets, at the very least, legible.

Goldstein: When we are thinking about tokenomics, the economics of tokens, we would like to understand supply, demand, how prices are formed. If we are thinking about other financial assets, like stocks, I think we have very well-established frameworks. You’re thinking about future earnings, future cash flows, you’re discounting them, and so on. Those rules are not working exactly like that when it comes to tokens, and this is what makes the economics a little richer and more interesting. What do you think are the other forces, and how should we think about the economics here?

Kogan: It’s a good question. First of all, let me say that it should be obvious from our channel so far that this flexibility allows us to create all sorts of tokens with lots of different features. I think one of the challenges of this industry is that there’s very little theory and not that much of an empirical work from academia to guide, say, new platform builders for how do their structure.

They often come and ask these questions like, “How should I control supply? What is the emission rate, burn rate?” Basically, the dimensions along which they have choices are quite broad. I think that there’s more that we don’t understand about optimal contract design, if you will, in the context of tokenomics than we do. That’s my personal opinion on this.

Now, I think it’s helpful to draw parallels to equities. There are some similarities and some differences. They look a little bit like each other because both, under some circumstances, give you some control rights and ownership rights, and some of them, although they don’t declare that, give you some cash flow rights. But let’s understand what world each of these live in.

In the world of securities or equities, essentially what you have is a legal structure that safeguards the holders of securities against exposed bad behavior by managers or controls. Obviously, you do not have that legal protection when it comes to tokens, at least not under the current legal framework. What you do have with tokens is the ability to what we call pre-commit. What you can do, for example, with tokens, that you cannot do with equities, is to say, “I’m going to program in the rate by which new tokens are going to be issued, and it’s going to be a function of these conditions.”

Take bitcoin, for example. It’s purely a condition. Like, it’s function of time, right? The price of bitcoin doesn’t affect the mission of bitcoin, how many miners there are. They don’t matter. That’s a particular choice that you can do in crypto world that you cannot easily implement with equities.

Goldstein: This leads me to something related that people would think maybe is on the fringe but is getting a lot of attention, which is meme coins. You have coins that are kind of based on nothing. If you think about dogecoin or shiba inu, others, you basically have a token that has value just because other people think it has value and not because it represents anything that is underlying it that would be valuable. Would you think about that also using the same framework, or do you think this is something completely different?

Kogan: I think that’s a good question. If you want to be provocative, you can ask whether bitcoin is a meme coin as well, right?

Goldstein: Do you think that bitcoin is a meme coin?

Kogan: No, I personally don’t, but —

Goldstein: No, because at least with bitcoin, at the beginning, there was this idea that it’s going to be a new currency people are going to use it to buy things, and so on. I don’t think it really panned out this way so far, but there were some use cases.

Kogan: Absolutely. I’m not suggesting that bitcoin is meme coin. All I’m saying is that if you take a few steps back and look from high-level perspective, you can ask yourself, what is the tangible utility? You’re absolutely right. By the way, with some of the meme coins, the process was kind of fake-it-until-you-make-it, in some sense. I don’t think it was designed.

But, dogecoin now, Elon Musk is suggesting that it’s going to be the payment rail maybe for X. You have now kind of a mini-ecosystem around shiba inu. Again, I don’t think it was there in the first place. And I do think that there’s a lot of other factors at play here that are more coming from behavioral finance than anything else, in terms of thinking about valuation.

I do want to mention something that we found, that I think is relevant for this discussion, in a paper where we had access to a really interesting dataset from eToro. EToro is a publicly traded company. It’s basically a retail broker that has operations in over 100 markets. One of the neat features of eToro is that from the get-go they offered retail investors the ability to invest in lots of different types of assets. They were one of the first to actually embrace crypto.

The question we asked was really simple. Do people seem to behave different in cryptos than in, say, equities or gold? We wanted to ask that very simple question. More specifically, what we’re interested in is how expectations of future returns of these asset classes actually respond to prices, which is kind of what you’re getting at, right? Under some assumptions, what we can do is back out the share in the portfolio for users dedicated to each of these asset classes, and you can estimate how these portfolio shares respond to past returns.

Very robust finding, right? Lots of different specifications. We find that when you look at equities and people have retail investors, in our sample, have contrarian beliefs. Equity prices go up, people believe that future returns are going to be lower than they were before. By the way, that’s true for gold as well, but not for crypto. So, they appear to have kind of momentum, like beliefs in crypto, and we try to understand where it’s coming from.

For example, we looked at whether people have momentum beliefs when you focus on lottery-like stocks, those are stocks that have positive skewness. Maybe young stocks, smaller ones. There are various known proxies for this. And interestingly, we don’t find that. We still find contrarian beliefs, even in these lottery-like stocks. So, there’s something specific about crypto.

Goldstein: This is the role of adoption and coordination, I think. This speaks very clearly to that. You say this can also support meme coins that might not have any underlying value, but the value is just coming from the fact that others are using it?

Kogan: That’s true, although I think that with meme coins it’s a very extreme case because there’s not even a pretense. I think it’s for regulatory reasons, right? Part of it, I think, started as a way of avoiding being classified as a security. There’s no pretense of anything underpinning its value.

It’s a very kind of extreme case of not where we push fundamentals to the future, where we have no fundamentals at all. There are some really interesting studies done in the ‘70s and ’80s looking at experimental markets where they tried to do this. They tried to see what happens when you push fundamentals further out into the future, and they found two things that could be actually relevant for these markets. They found that, first of all, you can create these bubbles in a lab, in a very controlled, very simple environment, in a reputable way.

They found that expectations are adaptive. When these bubbles happen and you ask traders what they think the price is going to happen, many of them understand that prices get detached from fundamentals. But these fundamentals are not going to show up until later in the future, so they exhibit these adaptive expectations. The second thing is that they underestimate how quickly the bubble will burst, on average. Because it’s clear that, because there’s something anchoring prices.

Goldstein: There is some parallel also to meme stocks, right? In the previous season, I talked to Matt Levine about meme stocks and social behavior in the financial market, and clearly that is a very strong force here as well. Maybe even more extreme, because with meme stocks, there is a grain of fundamental, whereas here there isn’t. These are maybe the same underlying forces, bit even more extreme that we see them here in tokenomics.

Kogan: I agree. With GameStop, AMC, you would think that at some point there are fundamentals that are going to anchor the price of a stock with meme coins. It’s not obvious what that anchor is. I think they really lean on similar drivers for users, this sense of community, shared narrative, in some cases, this idea that they are collectively rebelling against traditional powers. I think that’s very important to note as well, and we see this elsewhere. There’s a great appetite for gambling.

Goldstein: I want to go back a little bit to ICO, initial coin offerings. A few years ago, there was a wave of ICOs, and I think at that point there was hope that there is real economic value behind it. Because those are firms that, instead of issuing equity, they are issuing coins, and that is a way to raise capital and also supports the products of the firms. But unfortunately, there was also a lot of fraud associated with that, and then it came to halt. Now, there’s a lot of regulatory uncertainty where it’s going to go. Where do you think we are headed with that? You think there is still a future for this?

Kogan: I very much agree with your assessment, but I also want to point out that there are some legitimate platforms that were built around that.

Goldstein: Yeah, absolutely. There were some of them that were certainly legitimate, but there was also a lot of fraudulent ones around them. And the fact that it was hard to tell which is which, I think this is what caused the crash in activity.

Kogan: I agree. It was sort of combination of that. And it kind of coincided, roughly around the same time, with the Terra Luna debacle, the FTX, Celsius. There are a bunch of notable cases of what you would legally or otherwise probably classify as fraud. That led to an obvious response by the regulator, the SEC. I think the regulatory environment now looks very different in the U.S., and I think that’s worth mentioning, and I think there’s hope that under that new framework there will be ways in which you can actually do this with proper disclosure and guidelines and consumer protection. That’s what we’re concerned about.

The audience may be familiar with the GENIUS Act, which is standing for Guiding and Establishing National Innovation for U.S. Stablecoin Act. It’s basically a framework for, how do you issue payment stablecoins, etc.? Again, I’m happy to talk more about that if you’re interested. And there’s another, even more ambitious and broader attempt to clarify what is a security, what is a commodity — under the Clarity Act — and provide safe harbor to developers, and establish market rules, and compliance rules, etc.

These two may get combined eventually, and that’s part of the political discussion that’s taking place right now. We see very different frameworks slightly, but we see Europe being a bit ahead of the U.S. in that way through MiCA framework. It doesn’t cover everything, but it’s quite comprehensive and talks about guidelines for how you issue tokens and stable coins, and what custody services look like, etc.

I think that, yes, in the U.S. — I think everywhere, right? We’ve seen some regulatory lag, because the industry moves very, very quickly. It’s fascinating to see how quickly the evolution cycles in this industry are. There are some legitimate issues around that, or concerns around regulatory capture and regulatory arbitrage. I work as an expert witness for a number of crypto-related cases, and I see how the level of understanding on the supervisory and regulatory side, it’s very different from what it was a few years ago. There’s catching up to do, but I’m hopeful that it’s happening, and I think that this can actually lead to, at least from an entrepreneur’s perspective, a more sensible framework that’s based on activity and not based on type of institution.