This post is part of a series on how everyday investors can understand the word token in the context of blockchain networks.
The word "token" is most widely used to reference a type of crypto asset, or asset issued on a blockchain network. You might have heard someone talk about the "DOGE token," a "token for this new project," or a non-fungible token (NFT).
Austin Federa is the founder of blockchain native project DoubleZero. A recent tweet of his caught my eye:
Tokens are the best way to organize disparate action around a common goal of otherwise unaligned parties we've ever come up with. It's both an antidote and a natural successor to the joint stock corporation. But in order to do something, the token must do something.
Federa's tweet makes the point that tokens can be used to align incentives. I agree. Incentive alignment is about taking a set of self-interested actors and creating a system that gives them reasons to all work toward a common goal. Read on for details on why tokens are useful technology for this purpose and examples of this quality of tokens in action.
Tokens are programmable ledgers
As a technological primitive, tokens are ledgers. But they are not old-fashioned, rigid ledgers. They are programmable ledgers.
The typical ledger, the old-fashioned ledger, is a carefully designed, rigid structure built to support at most a few systems. Tokens are not. I know it is frustrating to hear "tokens are anything" when you want a straight answer to "what are tokens." I have avoided giving this answer throughout this series on tokens. But there is truth to the answer insofar as tokens are software code. Just like any software code, they are flexible to what the relevant computer can run.
As code, tokens have a well-defined base. But that base is highly extensible. It is extensible to the boundaries of the underlying blockchain network, just as the code for an iPhone app is limited to what's possible for an iPhone to run.
Programmable ledgers make for excellent incentive alignment technology
If you go play a game at an arcade, you get tickets. These tickets are the currency of the arcade. That currency rewards your performance in the different games. You can redeem these rewards for a prize.
These tickets are an incentive alignment technology, albeit a simplistic one. The tickets are used to align incentives between you and the arcade operator. You pay to enter their establishment and play games. The more games you play, the more money they make. You are rewarded for doing well at the different games. This often means playing many times to get good at a game, which means the arcade operator makes more money. What incentive do you have to play? You get tickets you can redeem for a prize. This system of you paying to play, and the more you play increasing the chances of a prize, aligns incentives between you and the arcade operator.
A roll of red tickets is a perfectly fine incentive alignment technology for an arcade. An arcade is highly local. You likely aren't too worried about losing the physical tickets. It's fine if the tickets get accidentally blemished by a spill. Very few other people, likely no one at all, cares how many of the tickets you've gotten. A long-running historical record is of low importance.
But what if the situation is more complex? Think of a global arcade. Imagine it needs to operate 24/7. Imagine a critical feature is that anyone can join the arcade. Imagine it's actually not an arcade, but a critical business function. Think, further, that it needs some built-in supply and demand regulation mechanics.
A roll of red tickets won't do. This is where tokens as incentive alignment technology come into play. Nothing mentioned is an issue for tokens on a blockchain network. They are programmable. They operate on a global system that functions 24/7. They are code, so they function comfortably in communication with code.
But that's all a bit abstract. Let's see some examples.
DAI and MKR: incentive alignment in action
DAI is a stablecoin. Specifically, it is a token designed to always be worth one US dollar. MKR is a governance token that gives its holders the power to manage the system that keeps DAI stable. The relationship between these two tokens is an example of how tokens can align incentives.
DAI is created when someone locks up crypto as collateral in a smart contract. As long as enough collateral backs the DAI in circulation, the system stays healthy and DAI holds its peg to the dollar. But who decides the rules for how much collateral is needed, or which assets can be used? That's where MKR comes in.
MKR holders vote on the rules that govern DAI. They set parameters like collateral requirements and fees. When the system runs well, those fees generate revenue that is used to buy back and burn MKR, reducing its supply and making it more valuable. So MKR holders are directly rewarded for governing wisely. The inverse is also true. If governance decisions are bad and the system becomes undercollateralized, new MKR tokens are minted and sold to cover the gap. This dilutes existing MKR holders. Good decisions increase the value of a holder's MKR, and bad decisions decrease it.
This is the incentive loop. MKR holders are self-interested actors with real financial stakes in keeping DAI stable. DAI users benefit from a reliable stablecoin without needing to trust anyone in particular. The two tokens create a system where everyone's self-interest pushes in the same direction. This is a structure that allows for a reliable service to be created, a stablecoin, with the efforts of many participants with different interests.
You don't need to understand DAI and MKR to understand that tokens are an inventive alignment technology. In fact, I chose this example intentionally because the system is not a simple one. Despite the complexity, there was no question that tokens could support this use case. Red tickets, on the other hand? Well, you already know the answer.
LINK: making honesty profitable
Chainlink is an oracle network. Oracles solve a fundamental problem in blockchain: blockchain primitives (think: smart contracts) can't access data from the outside world on their own. They need someone to feed them information like asset prices, weather data, or event outcomes. But there's a fundamental problem: how does a system decide what information to trust? What messenger does the system trust?
The token LINK is a fundamental part of how Chainlink is able to ensure trustworthy messengers. Chainlink network participants who want to provide data to the network must put up some LINK as collateral. If they deliver accurate data, they earn LINK as payment. If they deliver bad data, they lose LINK (more accurately described as "lose their stake").
This changes behavior in a straightforward way. An operator with a large LINK stake has more to lose from dishonesty than they could ever gain from it. The token doesn't ask operators to be trustworthy. It makes being untrustworthy expensive.
On the demand side, systems that need reliable data don't need to vet each data provider individually. They can rely on the network because every participant has skin in the game. The more LINK an operator has staked, the stronger the signal that their data can be trusted.
The result is a system where accurate data flows into blockchain applications not because anyone is altruistic, but because LINK makes accuracy the most profitable strategy. Self-interested operators, paying clients, and the broader ecosystem all benefit from the same thing: reliable information.
Once again, this is a more complicated example than our arcade tickets and prizes. That is precisely the point. Tokens are able to serve the need for a technology that supports this use case.
Incentive alignment is a key way in which cryptocurrencies and tokens can be similar
While this is not fundamental to understanding tokens as incentive alignment technology, I find this worth mentioning. I have clarified before that the term cryptocurrency and the term token are not interchangeable. But here we have one way in which tokens and cryptocurrencies can serve a similar function: cryptocurrencies are also used to align incentives of blockchain network participants. For node operators, they provide a financial incentive to keep producing blocks. Tokens, just like cryptocurrencies, can be used to incentivize behavior in novel systems. Just as tokens are ledgers built on the base blockchain ledger, tokens can also be incentive alignment tools built on the base incentive alignment technology of cryptocurrencies.
Conclusion
"Token" is often thought to mean "a type of asset." But one of the real powers of this underlying technology is in its natural use in aligning multiple parties in a digitally native way. Coordinating the interests of diverse participants is the backbone of how our society functions, from corporations to governments to markets. Tokens extend this power in a new way. They are programmable, transparent, and accessible. In my view, as more systems adopt this approach, the potential for new kinds of collaboration and coordination grow.