What is EOS? Do its tokens have value?

Image result for eos.io
Image credit: Investopedia

There’s a new blockchain that’s about to launch and it’s picked up a lot of steam in the blockchain community as an “Ethereum Killer“: EOS.io (though technically, EOS is not a blockchain but software for building blockchains – we’ll get to that later). EOS is a smart contract enabled blockchain platform like Ethereum, but it (allegedly) solves many of Ethereum’s issues with scaling and power usage, claiming to be able to handle millions of transactions per second. If true, that would make EOS much more viable for financial transactions and enterprise use. An overview of the issues current popular blockchains (Bitcoin and Ethereum) face, and the ways EOS solve them can be found here.

The EOS token has been rising in value quite a bit (with over $11 billion market cap as of this writing), and the EOS platform “launch” date of June 2 is fast approaching. I decided to take a closer look, and that’s when I saw this on the EOS website FAQ:

5. What features, uses or attributes do EOS Tokens have? Can the EOS Tokens be used on a blockchain adopting the EOS.IO Software?

block.one is building the EOS.IO Software but it will not configure and/or launch any public blockchain platform adopting the open source EOS.IO Software (the “EOS Platform”). Any launch of an EOS Platform will occur by members of the community unrelated to block.one. Third parties launching the EOS Platform may delete, modify or supplement the EOS.IO Software prior to, during or after launching the EOS Platform.

The EOS Tokens do not have any rights, uses, purpose, attributes, functionalities or features, express or implied, including, without limitation, any uses, purpose, attributes, functionalities or features on the EOS Platform.

What? Does that mean EOS Tokens currently trading at over $11 billion market cap are worthless? Is everyone buying EOS crazy?

Probably not to both questions (though one can never be sure with cryptocurrency).

What is EOS?

First of all, let’s talk about what EOS is. EOS is not a blockchain, it is software for building blockchains. A developer who builds a blockchain using EOS software is bound to the structure laid out in the EOS whitepaper. What’s innovative about EOS blockchains is mainly 2 things:

  1. It uses a way of creating blocks called Delegated Proof of Stake that requires much less resources (i.e. electricity and computing power) than mining blocks using Proof of Work in Bitcoin and Ethereum. In Bitcoin and Ethereum, many miners are competing to make the next block in order to get a reward (in transaction fees and cryptocurrency). Only 1 miner will succeed each block, which means all the other miners just wasted their electricity and computing power. In EOS, the “miners” are called “block producers”, there are only 21 spots, and they are voted in by the community of token holders before they produce blocks. Once voted in, these block producers take turns creating blocks so for each block there is only one producer expending resources producing that block. This makes DPoS a much more energy efficient and scalable way to make blocks and achieve consensus in the blockchain.
  2. There are no transaction fees on EOS; rather, the amount of tokens you have will entitle you to a proportion of the blockchain’s storage and computing resources (disk space, CPU, RAM). For example, if you have 1% of the tokens in that blockchain, you are entitled to at least 1% of that blockchain’s resources. Who provides resources on the blockchain? The block producers do – basically, when producers produce a block, they are expending their own computing power to compute the results of smart contracts that developers have written and verify transactions that the blockchain’s users have made. Each block producer’s computing capacity (which is published) determines how many transactions and what complexity of smart contracts they are able to process into a new block, so the community is incentivized to vote in block producers with higher capacities.

ERC20 EOS Tokens vs Native EOS Tokens

Ok, back to the original topic – so that means those EOS tokens being traded right now do have value right? They let me reserve resources on the EOS blockchain? The answer is NO. But probably. Let me explain. The current (pre-June 2, 2018) EOS Tokens that you see being traded on exchanges are ERC20 tokens issued on the Ethereum blockchain (ERC20 is a standard for issuing tokens on Ethereum). Which means that all the EOS tokens you see prior to the EOS’s June 2, 2018 launch date are Ethereum-based tokens that have no direct technological link to EOS technology or EOS blockchains. These ERC20 EOS tokens will be frozen on June 1, 2018, the day before EOS launch, and trading will be suspended. These tokens were issued by the creators of the EOS, block.one; however, as mentioned before, EOS is not a blockchain, it is software for building EOS type blockchains. The creators of EOS who issued the initial ERC20 version of EOS Tokens are not planning to launch any blockchains on EOS. Any developer can build a blockchain using EOS but s/he does NOT have any obligation to honor the holders of the ERC20 EOS tokens currently being traded. They can create their own native EOS tokens (which they can call whatever they want, but I will call “native EOS tokens” here to distinguish them from “ERC20 EOS tokens”) from scratch, do their own ICOs, or distribute tokens in whatever way they wish.

So was the EOS Token launch and its $11 billion market cap an elaborate scam? Well, you never know with cryptocurrencies but the answer should be NO. When the ERC20 EOS tokens suspend trading, a snapshot of who owns what proportion of tokens will be taken. Any developer building an EOS blockchain will be able to award their new, native EOS tokens in proportion to the snapshot of ERC20 EOS token holders.

Again, these developers are not legally bound to honor ERC20 EOS token holders so they do not need to issue you any of their native EOS tokens once they launch their own EOS blockchains – BUT – and this is where economic incentives come in – to the extent that there will be multiple developer groups looking to launch EOS type blockchains, the one that offers the best deal to current ERC20 EOS token holders will likely get the most adoption and become the main EOS blockchain (the “mainnet”). For example, if you and I are building rival EOS blockchains and I’m not giving any of my new native EOS tokens to ERC20 EOS token holders, but you are giving them a 1:1 trade in, then the current ERC20 EOS token holders will migrate to your blockchain, instantly making your blockchain and its native token valuable, whereas I would have to build my blockchain and my token market up from scratch. In a competitive market with many groups vying for their EOS blockchain to be the main EOS blockchain, there is an incentive for EOS blockchain makers to honor ERC20 EOS tokens and voluntarily award native tokens to ERC20 EOS token holders. In a non-competitive market, the developer groups will have more power to set less favorable trade in terms for ERC20 EOS token holders.

Stable Hosting Costs?

Other than token trading, EOS has another interesting economic characteristic.

As mentioned before, one of the innovations of EOS is that there are no transaction fees. Ethereum charges developers transaction fees to run decentralized applications (dApps) and smart contracts and these fees are paid to miners for lending their computing power. Basically, when miners make a new block, as part of the process of validating transactions, miners execute smart contracts that developers have made and compute their results – transaction fees go to pay for the computational power miners spent. Similarly in EOS, block producers provide computational power to developers on the blockchain by expending resources to compute the results of smart contracts these developers write, verifying transactions and changes in the state of the blockchain.

Each block producer has different computing capacity that they publish and developers can use at minimum x% of a block producer’s capacity during each block, where x is the % of tokens you hold in relation to the total number of tokens in the ecosystem. This x% is a lower bound as you may be able to use much more if there is excess capacity. For example, if you’re the only developer on the blockchain, then the capacity of the entire blockchain can be brought to verify your transactions and run your contracts no matter how many tokens you actually hold. Dan Larimer, one of the creators of EOS, seems to have confirmed this.

However, the absolute amount of computing capacity you get from the network can vary over time even if your absolute number of tokens stay constant. This is because:

  1. There is up to 5% per year token supply inflation built into the system as a reward for block producers for producing blocks. So if computing capacity and utilization stay constant, your share of capacity will degrade over time as your tokens will be a smaller and small proportion of a growing whole.
  2. Block producers may increase capacity faster than 5% per year, in which case your absolute capacity allocation will actually increase even if your proportion is decreasing.
  3. Block producers may reduce capacity (e.g. if token price falls and they have less incentive to contribute computing power to the blockchain), in which case your capacity is also falling even if your token holdings are constant.

This is interesting because one of the stated goals of EOS, and the reason it’s built on a no-transaction-fee model, is so that developers have predictable hosting costs that are not tied to token prices. But it seems like a developer’s share of computing capacity may still not be predictable. If things are going well – i.e. situation #2 where capacity increases keep pace with or exceed inflation, then yes, your hosting costs will be stable or even decreasing. But in the face of stagnant capacity or capacity reduction, your hosting costs will actually increase since you may need to continue buying tokens to keep your capacity allocation.

So how stable are your costs? This is where economic incentives kick in again. The reduction in allocation happens only if the network capacity is fully utilized, because at less than full utilization, there will be excess capacity for you to use above your % allocation. In a situation of full utilization and a competitive market for block producers, incumbent block producers and producer candidates should compete to add capacity as they compete for the community to vote them as block producer. In this case, capacity should increase, and your absolute allocation should be stable.

Weakness of EOS?

What EOS relies on foundationally is the discipline brought by competitive markets. ERC20 EOS token holders will be made whole if there is a competitive market for “mainnet” blockchain candidates. Developers’ costs will be stable if there’s a competitive market for block producers. And producers will be incentivized to good behavior (i.e. engaging in honest rather than malicious actions, continuously increase capacity, actively govern the blockchain) if, again, there is a competitive market for producers where bad behavior gets you voted out.

This leveraging of economics is the genius of blockchain in general and EOS in particular, but it is also its great(est?) vulnerability, as there are no guarantees that the assumption of competitive markets holds true now or in the future. I don’t know how many mainnet candidates there are but my guess is that given how difficult it is to build a successful blockchain there aren’t that many to start. And we know that incumbents will always look to monopolize their position and put barriers on competition, so once block producers get voted in, their positions may get sticky and their incentives misaligned with the community’s. The first test will be coming up soon, when the ERC20 EOS tokens are suspended and we’ll see if the new mainnet candidates honor them with native EOS tokens.

Conclusion

In a lot of the discussion boards, people think that EOS will be successful because it has a good founding team, or because the culture of the community will prevent fraud and make ERC20 EOS token holders whole. This may be true, but I put greater faith in the laws of economics, and I think the EOS team has wisely done the same. The system has been cleverly designed from an economic perspective, and if the team has spent as much time building a competitive market as they have designing it, there are good prospects for this ecosystem.

But as always, your investment of time and treasure in cryptocurrency is a significant risk, so don’t be too surprised if indeed the EOS tokens you bought – whether ERC20 or native EOS, turn out to “not have any rights, uses, purpose, attributes, functionalities or features, express or implied, including, without limitation, any uses, purpose, attributes, functionalities or features on the EOS Platform.”

 

 

 

Leave a Reply