Introduction to Tokenomics

Over the past few months, we have experienced a surge in the number of projects seeking guidance on the economic model for their tokens, commonly referred to as “tokenomics”. We consider tokenomics to be one of the most powerful aspects of cryptocurrency projects, and we work closely with our portfolio companies to design optimal tokenomics. We would like to share our insights to help prepare emerging Web3 entrepreneurs. After evaluating over a thousand different projects and their economic models, the team at Borderless Capital has identified several key areas of focus:

Incentive Design

Tokenomics are a tool for aligning the incentives of participants in a network. It is extremely important to identify what behavior is required from each participant in an ecosystem in order for the network to achieve a virtuous cycle. Equally important is designing suitable token incentives that encourage the desired market behavior. There are many examples of poorly designed token rewards being exploited by people who want to maximize their short-term gain at the expense of the long-term health of the project. Farnam Street Media Inc. published an excellent article explaining three pre-cryptocurrency case studies where poor incentive design worsened problems instead of solving them.

Bootstrapping a Network Effect

Tokens are a powerful tool that can encourage ecosystem participants to behave in ways that would otherwise not happen before a critical mass of users is attained. Prior to the invention of cryptocurrency, network-related companies required massive marketing budgets to onboard a user base large enough for their network to start organically generating enough value to attract new users. Today, crypto projects can utilize token incentives to encourage users to behave in ways that improve the utility of the network and achieve a network effect. Andreessen Horowitz partner, Chris Dixon has a wonderful tweetstorm that explains this concept.

For example, Snapchat would not have many active users unless people had their friends looking at their stories. They could use tokens to encourage users to continue creating content and onboarding their friends. Similarly, Uber would have very few riders if there were no drivers, and very few drivers if there were no riders. They could also use tokens to reward riders and drivers for participation or for referring their friends.

Ecosystem Incentives

Ecosystem Incentives are one of the most creative parts of tokenomic design. Examples of Ecosystem Incentives include:

• Activity Rewards
• Contributor Rewards
• Liquidity Mining Rewards
• Staking Rewards
• Partnerships
• Airdrops

Ecosystem Incentive tokens should be managed by a unique smart contract. This allows users to trust the code instead of trusting individuals to hold and distribute the Ecosystem Incentive tokens. This bucket should always have the largest share of tokens allocated to it within the token distribution. We recommend that the Ecosystem Incentive tokens be distributed over 5–10 years to ensure long-term viability of incentives.

Borderless recommends that the rate of Ecosystem Incentives distribution be linked to the protocol usage, for example by distributing more tokens when more transaction volume occurs on the network, and less tokens when less transaction volume occurs on the network. Examples of our favorite innovative models include Helium (HNT)’s Net Emissions, which ensures that the protocol will never run out of HNT tokens to reward hotspot hosts by distributing fees collected each period to the hotspots linearly over the next week, and Planetwatch’s Recycling Bin, which places all unmined tokens from each period into a bucket that is used to increase the number of participants eligible for future reward periods.

Value Distribution

Every protocol must define the method in which the protocol distributes value to its token holders. One of our favorite frameworks is what we call the Protocol Owned Treasury (POT), where fees earned are split between the treasury and developers of the project. Governance token holders control the assets in the POT, and can release them via the governance process. The assets on the POT provide intrinsic value backing each token. Governance tokens provide intangible value to token holders in addition to the assets in the POT. Thus, the governance token should trade at a premium relative to the value in the POT.

We often prefer the POT framework over models that distribute value outside of the protocol. Keeping the value inside of the POT allows token holders to maintain their existing share of the protocol by auto-compounding their investment. If value was distributed directly to individual token holders, then manual redeposit of distributions would be required to maintain the same position size. In addition, direct distributions often require increased accounting efforts for token holders.

We propose a novel value distribution method called Autonomously Provisioned Liquidity (APL), initially developed during a brainstorming session with Michael Cotton from Meld Ventures who implemented a version of this model on Algomint. Instead of burning the tokens earned by the protocol, the tokens are sent to the treasury and then paired with another coin (ALGO or a stablecoin) and added as liquidity on an automated market maker (AMM). This allows the POT to grow in value and generate yield while increasing liquidity for the project’s token. Automatically transforming treasury assets into liquidity for the governance token also eliminates the requirement to make the governance tokens directly redeemable for the liquidity in the POT, since token holders would always receive more value by selling their token on the AMM. In contrast to OlympusDAO’s protocol owned liquidity, APL does not require external market participants to provide their own liquidity to the POT. Instead, the POT itself is permanently providing its own liquidity.

Algorand’s native Atomic Transfer feature facilitates the APL model by enabling the protocol to make a token swap and add the proceeds as liquidity all in a single transaction. This eliminates the risk of the protocol getting front-run between the swap and the liquidity adding transaction.

Another popular model is the buy-and-burn model where the protocol uses transaction fees to reduce the total supply of protocol tokens, which (all else equal) results in a higher price per token because each token represents a larger percentage ownership of the protocol. We believe APL is superior to buy-and-burn because it utilizes Web3 tools such as AMMs to transform protocol fees into both a reduction in circulating supply, and an increase in token liquidity.

Multi-Token Models

For the vast majority of projects, we recommend only issuing one token. Multiple tokens make it confusing for the market to identify which token will accrue value and will often reduce the brand value of the protocol because there is no longer one clear way to invest in the brand. Usually, governance tokens should be the same token as the utility token. However, on some occasions it does make sense to have a separate token dedicated to activities that are temporary in nature.

Governance Token + Stablecoin is a common application of a multi-token model, with examples employed by GARD, Algofi, and xBacked. In these models, a governance token is used to distribute ownership of the protocol to its users, which boosts the protocol’s annual percentage yield (APY) while incentivizing governance token holders to stake their tokens for bonus rewards. This creates a virtuous cycle:

Governance Token + Certificate of Deposit Token is used by many DeFi protocols including Folks.Finance, Tinyman, and Humble to enable composability with other DeFi apps. In this model, protocols provide depositors with newly minted tokens representing their deposit, which can then be used as collateral in other DeFi apps, while the governance tokens allow participants to share the upside in the governance treasury coming from the DeFi protocol fees.

Fixed Supply Governance Token + Variable Supply Fuel Token is another multi-token model frequently used by play-to-earn (P2E) games. An example we helped design is Alchemon, which employs a hard-capped governance token (AlcheCoin) that controls the treasury and is earned by staking Alchemon aNFTs, and an uncapped in-game currency token (AlcheGold) minted during gameplay and burned to purchase power-ups and speed up waiting periods.

Circulating Supply

We have found that the market places a premium on projects that provide them with the ability to reference easily understood circulating supply forecasts for the token and we recommend creating a visual aid depicting the expected circulating supply until the coin is fully circulated. The circulating supply is primarily linked to two factors: the vesting schedules of the team and investors, and the Ecosystem Incentives.

For the vesting schedule, we recommend that the team cliff (i.e., the period of time before any tokens start unlocking) be 1.5x the length of the investor cliff, and the team vesting schedule be 2x length of the investor vesting schedule. This shows that the team is committed towards the long-term success of the network. After all, the team should consider their token one of the best investments available, and therefore should have no reason to want to reduce their exposure before their own investors can. Investors should be about 50% vested before the team vesting cliff kicks in.

Once the cliff is reached, we recommend daily vesting distributions instead of monthly or quarterly distributions. Large unlocks after long waiting periods may induce a Prisoner’s Dilemma because it incentivizes recipients to sell their distribution before other parties do in order to get the best price. Daily vesting eliminates this risk by allowing parties to sell a steadily growing portion of their total tokens at any time, so there is no FOMO to sell an unlock before others do. Algorand’s low transaction fees enable frequent token distributions at negligible costs.

Governance

We recommend designing the circulating supply schedule in a way that allows “team-aligned” tokens to maintain a majority of the voting power over the first two years of the protocol’s existence, and transition to true community-run governance by year three. Team-aligned tokens are usually those held by the team and strategic investors. These parties have dedicated a significant amount of time and effort towards the development and success of the protocol, and possess the insights and motivation required to make decisions that support the long-term health of the network.

Token Distribution

Most cryptocurrency projects begin with equity cap tables before a token is created. At the initial stage of a token project, it is often unclear the differences in how value will accrue in the equity versus the token (usually the vast majority of value accrues to the token). When creating a token, we recommend giving all equity owners exposure to the token instead of raising separate rounds for the token and equity. This aligns incentives between all stakeholders and prevents conflicts that can arise if parties only have exposure to one or the other.

Token distribution is different from traditional equity cap tables because there is no “unissued stock” that could be used at the company’s discretion. The entire token supply and allocations are defined at the public launch of the project. In contrast, companies with traditional equity can issue new shares which dilutes the ownership of existing shareholders. The industry standard is to allocate at least 50% of tokens towards the community. This effectively dilutes the amount of ownership that the team and investors are able to retain by at least 50%. For example: if the team owns 100% of the equity and releases a token with 50% of the supply allocated to the community, then the team has only 50% of the token supply.

Below are our token distribution guidelines:

Tokenomics is a highly innovative and increasingly significant field of research in the cryptocurrency industry. After all, bad tokenomics can destroy an otherwise great project. The insights shared above serve only as initial suggestions to enhance team decisions during the tokenomic design process. It is vital that each team customizes and fine-tunes these approaches to compliment the unique characteristics of their specific project. As such, the tokenomics experts at Borderless Capital spend significant time consulting with portfolio companies to ensure they launch with world-class tokenomics.

We hope that these insights are helpful to projects seeking tokenomics guidance and we look forward to hearing feedback from the community!

Finally, we would like to share a questionnaire we developed to help projects brainstorm their tokenomic designs. We have populated it using the Algorand blockchain as an example, but the questionnaire can be used to assist any project looking to launch a token. We have made it available for download here.

Borderless Tokenomic Brainstorming Questionnaire

Ecosystem/Network Questions:

Who are the ecosystem participants, what do they do, and why will they be attracted to your app or token?

How will the network or protocol earn revenue / collect fees / accrue value?

• Currently the Algorand Foundation receives fees of .001 ALGO per transaction. Once the value of transaction fees becomes significant, the Foundation will engage with the community to decentralize the reward system incentives.

How does the protocol distribute value to the token holders?

• The fees collected by the Foundation are redistributed back to the users via participation and governance rewards.

Explain your ideal Virtuous Cycle (Example for BTC):

Algorand’s Virtuous Cycle

How will the token help bootstrap a network effect?

• Participation Rewards
• Governance Rewards
• Grants

What is the ideal equilibrium state once the network effect is established? How will the model work after equilibrium is reached?

• Transaction fees are used to fund the infrastructure providers and Algorand governors.

How can the network or the protocol be governed?

• Each ALGO has one vote on each governance proposal.
• Currently, ALGO holders lock up ALGOs each quarter to be eligible to vote on proposals during the governance period.

Token Utility Questions:

How can people earn tokens?

• Yield Farming of DeFi apps
• Participating in governance
• Receive via grant
• Receive via investment

What can the token be used for?

• Paying transaction fees
• Buying aNFTs
• Staking
• Lending
• Using as collateral to leverage
• Creating smart contracts
• Opting into new ASAs
• Paying friends and vendors
• Transferring between exchanges
• Swapping for ASAs

Why will people want to hold the token?

• To have liquidity available to participate in ASA opportunities on Algorand.
• To bet on the continued growth of Algorand’s technology and ecosystem.
• To deploy smart contracts on Algorand.

How will the token accrue value from the success of the project?

• As demand to use Algorand increases, more ALGO’s will be required to be locked up since each wallet address needs to lock .1 ALGO per ASA it opts-in to.
• Smart contracts require ALGO to be locked up proportional to the size of their application data.

Disclaimer:

The information provided to you in this post is for general informational purposes only and is not intended to constitute advertisement for the purposes of the Investment Advisers Act of 1940 or an offer or a solicitation of an offer under the Securities Act of 1933. Any offer can only be made by a delivery of offering documents to qualified prospective investors. None of the information is offered as nor should it be construed, as legal, financial or other advice on any matter. We do not undertake any obligation to update any of this information, especially information provided by third party sources and do not guarantee any level of performance. Past performance is not a guarantee of future results.