The underlying economics behind a token is one of the key considerations when evaluating an investment. Commonly referred to as “tokenomics”, these powerful factors can go along way in determining the success of a project. Understanding the nature of the asset is essential — the intrinsic value, utility, and issuance are a few components behind how the token accrues value. Below are several areas to consider when designing or evaluating a token’s economic model.
Incentive Design
Economic invectives have historically been able to coordinate action amongst individuals, and crypto networks are no different. In fact, tokens are being used to create new incentive structures never before seen, rewarding contributions to global open-source networks. When designing a network, the founding team has to identify what actions are required to achieve a virtuous cycle and long-term sustainability. After these actions are identified, they must design a system that rewards network participants for positively contributing in these ways. Using mechanism design based on game theory, the team must create suitable token incentives that encourage the desired behavior required for longevity.
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. Good projects will prioritize longevity over short-term gains and will develop strong incentive structures to attract and maintain contributors.
Distribution of Protocol Value
A successful project will create value, capture value, and distribute it to its core contributors and stakeholders. Every protocol has a method for distributing value to the token holders. This can be done in many ways, including distributing revenue to investors (similar to dividends), protocol-owned treasuries (POT), and increasing the relative value of an investment. In a POT, the treasury accumulates a portion of the protocol fees. Governance token holders vote on how these funds are distributed. In this model, all fees earned are kept inside the protocol. Interlaizing the value created allows token holders to maintain their existing share of ownership by auto-compounding their investments.
If fees were paid to investors individually, the fees would have to be manually deposited to maintain the existing share of ownership. Direct distribution can be good for investors who are looking to generate cash flow, however, this encourages tokens to be sold which can lower the value of the protocol tokens.
Alternatively, the protocol can adopt a buy-and-burn model, where transaction fees are destroyed, reducing the total supply of protocol tokes. All things equal, this will drive up the price of the remaining tokens. This model distributes value to the token holders by increasing their share of protocol ownership and the overall value of their investment.
Bootstrapping a Network Effect
Businesses with network effects have a product or a service where the value depends on the number of existing users. The marginal value of the product or service increases as more people join, as is the case with social media or Uber. Traditional businesses have to onboard a certain number of users before the network effects kick in. This initial phase can be difficult to bootstrap, as large marking budgets are required to onboard a large enough user base so that their network organically generates enough value to attract new users.
Tokens are a powerful tool that can encourage ecosystem participants to behave in ways that would otherwise not happen before a critical number of users is attained. Network effect-reliant crypto projects can implement token incentives to encourage engagement and enhance the networks’ utility for their early users. As mentioned above, the team has to outline the desired actions, and reward early users with tokens for acting in alignment. a16z partner Chris Dixon explains the concept in this thread:
If Uber had been able to reward early drivers and riders with tokens, they may have reached their current level of network effects much quicker.
Ecosystem Incentives
Ecosystem Incentives are one of the important considerations when designing a project’s tokenomics, founders can get creative in how they reward creators depending on their desired outcome. Some examples of Ecosystem Incentives include:
- Airdrops
- Liquidity Provider rewards
- Staking rewards
- Partnership incentives
- Contribution and Activity rewards
- Bug bounties
Ecosystem Incentive tokens should be managed by a smart contract. This allows users to trust the code instead of trusting individuals to distribute the tokens. The largest share of the tokens should be issued to those pools. It is common practice for Ecosystem Incentive tokens to be distributed over a 5+ year period to ensure long-term participation.
The issuance rate of Ecosystem Incentives is commonly linked to the protocol’s activity during the period, distributing more tokens when more transaction volume occurs on the network and fewer tokens when less transaction volume occurs on the network. One of my favorite issuance models is Helium’s Net Emissions schedule, which ensures that Hotspot operators are still adequately incentivized in perpetuity to mine HNT by distributing transaction fees from one period to the next. Even when the protocol stops minting new HNT tokens, there is an incentive to continue deploying hotspots.
Multi-Token Models
While the vast majority of protocols only issue a single token for simplicity, there are certain instances where issuing multiple tokens can add additional incentives and utility within the protocol. Usually, governance tokens are the same token as the utility token. However, this is not always the case. Here are two examples of multi-token models that can be used:
Governance Token + Certificate of Deposit Token is a model used in many DeFi protocols. Liquidity Providers are minted tokens to represent their deposit to the pool. These tokens accrue interest, can be redeemed for the initial deposit at any time, and can be used to collateralized loans from other DeFi apps. The governance token is a separate token that helps users maintain the protocol and use the governance treasury, which collects protocol fees.
For Example, on Curve, a 2000 USDC deposit would provide $2000 worth of cUSDC which can be used as collateral on Aave. These c-tokens allow users to leverage their initial deposit and earn interest on it. Depositors also earn Curve’s governance token, CRV. This model increases composability and incentivizes users to provide liquidity with APY and governance tokens.
Stablecoin + Governance token is a common application of a multi-token model. In these models, a governance token is used to distribute ownership of the protocol to its users, which boosts the protocol’s APY while incentivizing governance token holders to stake their tokens for bonus rewards. This creates a virtuous cycle: more staking = more liquidity = lower borrowing costs = more borrowers = higher token price = higher (real) yield, and the cycle repeats itself.
Considerations for Investors
Proper due diligence is important when investing in a project. Here are a few questions to ask when reviewing a projects’ tokenomics:
- Who are the ecosystem participants? What do they do and why are they incentivized to do this?
- How can people earn tokens?
- What is the token used for?
- Is this an inflationary or deflationary token? All things being equal, how will supply and demand influence the price over time?
- How does the network earn revenue and accrue value?
- How is this value distributed to token holders?
- Why will people want to hold the token? Governance? Being able to use the network? Accrual of rewards?
- How will the protocol be governed? (If you are not looking to get involved with governance) Can my votes be delegated?
Only invest if you understand the project, believe in the longevity and can make a compelling case for how your tokens will accrue value. You should be able to explain why it’s valuable to your grandma unless she’s dead. Invest with a long-term outlook. Getting a good price matters, but making a sound investment is better. Don’t try to capitalize on volatility and buy with a long-term conviction. Ask yourself this question from Tushar Jain at Multicoin: If you're bullish on an investment and don’t have a strategy to trade volatility, why aren’t you 100% long at all times?
If you are a trader who has a strategy to trade beta and outperform the market, disregard what I said and degen away. Personally, I prefer to invest for the long run so these are questions I ask myself.
Considerations for Teams Issuing Tokens
Sound tokenomics are one of the most essential components of a project's health and all aspects should be carefully considered when developing your protocol. Here are some factors to consider when issuing tokens.
Circulating Supply
The circulating supply is primarily linked to two factors: the vesting schedules of the team and investors, and the Ecosystem Incentives. It is important to provide a circulating supply forecast for the market to view, outlining the release schedule from the TGE to full circulation.
For the vesting schedule, it is good practice to make the team cliff 1.5x the length of the investor cliff, and the team vesting schedule longer than the investor vesting schedule. This shows that the team is committed to 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.
Once the cliff is reached, the vesting period kicks in. The team can choose to any frequency of distribution (weekly, monthly, quarterly, etc.), but large unlocks after long waiting periods can lead to a prisoner dilemma where recipients are incentivized to sell their unlocked distribution before other parties to get a better price. For that reason, I would recommend a daily vesting schedule, so there is no incentive for large selloffs.
Governance
It is recommended to design the circulating supply schedule in a way that allows “team-aligned” tokens to maintain a majority of the voting power over the first few years of the protocol’s existence, and transition to true community-run governance in later years. 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. As time passes protocols can, and in many cases should progressively decentralize, however doing so too early can be a shitshow, causing coordination problems and inefficiencies which may ultimately lead to the protocol’s demise.
Token Distribution
Token distribution is different from traditional equity cap tables because 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 dilute the ownership of existing shareholders. There is no unissued stock of tokens to be used at the company’s discretion. Additionally, it is unclear how value will accrue to the token or the equity. Give investors the opportunity to be exposed to both.
Decentralization is at the core ethos of crypto. Because of this, it is standard practice to allocate over half of the token supply to the community. As mentioned above, it is recommended to do this slowly to maintain ownership and efficiency in the early stages. The community is generally more accepting of projects that progressively decentralize and encourage adoption.
Locking the team-aligned tokens for extended periods signals a commitment to longevity. The market usually pays close attention to this.
Tokenomics is one of the most innovative and important areas in the industry. The questions and insights above only serve as suggestions. It is vital that each team customizes these approaches to supplement the unique characteristics of their specific project. Decisions surrounding tokenomics require a lot of careful thought and planning as they are critical and can’t be reversed after the smart contracts are posted to the blockchain.
The views expressed in this article are meant for general information purposes and represent my opinions based on my own independent research. I am not a financial advisor, this is not investment advice. This article does not affect the views of Serafun or any other affiliated company. Do your own research before investing. Talk to a tokenomics expert when designing a protocol or issuing tokens.