A bad token economy model can kill your project, even if your ICO succeeds
If you open an ICO homepage at random, here is what you are most likely to find:
- Token with a fixed maximum supply
- Post-ICO tokens are burned
- HardCap and SoftCap, at a ratio between 5x-10x
- Allocation at around 70%-80% of tokens going to ICO, the rest being distributed to team/advisers/airdrops/other
- ICO done in a few consecutive waves, each more expensive than the previous, with huge bonuses for pre-ICO / private sales
- The token is a utility token and not a security
It is becoming more and more evident that there is a certain lack of attention to the topic of token economy and how it can affect a project in the long term. Majority of the projects seem to be looking for the “how to raise money — a copy/paste formula”, rather than paying attention on how the token economy would affect their project. It could be argued that this is due to the fact that majority of projects are not created with the long term in mind.
Inflation, inflation, inflation
One of the easiest ways to scare people away from buying into your ICO is either:
- Making the token uncapped and thus introducing possibly endless inflation
- Not burning the remaining tokens after the ICO, thus having the risk of a large portion of the tokens being dumped on the market by the token owners post ICO.
- Similarly to the one above — keeping a large proportion of the tokens for the team/other purposes. Anything above 30% and you are scaring people away.
While no one likes share dilution, and inflation is definitely not good for short term price hikes, adequate levels of properly managed inflation can and will keep your business model going, until it reaches a critical mass where it can start operating without it.
A bit of theory first. One thing commonly quoted in “tokenomics” is the quantity theory of money as a model for evaluating the relation between the circulating supply and the price of a token, over a certain period of time. In a nutshell the original formula is:
MV = PQ
- M is the quantity of money in the economy (in units of the economy’s currency)
- V is velocity, the number of times a unit of M is spent in a period (a scalar — no units)
- Q is the quantity of output (in units of output) in the economy
- P is the price level, which is in units of currency per unit of output of the economy.
If I need to oversimplify what this means: if the demand (Q) and turnover (V)* levels are fairly correlated, then introducing more money into the circulation, would essentially increase the prices in order to balance the equation. Similarity, if we contract the turnover (V) , either prices or production would need to go down.
- Disclaimer: I fully understand that money velocity (V) is not the same as turnover, however it is applicable in the cases that follow.
In the space of cryptocurrency the above is not directly applicable, if only for the case that our P and Q are not denominated in tokens (a product’s value is usually fixed to a FIAT currency, not crypto). If we need the equation to balance properly, we can substitute M (money in circulation) with the Tokens in circulation (T), multiplied by their dollar price (D) (for more on the topic I recommend reading this article when you get the chance). Essentially we get:
TDV = PQ
The above assumption is used to illustrate, that in case the rate at which goods are being purchased and the amount/price of goods available are constant, if you increase the supply of your (T) tokens, their dollar price (D) decreases in order to balance out the equation. Hence — inflation is bad for cryptocurrencies.
What this fails to account for, however is that inflation gives incentive for people to use and operate with the tokens, thus bringing life into the project’s ecosystem and preventing stagnation. I would like to illustrate this with an actual token /business case— LEON from the project Leonardian, on which (full disclosure) — I am consulting.
The project is essentially a marketplace between digital content providers (music, video, 3D, freelancers) and customers seeking those services. The team has decided to keep 40% of the total amount of tokens for liquidity of the actual platform which they are developing. Obviously this was (understandably) not met with enthusiasm form potential investors. In the particular project however, there was a solid reason having those tokens as reserve.
Imagine if the Token’s price was on a constant upward trajectory. No one would want to sell, as their tokens would be worth more tomorrow (HODL). This would drive the rate at which the token changes hands (V) very low. As a result, tokens would not be available for customers to purchase services on the platform and in order to balance the equation one (or more commonly — a combination) of the following has to happen:
- The number of transactions on the platform (T) would have to decrease to match, essentially driving both customers and providers away and defeating the purpose of the platform.
- The price at which providers offer their services (P) will need to drop, driving providers to other platforms.
- The dollar price (D) of the tokens would need to increase, essentially feeding the same cycle further.
- OR the tokens in circulation have to increase, introducing inflation, stabilizing the prices and giving incentive to people to either trade or use their tokens on the platform.
I will not insult you, by pointing out which is the best option. What is more, having tokens available on the platform directly, provides a much needed level of abstraction to end users. They can go and purchase tokens & use them on the platform directly, even if they have no knowledge of cryptocurrency, wallets and exchanges, further enlarging its user pool. More users = more providers = more transactions = more liquidity = more stability.
This is all great, but what happens if the price of the Token is on a downward spiral? Obviously the reverse of all points above holds true, but none of them are severely detrimental to the health of the system, and it is likely to recover on its own:
- If transactions on the platform (T) start increasing, this would eventually lead to increase in demand of LEON. After certain period of time, reserves on the platform would be depleted, forcing users to go to an exchange. Furthermore, the project team, would need to act as a facilitator of the process for non-crypto savvy customers, purchasing tokens off the exchanges and making them available on the platform. So if the platform is already popular enough, this should create adequate levels of buying pressure on the exchanges in order to stabilize the token.
- If price at which providers offer their services (P) increases, the effect is similar to the one described above. It’s just that the buying pressure will come from volume rather than velocity.
- Last but not least, having tokens available, enables the team, in extreme circumstances to enforce a monetary policy and contract the supply of tokens in circulation either by burning certain amount of tokens or locking them in an escrow smart contract, in order to stabilize prices.
Going back to the Leonardian project, dumping 40% of the tokens in the ecosystem in a single go is obviously not a good move either. So eventually, we agreed with the project team, that the extra tokens would be introduced to the system gradually, over the course of 8 years, making sure that both the platform does not stagnate and the token does not suffer from huge inflation. Each ICO is a like a micro country — you still need adequate fiscal and monetary policies, to ensure its success, funding alone is not enough. If would want to read more on the subject, I can recommend a great article on the monetary and fiscal policies of tokens.
The point eventually is — properly managed inflation is tool, which under the right conditions is an asset not a liability to a token ecosystem. The question is — are you sure your token has the appropriate model to meet the actual business needs of your project?
ICOs are in a strange spot (well at least the honest ones with solid projects/teams behind them). Should the economy and setup of the ICO/token be tailored towards making sure the Soft cap is reached, or should it be tailored towards giving the project itself the best chance of success?
As always, the truth is somewhere in the middle, however the worst approach any ICO (or any other project for that matter) can take is “let’s get the money first, we will figure out the rest later”.