What the heck is Tokenomics? Please no math.
This article is structured as a conversation because humans learn better with experiences and narratives.
This conversation covers the basic principles and general framework of tokenomics.
It’s been a few months since we last talked. Back then, you were making up terms like NFTs, P2E, DAOs, and Web3. Now it’s full-on words like Tokenomics. Will you please stop?
Ah! Good to see you again, it’s been a whirlwind 4 months in the crypto rabbit hole. Since then, the crypto world has rebranded to web3 now because it’s so much bigger than just crypto. The term web3 didn’t even exist in the public consciousness a couple months ago, did you realize that? But that’s a topic for another TED talk.
Crypto and blockchain infrastructure might make up the foundation of web3, but the benefits of internet ownership will be what changes the world. For the first time in human history, we have a ridiculously easy way for an organization to become their own central bank and create their own governance/laws to determine their future. Interestingly enough, these are the very building blocks of a sovereign country.
You sound even more like a utopian Lunatic talking about how the whole world is gonna change or whatever. But what’s this headline about ‘tokenomics’ all about?
Clearly you haven’t drank the crypto coolaid yet. Terrable.
Tokenomics is a portmanteau of the words token + economics.
Tokenomics is the design of the token use cases within a crypto community. Typically, math and incentives are combined with phrases like ‘algorithmic bonding curves’, ‘vesting schedule’, and ‘really robust roadmap’ to create the structural support for a new crypto community. Since we can assume tokens are traded freely in the crypto marketplaces (see DeFi), tokens are essentially money with additional bonus effects that the founding team has determined will make the project/protocol attractive.
Woah, they have a really robust roadmap? Bullish. Why are token economics important though?
I’ll come back to that question. First, I want you to understand something about game theory, microeconomics, human behavior, and incentives.
Oh God, here he goes again. Why can’t we just talk about politics like normal people.
Don’t worry, we’ll talk about politics in our next crypto convo. You’re gonna love it govna.
Game theory is the study of how individuals in a game/rule set make decisions. In microeconomics, it’s customary to assume that individuals will try to make optimal, rational decisions whenever possible. Setting aside crazy ex-girlfriend emotions for a moment, let’s assume everyone will be rational. When presented with a typical game, you’ll make optimal decisions in order to try and win. As a game designer, I’ve spent my entire life pondering how to design ecosystems through rules that will incentivize fun and interesting strategies.
The US economy functions very similar to a game, albeit an extremely complex and nuanced one. Its rules include things like taxes, regulations, the stock market, and entities which transfer value all over the world.
Regardless of your political opinions about our economy writ large, I hope we can at least agree that economies represent the transfer of value in an ecosystem.
When the central bank (aka The Fed, aka DJ J-Pow) increases the issuance of new currency or raises the interest rates of the economy to combat inflation, they are directly impacting the rules of the game.
Since the rules have changed, different player strategies emerge to optimize for those changes. Home loan rates increase, and thus home buying theoretically falls because it’s more expensive to buy.
High prices caused by inflation cause less spending, which eventually lowers prices because there is less spending, aka demand.
No it doesn’t, I’ve seen prices skyrocketing everywhere. And look at the price of gas!
Tell me about it, if crypto is meant to be for the masses, we need lower gas prices. Bear with me though, the US economy is complex — let’s try something simpler — crypto economies! Fundamentally, we need to look at supply and demand. When demand is higher than supply, prices rise, just like our economy right now.
I heard it was because the money printer go brr.
Fine, I’ll stay with the US economy a bit longer. It’s happening for many reasons, one of which is the Supply chain. This lowers the Supply side, raising prices.
Another reason is the issuance of new money into the ecosystem. When more money enters, everyone’s money becomes worth a little less, known as inflation. The idea that your money will be worth less in the future spurs consumer spending, which drives our consumer economy. The Fed tries to keep inflation at around 2% to give you anxiety that the money under your mattress really is disappearing while you sleep.
The same basic forces are at work in crypto economies. If a crypto ecosystem has the potential for infinite tokens and they are issuing more and more tokens each day, then each day, your tokens in your hand are worth less. However, if those tokens are leaving the ecosystem in some way, like being burned (exactly what it sounds like) or bought back by the protocol’s treasury like a company does with shares.
Going back to supply and demand, since these tokens are traded on the open DeFi market, if everyone wants to sell these tokens but no one wants to buy them, there’s a lot of supply and little demand, meaning lower prices for the token. If there’s only a few tokens and everyone wants them, then the price of the token rises.
Sounds simple enough. I demand you supply more info on tokenomics though.
Tokenomics is the design of incentives within a crypto ecosystem to drive repeatable human behavior.
Ideally, tokenomics are designed to be sustainable (long term), profitable for investors, and should create real world value as a result. Or ‘metaverse value’ if you wanna get those juicy clicks on your article.
Tokenomics provide the Framework in which value is transferred within the crypto ecosystem. Just like the dollar is the main transfer of value in the US economy, a DAO’s native token is the main transfer of value in their crypto economy.
Because of this, great tokenomics can financially incentivize human cooperation to create value without needing to trust or meet each other. This is huge. This trust bridge is what allowed Uber to pick strangers up in cars without pervasive issues. And now we can do this trustless cooperation on the internet in infinitely composable business structures. Really let that one soak in.
Isn’t Bitcoin issuing more tokens every day? Why doesn’t that inflate the value away?
Since there is a hard cap to the amount of Bitcoin that can ever be in existence, and since some people will irrevocably lose their Bitcoin at some point, you could theorize that it’s actually slightly deflationary. While new Bitcoin is entering the ecosystem, technically that would lower the price, but in general, adoption has been higher than the issuance. Demand for the Bitcoin has outstripped supply, raising the price.
Ether on the other hand, has an infinite supply cap. However, they introduced a burning mechanism that removes Eth from the ecosystem during some transactions, making it deflationary when more people use the blockchain. With less supply, the price of each existing token goes up.
Using the basic principles of supply and demand, you can begin to postulate what may occur in different crypto ecosystems.
You’re not an expert yet though, there are more complicated factors such as staking. When you stake a token or NFT (which are tokens, that’s the T), you are temporarily removing it from circulation (liquidity), meaning that the tradable tokens on the market are less, artificially lowering supply. When you lock up your tokens in a contract for a certain amount of time for additional interest or additional community benefits, you are helping keep the value retained in the ecosystem by not having it be tradable. This should get you started when evaluating crypto ecosystems.
Ok so when more people bring more money in the ecosystem, prices rise and everyone gets richer. It’s dependent on more people? Explain why all of this isn’t a Ponzi.
Now we’re getting into the hard-hitting questions. Chad from Phi Psi won’t be able to answer this one. If the only value of these tokens is a financial asset, then it may be considered a security (regulation from the SEC). Ponzi scams will likely be a thing of the past in the near future, warnings will be plastered all over them.
The key may be the additional value these tokens provide or create for the world through products, services, or human organizations to create those goods. The tokens exist in an ecosystem that can create real value.
- In crypto games, the non-financial value often is playing the game for entertainment, creating a strong pvp player base, or getting exclusive in-game assets.
- In profile picture art projects, the non-financial value often is the networking or friendship of the community or simply wanting to support the artist on their journey.
- In DeFi, the value often is in the form of rewards for supporting the protocol or governance, which underpins risk management and capital liquidity. Usually DeFi is financial value though, for obvious reasons (it’s in the name).
- Mix and match any of the sectors and traits above to get new combinations. Value can be created in a vast array of ways.
Token value could be representative like tickets to sports games, membership passes to a gym that is gamified + personalized, secure company ID cards for login purposes, fractional ownership of assets to handle shared ownership easier, and many more. Check out my first crypto convo to see more.
While it is true that the financial value often comes first from people buying into the community, this is not so different from companies. Companies start by getting investment to make a product which is sold to consumers, increasing the value of the company. Crypto communities are the same, especially if there’s a product that’s being offered… which includes digital products.
I believe the future of value will be added from the actual work of these communities/companies creating products for use in the entire web3 ecosystem. When you buy a product, you might even get their community tokens in return, turning you, a customer, into a stakeholder who is financially incentivized to spread the word about that thing you just bought.
With Ponzi schemes, the early investors are entirely reliant on more people coming in. With crypto ecosystems though, you’re not — you can create real products (and thus real value) with the communities due to the magical internet powers of virtual cooperation. If more people want to be involved, then the price will rise and you’ll get the appreciation of the token along with the sales cut!
So now you should be asking: “What is the right structure to create that value sustainably?”
We’ve seen examples with Layer 1’s and several DeFi protocols so far, but we’re just at the tip of this iceberg. Real value absolutely has been created and will continue to be created. We’ll see TONS of new tokenomics and governance models over the next decade. Some will work, some won’t, but that’s the exciting part of this innovative time… and it’s why it’s Near impossible to regulate — the sheer diversity of models will make the SEC’s head spin. Better to let innovation happen than stifle at this point. Some patterns will emerge eventually.
Right, I think I’ve got it. Tokens underpin crypto communities, most tokens are different, and thus difficult to compare easily. The more people want to sell, the lower the price goes. Value is created for the token when humans cooperate effectively within well designed tokenomics and governance structures to make goods or services for the broader economy.
Couldn’t have said it better myself.
Couple more thought starters. With tokens, you can buy and use products while having financial upside the more you use it; this is due to tokens being issued to you as a result of the sale. If the demand of the good or service grows, then you just made passive income for supporting a product you already wanted to use. That’s a Win Win if I’ve ever seen one.
This isn’t ‘set it and forget it’ either. Tokenomics can change and be adjusted just like how the US economy adjusts their economies in order to maximize long term potential of the project. Since crypto community economies are much simpler and smaller, changes are drastically easier to handle.
Every business, every brand, every community, and every game that wants to truly enter web3 will need tokenomics and governance of some kind. Many will be standard structures, and many more will be customized, but it will pay to understand these concepts.
This is why I’m excited to evolve from a Game Designer into a Tokenomics and Governance Designer, with Framework Ventures.
Check out my next crypto convo for a rip-roarin’ political discussion on Governance.
**Please note, inflation in the US economy is so much more complicated than our money printer going brr. There are thousands of forces at work that drive inflation.**
Want to go deeper?
The New York Times mimicked my conversational writing style. Great overview of crypto for n00bs!
Overview of 3 play to earn tokenomics models analyzed by a thought leader
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I’m not a certified financial planner/advisor, nor a certified financial analyst, nor a classically trained economist, CPA, accountant, or lawyer. The contents in this article are for informational and entertainment purposes only and does not constitute financial, accounting, or legal advice. By responding to this article, you agree to hold me harmless from any ramifications, financial or otherwise, that occur to you as a result of acting on information found in this article. These opinions are my own and may not reflect the opinions and investment theses of Framework Ventures.
