Aug 4, 2022
How to Design a Tokenomics from Zero — Eloisa Marchesoni
Intro
Token design is an undervalued and critical aspect of a blockchain project.
Many teams or lone token creators are exposing themselves to a failure risk because their projects lack properly designed tokenomics.
No matter which chain and technology you use to create a token, it can be doomed to failure without properly designed token economics.
No matter if you want to launch an ICO or you only have a simple and abstract idea about a token: you cannot miss the token design.
Tokenomics dictionary
First of all, let’s start with the basis
For every purpose or use case, we need a different kinds of tokens: there are Layer 1 and Layer 2 tokens, security and utility tokens, fungible tokens and NFTs, and so on.
Layer 1 Token
Layer 1 blockchain refers to the underlying blockchain architecture. This layer allows the creation of tokens the, with a few lines of code using smart contracts.
Layer 2 Token
Layer 2 tokens are built on top of the existing layer: for example, all the tokens built upon the Ethereum blockchain are called ERC-20 tokens.
Utility Token
A utility token mainly revolves around regulatory aspects and is much simpler to set up than the next kind of token.
Security token
A security token is typically used as a form of identification for physical access or as a method of computer system access and is a device that provides two-factor authentication (2FA) to prove the identity of a user during the process of login.
Fungible Token
They are identical to each other, and with the same value
Non-fungible Token
NFTs are unique, non-divisible, and non-interchangeable.
The four fundamental points in Token Economics Design
You can have the best idea of the world about a token, but the essential point to make it worth it, is to design its tokenomics and define use cases
There are a few underestimated steps to follow in creating a valuable token economics model.
1) Define Token Utility and Workflow
If you cannot answer the question “Why do I need a token?” you can stop to read this article: the token should have a reason to exist, otherwise, it’s just greed, with no value for an investor or an end user. The purpose of a token is usually determined by the utility it provides in a product ecosystem.
Then there is the WWH
Who, Why, and How will use your token?
Here’s for you two examples of existing token workflows:
Ethereum (ETH)
This ecosystem is populated by Actors, Users, Validators, and Developers The user can send transactions and use apps
The validator can earn rewards for validating transactions and mining tokens. He can also govern ecosystem decisions
The developer can earn rewards for building apps and improving the network code
Binance (BNB)
This ecosystem is populated by Actors, Customers, Developers, and the Platform.
The customer can buy tokens, pay online and gain discounts if pays using BNB.
Various ways to earn are using the BNB credit card, holding BNB, and participating in Binance launchpad projects.
The developer can build apps, and create and list their tokens on the platform. The platform can earn service fees, and sell and burn tokens.
Distribution and workflow
We have a lot of ways to get tokens flowing in and out of your network and we have to maintain a high circulation volume, with a consistent amount of transactions.
There has to be some sort of incentive to increase the “ins” and create some sort of the pressure that, in some particular cases, can precede a FOMO: Fear Of Missing Out.
So we have to ask ourselves what are the values that we are promoting and how can we render them more palatable the token.
Another thing that we have to do is to make a census of the ways to inject or payoff.
Last but not least, we have to find a way to guarantee and to incentive, a long-term holding, with a low cash-out rate, which can be detrimental, especially in the early phases of our project, with sustainability in the long run.
2) The Basics
When you use a layer 2 solution to create your token, all the token code and business logic will be inside a smart contract. Therefore, since it is not possible to change most of the things written in the code once it goes into production, it is vital to lay in advance a business model.
Now, let’s go a little bit inside the technical aspects and the basic terminology of token economic modeling.
Smart contracts
Literally intelligent contracts are incorporation of contractual clauses encoded in computer language, in software or computer protocols, which are used for the conclusion of contractual relationships by conferring autonomous execution of the programmed terms upon the occurrence of certain conditions previously defined.
Three fundamental characteristics of a smart contract are transparency, automation, and immutability.
Market Cap
Market capitalization is the total value in FIAT of all the shares of a company. In the cryptocurrency industry, market capitalization is calculated by multiplying the total number of coins that are in circulation by the price of a single coin at any given time.
In short:
Market Cap = Token Supply * Token Price
The Market Cap will be hugely dependent on how much money you will raise during your ICO.
ICO
Initial Coin Offerings are a funding mechanism by which cryptocurrencies are collected or obtained, allowing the launch of a new service or a new currency. The investor delivers the cryptocurrencies and receives in exchange a token from the company.
Total Token Supply
Total supply refers to the number of coins or tokens currently existing and in circulation or locked in some way. It is the sum of the coins already mined (or issued) minus the total of the coins burned or destroyed.
Therefore, the total supply includes both the circulating supply and the coins that have yet to enter the open market. For example, coins that are held under a vesting period, typically follow an ICO event.
Any burnt coins or tokens are excluded from the total supply.
Mint or Mine?
Mining is a competitive process that verifies and adds new transactions to the blockchain. The winning miner is rewarded with some amount of currency.
The reward is called POW: Proof Of Work.
For a lot of understandable reasons, nowadays mining is getting old fashion and all the tokens in the Layer 2 protocols are minted.
Token minting is simply a process of creating new tokens.
Transaction Fees
“Token Tax” is a term often used to describe tokens with transfer fees that cause deflation or redistribute commercial profits to protocol development: Each time a token is transferred, a portion is burned, redirected to a development fund, or taxed. The token tax is usually paid from the wallet of the originator initiating the transfer. The tax is taken from the amount sent during the transfer that must always be higher than the amount of the received transfer. The token tax can also reduce the supply of tokens and create deflationary tokens, given the economic theory that by reducing supply, the value of goods should rise.
The most famous deflationary cryptocurrency is Ethereum and its EIP-1559 burning mechanism. The token fee may redirect some of the transfer and trading fees to the protocol development fund, ensuring sustainable development of the protocol outside of any initial fundraising.
An example, of 2% transaction fee redistribution could be: 1% burned, 0.5% to the developer’s wallet, and 0.5% to the liquidity pool.
Usually, a high transaction fee could scare the investor, but there is some project that has a two digits fee, for example, Safemon: 10% fee of which half is redistributed to existing holders, with the other half added to the liquidity pool.
3) Inflationary or deflationary model
Inflationary
There is no upper limit on the number of tokens created, which means that the supply of tokens increases constantly. Tokens can be issued on a fixed, logarithmic, or random schedule, others are minted on demand.
Some good advice in designing an inflationary token are:
Do not go beyond 150% of the annual inflation rate, and remember that going below 20% could demoralize investors.
Do not permit the token to be minted on-demand: obviously is not a good idea to allow someone of the team to issue new tokens. The investors for sure won’t be happy to discover something like that.
Staking is necessary for validating transactions and increasing the security of the network, it is also crucial in building a loyal investor base. The validating rewards drive of inflation.
Deflationary
In this circumstance, that there is a limit to the number of tokens that can be created, and this supply decreases over time.
Another deflationary drive is the burn mechanism.
Deflation models are made possible with the burn mechanism: when you burn a token, you remove it from the system.
When you burn a token, a certain quantity of crypto is removed from circulation. To carry out the procedure, it is sufficient to send an amount of digital currency to be burned to a special digital wallet, which takes the name of “eater address” or “burn address”. Wallets of this type are not owned by anyone, it follows that it is not possible to enter them and move the cryptocurrencies inside to another virtual wallet, much less cancel the transaction and recover the sums sent.
There is also another way to remove digital coins: auto-burn, which is a function present within the smart contract of the single Altcoin thanks to which elimination is carried out automatically and on a cyclical basis. An example of a digital currency that has adopted auto-burn in recent times is Binance Coin, whose management decided on a quarterly coin burn.
There’s a lot of debate about whether to consider burnt or not the tokens inside a wallet if the access has been lost (a forgotten password or stolen ledger, for example).
Both of worlds
You can also lay a mixed model using a combination of deflation and inflation: usually, the primary model is inflationary, with some deflationary routines, like the token burn.
Many projects successfully use a combination of deflationary and inflationary models. More precisely, they use a primary inflationary model with some deflationary mechanisms (token burns).
Solana is at the same time “inflationist” and “deflationist”. The inflation rate started at 10% and will reach its final rate of 1.5% in about 10 years. However, there are also deflationary factors in Solana. For example, a percentage of each transaction fee is burned. . With enough transactions per second, the transaction fees that are burned could be as high as 1.5% per year which would bring Solana’s inflation rate to 0%. The fees burned could also be more than 1.5% per year if it would occur a lot of transactions, which would make Solana deflationary in the long run.
4) Final touches and last checks
Let’s have a look back in the search of potential flaws in the model. This will also be the occasion to further improve your model and make it even more attractive for investors: what could be the most appreciated features from his point of view?
Profit sharing
There are a lot of ways to allow users to take advantage of holding their tokens. You can reward them with airdrops, commissions, or unexpected distribution events.
Vesting
You will agree with me in saying that is a bad feeling to purchase a token and finding yourself unable to immediately sell it.
Yes, is bad but necessary, and this could also be seen as a way to reassure investors that a great amount of tokens will be held.
During an ICO, for example, a good rule is to specify in the smart contract that the buyer will be able to manage only 25% of the purchased tokens, with the remaining part logarithmically or linearly locked during the next months.
Governance
Governance tokens allow their holders to vote on specific matters, such as the future of a protocol or new features. Protocols are usually decentralized and have no central boards or authorities, making tokens extremely useful in the case of big decisions. Someone a little more philosopher than me could define it as an attempt at crypto democracy.
Key properties:
A well-designed token should stick to these principles:
Simple rules: like in monopoly, the user has to know what he can do and what he cannot
The token must have a purpose: without it, the entire projected ecosystem could be endangered
Better if the token proves itself to be inflation-resistant
Easy, fast, and cheap transactions
A good social campaign to make the investors feel cared for and safe
A lot of use cases in the real world: for example, who would have a MasterCard with no possibility to buy anything?
After the launch phase, the token need to have a substantially high volume of trade, to reassure the investors about the liquidity of the crypto
GOOD TOKENOMICS
1) Ethereum (ETH)
Ethereum’s tokenomics was in the beginning very similar to Bitcoin. In its current version, it relies on a “Proof of Work” consensus mechanism as well. Smart contracts give Ethereum more utility, and a vast ecosystem of decentralized applications has evolved and led to a very high transaction volume. Some issues with this have recently been addressed in an update which has also led to interesting new tokenomics dynamics.
One big difference to Bitcoin is that not all ETH is mined, in fact, the majority was part of the genesis block pre-mine. The mined and pre-mined ETH are more than 100 million.
The Ethereum 2.0 beacon chain has already been launched, and a merge with Ethereum 1.0 is planned for the end of 2022.
There will be a “green shift” from a Proof of Work to a Proof of Stake. The validators (at least 32 ETH staked) will be the only protectors of the network. The extracted and pre-tested supply will remain in circulation after merging, so the actual testers won’t be affected.
Since the chain of beacons with Ethereum 2.0 has already been launched, staking is possible today. The funds, however, will be blocked until the official merger of version 1 and version 2, and we’re talking about 13 million ETH at the moment.
2) OCEAN PROTOCOL
The native token of the Ocean Protocol is called OCEAN.
OCEAN is a layer 2 token and is built upon the Ethereum blockchain.
OCEAN staking differs from the staking of many other coins. Stakers become liquidity providers and they are directly curators of data.
These data tokens are ERC-20 and they can repurpose ERC-20 wallets as data wallets and crypto exchanges as data marketplaces
What’s more, the fact that data tokens are ERC-20 tokens means that they can repurpose ERC-20 wallets as data wallets and crypto exchanges as data marketplaces.
OCEAN also acts as a governance token to allow the community to make important decisions about protocol development. Finally, investors can benefit from OCEAN to provide liquidity to the market and earn a return. The total supply of OCEAN tokens is limited to 1.41 billion tokens. However, there are only 613 million OCEANs in circulation at the moment. The rest of them, more than 50% of the total supply, is expected to come out in the next 40 years.
Nowadays, the price of a token is about 20 cents each for a market cap of 120 million dollars. In 2020, the Ocean Protocol team delivered a proof of concept for a data market to Daimler AG (a controlled of Mercedes- Benz). The concept allows companies to use blockchain technology to store and monetize their data. Last year, the OCEAN team also partnered with WISeKey to launch an NFT market and with Polygon Network to reduce gas tariffs on the congested Ethereum network.
BAD TOKENOMICS:
1) TERRA (UST)
Terra was a project that allows cross-chain token swaps and automated liquidity mining.
Terra had a dual-token economic model when they launched, with Luna being a primary value token and UST a utility stablecoin.
The UST token was designed as an algorithmic stablecoin tied to the price of the other crypto within the pool (LUNA).
As opposed to the USDC (the more famous stablecoin), which has fiat assets as a reserve to back its tokens, the UST was an algorithmic stablecoin created and managed by Terraform Labs. It depended on computer code to self-stabilize its value by creating and destroying USTs and LUNA in a sort of seesaw effect between supply and demand.
When the project was launched in 2019, a picturesque ecosystem was progressively deployed, for a total of six different tokens.
Probably the most significant incentive in the entire scheme was a companion credit platform called Anchor, which guaranteed investors a 20 percent annual return on their UST stakes, a rate that many analysts said was unsustainable.
And in fact, it was.
When the cryptowinter hit in may 2022, the selling pressure on LUNA caused the UST/TERRA pair pool to go out of the seesaw range and to spiral down nearly to $0 in three days, with a 45bn dollars loss.
2) Dogecoin (DOGE)
Dogecoin is probably the most famous meme-based token and blockchain was forked from Bitcoin.
DOGE exceeded all expectations (including those of its creators) because at the beginning it was considered a joke. It was devised in 2013 by Billy Markus and Jackson Palmer and takes its name from the famous “Doge” meme of the Shiba-Inu dog that was quite popular at the time.
Being its clone, DOGE shares all the main features of the Bitcoin blockchain and all its weaknesses too; unlike Ethereum, developers cannot create smart contracts or build apps: only send and receive.
By the way, the powerful meme-token in circulation is not so much useful in a tokenomics perspective: currently, Doge tokens in circulation are over 130 billion with the big risk of an inflationary spiral, even if they are decreasing at the rate of over 5 billion units a year.
Another problem is the lack of differentiation, which makes this virtual currency similar to dozens of currencies that nevertheless do not enjoy the same hype. We should also speak about the fact that the project has been an “orphan” because the developers of the project have abandoned their creation a long time ago, so a real driver is missing.
The judgment that looks like a tombstone on Dogecoin’s future comes unexpectedly from Billy Markus, one of the two developers of the token, who defined the quotation of his creation as “absurd”.
Conclusion
It is not necessary to generate a complex tokenomics model: there are also simple and successful ones, the most important thing is to create a product that makes sense and that at the same time creates value for investors.
The architecture model, however complicated, must still underlie a token that is easy and pleasant to use, so we must also consider the interface.
Furthermore, the human psychological factor should not be overlooked, as tokenomics is interconnected to a series of mathematical disciplines, but, above all, humanistic.
Just as we cannot ignore the expectations of investors and at the same time we must consider the macroeconomic framework that is in front of us.
Before moving on to the launch phase, it would be advisable to consult a specialist to have an opinion from the outside about the entire project.
I would like to conclude this essay with a series of questions which should ideally always be answered “yes”.
Question time:
Is buying something part of the business model?
Is selling something part of the business model?
Does the token grant a reward to user disclosing or sharing some data about them?
Does it give exclusive access to contents or products?
Is the token tied to the use of a product?
Does it provide the user with exclusive access to it or does it provide interaction rights on the product? Can users create a new product or service?
The token translates into a reward based on the grade of interaction of the user in the project?
Does the token provide a real connection between users?
The token can be used to pay certain services?
Is there a related benefit to your users from embedded currency inflation?
Does the token guarantee some democratic rights, such as votes and vetoes?
Is it possible to purchase a token with some form of discount as an incentive to encourage trial or its use? Is the token required to join a network or other related entity?
Is the token necessary to execute a smart contract?
Is the token your primary payment unit, essentially functioning as an internal currency?
Does the blockchain autonomously distribute other benefits to token holders?
Is the token required as a security deposit to guarantee some aspects of the functioning of the blockchain? Does the token allow the user to contribute to a value-added action for the network or market being built? Does your blockchain autonomously distribute profits to holders?
Does the token guarantee some kind of ownership, be it real or fictitious?
Shima Capital Tokenomics Expert — Eloisa Marchesoni
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