Rethinking tokenomics

I was given my first computer back in 1979 and became instantly hooked on coding. By 1984 I was exploring online services with Prestel and Compunet and a growing number of independent bullet boards.

I witnessed the birth of the public Internet, started working as a professional software developer during the rise of the .com bubble and the period of shock as the bubble burst in 2000. Since then I’ve through the time of millennium bug, the birth of mobile computing, the birth of IoT, AI and now, the birth and growth of blockchain.

Over the years in IT I’ve learned many lessons, none more valuable than to never trust my own assumptions. Be willing to challenge my assumptions and where possible, measure and test.

Recently I did just that with my assumptions of how tokenomics in popular dApp projects work, in particular how tokenomics in DeFi projects work.

The problem

I’ve had the pleasure of working with amazing teams building amazing projects and so I always assumed their achievements would be recognised and reflected in the project token price. I had a rather naive view that tokens would behave like shares and track project success.

To test this belief I looked at my own investments over the past two years and was surprised to find no correlation between project performance and project token price or market cap. To see if this was just my investments I expanded my analysis out to cover the most successful DeFi projects out there, the A grade projects such as Uniswap, Sushiswap, Balancer, Curve etc. Wherever I looked I found the same pattern. All DeFi tokens lose price and market cap over time, regardless of bull or bear markets, regardless of project performance, the charts always invariably grind in one direction.

In the above charts for Uniswap and Sushiswap, there’s a gradual fall in both token price and market cap over a one year period.

Uniswap has seen token price drop from around 44 dollars to 7 dollars, a fall of around 84% and market cap fall from around 22 billion dollars to 4 billion dollars, a fall of around 82%.

Sushiswap has seen token price drop from a high of around 22 dollars down to around 1 dollar, a fall of around 95% and market cap fall from around 2.75 billion dollars to 125 million dollars, a fall of around 95%.

In both cases, the downward trajectory isn’t just in the recent bear market but has been a longer term pattern.

By contrast, TVL in the projects themselves have been fairly consistent over the same period, with drops mostly in the recent bear market.

This same pattern can be seen across DeFi projects and is even more pronounced in smaller projects.

The question becomes why do high functioning, successful projects lose token price and market cap over time regardless of how the project itself performs?

Feel the force

All projects need funding and the most common way to do this in blockchain projects is through a token sale. The most common approach in DeFi projects is to issue issue a token with an up-front sale followed by a continuous mine of new tokens to use as rewards for project users.

From a project perspective this is intuitive. Take an AMM project, LP’s earn fees from trade volumes. Issuing new reward tokens over time and awarding them to LPs adds a secondary reward layer and a further incentive to provide liquidity. This is good for the project, attracting increasing levels of liquidity.

But the act of issuing more tokens as rewards is inflationary which in turn creates a downward force on token price. If a project issues 1% more tokens each week as rewards then that devalues the token by 1% in the same period.

Holders of that token lose value over time. This creates an incentive to sell those tokens in place of tokens that exhibit better price performance.

LP’s that receive tokens as rewards face the same decision. Do they hold the inflationary reward token or sell for a value increasing token? Most will sell which adds to the downward force on the token.

Token holders and LP’s selling adds further downward force that in turn accelerates the downward spiral.

All tokens that issue new tokens on a schedule are inflationary and so start from the position of a net downward force on the token.

Dollars, euros and other fiat currencies are also inflationary but they have counter forces from utility driving demand along with population growth further driving demand. Inflation creates a downward force on the currency but demand for the currency to pay for goods and services provides a countering upward force. Tokens in most projects provide no real utility.

So one way to counter the effect of inflation is through the provision of utility such as requiring users of the dApp to pay for its goods or services with the projects token.

Another comparison frequently made is with shares. However, tokens lack one crucial property of shares which is that shares pay dividends that creates value flow from the project back to the share. If a share in Microsoft pays out $5 in dividends while a share in Apple pays out $9 for the same period then there’s increased incentive to buy and hold Apple shares which drives up share prices. Tokens provide no value flow back to token holders.

Fixing the problem

My belief is that a healthy tokenomics model need to have two broad characteristics.

Firstly, it should not be inflationary or have very low levels of inflation. The higher the token issuance rate, the higher the rate of inflation and the more quickly token holders lose value.

Secondly, it should provide either real utility or real value flow back to the token. This could be achieved with an NFT or a fungible token. NFT’s where a share should be indivisible such as situations where a project desires 1 token for 1 voting user. ERC20 tokens where there’s a more free form approach that allows people to hold small fractions of tokens.

These characteristics are behind the model applied to Jeskei tokenomics where we have applied the following principles.

1. All tokens are created on day one. No more tokens will ever be issued and so the token starts from a position of zero inflation.
2. The project itself charges fees in USDC, EUROC and ETH and pays out 25% of all fees to token holders. This creates value flow back to the token holders in high value tokens, an upward pressure on token price. Tokens used for fees must either be stable coins or non-inflationary tokens or tokens with sufficient utility or value flows to support them, such as ETH.
3. The token is also used for governance and so while the project generates revenues that flow to token holders and team, 50% of fees flow to the DAO for the purpose of providing community grants and supporting community activities. The more revenues generated, the more funds exist for the DAO aligning the DAO to token holders while maintaining decentralisation.

This in principle means that token price should track project performance. The more successful the project, the higher the fees raised, the greater the value flow to the token. Since the core team holds the same tokens, they are incentivised to increase revenues and grow the project which aligns the core team closely to other token holders.

As a worked example we can look at three clone AMM’s and their performance. Honeyswap has a daily volume of approximately $100k, Ubeswap has a daily volume of approximately $500k and Beets has a daily volume of approximately $30 million. If each AMM applied a 0.2% fee to transactions which was entirely paid out to token holders with a total of 120,208 tokens in total we would find that each token pays outs over 1 year the following. Honeyswap pays out $0.61 per year, Ubeswap pays out $3.04 per year and Beets pays out $182.18 per year. This sets a base token price since it’s a continuous passive income to the token holder. If we compare this to dividends for a well known company, in this case Microsoft we would find the following. Microsoft is presently paying out dividends of 62c per quarter, so $2.48 per year per share with a share price of $259.58. So the share price can be much higher but the performance of the company is reflected in part by the dividend payments which provides a positive force and even a base price. In the case of tokens, the payout is from revenues and while there remains plenty of scope to increase prices higher, this value flow creates a measurable base.

The Jeskei project did consider the alternative approach of using its tokens as a form of payment to create utility but decided against that in this instance since forcing users to use a new token would not be positive for the user experience. Allowing users to pay for services in USDC, EUROC or ETH provides a seamless experience for the user and so the value flow approach was chosen instead. Projects must ultimately provide positive user experiences and so there will always be a balancing act for projects deciding on these approaches.

There will be many other ways to generate utility and value flows but these considerations must be core to thinking when designing new tokenomics models. The current bear market should provide the right environment to encourage projects to think deeply about utility and value flows.

For a project such as Jeskei in a bear market, if the service provided is popular then it will generate revenues and those revenues will flow out to token holders and that will generate demand and provide positive price pressures. The wider market might decline but income will always have a value. Projects that look at these types of approaches can not only survive a crypto winter but can thrive in one.

Website: https://jeskei.com

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Twitter: https://twitter.com/jeskei_studio

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GitHub: https://github.com/JeskeiStudio/