What is Tokenomics?
Though tokenomics originally referred to the issuance rate and total supply of tokens in a blockchain project, the range of token mechanics used to incentivize ever-more nuanced action from blockchain project participants has grown alongside the adoption of the technology.
What is Tokenomics?
Tokenomics combines ‘token’ and ‘economics’ to describe how tokens are managed within a blockchain project to accomplish goals. Because we can count on humans to act in their own best interest, good tokenomic designs increase the value of the protocol’s token when token holders take actions that benefit the protocol such that their long-term value outweighs the short-term gain of malicious actions.
Good tokenomics ensure a greater reward for being nice and continuing to play the game than for being mean for short-term gains.
The original example of tokenomics which relies on issuance rate and total supply of tokens comes from the first blockchain. Bitcoin incentivizes disparate and even potentially adversarial people to secure the network and maintain the core tenants of the protocol through 3 token mechanics that synergistically cause the price of BTC to go up over time:
- Proof-of-Work pays miners in bitcoin for solving puzzles needed to add a block to the blockchain. The more blocks in the chain, the more energy an attacker would need to expend to counterfeit any transactions on the network.
- Bitcoin paid to miners (the block reward) is the only means of creating new bitcoin. These rewards are are cut in half every 4 years creating a supply shock that increases the price and draws more attention to the protocol.
- A maximum supply of 21 million tokens means (among other things) that early adopters are rewarded for taking risk on an unproven technology, and paving the way for later adopters.
Because the value of BTC increases by maintaining these factors, Bitcoiners acting in their own best interest are also acting in the best interest of the network.
Shifting tokenomics for Web3 and DAOs
In decentralized autonomous organizations (DAOs) where there is no hierarchy yet many people working together, tokenomics need to be well thought out to be succesful long term. The survivability of the project depends on aligning the goals of both token holders and project contributors, especially as the project increases in size over time.
Though Bitcoin mainly uses 3 tokenomic mechanics, Web3 projects are experimenting with others as they organize people for more varied tasks and move from Proof-of-Work to Proof-of-Stake.
Staking
At the heart of many smart contract platform’s tokenomic designs is staking. Staking is like locking up your tokens in a savings account — there’s rewards paid out incrementally over the duration that your funds are staked.
Proof-of-Stake networks use the staking mechanism to power validator nodes that vote on what transactions should be incorporated into the blockchain. These nodes have more sway the more tokens are staked to them, and by validating true transactions the nodes earn rewards for the users who choose to stake with them. If a node validates a malicious transaction, that node has a portion of their staked tokens burned. This incentivizes users to perform due-diligence on what nodes to stake with, and nodes to only validate true transactions.
Some projects who do not need the validation component of staking can still make use of the mechanism to increase available capital by offering staking rewards.
Tokenomics case-study: API3
Though one initial function of project-specific tokens is to seed their treasuries, there must be additional utility for good tokenomic incentives.
The API3 token is interesting in that one of its utilities is to act as collateral for a unique service coverage on the datafeeds enabled and curated by the API3 DAO. As such, the tokenomic incentives for this project not only need to encourage people to hold the API3 token, but also to stake it to enable service coverage to a larger base of smart contract developers.
In the API3 white paper, the governance, security, and value capture utilities of the API token are highlighted as tokenomic mechanics, though co-founder Burak Benligiray clarified additional measures for value capture, like token burn, which we will explain in detail.
Governance
Governance is a cool tokenomic incentive because it encourages participation from those who see the long term potential of a project and share in the overall vision.
API3 uses this mechanism, allowing token holders who stake to participate in the DAO’s open and direct governance model.
These contributors are incentivized to stay around for the long-haul by trading token liquidity (the ability to sell their tokens any time) for the ability to make and vote on proposals that affect the direction of the DAO, including direct function calls for token grants and parameter updates to the DAO governance contract itself. As the proposals directly interact with the DAO contract, token stakers are not reliant upon a multisig or third party action to fulfil validly passed proposals.
Discussions on proposals are hosted on the API3 forum, and you can see detailed proposals that are currently being voted on by visiting the API3 DAO.
Yield on staked tokens
Staking comes with direct financial rewards to compensate for the service coverage collateralization risk and for locking up capital. These rewards (sometimes called yield) are like interest, and programmatically mint new tokens to staked addresses at a floating rate. This type of reward which issues new tokens is called an inflationary reward.
Because API3’s staking pool is the collateral for datafeed service coverage, the rate of inflationary rewards issuance is linked to the ratio of funds in the pool versus the target stake amount. The target stake is set by the DAO and based off the cost of servicing coverage plans.
The greater the difference between a lower staking pool value and a higher target value, the greater the rate of issuance should be as set by the DAO. This will either incentivize new capital to enter the pool to take advantage of the rising rates, or the inflationary reward itself will reach the target on its own given enough time.
The above covers the case when the target stake is greater than the capital contained in the staking pool, but what happens if the target stake drops below what’s already there?
In the event that a DAO proposal passes to drop the target stake below what’s already in the staking pool, the rewards will be reduced on a weekly linear schedule: 1% per week until reaching equilibrium or the inflationary reward lower bound of 2.5%.
Because the inflationary rewards rate can be monitored and adjusted by DAO governance vote, there’s flexibility in changing conditions without the need for centralized intervention. Additionally, this design does not disproportionately reward early adopters and leads to a broader distribution of tokens over time as the inflationary reward only increases as demand for service coverage offered by API3 grows.
To balance positive and negative supply mechanics, API3 is combining the ideas of revenue distribution and token burns.
Revenue distribution and token burns
Flat revenue distribution has its own set of downsides, such as creating swings in the total amount of staked tokens, and attack vectors for the wealthy to exploit distribution events (see dividend capture strategy). To combat this type of action, API3 uses profits generated from a dApp’s use of datafeeds or service coverage to buy-and-burn API3 tokens.
This has a couple benefits:
- Stakers only need to receive inflationary rewards.
- Token value increases proportionately to the amount of tokens being burned as the service is “paid” for (supply decreases as demand stays the same).
- Supply changes are smoother, rather than having periodic spikes if revenues were shared monthly or yearly.
- Simplifies governance: the DAO only has to adjust the target stake which is linked with how much demand there is for service coverage.
Game theory for the win
It’s fascinating to see how goals specific to each project directly impact the type of tokenomic incentives that can be employed. If API3 didn’t offer service coverage to smart contracts using API3 datafeeds, the mechanics of token burns and yields wouldn’t synergize well at all.
When assessing a Web3 project or joining a DAO, it’s important to see how their tokenomics align with their road map and goals. Play various scenarios out in your head and see if you can find vulnerabilities. The Bitcoin maxim “don’t trust, verify” is beautiful as applied to the Web3 environment where there’s ready access to information thanks to the open source culture.
With curiosity as our guide, there’s very little we can’t learn with a little digging and mental work.
More articles about tokenomics on Medium
The good, the bad, and the ugly of tokenomics — Rishi Randhawa
Tokenomics: a business guide to token usage, utility and value — William Mougayar
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