Elk Academy Lesson 3: DeFi Tokenomics
Hello again! Welcome to your third lesson in DeFi, which will cover all of the factors that influence the price of tokens. The goal of the lesson is to help you maximize your returns while managing to avoid some of the common mistakes that new DeFi users make.
What are tokenomics?
If you are considering investing in a cryptocurrency, it is important to consider the variables that will contribute to the token’s price outlook in the short, medium, and long term.
“Tokenomics” (a portmanteau of “token” and “economics”) refers collectively to all the dynamics that determine the value of a token, but more specifically the supply (number of tokens available now or in the future) and distribution (how the tokens are given out, and to whom).
Many projects distribute their tokens at predetermined rates over set intervals of time. The rate of token distribution is referred to as emissions.
Identifying these three variables — supply, distribution, and emissions — should be your starting point when considering whether or not to invest in a project’s token. These details are typically available in a whitepaper, which is a document, written by the project team, that provides a thorough overview of the project.
As an example, here is a link to Elk’s litepaper, which is a condensed version of the whitepaper released prior to launch.
Supply
In basic terms, price is a function of a token’s relative scarcity measured against demand for that token. Since gauging demand for a token can be difficult, supply typically serves as the more reliable metric for evaluating a token’s outlook.
There are actually two key numbers to consider: total supply, which refers to the total amount of tokens that will ever exist, and circulating supply, which is the amount of tokens currently in existence.
Price tracking sites like CoinGecko and CoinMarketCap will generally prioritize market cap, which represents the token’s current circulating supply multiplied by its price in a reference currency, most often US dollars.
Another number, the fully diluted market cap (total supply x current price) represents the hypothetical market cap if all tokens were in circulation. This latter number is more abstract, but it can be useful for speculating about the future price of a token.
A majority of tokens have a finite total supply, meaning that there is a predetermined amount of tokens that will ever exist. Total supply can vary widely, however, from one project to another.
For example, it is fairly well known that the supply of Bitcoin ($BTC) is limited to 21 million.
By contrast, Dogecoin ($DOGE), to take another popular example, has a total supply cap of over 130 billion. This is one of the main reasons why a single Dogecoin is worth much less than a single Bitcoin. Similarly, there are some tokens with lower total supply.
The token for the popular lending protocol Yearn Finance ($YFI), for instance, has a total supply of only 36,666. On the other side of things, some tokens have an unlimited supply, which means there is no set limit or hard cap to how many tokens can be created. Infinite supply!
The total supply of $ELK tokens is set to 42,424,242, or roughly double the total supply of $BTC. This number represents all of the $ELK tokens that will ever exist across every chain Elk supports. The circulating supply of $ELK, however, is far lower. At the time of this lesson’s publication, there are just over 1 million $ELK in circulation, so only ~2% of the total supply of $ELK tokens are currently in circulation.
Emissions
The vast majority of cryptocurrency tokens are inflationary, meaning that their starting supply is lower than their total supply, and more tokens are introduced over time through a system of mining or farming.
The frequency with which additional tokens are put into circulation is known as the rate of emissions. It is best to think of inflation and emissions as time dependent variables impacting supply, i.e. how quickly will circulating supply increase?
A token with a high rate of inflation will release a higher percentage of its total supply faster than a token with low inflation. Some projects will opt for a lower emissions schedule, distributing tokens more slowly over a much longer period of time.
Emissions are a delicate balancing act, since increasing supply can place a downward pressure on a token’s price, which may offset the value created. One pickle that costs $10 carries the same total price tag as ten pickles worth $1 apiece. (More on pickles later!)
Since annual percentage rates (APRs), are partly determined by the rate of emissions, many projects will launch with sky high, hyperinflationary emissions rates in hopes of attracting yield chasers who are drawn to the huge advertised percentage returns.
More often than not, however, hyperinflation will cause a token price to depreciate, or lose its value, even more quickly.
It is possible to make profitable investments in projects with high inflation. To do so, we follow the Elkstein Rule: the rate of inflation must exceed the rate of depreciation.
If you started with one pickle for $10, and you end up with ten pickles priced at $1.1 dollars, congratulations, your investment is now worth $11, representing a 10% return on investment (ROI).
For the most part, however, it is generally good to look for projects with healthy, sustainable inflation rates spread out over a longer time horizon. $ELK tokens benefit from a lower than average emissions rate, such that the tokens reserved for farming will slowly be emitted over the next four years.
To offset the effects of inflation, many tokens will also include deflationary mechanisms, which are designed to reduce the supply of tokens over time. The most common of these are burned fees. In this model, every time a transaction fee is collected during token trades, instead of that fee being redistributed to liquidity providers, a portion of the fee will be locked into a contract that removes it from circulation permanently, a process known as token burning.
There are some niche tokens that are purely deflationary, meaning that their total supply is designed to go down instead of up over time. In most cases, however, deflationary elements are introduced to offset the effects of inflation over the long term, meaning that a token will enter a deflationary phase once the total supply has been reached.
ElkNet will eventually include fees for cross-chain transactions, which is designed to have a mild deflationary effect, reducing the supply of tokens and increasing the value of $ELK over time.
Distribution
Farming and mining only account for one of the ways that tokens are distributed. As we mentioned in a previous lesson, projects will allocate the total supply of their tokens in a variety of ways, establishing separate funds to pay developers and reward early investors, finance marketing strategies (including airdrops and community giveaways), or to hold in reserve for some other purpose.
There is nothing inherently wrong with some amount of tokens being reserved for the team or early investors (in fact, it can be a sign of a good project, since it means the team has incentives to make the project a long term success). When you do your initial evaluation of a project’s token distribution plan, however, you should keep a close eye on how the tokens are distributed to make sure that overall scheme is fair and reasonable.
Case Study: $ELK Token
We’ll conclude by considering the distribution of $ELK tokens as a concrete example.
As you can see from the chart, $ELK follows a fairly typical distribution model, with roughly 5% of tokens set aside for the team and advisors, and the rest divided between farming and community initiatives. Approximately half of the tokens have been placed in a community fund, and their distribution will be decided in the future through community governance.
A unique feature of Elk’s tokenomics is the insurance pool for Impermanent Loss Protection (ILP) that matches the Yield Farming rewards. This special fund, which protects liquidity providers and yield farmers on ElkDex from impermanent loss.
Impermanent loss will be the main topic for discussion next week. Is it misnamed? Perhaps. Is it often misunderstood? Definitely.
Class dismissed!
