DeFi is all about tokens — but what is tokenomics?
Tokenomics is key to the success of a cryptocurrency project. We break down the terminology and the challenges.
In the world of cryptocurrencies and blockchain technology, it is common to hear people talking about tokens, both for their inherent properties and specifically for their role in funding many different types of Web3 startups.
In the non-crypto world, tokens can mean many different things. There are parking tokens, gift tokens and — in the digital world — security tokens that allow you to prove your identity on a particular website, for example.
These may seem very different use cases, but in fact, they have one thing in common: a token represents an entitlement to access a particular item or service, and in this way it acquires value.
In the world of cryptocurrency, Web3 and decentralized finance, tokens have three primary functions:
- To act as a security, in which case the token represents an underlying asset and entitles the bearer to a specified quantity of this asset, for example, equity in a company or a set amount of gold or any other precious metal. Nexo, a security token which entitles holders to dividends in the underlying crypto lending platform, is an example of a security token.
- To provide utility, when it is used to access a platform and allow the user to consume a service or to express their opinion via a governance mechanic. Filecoin and Golem — offering access to decentralized storage and computer processing respectively — are examples of utility tokens. Another example might be giving access to data, whether this is something like cryptocurrency analytics data or user-generated data as offered by services such as Ocean Protocol
- To represent value, in which case it can be used in payment systems in the same way that fiat currency has traditionally been used (although the programmable qualities of many cryptocurrencies offer a technological advantage that fiat currencies lack). Examples are Bitcoin and Litecoin.
To these three primary cases can be added stablecoins, which are a sub-category of the third type. A stablecoin can be pegged to any underlying asset — usually a fiat currency such as the dollar — and keeps its parity with it either by adjusting algorithmically or else because it is backed by a set amount of the currency.
Issuing tokens on a public blockchain
When new crypto networks began to raise funding by token issuance, an ICO — Initial Coin Offering — was the most common way of doing this. With a name inspired by the Initial Public Offerings that are used by traditional startups, ICOs proliferated during 2017 and 2018 but many issuers did not put enough work into the tokenomics of their offerings, or were thinly disguised securities that later fell foul of regulators.
After the ICO boom, there was a desire among fund-raising teams to regularise their token offerings and make them more compliant with financial legislation. Security Token Offerings (STOs) began to be used to issue tokens that were genuinely securities. In order to minimise the risk of non-compliance, some teams turned to the expert knowledge and wide reach of exchanges, and Initial Exchange Offerings (IEOs) were born. However, the mechanism that is currently attracting most attention for token launches is the Initial DEX Offering (IDO). In this context, DEX stands for ‘decentralized exchange’.
What factors are considered in crypto token design?
Tokens have their quantity, purpose, behavioural mechanisms and burn rate (if any) defined when their initial smart contract is deployed or their initial genesis block mined, so a considerable amount of effort is required to ensure that no mistakes are made that could affect the functioning of the token further down the line.
For example, the code that defines Bitcoin specifies that there will only ever be 21 million coins issued, and the issuance schedule is a decreasing curve that will mean that the last Bitcoin will be mined sometime in 2140. The ability to look decades ahead and predict the demand and usage of a token is a challenge that preoccupies many mathematicians, economists and game theorists today.
For tokens issued on Ethereum, an alternative to setting a hard upper limit on the total token supply is to create a bonding curve contract. A bonding curve is a curve that connects two variables. For example, token prices change when the token supply changes. This is determined by mathematics, coded in a smart contract.
Even without having to decide hard limits on token supply and issuance schedules, the person programming the smart contract needs to take into account:
- Market Design: to design the environment for participants to interact and transact with each other
- Mechanism Design: to design the rules of user behaviour
- Token Design: the incentive itself
Assuming the token is issued on Ethereum, the token supply is determined by the quantity of Ether in existence and by the price curve that has been programmed into the contract. Together, these two variables determine how many tokens can circulate in the market.
How do you use a crypto wallet to interact with the tokens?
Decentralized exchanges (DEXs) such as UniSwap, SushiSwap and PancakeSwap have become increasingly popular for exchanging tokens with no intermediary and no order book. In the place of order books and human market makers, we find automated market makers and liquidity pools that are entirely funded by anyone with a crypto wallet who sees the opportunity to make some return on their crypto investments. It is worth reiterating at this point that as with most investments, there can be considerable risk involved.
How does it work? Let’s take the case of a fictional token called $SKYTALE.
- A liquidity pool is created with $ETH and $SKYTALE
- Skytale as liquidity provider add the same value (10%) of $ETH and $SKYTALE
- Anyone can add assets ($ETH) and earn native tokens of the protocol ($SKYTALE)
- The price fluctuates based on the amount of tokens in the liquidity pool and the amount of the exchange request
Advantages of using a DEX for token swaps
Decentralized exchanges have both advantages and disadvantages. For issuing tokens using a bonding curve contract, there are no issuance fees. Centralized exchanges can charge astronomical sums for listing new tokens — and the process is far from transparent.
Additionally, there is total valuation transparency, and also transaction transparency because all trades happen on-chain, instead of within the internal ledgers of centralized exchanges. DEXs also ultimately have the capability of attracting a much wider global pool of investors to their liquidity pools.
However, if your token is in a pool with low natural liquidity, there is no centralized market maker ready to intervene. Additionally, in jurisdictions that are hostile to DeFi, some investors from more traditional backgrounds may feel more comfortable with the familiar log-in procedures and order books of traditional exchanges.
Note that an increasing number of DEXs now offer order books (for example, dxdy, Deversifi, Loopring, IDEX, DDEX, Radar Relay, EtherDelta, Paradex, Ethfinex), which is a good alternative for people who are not familiar with AMM principles.
In summary, using the powers of tokenomics to issue tokens via a bonding curve on a DEX can bring great opportunity, flexibility and the chance to reach a large pool of people. Decentralized technologies that use mathematics in place of intermediaries and bureaucracy are one of the most compelling business trends right now and it is hard to see a future where they do not make up a large part of funding for new enterprises.
We’re about to launch our private beta and have a few spots open. Interested to join? https://www.skytale.finance/
