How Can Tokenomics Auditing Guarantee Profitability and Expose Risks in Stablecoin Projects? — part 1
Author: Stylianos Kampakis
This research article is a comprehensive extract from a peer-reviewed research paper, Auditing Tokenomics: A Case Study And Lessons From Auditing A Stablecoin Project, which I wrote at the Centre for Blockchain Technologies, University College London, UK. The Journal of The British Blockchain Association has published the complete paper.
Kindly note that this article has two parts — part one introduces auditing and tokenomics. In contrast, part two delves into the specifics of BankX tokenomic auditing, factors essential for tokenomics auditing and the future of tokenomics in blockchain development across industries. While you complete this first part, find, and read the second part to complement your understanding of how tokenomics auditing can guarantee profitability and expose risks in stablecoin projects. I hope you will eventually implement the practical concepts discussed in this article to minimise risks and optimise profits in your current and future blockchain projects.
Contents:
- What’s The Origin of Tokenomics?
- Auditing Tokenomics; What You Need to Know
- What Are The 5 Methods of Auditing Atablecoin Projects
Tokenomics auditing enables token founding teams to foresee the success or failure of a blockchain project while gaining insight for improvement by revealing project feasibility and exposing risks.
As blockchain, an evolving technology for a sustainable digital future, helps increase trust, security, transparency, and traceability of data shared across multiple channels, relevant stakeholders have adopted tokenomics to save cost and improve efficiency.
Tokenomics should be the focal point of any successful blockchain project that aims for sustainability and reliability. Tokenomics is a scientific and economic study of the utilisation of cryptocurrency tokens in the blockchain ecosystem, including their designs and optimisation to achieve efficiency.
Following recent innovations in blockchain, there are several approaches to designing crypto tokens. They can be designed to assume a fixed supply so that there is neither inflation nor deflation in the ecosystem.
Hence founding teams can create tokens that provide voting or governance rights to holders, encouraging them to retain their tokens instead of selling them out.
The range of options available to the token founding teams often makes them vulnerable to mistakes. Even determining the effectiveness and profitability of a token at the initial stage is a huge challenge. Such uncertainty leaves unanswered questions and loopholes.
Considering this dilemma, it is paramount to note that any blockchain project should be convincing to developers and investors alike. So, to assure the project’s viability, founding teams often undertake feasibility studies known as a tokenomics audit.
The primary importance of an audit in the blockchain is to assess the possibility and profitability of each token project in which strengths, weaknesses, opportunities, and threats are detected while suggesting potential improvements.
Surprisingly, there is no standard modus operandi to execute tokenomics audits, but this article attempts to establish a reliable method based on practical experimentation with the BankX stablecoin project.
1. What’s The Origin of Tokenomics?
“Tokenomics” was coined from “token” and “economics” to describe the use of tokens in the corporate business ecosystem. It studies and tries to establish how tokens can be utilised as an autonomous currency for digital services.
According to recent research, Chris Dixon is believed to be the first venture capitalist to use “tokenomics” at Andreessen Horowitz. In his article, he extensively discussed how tokens could be used to motivate and generate the desired behaviour to create an economy around a product or service.
In 2009, Bitcoin introduced the first token to develop a decentralised currency that any government or financial institution won’t control. The rise of Ethereum succeeded in the emergence of Bitcoin’s token. Over the past decade, there has been an explosion of several blockchain projects operating with their unique tokens.
2. Auditing Tokenomics; What You Need to Know
The infancy and consequent unavailability of in-depth research on tokenomics limit understanding of the field. This makes it difficult to establish a standardised method of auditing tokenomics projects.
Even if available, most studies in tokenomics do not come from the perspectives of entrepreneurs and investors. No business investor would like to engage in a business whose profitability and risks are not outlined.
The need to ascertain the viability of blockchain projects and know the contemporary risks beforehand has given rise to auditing.
Tokenomics auditing often involves critical analysis and inspection in which the auditing team can combine quantitative techniques with subjective judgments to arrive at an optimum conclusion.
The goal of the tokenomics audit then is to convince the audience and assure investors that the blockchain project is worth the price.
3. What Are The 5 Methods of Auditing Stablecoin Projects?
The five known methods for auditing a stablecoin project which was influential in the BankX stablecoin auditing are:
- Empirical Proof, Data Analysis, and Benchmarking
- Game Theory
- Agent-Based Modelling
- Marginal Cases
- Probability Theory
Auditing tokenomics projects before and after launch can yield different results and require varying approaches. Unlike after launching a stablecoin, auditing tokenomics before the official launch of a project is a challenging endeavour primarily because the analyst is being asked to create an inexistent model.
Studying existing real-world economies is challenging, but at least economists have access to proven data that they can use to develop econometric models and test their theories. Unlike inexistent models. More importantly, the methods employed by authors can vary, and the list of approach are inexhaustive. But in the BankX project, these five methods prove to be highly efficient.
- Empirical Proof, Data Analysis, and Benchmarking
The first method an auditor should always employ is learning from similar cases. When coin offerings were initially invented, there was a high chance that a new project created a proposition or mechanics never encountered before.
Now, it is likely that a new project will find at least some points of similarity with existing projects.
For example, there is a lot that can be learned from the successes and failures of diverse types of stablecoins. From the controversy surrounding USDT to the success of Terra/Luna or the bank run and the eventual collapse of Iron Titanium, a project can likely learn a lot through similarities with existing projects.
The analysis becomes even more helpful if data is available which can be used to make an argument. An example of this approach is seen in an audit of the tokenomics of Frax by Albaron Ventures, where they compared the peg stability of Frax and other stablecoins.
2. Game Theory
Game theory has an integral significance to the blockchain, given that the root lies in how trust can be ensured in a network without trust through algorithms. It, therefore, follows that game theory can be a valuable tool for a tokenomics audit.
One of the best examples of this is OlympusDAO. While OlympusDAO did not go through a tokenomics audit, the project is well known for its use of game-theoretic analyses to prove the sustainability of its protocol.
Game theory is a branch of mathematics that studies the mathematical models of conflict and cooperation between rational decision-makers, first devised by Von Neumann. Game theory is used in economics, political science, and psychology to understand how humans interact with each other when there is limited or no trust.
Another type of analysis, closely related to game theory, is what we will term “structural” analysis but also called “balance-of-forces” analysis. This is a higher level of abstraction, where the analysis lists all dynamics and their impact upon a token economy, but without explicitly creating an incentives matrix.
The dynamics and the tools employed create a narrative, which aims to convince an informed reader that they should work as expected when deployed in real life. The balance of the different forces applied to a token and an ecosystem should ideally be driven by a clear objective, such as token appreciation, stability, or sustainability. While this is not explicitly stated, most new blockchain protocols follow this logic, starting with Satoshi Nakamoto’s original Bitcoin paper.
A more recent example of a successful project outlying this is Terra/Luna’s documentation. However, the aim of structural analysis for a tokenomics audit should be to formalise the different dynamics at play in a more structured way and troubleshoot for issues that might arise, thereby highlighting weaknesses.
3. Agent-Based Modelling
One of the methods suggested in the past for auditing blockchain projects is agent-based modelling. Agent-based modelling is used to study complex systems and solve problems that are difficult or impossible to solve analytically.
The agent-based modelling process starts with identifying the system’s components and their relationships. The next step is to identify the rules governing how these components interact, which can be done by observing the system in operation or using expert knowledge.
The last step is to run simulations with different sets of initial conditions and parameters and compare them against one another to find an optimal solution. The flexibility of agent-based modelling has given rise to different flavours of this approach.
Agent-based modelling is an excellent method for analysing token economies, given their complexity and interconnected parts.
4. Marginal Cases
Another mechanism often informally employed is the study of marginal cases. These hypothetical scenarios could break a system, though they never happen in practice. This is like the stress test practice that financial institutions undergo. Analysts have become famous for publishing these analyses on Twitter as posts.
5. Probability Theory
Some analyses resort to probability theory and stochastic models, sometimes combining aspects of the previous tools mentioned, like game theory and agent-based modelling. An excellent example of this approach is the analysis of Bitcoin’s defences against attack vectors and mining pools.
Read more: Part two of this article follows
