Tokenomics 101

Introduction

There is an increased interest in token economics, or tokenomics, which explores the use of cryptocurrencies. Crypto coins or tokens allow greater financial transparency, control resources, and unlock infinite use cases for decentralized organizations.

You need to understand tokenomics to achieve sufficient decentralization. While outcomes differ from one organization to another, tokenomics helps community members project vision and mission around a crypto-enabled currency, coin or token.

Tokens are used in many ways by decentralized autonomous organizations or DAOs. They allow token holders to vote on decisions that affect the network as a whole. Token holders can use to exchange goods or services without leaving the network.

Understanding the fundamentals of token economics is essential to using tokens effectively. A token is a digital coin that allows its holder to participate in crypto economies. You may have heard about Bitcoin, Ethereum, Litecoin, Dash, and Dogecoin. Each has some utility, but unlike conventional fiat currency, each has unique intrinsic value.

Blockchain technology allows anyone to create, also known as minting, their crypto tokens. Smart contract developers can mint tokenized communities and deploy them on blockchain networks, such as Ethereum, Flow, Binance Smart Chain. This blog post will present a brief overview of tokenomics, dive deeper into its pillars, and help DAOs define their own.

Token economics

Tokenomics is the study of crypto-enabled economic models, and it is the study of how crypto coins or tokens are created, distributed, and used in financial systems.

Token economics encourages interactions between agents (members, community speculators, and stakeholders) in a network or a protocol. It uses cryptographically secured coins or tokens to represent products or services, typically digital asset ownership.

Tokenomics is defined by what tokens can do and cannot do. DAO members or speculators are encouraged to take positive action to achieve its mission and vision.

Token economics deals with the relationships between producers (products or services) and consumers (members or speculators). DAOs use crypto tokens to incentivize token holders, community members, and investors in a virtual economy.

Token design

Token design is where you ask, “What does this token do?” It is important because the value of a token depends on the decisions you make about it. While there are infinite use cases for tokens, equity, utility, and governance are the top three.

Equity tokens are fungible tokens that represent ownership in an asset or a pool of assets. Utility tokens incentivize participants to participate in a network by providing scarce resources (units of work, time, or capital). Equity tokens incentivize participation in a protocol. Smart contracts unlock utility tokens using on-chain or off-chain systems. Utility tokens unlock functionality in a protocol while easing coordination among participants. Governance tokens represent percentage ownership over voting rights.

A new coin issued by a blockchain’s creator might inherit its value from the exchange of capital or time, for instance, to pay the developer to share their computer compute time. Tokens designed for this purpose are known as utility tokens. And people use tokens to pay for services; it’s an equity token. If people purchase tokens with an expectation of future profit, the token is a security. Tokens designed to vote on the direction of the DAO are known as governance tokens.

Token distribution

Token distribution is essential, but it is even more important that the tokens you distribute are valuable. Tokens are worthless if no one wants them. But if no one wants them, why distribute them in the first place?

The distribution of tokens is fundamental to the economy of any smart contract ecosystem. Simply put, tokens are valuable because they allow control over a specific asset from one owner to another without a mediator. Tokens represent ownership or other attributes of certain digital assets. Community members may exchange these tokens for goods or services on specialized blockchain-enabled marketplaces or apps.

Token distribution can boil it down to two things. One is whether to give away tokens for free or not, and the other is how to give them away. Popular token dropping mechanisms include crowdfunds, auctions, and airdrops. Cryptocurrency airdrops are free coins that are dropped directly into your wallet.

Token distribution is an art and a science. You don’t want it to be too hard for people to get tokens. If it’s too hard, then no one will bother to acquire them. And if it’s too easy, people will stop caring about the utility of the token and instead focus on how many tokens they hold in their wallets.

I think there is a sweet spot between these extremes: you want to make it easy enough for people to get tokens, but not so easy that no one cares about what the tokens do. The best way to accomplish this is to try different things and see what works best for you and your organization. By considering all incentive structures, you validate not only the token itself but how your community responds to your tokens.

You can gift your tokens to your early adopters. This process can help DAOs build communities while boosting the value of their tokens. Please resist the temptation to distribute tokens by giving them out to anyone. DAOs must resist this temptation by airdropping tokens to only the most engaged community members. Remember to account for the costs of minting and distributing tokens, which incur transaction costs depending on blockchain networks. By airdropping tokens to your community members, the DAO increases the number of coins in circulation and increases the asset’s value.

You can also sell your tokens for profit. If people see value in your project, they will buy your tokens. Let’s say your goal is to generate 10 $ETH (30,340 $USD or 38,410 $CAD) from the drop. You can use different pricing tiers to accomplish this. If you charge 1.0 $ETH (3,034 $USD or 3,841 $CAD) per token, you need to sell 10 tokens. If you charge 0.1 $ETH (303 $USD or 381 $CAD) per token, you need to sell 100 tokens, and so forth.

While some blockchain networks have costly transaction costs for minting tokens, others have zero to low minting and transferring costs-Ethereum for the former; Polygon, Flow, Binance Smart Chain for the latter.

The token release schedule, including token supply or token price, can be hard programmed into smart contacts. Developers use smart contracts and programming languages (Solidity, Cadence, Go) to mint and release tokens on DAOs.

Token distribution differs depending on the project use cases. Here are some of the most common economic models for tokens:

1. Deflationary Model (Currency). There is a hard cap on the number of tokens created in a deflationary token economic model. In this economic model, demand increases with time, but supply does not. Examples: Bitcoin ($BTC), Litecoin ($LTC), Bitcoin Cash ($BCH)
2. Inflationary Model (Utility). In an inflationary token economic model, there is no hard cap on the number of tokens created. Some token issuers limit token creation yearly, others go off a set schedule, and some opt to determine supply-based on-demand data. Examples: Ethereum ($ETH), Polkadot ($DOT), Solana ($SOL)
3. Duel-Token Model. In a dual-token economic model, two tokens exist on a single blockchain. This model generally includes a store of value token as well as a utility token. This model aims to incentivize users to hold the store of value token to receive returns in the form of the utility token. Examples: VeChain ($VET) & VeThor Token ($VTHO), NEO ($NEO) & GAS ($GAS)
4. Asset-backed Model (Stablecoins). In an asset-backed token economic model, an issuer pegs the value of an asset to the token’s underlying assets, similar to asset-backed security in traditional finance markets. Asset-backed models can rely on fluctuating valuations such as gold or fixed assets like the US Dollar. Examples: PAX Gold ($PAXG), Tether ($USDT), USD Coin ($USDC)

Token incentives

DAOs are modern organizations, but they act more like crowds. And like crowds, they need ways to coordinate using incentives. DAOs can define crypto-enabled incentive structures to motivate positive behavior and discourage negative behavior. Token incentives can reward people for their contributions, which might be contributions to development, marketing, or sales. DAOs can also punish people for their misbehavior but imposing restrictions on specific tokens.

Tokens can be for anything from funding scientific research to building infrastructure to solving the world’s most complex problems. Aligning token holders, communities, and investors around a token is essential for the long-term success of DAOs.

Token incentives must appeal to the project’s ideal customers, including the project team, community, and investors. You can design token incentives to increase engagement so your ideal customers continue to interact with your tokens.

Token supply and demand

There are two parts to any economy: producers (people who make or produce stuff) and consumers (people who use or consume stuff). Crypto coins or crypto tokens are the financial tools that allow for exchanging value between producers and consumers. Think of tokens as digital representations of goods or services-like Bitcoin ($BTC) or Ethereum ($ETH)-that you buy and store in your wallet. These crypto primitives allow everyone to move capital (crypto) without requiring permission from banks.

In economics, supply and demand are related but different. Supply means the number of tokens issued or distributed; demand means how many people are willing to buy tokens. The community’s perception drives the demand for tokens, and the demand for tokens on a protocol or a network is related to their utility, equity, and governance. Perception is how users perceive the token’s value, either its utility, security, or governance. Tokens are valuable because they enable applications to take risks and meet users; they afford the developer access to an unbanked asset class.

Think of tokenomics as a token supply chain controlled by smart contracts. The smart contract controls the tokens and enables the use of the tokens in various applications. Smart contracts control the supply of crypto tokens and the minting or burning of tokens.

DAOs use various supply control mechanisms to manage and control their financial economies. Here are some of the most important mechanisms we see today:

1. Hard Cap (MEME $MEME)
2. Reserves (Ethereum $ETH)
3. Inflation (Bitcoin $BTC)
4. Lockups (XRP $XRP)
5. Node staking (Dash $DASH)
6. User staking (EOS $EOS)
7. Vesting and transaction penalties (NEM $XEM)
8. Buybacks and burning (Binance Coin $BNB)

Define your tokenomics

Tokenomics is a new way of thinking about organizational success. By understanding tokenomics, you will prepare yourself for token drops.

Understanding the supply and demand for tokens, including how it affects the price you pay for them, is crucial to understanding how mass adoption can occur. In addition, understanding the differences in technical and cultural contexts allows us to frame questions in more relevant ways to future users.

A successful token sale and growth of the tokens value depend heavily upon how well the tokenomics is structured. DAOs are encouraged to drop their fungible tokens and non-fungible tokens to maximize revenue.

DAOs often rely on founders, teams (data scientists and developers), communities, and investors to maximize their project potential. Defining your tokenomics is more than considering token use cases for governance, utility, and equity.

Successful token projects consider the following pillars:

1. Token distribution (how tokens are released)
2. Incentives (how tokens motivate individual behavior)
3. Token supply (how many tokens there are)
4. Token demand (how much someone is willing to pay for them)

There are many factors that DAOs must consider when designing their tokenomics. Combined with the technical expertise necessary for project success, tokenomics are challenging to implement.

DAOs often hire data scientists for tokenomics modeling (Python, R, Jupyter Notebook) and developers for smart contract development (Solidity, Cadence, Go).

Are you a DAO interested in defining your tokenomics? Reach out. At 🦄 Unicorn Team, we can help!

Originally published at unicornteam.xyz on September 27, 2021.