Our Token Design Process

Introduction:

In web3, tokens have emerged as a potent tool that represent a wide range of value, from monetary, to membership, to identity, and alignment of interests. Token design is a critical process for Web3 companies and projects to create a robust and efficient economic system around their products or services. Tokens are digital assets that represent ownership, participation, and value in decentralised networks. By designing tokens effectively, Web3 companies can incentivize users to engage with their platform and build a strong community around it.

If you are new to concepts in tokenomics and token standards, please check out our respective crash course articles on the topics.

Despite their power, token design is still a nascent field and crafting a “successful” token can feel more like alchemy than chemistry. Nevertheless, as more teams venture into this new landscape, we are starting to identify common patterns and pitfalls that arise during the design process.

In this article, we leverage our experience collaborating with web3 teams to introduce a work-in-progress framework for designing tokens. We will explore our four stages of the design process, and then discuss some of the common pitfalls of token design.

Some background about us: Six years ago, we founded Verum Capital in Switzerland with a core team of financial experts, software engineers, designers, cryptographers, and quants. Today, Verum Capital is the leading Web3 venture studio in Switzerland with over 100 blockchain projects launched and an investment portfolio of 15 companies across the globe. If you are interested in exploring web3 design for your needs please feel free to reach out to us on twitter or email.

Why Token Design Is So Important

Before we start we should state that token design is a new and experimental field, and not an exact science with many teams exploring different approaches and mechanisms. Due to the novelty of this field we actually think that it is incorrectly named. In our opinion, protocol design could be a more accurate name, because token systems are a means not the end. The ultimate goal is to design great and sustainable protocols. Again, tokens are an amazing tool, but they are not valuable in and of themselves. They are likely to be part of an ecosystem design as a means to distribute ownership, authority, and alignment to the community, all crucial to long term decentralisation and a means to achieving protocol success.

Token design involves economic, technical, and regulatory considerations, and each project may require a customised approach. However, we felt there was a need for a general guide to the token design process to ensure that the token serves its intended purpose effectively. We would like to propose our token design framework as a mental model for designing great protocols. This consists of four stages: goals, limitations, mechanisms, and token design.

The 4 Stages Of Token Design:

1. Objectives: In the first stage, the protocol needs to define its objectives, its raison d’etre, what is it doing, and why. This could be to incentivize users to perform specific actions, enable access to services, or simply represent value. Goals should be specific, measurable, achievable, relevant, and time-bound (SMART). If we don’t have a goal then forget tokens.
2. Limitations: In the second stage, the protocol identifies the constraints and limitations that will impact the token’s design. These can include legal, regulatory, technical, and economic factors. Understanding the limitations is critical to ensuring that the token design is feasible and sustainable. There are also endogenous constraints: limitations we put on ourselves.
3. Mechanisms: In the third stage, the protocol defines the specific mechanisms that will be used to achieve the token’s goals while operating within the constraints. These mechanisms could include tokenomics, distribution models, staking, governance, and more. Mechanisms need to be designed carefully to ensure that they align with the goals and constraints. In the end we should have a step-by-step system that achieves the goals under our limitations.
4. Implementation: In the fourth stage, the protocol focuses on implementing the mechanisms that were defined in the previous stage. This includes developing the necessary software, infrastructure, and user interfaces to support the token’s use and adoption. It also involves testing and auditing the protocol to ensure that it is secure, scalable, and reliable. Implementation can be an iterative process, with feedback from users and stakeholders incorporated to improve the design and functionality of the protocol.

During the implementation stage, it’s important to consider factors such as user experience, education and adoption strategies, as well as marketing and community building efforts. These factors can play a crucial role in the success of the protocol and the adoption of the token.

After the implementation stage, it’s important to continue monitoring and evaluating the protocol’s performance to identify areas for improvement and potential opportunities for growth. This could involve analyzing usage metrics, user feedback, and market trends to inform future updates and enhancements to the protocol.

Each stage is important in its own way. The goals stage sets the direction and purpose of the token, the constraints stage identifies the boundaries and limitations, while the mechanisms stage provides the implementation details. Without a proper framework, the token design may fail to achieve its intended purpose or run into legal and regulatory issues. Therefore, a well-designed token can provide a sustainable economic system that drives adoption and growth of a Web3 company.

Pitfalls in Token Design:

Highlight some of the common pitfalls in token design, such as regulatory compliance, lack of liquidity, and complexity in token economics. Provide examples and solutions for each pitfall.

1. Token First Thinking: Token first thinking refers to the tendency to focus on the token rewards and allocation instead of the agents/roles, retention, engagement, and alignment. This approach can result in a token design that does not address the needs of users and stakeholders.

Example: An example of token first thinking is the initial design of the Filecoin protocol, which focused heavily on the token economics and incentivization rather than the needs of the network’s users. As a result, the protocol experienced several challenges and delays, and the team had to adjust the token economics to better align with user needs.

Solution: Designers should avoid token first thinking by focusing on the protocol’s needs and requirements first. It is important to understand the agents and roles involved in the protocol, as well as the user needs, to determine how a token can be used to achieve the desired outcomes. Asking the question, “How would this system work without a token?” can help designers determine whether a token is necessary and how it can be integrated into the protocol effectively.

2. Overburdening The Community: The community can play a significant role in the success of a token design, but it is a mistake to rely on the community to make critical design decisions and key behaviours. Expecting the community to take care of these decisions can lead to a lack of direction and confusion, which can negatively impact the token’s success.

Example: An example of the community wastebasket pitfall is the initial design of the BitShares protocol, which relied heavily on the community to make critical design decisions. This led to confusion and a lack of direction, which negatively impacted the protocol’s adoption and success.

Solution: Designers should be proactive in making critical design decisions and behaviors instead of relying solely on the community. It is important to clearly communicate the expectations of the community and what the designers are providing them. Designers should also consider the powers and control being given to the community and ensure that they are balanced with responsibility. Asking questions such as “What is expected of the community?” and “Are you balancing power with responsibility?” can help designers determine the appropriate level of community involvement.

Other Pitfalls:

3. Regulatory Compliance: One of the biggest challenges in token design is regulatory compliance. Tokens that do not comply with relevant laws and regulations can be deemed illegal, resulting in legal action or penalties. Some countries have clear regulations in place, while others are still developing their regulatory framework for cryptocurrencies and tokens. It is essential to research and understand the regulatory environment in the relevant jurisdictions to ensure compliance.

Solution: One potential solution is to consult with legal experts who specialise in cryptocurrency and blockchain regulations. They can help navigate the complex regulatory landscape and ensure that the token design meets all applicable laws and regulations. It is also essential to monitor changes in regulations to ensure ongoing compliance.

4. Lack of Liquidity: Tokens that lack liquidity can make it challenging for investors to buy and sell them. Liquidity is essential for tokens to be able to fulfil their intended function and maintain value.

Solution: There are several solutions to improve liquidity, such as listing on multiple exchanges, implementing market-making programs, and building relationships with market makers. Providing incentives for liquidity providers and creating trading pairs with stablecoins can also improve liquidity.

5. Complexity in Token Economics: Tokens that are too complex can be difficult to understand for investors, which can lead to confusion and a lack of adoption.

Solution: Token economics should be designed with simplicity in mind. The token’s use case and value proposition should be clear and easily understood. Providing clear and concise whitepapers, tutorials, and user guides can also help investors understand the token’s functionality and benefits.

6. Lack of Governance: Tokens that lack proper governance can lead to a lack of transparency, accountability, and decision-making.

Solution: Tokens should have a clear governance structure that outlines the roles and responsibilities of token holders, developers, and other stakeholders. The governance structure should include clear decision-making processes, voting mechanisms, and dispute resolution mechanisms.

7. Security Vulnerabilities: Tokens that are not secure can be vulnerable to hacks and attacks, resulting in the loss of value and investor trust.

Solution: Tokens should be built using best practices in cybersecurity and undergo regular security audits. It is also important to implement measures to protect against theft, such as multi-factor authentication and cold storage for large amounts of tokens.

Examples of tokens that have experienced these pitfalls include BitConnect, which was deemed a Ponzi scheme and resulted in legal action and penalties. Another example is the DAO token, which was hacked due to a vulnerability in the smart contract code. For more information about cyber security in DeFi, check out our article on the topic.

Final Thoughts

We at Verum Capital believe that in order to unlock the applications and protocols of the future, several key technologies are needed to be developed on and explored deeper.

These technologies include account abstraction (enabling on-chain identity and SIWE), Verkle trees, and zero knowledge machine learning. With these technologies, it is possible to alleviate design constraints and enable new goals. By understanding what nearby technologies enable, designers can create applications and protocols that were previously impossible.

These “nearby technologies” will play a critical role in the development of the next generation of technological advancements, and designers should consider them when going through the design process, asking themselves “What applications and protocol will be unlocked by nearby technologies?”

Conclusion

Proper token / protocol design is an essential process for Web3 companies to build trustless and efficient products or services. Despite being a nascent field, more teams are exploring different approaches and mechanisms to design tokens successfully. Token design involves economic, technical, and regulatory considerations, and each project may require a customised approach.

To ensure that the token serves its intended purpose effectively, a mental model for designing great protocols was proposed, consisting of four stages: Goals, Limitations, Mechanisms, and Implementation. To learn more about current capabilities of tokens, stay tuned for a follow-up article.

Also! Don’t forget to follow us on Twitter and Medium for more insights and updates.