DeFi 101: The Role of Token Emissions
Token emissions play a crucial role in DeFi, enabling protocols to incentivize participation through multiple different methods
Overview
What are Token Emissions?
Within DeFi, “Token Emissions” is a term you may have heard quite often, but what does it really mean? Well, essentially, it refers to the distribution of token rewards to users participating in activities such as staking or yield farming. For instance, liquidity is highly sought after, therefore protocols may start incentivizing users to deposit in their pools on decentralized exchanges like Velodrome, for these token emissions.
When a protocol starts issuing these tokens, it’s crucial they adopt a sustainable emission schedule and model. These schedules can greatly differ across projects with some sticking to a constant emission rate, while others may choose a declining rate to curb inflation over time.
But, like with most things in DeFi, token emissions can be a double-edged sword. Sure, they can provide enticing rewards, but they also carry certain risks. New token emissions can spark inflation, potentially reducing the value of existing tokens over time. So, it’s always a good idea to be fully aware of a protocol’s emission schedule and inflation model before getting too deep into it.
Popular Methods of Token Emissions
Token emissions can serve a variety of purposes, with their applications depending on the intended result. Let’s walk through some common uses:
Staking Rewards: When users lock their tokens, for security or governance purposes, they can earn token emissions, kind of like a thank you for participating. These rewards are typically dependent on multiple factors, such as the total amount they stake, the duration, and the emissions schedule of the protocol. A good example of this would be Curve, who enable users to lock their tokens up for a period of anywhere between one week to four years. In doing so, users receive veCRV which can give a multitude of bonuses to users, such as boosted rewards, the ability to earn trading fees, and governance voting rights.
Yield Farming: When protocols aim to increase liquidity in their pools, token emissions will often come into play. The steps are simple: a liquidity pool is created on a decentralized exchange like Velodrome, and token emissions are directed toward it. Users supplying liquidity to these pools can earn rewards based on the total time they stay in it and the amount they provide. This strategy, which effectively boosts liquidity while rewarding users, is widespread across multiple chains. Velodrome, in particular, has shown success in creating liquidity within the Optimism ecosystem for a variety of protocols.
Airdrops: Airdrops have become a key part DeFi, used by many protocols as a tool to either increase app usage or spread tokens around. They’re primarily used to raise awareness, incentivize token usage, reward loyal supporters, or spark user involvement within the digital ecosystem. A recent instance of this approach was seen with Arbitrum. They offered an airdrop for users who partook in activities on the Arbitrum chain. However, they implemented strict criteria to ward off airdrop bots and stop sybil attacks. These types of practices are quite common when new protocols are launching to ensure fair token distribution and governance. They essentially celebrate the users who are most engaged in their ecosystem and deserving of the reward.
Governance: Some protocols put aside a portion of tokens for users who actively partake in their governance processes, thereby impacting the protocol’s future and ensuring involved users genuinely care about its direction. This active engagement could range from voting on proposals and participating in on-chain governance, to contributing towards the project’s development. A classic illustration of this was Optimism, which executed multiple distribution rounds, specifically rewarding users who took part in their governance. Their first airdrop disseminated over 200 million OP tokens to a quarter-million early adopters and engaged users in May 2022. The second distributed roughly 11.74 million OP to just over 307,000 unique addresses, with the aim of rewarding active participants in their governance and frequent users of the OP Mainnet. Sometimes it pays to get involved early and play an active role in protocol governance.
Token Emission Models
To fully grasp how token emissions work, it’s essential to recognize that each project’s emission model may be different. Among the many available, there are a few that are most commonly used:
Fixed: With a title that pretty much says it all, a fixed emissions schedule consistently releases tokens at a steady pace over a given timeframe. It’s a common go-to as it carves a clear roadmap for users and protocols alike, enabling them to predict future emissions and manage expectations accordingly. Take for example a token with a maximum supply capped at 100 million. In this case, there would also be a pre-defined emission rate, providing a transparent and predictable token distribution pathway.
Dynamic: Unlike a fixed model where the emission rate remains the same or a variable model that requires community voting for example, a dynamic model automatically changes the emission rate based on predefined rules or conditions. This type of schedule has certain advantages, such as swift, automatic responses to market fluctuations or changes in the protocol’s activity.
Balancer is a key example of using a dynamic emission schedule through its BAL token. Through liquidity mining, BAL tokens are distributed weekly to liquidity providers. The interesting aspect of Balancer’s model is that the number of tokens distributed can adjust based on the total liquidity provided in each pool during that week. If a certain pool sees an influx of liquidity, its share of the weekly BAL emissions increases accordingly. On the other hand, if a pool sees a decrease in total liquidity, its share of the emissions decreases.
Inflationary: Inflationary emissions present a constant surge in total supply as time progresses. This scenario can potentially devalue the token if market demand doesn’t keep up. The concept behind inflationary tokens might remind you of traditional fiat currency, where central banks can ramp up the supply to meet demand. Taking Curve as an example, they use an inflationary emission schedule, but with a twist. Instead of a constant emission rate, Curve’s supply inflates at a decreasing rate every year. It started with an annual inflation rate of 2% at launch, with the rate decreasing by half each subsequent year. As such, it’s a unique blend of inflationary and deflationary mechanics. This approach helps balance the need for token rewards to incentivize participation while also managing the potential devaluation caused by token oversupply.
Deflationary: Deflationary emissions take a different route. With this model, tokens are “burned” or permanently deleted from circulation, causing the total supply to gradually diminish over time. But what’s the point of burning tokens in DeFi projects?
The principle behind deflationary emissions is straightforward: lower supply can potentially raise the value of tokens, assuming demand remains the same. A classic case of deflationary emissions is MakerDAO. Their Maker Burn Engine, fueled by the protocol surplus of Maker Core, accumulates Elixir (a liquidity pool token made up of 50% Dai and 50% MKR). The stockpile of Elixir supports Dai and MKR liquidity. When the valuation model determines that MKR is undervalued, the Maker Burn Engine uses its Elixir to burn MKR, thus lowering the supply and potentially raising the token’s value.
Variable: A variable token emission, as its name implies, enables flexibility and adaptability in the rate at which new tokens are introduced. This emission rate is not set in stone and can be changed depending on a variety of factors, including variables such as market conditions, community voting, or certain protocol-specific criteria. A prime example of this in practice would be SushiSwap. Initially, they had a fixed emission rate, minting 1000 SUSHI tokens per block, rewarding liquidity providers. However, as SushiSwap matured, they introduced a community governance model that empowered SUSHI token holders to vote on key decisions, including adjustments to the token emission schedule. In December 2022, they introduced new tokenomics that enable xSushi stakers to earn emissions-based rewards in time-locked tiers.
Summary
To summarize, token emissions are a vital part of DeFi, acting as incentives for participation in activities such as staking, yield farming, governance, and liquidity provision. Different protocols use diverse emission schedules and models, each with their own unique effects on inflation and token value.
Essential models like fixed, dynamic, inflationary, deflationary, and variable have their unique impacts. For instance, protocols like Curve cleverly balance inflationary and deflationary elements, offering rewards to stimulate user engagement while also managing potential devaluation.
