Tokenomics Guide: Developers, Investors and All Essential Technical Terms
The 2020’s have seen the adoption of blockchain technologies such as cryptocurrencies, NFTs, DAOs etc, reach levels once only dreamed of. And with the cryptoverse being a jargon-intensive space, you could be forgiven for thinking you have to learn an entirely new language, because in some sense - you do.
For the purpose of this article, we’ll be diving deeper into one of the concepts this movement has borne: token economics or more commonly known as tokenomics, sometimes even referred to as token metrics. Why is this hybrid so important and one of the primary metrics used when assessing a project’s potential success? In order to answer that correctly, a little context is required. What is a token? How does it differ from a cryptocurrency? What is the difference between tokenomics and economics? After answering these questions, we’ll take a closer look at the important features of tokenomics, what it aims to achieve and the mechanisms it uses to do so.
Before continuing, one very important disclaimer must be made: a project must have real underlying value in its product or service, token economics alone is not enough to create a viable project.
Let's Start at the Beginning
As the abusive and manipulative nature of third-party controllers has become a bigger issue in global systems, blockchain technologies and the need for transparent, trustless, and democratic systems have become clear. This has encouraged and enabled once-small communities to organize into fully-fledged self-sustaining ecosystems.
In response, tokens have been adopted as a tool to facilitate the complex interactions and transactions within these communities. What makes tokens special is that they possess multidimensional utility. While this initially seems like an incredibly complex concept straight from the pages of a physics textbook - it means they are able to store more than one type of value or characteristic. This differs significantly from tokens we use every day which represent only one type of value, for example, your gym membership card or driver’s license.
Community organization is a cornerstone of almost every blockchain-based project. Communities are usually diverse, and with diversity comes complexity - especially when attempting to align people to a certain vision or goal. By being able to store more than one type of value, tokens allow us to trade qualities that in the past weren’t nearly as liquid. And as such, meet a diverse range of needs within a community. Tradeable qualities in this sense may be voting or staking rights. This facilitates enfranchisement (in more ways than one) and allows for the successful development of these self-sustaining ecosystems.
At this point, it’s important to make clear the difference between a token and a cryptocurrency, and the difference between tokenomics and economics. When it comes to tokens vs. cryptocurrencies, the biggest difference between the two is that cryptocurrencies have their own blockchains, whereas tokens are built onto existing blockchains. Secondly, cryptocurrencies are developed to represent monetary value, whereas tokens represent a wide range of values.
Tokenomics can be defined as the quality of a token to convince users and investors to adopt and help build the ecosystem of the underlying project. Furthermore, every external factor that impacts a token’s value can also be considered a part of its tokenomics. The major differences experienced by projects using this system instead of traditional economics and finance are that their characteristics are decentralized, require far less capital to scale, and offer significant security of transactions. In certain cases like token distribution, fair on-chain governance mechanisms are particularly important in order to ensure decentralized governance.
What makes tokenomics useful is its ability to catalyze the creation of value, the capture of that value, and the protection of that value within communities in a democratic and secure manner. This means that the underlying value generated by the project (the product/service itself) can be turned into monetary value with greater ease. This value can then be used and maintained within the community's ecosystem. Hence the major components of tokenomics are value creation, value capture, and value protection.
One of the most important elements that set tokens apart from cryptocurrencies is that they have the ability to represent a wide variety of values. Instead of trading with them in a way like you would with cryptocurrencies, tokens can hold and fulfil several different functions within ecosystems.
A token without a project built around it is not fully functional as it is an incentive layer and it cannot create value on its own. The utility proposition of the underlying product or service is what creates the value and the tokens used in this system hold and represent that. This is the first stage of the value cycle within a newly built ecosystem’s tokenomics. When it comes to tokens, there are several mechanisms through which they can help generate value, and this is exactly what gives them unique features.
Token Distribution Methods
Token distribution happens in a variety of different ways that can contribute to value creation. In the early phases of most blockchain projects, the core team creating the new technology (a protocol for example) drives the development forward. As time goes by and the protocol’s user base grows, eventually there is going to be a need for developers to contribute to the development. In return, tokens can be given out to these developers as a reward to incentivize innovation. This mechanism is a form of internal token allocation and it is a great method of community building within a DAO as well. Always remember, that community equals value!
There is no general rule on how tokens should be distributed. It all depends on what stage a certain project is at and what purpose they want to serve with their token. It is not a one size fits all, but there are some general rules that can help your project stay on track. There are tokens out there with an ever-expanding supply that constantly dilutes the price. The inflow of money going into the token needs to be greater than the growing supply in order for it to appreciate. Instead of releasing massive amounts of tokens, a project should consider keeping a limited supply and using a deflationary method. As more investors come on board, the value of a token will increase due to its scarcity.
Another widely adopted value-creating strategy is to distribute tokens to the users of the protocol in the form of an initial token offering (ITO). An initial token offering has a clear advantage over an initial coin offering (ICO) as it is way safer. ICOs can easily turn out to be exit scams. This happens when a greater amount of people invest in a certain coin, then the provider simply vanishes. In the case of a token offering, instead of releasing the tokens to gain wealth, a project promises to provide service to those who invest in their tokens.
As part of a project’s marketing strategy, airdropping tokens can also be a way of distribution. What this means is that a developer gives out tokens for free as a form of advertising for their project. Why is this beneficial from a project owner’s perspective? Simply because airdropping a number of new tokens to the public can raise awareness and excitement for the project. Furthermore, you can collect information like social media follows email addresses etc. from the users who receive your coins. Airdrops can easily fall into the category of meaningless advertising unless there is an actual utility behind the tokens. For example, many projects reward early adopters by airdropping governance tokens, thus allowing them to vote on changes. Uniswap, a cryptocurrency exchange did just that in 2018 when they retroactively airdropped their tokens to their early investors and provided governance for them.
In projects that have been out there for longer, users are usually already benefiting from using certain services within a protocol and the introduction of a native token within that ecosystem can accelerate their adoption. Ever since automated market makers (AMM) appeared, decentralized protocols like Balancer, Uniswap, Curve, and many others adopted the technology, making it able for users to receive LP tokens once they provide liquidity for the protocol. Once again, a great example of how a token is always backed by a certain value.
Tokenomics at Work
Once a project gains traction and starts creating value, the demand for tokens usually begins to grow accordingly. The success of these projects depends on timing. You could decide to give out governance tokens from the very beginning and enable holders of these tokens to make decisions within the protocol by voting. However, giving away value when there is no sufficient revenue only to reduce inflation and liquidity requirements is probably not the best idea. Unless you are bootstrapped with limited funds, just keep on building your project. The longer you wait, the more stable your project will be.
It all depends on the project size, but in the ideal situation if you have enough liquidity to start with, what your project should do is try to release not more than around 10% of the token supply and wait patiently for the community and the number of developers to grow. From a project founder’s point of view, the best way to go is to try to raise as little money as possible to bring a project to an MVP (minimum viable product). It is relatively easy to amass money in the early stages when there is a bull market, but who is going to buy your token after that?
What is the correct way to capture value? In the early stages, investors usually fund into a reserve pool. In exchange, they are issued a native network equity token. This token allows them to vote on the distribution of the reserve pool by the company DAO. This means that a certain percentage of the reserve pool is brought into the company DAO and is voted on to determine what proportion of it gets issued as stake rewards, or how much the developers will be paid by the customers/users.
This can happen because the customers pay money to use the services provided by the workers. In an ideal situation, some of these fees paid to go to the company DAO, while the rest goes directly to the workers. The money that goes to the DAO can be used to give out grants, return revenue to investors, fund operations expenses, support core development, and also for buyback and burn.
Buyback and burn are when the creator of a token buys back formerly issued tokens from secondary markets to reduce supply. This increases the token’s market price and is a form of value capture on its own. Burning a token also results in the reduction of supply and the increase of token value, but it does not create actual network growth. Additionally, it can propose risks as in the long run it may cause an insufficient token supply which is a huge red flag for potential investors. The best and safest way to go is to freeze some of these assets in the treasury and simply save them for future growth.
On a user level, the best practices to capture value are to distribute revenue directly to the token holders once a project becomes financially sustainable. These tokens help increase holders’ participation in governance. Once they are issued, you can translate participation on the protocol into buying pressure by saying that work tokens are needed to be acquired by contributors in order to be able to perform and make changes on the network.
You want to make sure that token holders have the power to shape the future of the protocol by making their own decisions. By requiring them to stake their tokens on the network for a certain period of time, users become committed and attached to the network. These users can even encourage new users to come on board. In return for their contribution, they can be given rewards. The more tokens staked, the more secure the protocol is.
If we look at the industry itself, as time goes by it is only getting harder for new projects to retain users. There are simply too many similar token projects out there with the same target groups. The key is community management and clear communication with the investors.
From an investor’s point of view, the most attractive thing you can do as a developer is to simply make users stake most of the project’s tokens right after a TGE (token generation event), thus slowing down token velocity. Token velocity is what indicates at what speed a token’s transactions take place. It is also an indicator of the token’s volatility. If token value increases rapidly, chances are your investors are going to cash out faster. The longer your investors hold their tokens, the less volatile your token is going to be, not to mention that it also results in an actual increase of token value.
Questions to ask when evaluating a token
- What type of token is this? Is it a spending token or a holding token?
- Where is the supply currently? (If already launched) or what will the initial supply be? (If designing)
- Where will the supply be in the future?
- How will the token reach its future supply and how fast will it get there? (What does the emissions schedule look like?)
- If it’s a holding token, why should I hold it?
- Is there an active community around the token?
- What utility does the token offer me? (Cash Flow, Staking Rewards, Governance, Collateral etc.)
- If it offers staking rewards, what currency are the rewards paid in?
Supply and Demand: Everything boils down to these two variables and understanding these are essential to understanding whether an underlying token will succeed.
Supply: Emissions, Inflation and Distribution: Based on supply alone, ask yourself, will this token hold or increase in value over time? And will its value be inflated?
Deflation is when a tokens value increases with decreasing supply. Inflation is when a token loses value with increasing supply.
One must evaluate the supply and how it will change over time.To learn more about this topic we would highly recommend you to check out our bonding curves article written by our CEO, Paula Pettit.
The questions to ask are:
- How many are there right now? (Circulating supply)
- How many will there ever be? (Total Supply)
- How quickly are new ones being released? (Inflation)
- Do a few investors hold a greater proportion of the tokens to be released soon?
- Did the protocol give most of its tokens to its community?
- Does the distribution seem fair?
- This is known as token emissions. If a bunch of investors have 25% of the total supply and it’s to be unlocked in a month then caution should be taken. These investors could dump their entire holding into the market causing the supply to inflate and the token’s price to crash.
Having a fixed supply of tokens means that there will only ever be x amount of token in existence ever while having a variable of infinite supply means that the token could potentially inflate its price to zero.
Demand: Return On Investment (ROI), Memes and Game Theory:
Having a fixed supply of tokens alone does not make a token valuable. There needs to be a demand and/or utility for the token to create value.
ROI: This refers to how much you think a token’s price will increase by. It’s how much cash flow or income that can be generated from the token just by holding it. One example of how a token can generate a ROI is by staking it and earning fees in that token, or another token. If a token has no intrinsic ROI people have to rely on the belief that it will increase in value.
Memes: Memes refer to the belief that other people will want to own the token. It’s harder to analyse and can be described more as a feeling. Does the community have an active discord? Are they active on twitter? How long has the community been active? Does the community really live their beliefs?
Belief in future value can be a powerful driver of demand.
Game Theory: Game theory asks you to consider what other elements of a token’s design could increase its demand.
One good tokenomic game theory is called lockups. In some protocols, the longer the “lockup”, the better your rewards, incentivising people to hold their token and thus maintain its demand and its value.
Important aspects of supply:
The most important aspects of supply to be considered are:
- Where is the supply of tokens right now?
- Where will it be in the future?
- How fast will it get there?
- And how will it get there?
Market Cap and Fully Diluted Valuation (FDV):
Market Cap is the current circulating supply of tokens multiplied by its current price.
FDV is the total supply multiplied by the current price of the token. If a token has a price of R10, a circulating supply of 10 000 000 and a total supply of 100 000 000 then:
- Market Cap: 10 000 000 x R10 = R100 000 000
- FDV: 100 000 000 x R10 = R1 000 000 000
These two metrics tell us how the market values a token today and how the project needs to grow in the future to justify its current price.
If the market cap is 10% of the FDV and the tokens are all released in the next year, the project needs to grow 10x, or 1000%, in a year just to maintain its current price.
But if the market cap is 25% of the FDV and the tokens are released over 4 years, that’s only a 4x in growth over 4 years or about 40% growth year over year.
Circulating supply can be a bit tricky to work out as tokens locked or vested are deemed to be out of circulation and therefore are not included.
Circulating supply and Max Supply answer the questions:
- Where is the supply of tokens right now?
- Where will it be in the future?
Emission Schedules will answer:
- How fast will it get there?
- And how will it get there?
These will be in the project’s docs and will take a bit of detective work.
Find out who the tokens are going to and what percentage of tokens are going to them over a given time period. You can then see the inflation rate of the token. If a large percentage of tokens are going to a certain group, those investors could dump their entire supply into the market and decrease the price of the token. Tokens can be vested on release for a certain period to prevent this type of behavior.
Another style of emissions are platform based emissions. Convex is an excellent example of this. Their emissions are based on the amount of curve tokens generated from people using their pools.
How Liquidity Affects Emissions Rates
What does the percentage change of the token look like? For example, if there is a 4 year emissions schedule but a very small amount of tokens are being initially released, this could be hurtful to early adopters.
Say for instance, 30% of a token is initially released in a private auction to raise liquidity and then 35% is released over two years beginning in month 6. That’s about 2% of the total supply hitting the market every month for 18 months, then the inflation stops.
2% hitting the market when 30%+ is already in circulation is a relatively small increase. The token supply will double over 15 months, but that’s more than enough time for the value of the project to catch up to the token price.
Compare that to if only 10% of the tokens were initially released. Then the token supply would double in 5 months instead of 15. This would not be ideal for early investors as the token price would have a hard time keeping up with such inflation.
What you want to see are at least three to six month lockups for teams and investors, with linear vesting after that.
It’s also important to check when large amounts of tokens will be unlocked. When Convex introduced their rewards mechanism, it required users to lock up their CVX for 17 weeks to earn rewards. A large number of users then locked away their CVX. 17 weeks later, these tokens were then released and their price doubled.
When you’re digging into the token of a project, getting a good understanding of the supply and how it will change over time will give you a better sense of whether or not now is a good time to invest.
The greater a token’s utility, the more reason there will be for people to hold it and the more in demand it will be.
Spending vs. Holding:
Ask yourself, is this a token that I am supposed to hold as an investment or a token that I’m supposed to spend.
A token that is supposed to be spent does not make sense and an investment because you could just buy it as needed.
If a platform’s token is to be used for in-app purchases and the price increases, then the cost of using that platform increases as well, which would drive users away.
Most platforms have a variable supply token for in-app purchases and a staking token for holding and long term gains.
If a token is an investment token, then the next question to ask is, why should I hold it?
The most common compelling form of utility that makes a token worth holding is cash flow. If there is some mechanism where you get paid for holding and using a token, then it might be worth buying even if it doesn’t completely hold its price against majors like ETH and BTC
Fee sharing is one way of generating a cash flow for holding a token. The user stakes the token for an amount of time in exchange for a fraction of the fees generated from users interacting with the protocol.
One catch to this model is if the rewards earned are in the same token as you’ve staked. This is then just the way the project is releasing their tokens into the wild and you are just protecting yourself against inflation. You want to look for projects where the cash flows are based on actual revenue, and ideally not paid in the token you’re staking. Convex pays you based on bribes, and you get paid in a variety of tokens.
If you love a protocol and want to have a say in its decisions, then governance powers are a good reason to hold the token. Aave’s token has had a tough time against eth but it is still in demand because if you are a whale or VC firm with money in Aave, you can have a say in which direction the protocol moves.
The last thing to consider is whether or not the token can be used as collateral. If you’re buying into a project and you want to hold it long term, the last thing you want to have to do is sell that token if you suddenly need liquidity. Can this token be used as collateral to borrow against, using one of the major lending platforms?
A project's tokenomics provides users with a framework to understand how their token is intended to work. If you want to make your project sustainable in the long run, the most important factor when building this tokenomics model from a developer’s point of view is the investors. Try to maximise return on investment for pre-sale investors. Provide a clear roadmap. Investors like utility tokens: a subscription model, a tier system, something that provides governance, staking, and maybe even passive income. Go for utility, this is what survives bear markets.
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