Token Economy – Tokenomics

At the core of human behavior are fear and the instinct to avoid pain, which are the most basic and potent emotions. People tend to be more motivated by the need to avoid pain than the desire to attain pleasure, a phenomenon called “risk aversion” by behavioral economists. Therefore, when introducing a new product, it is essential to emphasize how it can alleviate pain points.

The perception that Satoshi Nakamoto’s revolutionary invention, credited as the godfather of Bitcoin and Decentralized Ledger Tech, is solely focused on digital money is limited. In reality, Nakamoto’s invention revolves around decentralized trust, providing a mechanism for ensuring certainty.

Effective tokenomics design shares similarities with effective product design, as both prioritize the needs of end-users. Customers crave transparency and trustworthiness, as they align with their inner motivations. Products that provide certainty and comfort tend to be more popular with consumers.

Tokenomics is shortened expression of token economics, and I don’t refer here on tokens as ERC-20 tokens running on Ethereum or anything like that. Idea of token economics applies to all cryptocurrencies as a whole.

Tokenomics explains economy of the cryptocurrency.

Word of warning: Do not confuse tokenomics to token-metrics! Common and valuable token-metrics are market cap, total and circulating supply, total value locked (TVL), token distribution & allocation, and more. For the simplicity it is easier to use one term “tokenomics” but just don’t trivialize it.

I often see that others are referring to tokenomics as only a circulating supply in comparison to total supply. If circulating supply is significantly lower than total supply, than they will conclude that it is a bad cryptocurrency to invest into, which is nonsense.

It is nonsense because maybe this is the best thing that could happen to cryptocurrency, if new supply that is entering into circulating supply is initiating growth of usage of the cryptocurrency. With bitcoin new supply was going to miners, so function of growing supply was to enable decentralization early on when no one was interesting in mining bitcoin.

But what happens when decentralization of cryptocurrency is solved, which is de facto case with all tokens „living“ on already decentralized blockchain such as Ethereum or Solana? That’s why we need to look more comprehensively into tokenomics.

Tokenomics is essentially some of the microeconomic factors that affect the supply and demand of a coin, that will ultimately have an impact on the price.

Let’s continue with inflation or an issuance rate. As I said already many think that no matter how much utility adoption, censorship resistance a cryptocurrency project has. If its inflation rate is just too high, then the project won’t succeed.

By issuance rate is the amount of new coins that are added to the existing stockpile on some kind of annual basis. As a cryptocurrency investor, you won’t get the capital appreciation you want to see if too many new coins are continually being added, diluting the value of the existing supply.

For example, let’s take a coin with a 100% issuance rate on an annual basis. That would mean that in a year from now, the amount of coins in the circulating supply would essentially double. If demand cycle (amount of bought and sold in same time period) remains fairly equal, you would actually be down one year from now by 50% in dollar terms, simply because of all the new coins that have been created. As a cryptocurrency investor, you’re facing an uphill battle because of selling pressure that would need tremendous amounts of adoption just to keep up with the amount of new coins that are being added to supply and diluting the existing stockpile.

Therefore, whenever you’re doing your homework on a project and assessing factors such as adoption and utility, pay attention to the existing supply, total supply, and how many new coins are being created and issued on an annual basis. Ideally, the lower the issuance rate, the better.

This is where the idea of stock-to-flow applies which deals with ide of how scarcity can affect the value and price of any coin.

Token distribution

Token distribution is also worth looking at, but not too much. Institutional investors are actually more disciplined to hodl, but it is useful to be aware of distribution. The great team at Messari created the chart below, which demonstrates the wide-ranging distribution among leading blockchains.

More prominent metrics to keep in mind are the entry prices for each investor and their return expectation, which in part depend on the investor type and their risk tolerance. A retail investor may be content with a return of 50 percent on his investment, but for an institutional investor, this ROI may be unsatisfactory. 

Solana’s seed sale, which constitutes ⅙ of all market tokens, was at $0.04 and at its ATH it surged to $260 (x65 relative return).

You can also inspect some additional metrics: do the tokens have a cap (BTC)? Are they inflationary (SOL), deflationary or a combination of the two (ETH)?

Bringing all these metrics together paints a more wholesome picture.

Value creation

So high inflation bad, no inflation good, right? Nothing can be further away from the truth!

Value is created when one side (the supply side) produces something that is perceived as valuable to the other side (the consumer). Two clichéd rules of thumb to remember: there are no free lunches, and if you’re not paying for it, you are the product. A Token is a medium of exchange and in order for a rational person to exchange value, they need to get a slightly greater value in return (to be worthy of his effort), hence Value Exchange.

What if you have a cryptocurrency with $50 million market cap, and superhigh inflation which is used to drive the adoption of the cryptocurrency? Let’s imagine that during next 5 years there are 5x more currency in circulation. That sounds scary, if the price remains the same, that is now $250 million market cap.

But how can price remain the same, when all these currencies are entering the circulation, wouldn’t they eventually be sold to the market? They will. So better to not buy it right?

Because so many things are going on with cryptocurrencies, it is easy to miss the forest for the trees. Good Tokenomics are the flywheel that brings new users to platforms. They are also the reason they keep using the platform. 

Let’s approach that from this perspective: What if, cryptocurrency achieves so big adoption and success thanks to that inflation, because it is going towards the adoption and helping attracting users, that there are thousands of applications that are integrated solution which requires that cryptocurrency, and latest news is that Facebook Google and Amazon are adopting it as well. How would that impact the price?

Let’s assume that net effect of that new supply would be 50% sold to the market, but because it achieved tremendous success, billions of dollars were poured in to that cryptocurrency because suddenly million people want to own it? That would make market cap in dozens of billions of dollars.

As we have seen in this example, inflation is very good, if used correctly. So your job is to figure out if new tokens are going towards bigger adoption. If there is no inflation, no subsidy that can drive adoption, that is much worse than if there is high inflation.

Crypto gets a bad reputation in respect of fraud (largely inflated by today’s clickbait news environment). Yet if we are honest, some of this is deserved. First we look for the value creators or producers in a project. If they aren’t immediately obvious, that’s a red flag.

Projects who’s Tokenomics are based on others buying, holding, and encouraging others to do the same in a pyramid structure, create no value thus aren’t sustainable. 

Olympus DAO (OHM), is a (somewhat contentious) project which has the merit of trying to be the crypto world’s reserve currency, but some criticize its structure. OHM offers extraordinary APYs (which fluctuate) reaching into 5 digits at times.

OHM’s “motto” (3,3) comes from game theory, meaning it is in the best interest of all players to keep on holding. As a result of OHM’s success, hundreds of projects have been forking its code and a shortlist of projects illustrating the phenomena can be found here. 

Lending and borrowing services are of the simplest barter mechanism. There is the supplier, i.e lender who creates value in proportion to the demand of the borrower. But what is the underlying product here? Only time (and the market) will tell.

Capturing value

In order for people to invest/spend money, there needs to be Value Creation – which in turn enables Value Exchange among its counterparts. But Value Creation is not enough. History is full of one-hit wonders, but a platform or product that aspires to be sustainable has to devise a Value Capturing plan, and that has to start with the users in mind.

For a Poly Victorious ecosystem to thrive it needs to provide its users with clear shared goals and facilitate cooperation among its members.

Platforms create value for their users by facilitating interactions between their different stakeholders. The type, frequency, and density of these interactions can lead to one of the buzziest of buzzwords in the crypto-verse which is…network effects. 

Ok cryptocurrency gained a lot of adoption, but does it/can it capture any value?

To help explain this, let me ask you how much value the technology which enables email managed to create? I believe we agree that the answer is a lot.

Now, what if I ask you how much value the email these technologies were able to capture? If you think about it for a moment, you’ll realize the answer is basically zero. The creators of the email protocols and technology that billions of people around the world use today did not make a fortune out of it. They are not billionaires, and you even know who these people are.

The reason for this is that there is no mechanism for capturing the value that was being created. The lesson to learn from that, applied to cryptocurrency investing, is that even when a protocol or technology is creating an enormous amount of value, getting mass adoption by a huge number of people, you have to ask yourself if there’s a mechanism for actually capturing the value that’s being created or if it’s being accrued elsewhere.

Fundamental reason why email protocol did not capture any value is because then protocols could not capture any value. Cryptocurrency changed that. That’s why you heard that it’s not cryptocurrency what is important, but the blockchain is the main thing what is driving (r)evolution. Well, because protocols now can capture value, I can safely say that iIt’s not about blockchain, it’s about cryptocurrency.

Email is capturing massive value, but on application layer, not on protocol layer. Gmail is very evident example. Check out this blog post about fat protocols to learn more about this topic. Essentially before there were thin protocols and fat applications, but in the blockchain space, we will have fat protocols and thin applications.

Only bold sentence in that blog post goes like this: “The market cap of the protocol always grows faster than the combined value of the applications built on top, since the success of the application layer drives further speculation at the protocol layer.“ That is btw why I am interested only in crypto that are serving as protocol layer, not (only) as application layer.

Let me give you an example of where I think this has been the case in crypto so far, and please don’t consider this to be me berating or belittling any projects. I just want to illustrate this point.

If you were to take a project called 0x, the 0x protocol, which basically decentralizes exchange technology, from what little I know about the technology, and let’s just be clear, I’m not an expert on 0x by any means, so I might be wrong about this. But from what I understand, the technology works fine. You can actually use the technologies just fine and dandy. However, the token that sits on top of the 0x protocol, ZRX, from what I understand, is useless. There are actually ways by which you can use the technology without incorporating the use of the token. There’s been a lot of questions about if people can use this without having to use the ZRX token, then how is that token going to accrue any value? This idea I think can apply potentially with other coins as well.

Another example is EOS. You need to stake EOS tokens in order to use EOS network. Then there came a project that used EOS technology. The thing is, they did not buy EOS tokens and went to EOS blockchains to use it, but they hard forked EOS, made a copy for themselves because it is free and open sourced, and now they are using their own EOS blockchain. EOS token is not touched in the process.

If you were to take a very popular coin, like XRP, it’s the same kind of thing where you have this technology that’s created by the Ripple corporation that helps banks with making payments between banks. But people question the role of XRP coin and ask, well, if you can use a lot of this technology without the native XRP token, then how will that token actually accrue any value? How will that capture any value that’s being created by this technology, which assisting the banks with what they do on a day-to-day basis if they can use the technology without the XRP coin?

Whenever you’re assessing the merits of a cryptocurrency project, not only do you have to figure is it useful and valuable, but you also have to ask yourself, is there a mechanism, is there a method for capturing any value that’s actually being created by this technology?

The most effective method you can use to try and determine this for yourself is to ask yourself, does this token on this protocol has to be used? Is it actually required in order to benefit from the technology, to benefit from the value that’s being created? Or is there a way for users to get around it? Because if there is, if there is a way for users to not have to pay, then they’re not going to do so. And so that’s just another factor to bear in mind at all times.

One more thing

Another reason Tokenomics are so important relates to the nature of decentralized organizations and the immutability of smart contracts. Once a Tokenomic model has been implemented and agreed upon, it is harder to change it and thus fix it (when compared to a centralized product with quick product interactions and a “move fast and break things” culture).

There are many examples of great crypto projects that failed, purely because they used a “bad” model.

Different people need different amounts of motivation to behave in a certain way, and it’s the same with products. There isn’t a one-size-fits-all model. Planning, designing, and creating a proper token mechanism is a difficult balancing act, and it requires many iterations of trial, error and communication.