Tokenomics: The Builder’s Handbook

In this blog, we’ll present our practical, 5-step process for designing and building Tokenomics.

Step 1: Identify your Users

Step 2: Identify Their Needs

Step 3: Define Actions & Goals 

Step 4: Build an Incentive mechanism 

Step 5: Test and Simulate KPIs

In a previous blog post, we defined Tokenomics as the economic mechanism that motivates and aligns multi-sided platform participants towards an optimal outcome for all parties involved – the engine, fuel, and generator. Today, we’ll discuss how to start and maintain these engines, add the appropriate fuel at the right time, and harness the stored energy to generate even more.

Mechanism design, or Tokenomics, and product design follow similar steps and are closely intertwined. However, what distinguishes one product from another? We all possess products that we simply can’t live without. Some are obvious, like our smartphones or TVs, while others we take for granted and only notice when they’ve malfunctioned or are gone, such as our cars, fridges, or even ex-partners.

The dry definition of product value is “the benefit that a customer receives by using a product to satisfy their needs, minus costs.” We value products because they enhance our lives, fulfill our needs, and keep us content. Occasionally, they even exceed our expectations, leading us to love them.

Every decision we make is rooted in perceived value, whether consciously or subconsciously. Is it worth my time, money, or effort? We calculate each decision’s value for money or return on investment according to our intrinsic “incentives function.” Systematically adding incentives can make all the difference.

One of the significant advantages of well-conceived and executed Tokenomics is the ability to adjust and time incentives. When done correctly, this can propel a powerful, self-sustaining network effect and viral community growth. When we developed Colored Coins back in 2012, another protocol called Counterparty existed. While we (#objectively) provided superior technical value, they grew four times faster than us because they had an incentive mechanism and community built around their protocol, while we didn’t appreciate the value of adding Tokenomics to our open-source code at that time.

Step 0: Do You Want to Build (on/) a Blockchain?

As with any emerging technology, using a blockchain as a tool has its advantages and disadvantages, depending on the intended application. Choosing the wrong tool can be detrimental to the project, rendering it infeasible or less than optimal. Therefore, before embarking on a blockchain project, it is crucial to assess its suitability by asking several fundamental questions.

Firstly, is a blockchain truly necessary for the project? Secondly, would immutability and transparency enhance or hinder the end product? Thirdly, can a smart contract, which essentially acts as a self-executing lawyer and judge written into code, replace the need for a trusted human intermediary? Fourthly, does the removal of intermediaries and central authorities create a novel and profitable service? Lastly, what is the value-add of incorporating a token into the product?

Ultimately, the decision to use a blockchain must be driven by practical considerations, rather than mere fascination with a new and exciting technology. Otherwise, the blockchain could simply be an unsuitable tool in search of a problem to solve.

Blockchains can be immensely powerful tools, but as with all double-edged swords, great power comes with great responsibility. The following list highlights some of the tradeoffs associated with blockchain technology, which can be both features and challenges. It is important to handle them with care and ensure that you don’t lose your sheath.

The decentralized nature of DLTs creates redundancies as all nodes in the network “hold” the same copy of the transaction history, which prioritizes security over efficiency (SPoF). However, scalability can be at odds with decentralization or computing power (ETH vs. SOL). Immutability prioritizes data integrity and trust over development speed and flexibility (no undo button). Self-management of private keys (#NYKNYC) trades off autonomy with responsibility. Public, on-chain data favors transparency over privacy, and interoperability favors a wider reach but increases the risk and complexity of bridges. Finally, creating a legal structure for a crypto entity and the vagueness around regulations mean that few know how to navigate this maze.

However, if you are a glass-half-full kind of person (as all entrepreneurs should be), most of the above can be a tremendous opportunity for your project. These tradeoffs result in a relatively homogenous user profile or persona, which can help you better refine your target audience before interacting with them and thus better match your product design.

If the answer to step 0 is “yes”, the next step is…

Step 1: Identify your Users

You probably had experience of entering the store, and uninterested young employee would just ask you: “Can I help you,” and you just want to answer: “No thanks, I am just looking.” But if someone who cares about the store like the owner would approach you, you would feel it because he would genuinely want to help you.

There is a significant difference between an employee and an owner in terms of the level of dedication and commitment to their work. The store owner, who has a stake in the success of the business, is more motivated to provide excellent customer service than the young employee who was just working for a paycheck. Disparity in attitude and motivation is a reminder that there is a significant difference between an employee who is just doing their job and someone who is fully invested in the success of their business.

That is why it’s important to have right incentives. If someone is payed just to be there 8 hours and do whatever he is told, he will act like that. But if there is right incentive in place, you would do your best to know everything you can about your users.

Mapping the Key Users

When trying to identify your project’s key users, you should ask yourself the following questions:

Who is creating value?
Who is providing a service?
Who is providing resources?
Who is exerting meaningful effort?
Who is taking the risks? 

Every protocol has leading actors who provide the product or service, and supporting actors who enhance and add value to it. Let’s take some examples.

In Bitcoin, the main actors are the miners who compete to produce the next block, hoping to win the block reward and maintain the blockchain’s safety and consistency.

Currently, in Ethereum, the main actors are also the miners who provide the same service. However, with the release of ETH 2.0 and its transition from PoW to PoS, validators will become the main actors. They will provide resources to the network by running nodes and creating blocks in exchange for potential rewards. Validators also improve network security by increasing the amount of ETH required to control the network. However, they take on the risk of getting slashed and losing their staked ETH for misbehaving.

The supporting actors in Ethereum will be the users who join a staking pool by staking their ETH with their chosen validator. By staking their ETH, both validators and supporters add value by making ETH scarcer. Joining a staking pool also serves as an important signal to the network of who is a “good” validator.

Later, in step #4, we will use this contribution hierarchy to determine who deserves greater rewards.

Alienate Bad Actors

It is crucial to identify and map out the types of users you want to keep away from your service. Every service has its share of bad apples, ranging from annoying Twitter bots to users who can render the service unusable. In the world of cryptocurrency, a single user can bankrupt a service single-handedly.

As a web3 developer, you establish the “rules of the game” through your smart contracts, following the principle of “code is law.” However, with current technology, you must balance the need to limit the number of wallets per user by requesting KYC with the risk of losing users who don’t or can’t reveal their identity. It’s likely that DID solutions will emerge in the future, potentially eliminating bot-related problems. However, like computer viruses, they’ll always be lurking, and it’s essential to ensure that the service remains privacy-conserving.

To tackle the MEV problem, more technical projects are attempting to use or build on top of services that provide solutions to this issue. By doing so, they can significantly enhance and improve their products.

Another helpful framework is to differentiate between investors and speculators. Investors are long-term players who are invested in the project’s success, putting in their time, effort, and tokens into the service. They may also add value by assisting others in the community and spreading the word, which is a by-product of having skin in the game and/or love for the product. A thriving and cohesive community is noticeable in projects with long-term investors, while projects with users solely focused on reaping rewards with minimal effort do not usually thrive.

Warm to the Early Bird

The crypto community often repeats the mantra “crypto is in its infancy” and #WeSoEarly because it’s true. The user experience is generally challenging, clunky, and burdensome, which can discourage those who are not tech-savvy. Additionally, high volatility, unknown risks, and associated dangers can deter risk-averse users.

However, this is both a blessing and a curse. On the one hand, there is room for growth and improvement, and as a web3 builder, you have access to a more homogeneous user base and a large pool of untapped potential users. On the other hand, you presently have only a few hundred million users instead of billions.

You can broadly classify crypto users as early adopters. In this phase (2022), we recommend concentrating on these early adopters or “the believers” first and focusing on bridging the gap later. However, this is not an excuse for neglecting UX/UI investment; instead, it can be a significant differentiator.

As a result, you should design your product and tokenomics around the crypto natives. These users already have a wallet (most likely Metamask), a preferred chain or two (such as Ethereum, Solana, Algorand, Terra, etc.), and are aware of the risks and potential rewards. By targeting these users, you can save a significant amount of time and effort in acquiring users, particularly during the bootstrapping phase of your platform. Once network effects have started to kick in, you can expand your target audience.

Chickens and Eggs – Who to Court First?

A market is where buyers and sellers exchange value, and its value is derived from its participants. However, the question of how to get the flywheel going remains the one billion Satoshi question. Despite what you may hear on compulsory YouTube ads, there is no magic formula for building a viral product. To build something that people want, you need to establish trust and provide users with proof.

In the beginning, some users are more important than others. A good rule of thumb is to start with the supply side, i.e., the value creators. For Uber, this was the black-car owners. For AAVE, it’s the lenders. For data providers like SubQuery, it’s the indexers, and for Forta, it’s the threat detection-bot developers.

Another tactic is to focus on a niche or specific segment. Amazon did this with books, and Facebook (now known as “Meta”) did it with college students. In the crypto world, this can mean focusing on a platform that aligns with your user’s needs. For game developers, it may be choosing Solana or Polygon over the currently slow and expensive Ethereum. On the other hand, for a DeFi protocol, Ethereum offers the best liquidity with the biggest network effect.

Another way to provide quality evidence is to use a trustworthy witness. In a low-trust environment, key opinion leaders (KOLs) and experts with a proven track record can foster trust, credibility, and highlight the benefits associated with the product, both obvious and obscure.

Many play-to-earn (P2E) projects start by offering NFTs in the form of characters and/or lands to build their community before working on the game itself. However, this is not a silver bullet and requires a crafty team with strong community development capabilities.

Step 2: Identify Their Needs

Which is better: a minivan or an electric scooter? CEXes or DEXes? P2E or PS6? Ethereum or Solana? The answer of course is “it depends”. Different users of different products have different (and unique) needs, but there are universal needs that all users share. These needs reflect aspects of Maslow’s hierarchy of needs. This is a modified version that fits the crypto world.

Like with Maslow’s pyramid, these steps are in order, meaning you don’t optimize the UX before securing their security needs. When trying to anticipate your users’ needs, some questions you can ask yourself are:

What is the risk tolerance of the average user?
What does each party want to achieve or gain?

How do you reward in proportion to contribution?
How can you articulate and communicate your solution in a way that promotes predictability?
What level of quality they will need?

How can you align the needs of all users?

In step #5 of testing and simulating assumptions, it’s important to revisit this step and adjust your insights accordingly based on your findings.

Different personas have varying risk tolerance levels and are attracted to different APYs. For example, Degens may prefer riskier strategies with triple-digit APYs, while long-term investors may favor lower rewards with a less aggressive inflation or emission schedule.

Security is the foundation of every crypto project and is therefore positioned at the base of the pyramid. It’s akin to a person not caring about the taste of their pizza if the roof above their head is about to collapse. Security, or certainty, is a basic element that every project must have, as the crypto space is infamous for hacked and rugged projects that erode user trust.

User needs evolve over time, and as a project matures, safety becomes more critical, and other needs emerge.

ROI is a universal need, and all decisions are made through a mental cost-benefit analysis. Nexus Protocol provides both certainty and ROI, reducing the stress and uncertainty associated with leveraged positions through its built-in anti-liquidation mechanism while delivering greater returns.

Oracles such as Chainlink, along with data and infrastructure providers like Subquery, offer predictability, consistency, and reliability in several ways. These services use multiple data sources to prevent skewed and unreliable information, leading to improved quality, performance, and variety for your dApp. Additionally, reliable data sources can be leveraged to predict future behavior using various tools, including AI, ML, and NLP.

To offer more variety, you can add support for additional smart contract platforms or more wallets.

Subquery has also improved its payment methods, offering a variety of plans tailored to different user needs based on direct feedback from the community and indirect feedback from statistics and behavioral analysis.

Once you’ve addressed the four levels outlined above, you can focus on enhancing the user experience through a visually appealing and high-performing UI, improved tutorials and guides, and the addition of new features and Easter eggs. The ultimate goal is to pleasantly surprise users and exceed their expectations.

By implementing these steps, you can transform a product that no one wants or is indifferent to into one that users love, appreciate, and eagerly share with their friends and family.