Introduction

It has been over a decade since the whitepaper of Bitcoin was released, and we can see the impressive evolution of blockchain technology since then. However, the development of the on-chain economy and business implications is not keeping up with its technology.

Designing a well-functioning tokenomics is the most important part of any on-chain protocol, as it defines the pattern of a cryptocurrency’s issuance and supplies within the system. We can find many famous projects that rise and fall because of their tokenomics.

Before we dive into more discussions about tokenomics, let’s first look at the token itself and how it performs in the system.

From the ground level, the token can be defined as any digital assets issued on and utilizing the blockchain. However, in this paper, I will only refer to cryptocurrency or digital assets that run on the top of a public chain with specific utilities, which exclude cryptocurrencies like $BTC and $ETH.

This type of token, they are worthless without the protocol it stands for. Its value is only determined by what it represents, but its role can be diversified, from the right to reduce the exchange rate in DEXs to the membership representation in SocialFi projects. Thus a general definition of the token can hardly be concluded without considering the tokenomics behind it.

The emergence of tokenomics, or digitized value, is because blockchain technology introduces the idea of digital scarcity, thus creating a new type of digital economy. This digital economy system is coded by token designers using smart contracts within a self-governed economic system, and they generally define the token economy from Two major aspects: Monetary Policy and Incentive Behaviors

Monetary Policy

In traditional finance, monetary policies are used by the central bank to control the overall money supply and promote economic growth and employ strategies. Monetary policy is about controlling the amount of money available in its economy and the channels through which money is printed. The policy can either be expansionary or contractionary depending on the performance of its economy.

For tokenomics, the monetary policy refers to token issuance and whether it’s deflationary or inflationary. Projects control it with pre-coded smart contracts, and it is mainly controlled from two sides: Burnability of Token and Token Supply.

The burnability of the token determines whether the token can be burned to create artificial scarcity, and adjust the circulating supply of token.

The token supply is fundamental to tokenomics as it determines the dynamics of tokens. Similar to the role of the velocity of money in traditional finance, the velocity of token indicates whether its ecosystem is expanding or contracting. It measures the transaction frequency of a token in a set period.

Typical classifications are:

Time-based: Tokens are all minted at the TGE event and distributed afterward according to a pre-defined schedule. This supply strategy is implemented directly through smart contracts that control the ecosystem. This strategy has the best transparency but the least flexibility, requiring a carefully designed ecosystem to sustain the most extreme cases. It is generally used by protocols that leverage the TGE events as a fundraising opportunity.

Demand Driven: Tokens are created, distributed, or burned according to current demand, which is monitored by a pre-coded algorithm on smart contracts. In this way, supply levels are artificially aligned with the progression of the project. This strategy is generally used by projects that intend to control the price range of their tokens and maintain the motivation of demand. However, a pre-defined algorithm can sometimes fail under boundary cases, especially when the fluctuation of cryptocurrencies is high.

Discretionary: Tokens are created and distributed or burned without a pre-defined schedule, but are determined by the need of the DAO of the project. The DAO passes the proposals and generates & distributes these tokens according to the progression of the project or dealing with unanticipated events. This type of delivery strategy sacrifices a portion of transparency and trust to gain more flexibility and risk resistance.

The discretionary strategy provides the most flexibility and risk resistance if its governance system works as it intends to. However, there are always conflicts between organizations in an ecosystem. For example, investors may want the value of their tokens to increase, but users benefit from lower inflation and reduced volatility. The governance system can easily mess up tokenomics by passing malicious governance proposals. In this case, the development of tokenomics also relies on the development of DAO management.

Recent on-chain protocols have a more compound token economy that can hardly be defined by a single characteristic, but it still has the features of the types above.

StepN is considered one of the hottest properties in the GameFi track at this moment. It is an M2E project that pays its users to walk with a similar tokenomics system like the Axie Infinity in general. Players are rewarded in tokens for the walk they have done each day. To play, users must buy a STEPN NFT beforehand. This type of project will initially offer attractive token rewards but gradually drop in value as more users farm these rewards. The major issue of this type of tokenomics (Before the StepN) is that they are unsustainable in the long run because their source of yields/rewards is generated without real value.

StepN inherits the Dual-Token system from Axie Infinity: GST, the primary reward token, has an unlimited supply so it can be minted to fulfill unpredictable future demand. The inflationary pressure of GST is partially hedged by the price of its NFTs, which creates an entry barrier. Players are willing to stay for a longer period, so inflation can be held off. GMT, the governance token of its ecosystem, has a limited supply and a time-based vesting period.

The token economy of StepN combined three typical classifications of tokenomics mentioned above. GST token can be minted by the will of its team to extend the reward size according to the growth of users, so the GST can keep its incentive. It is a demand-driven tokenomics with a discretional approach. For GMT token, it has a time-based tokenomics.

Additionally, the velocity of the token transaction is also affected by technical constraints and the improvement of technologies like ZK rollups and the PoS merge of Ethereum can unleash the greater capability of tokenomics.

Incentive Behaviors

As we just mentioned, the conflicting incentives in an ecosystem can easily lead to a mess. The design of incentive behaviors is another important part of tokenomics.

Incentives in any on-chain ecosystem can be classified into two types: passive incentives and active incentives. Passive incentives are attributes of the token that enable incentivized behavior, which stands as a prerequisite for certain activities in the network. This type of incentive does not profit their holders directly compared with active incentives. On the other hand, active incentives are tokens that profit their holders from certain activities in the ecosystem. More precisely, it will agitate its holder to perform the incentivized behaviors. It is noteworthy that negative incentives such as punishment for holding certain token/digital assets are considered alternatives to active incentives.

Passive Incentives

Medium of exchange: The same function as traditional money. Some tokens can be used to exchange services or other assets in the protocol.

Governance Rights: For the vast majority of current protocols, governance rights are a common characteristic of their tokens. Holding or staking tokens is a prerequisite to voting on proposals that can greatly influence the performance of the protocol, which is fundamental in the DAO governance system.

Rights of governance can also be an active incentive when its holder can gain profit directly from certain proposals. A clear boundary should be established for a well-defined governance token, or governance attacks will easily destroy the protocol.

Active Incentives

Accessibility: The tokens grant holders the right to access services and content on the platform. This is the most common incentive behavior of tokens for on-chain protocols, and its value is greatly influenced by the performance of the protocol itself.

Speculation: Token holders expect the price of their tokens to go up with the development of the protocol. In this case, tokens are stores of value that their holders are willing to keep and this will reduce the velocity of the token within the system greatly.

Profit Sharing: Token holders can receive a share of the revenue generated by the protocol through staking/holding their tokens. This type of incentive might come in two different ways: The first one is that the token issuer mints more tokens or unlocks tokens from its reserve to pay the holders. In this case, the circulating supply of tokens increases. Or, they can distribute a portion of its profits with another cryptocurrency, and maintain the scarcity of its token.

Passive incentives and active incentives listed above are generally combined to create current tokenomics, and there are also some other incentives shaping the behavior of token holders in real cases. For on-chain protocols, its ecosystem is generally closed compared to traditional finance, and only chosen tokens can capture or generate value within it. In this case, the expected incentive behaviors of the token in a specific protocol should be limited to create controllable token dynamics with the token supply.

Conclusions

The tokenomics can reflect economic and social costs when accounting for on-chain projects. For me, I would prefer to define tokenomics as a social-technical system that designing a well-functioning tokenomics is about shaping effective incentive schemes according to both its financial objective, and the expected behavior of the community of token holders.

Disclaimer: This research is for information purposes only. It does not constitute investment advice or a recommendation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision.

🐦 @SoxPt50

📅 4 August 2022