By Brook, Elaine, Dirk

Vitalik, the founder of Ethereum, pointed out in a tweet on July 8, 2022,

“The first law of tokenomics: don’t get your tokenomics advice from people who use the word ‘tokenomics’. ”

This may seem confusing at first glance, but on closer inspection it becomes clear that Vitalik intended to express that people who focus too much on tokenomics fail to govern the overall course of the protocol.

Indeed, tokenomics is undoubtedly an essential part of building a protocol-based economic financial system, but as Vitalik said, it is not the whole part of the protocol.

▶️ Imagine a scenario: you are the founder of a stablecoin project. What do you need to consider on the first day?

· The first and most important thing to consider is what the market demands. There are many similar projects in the stablecoin market, but what is really rare are those can solve the pain points of the market. This is an important prerequisite for whether the project can have positive externalities and generate real revenue.

· Second, we need to think about the business model, whether it is a fiat-backed stablecoin, a crypto-backed stablecoin, a commodity-backed stablecoin or an algorithmic stablecoin. What is the pledge rate? Which liquidation mechanism should be chosen? How to set the liquidation parameters?

· Then comes the design of the incentives: Do we need to launch a token? How to design the tokenomics mechanism? What financial incentives should be chosen? What are the appropriate areas for setting transaction fees and incentive parameters?

· Finally, governance. Do we need to set up a DAO? What are the rights of the community? Do we need a governance token? How can we improve community engagement? How can we prevent a Sybil attack? How can we understand the distribution of community members’ beliefs, etc.?

Therefore, don’t limit your vision on tokenomics. Internet was a technological innovation, but it was the “Internet+” model that had a profound impact on society and the economy. Similarly, the current crypto market is no longer just a competition of tokenomics, but has evolved into a comprehensive power game, including the aspects of “business, incentives, and governance”. Only by coordinating these three aspects and finding a logical and coherent “token+” economic model can project protocols continue to attract new attention and become the ones that truly “shape the future”.

Based on this, we put token business and token governance, which have been ignored by most people, back to the same level as tokenomics and innovatively proposed a more complete idea — — “token dynamics”.

It regards the token-based economic and financial system as a dynamic system, and the positive externalities are viewed as the objective function of the complex adaptive system. The system is complemented by the three major dynamic mechanisms of business, incentives, and governance to help to complete the adaptive optimization and upgrading of the system, and finally realize the positive externalities of the protocol. It contains the scientific principles, methods, and cutting-edge theories of the three levels of business, incentives, and governance to provide more scientific and comprehensive help and guidance for the development of future crypto projects and DAOs.

1. The crypto markets have been stuck in “tokenomics” for a long time.

▶️ From a theoretical perspective, the study of “tokenomics” is relatively narrow.

It is generally considered to be a term that describes all factors that influence the value of token, including supply and demand mechanisms, incentive mechanisms, consensus mechanisms, role definitions, technical determinations, target group definitions, etc. In this ecosystem, the token economy has a strong influence due to transparency, consensus, and algorithm mechanisms.

However, the token-based economic and financial system is a complex, chaotic, and nonlinear open game system with inherent emergent properties that need to be described using mathematical, modeling, and computational interdisciplinary research. For tokenomics, it is impossible to explain the complex outcomes of the system simply from an economic perspective.

▶️ In practice, the application of “tokenomics” is also extreme and immature.

On the one hand, everyone has focused on the supply and demand and incentive mechanisms of tokenomics, almost ignoring the importance of business and governance.

This is of course understandable, as the unregulated early crypto world and the rush for capital led many in the crypto market see the wealth-concentration effects brought by tokenomics. No one bothered to carefully to design business or refine governance, because studying tokenomics appeared to be an easier way to create bubbles, which became the shortcut to wealth. Pursuit of profit and avoidance of harm are human nature. In the face of a huge market, everyone wants to leverage tokenomics, and the fear of missing out, gambling psychology, and herd mentality are prevalent in this dark forest.

The consequences of ignoring business and governance are also obvious. Many popular crypto projects only focus on the economy, but they did not even survive a market cycle. In contrast, projects like Compound and Uniswap, which carefully designed their business and polished their governance, have survived until today without relying on leverage from tokenomics. The results speak for themselves — token business and token governance cannot be ignored.

On the other hand, the industry, as a class of the most complex economic and financial system, is still using Excel and experience to judge the quality of a project.

It is quite surprising. The traditional economic and financial system requires mathematicians and computer scientists to model and control risks. However, the token-based economic and financial system is more complex and chaotic, and its adaptability and non-linearity make the speed of the system’s gameplay and evolution incomparable to that of the traditional financial system. Yet, such a fast-evolving ecosystem is still making qualitative judgments and qualitative analysis based on experience and Excel.

If the theoretical guidance in the crypto field remains at the level of “tokenomics” from the previous bull market, it will undoubtedly create a huge obstacle to the industry development today.

This is not to be little “tokenomics”.

We must admit that the development of tokenomics has indeed brought about the ICO craze, the DeFi summer, and the “x2earn” boom. Moreover, the development of the crypto industry today cannot leave the help of tokenomics. However, the industry is evolving and theories cannot remain stagnant.

Going back to the beginning of the article about Vitalik’s view: The first law of tokenomics: don’t get your tokenomics advice from people who use the word ‘tokenomics’. In essence, it’s not the people who use the term “tokenomics”, but those who have not found the positive externalities (which is, value creation) of the project and designed a bad tokenomics for the project.

Therefore, it is clearly insufficient to only discuss the incentive mechanism without considering the positive externalities, business logic, and governance structure of a project, as this will likely create hidden risks for the project. By focusing too much on tokenomics, the visible consequences are repeatedly increasing economic risks, from Fcoin to Luna, then to FTX. We cannot estimate the full extent of each crisis’s butterfly effect, but we can do our best to curb the risk at its source. Otherwise, faced with the market fluctuations, everyone will be hesitant and the next dawn in the dark forest may be difficult to come by.

2. Preventing the birth of risks at their source — theoretical innovation.

The token-based economic and financial system is a complex and rapidly evolving open-game system. In a three-body motion, the three main bodies interact and interfere with each other, and their non-linearity, dynamism, and complexity lead to an inability to provide an analytical solution that accurately describes their dynamic trajectory. The general three-body problem is often chaotic, meaning that if the initial conditions of two three-body systems are even slightly different, the dynamic states of the two systems will be significantly different in the subsequent evolution process.

The multi-body game system is far more chaotic and evolving than the three-body problem, so the multi-body system often has stronger dynamism, adaptability, and emergence. This is certainly not a problem that can be solved by “economics” alone, and requires the coexistence of interdisciplinary research to view the system as a whole, in order to achieve the same breadth and depth as a complex non-linear system.

▶️ Therefore, we propose the concept of ‘Token Dynamics’.

Token Dynamics is a discipline that studies the growth pattern of token-based projects as complex dynamic systems. It explores the interactive logic between token business, incentives, and governance, and researches various models that may be involved in the token ecosystem. Token Dynamics describes all factors that affect the value of a token project, including but not limited to its business logic, token incentive mechanism, and community governance approach, etc.

Token Dynamics will also integrate research methods from multiple disciplines to open up a new perspective on the study of token-based economic and financial systems. It will be supported by disciplines such as industrial and systems engineering, artificial intelligence, optimization and control theory, computer science and cryptography, economics and game theory, psychology and decision science, behavioral economics (cognitive psychology), political science and political economy, institutional economics and governance, philosophy, law and ethics, etc., aiming to build a more robust, comprehensive, and systematic theoretical and practical basis.

3. The driving force behind sustained value growth: the self-reinforcing snowball model.

According to token dynamics, the core driving force behind the growth of a token project’s value is its positive externalities. Without it, even the largest snowball will be nothing more than an empty shell that will collapse at the first blow.

Looking back at previous flash-crash projects, we can see that any project without positive externalities will eventually crash. (But this does not mean that all crashes are due to the lack of positive externalities. Any part of the project that is not well managed, including business, incentive, and governance, will eventually crash. It’s just a matter of speed.)

So what is positive externalities? Simply put, we view the project as an independent subsystem. If it provides value to the external system, solves real market problems and pain points, meets the actual needs of the market and therefore gains benefits from the external system, we consider it to have positive externalities.

However, there are countless market demands, and it is difficult to pinpoint real pain points. This requires project teams to sharpen their eyes and carefully explore the value of the business itself, consider whether the market truly needs it, whether the current technology matches it, and whether the entry timing is appropriate — and even plan the ideal implementation path in advance. Many project teams enter the crypto market with good intentions, but do not carefully examine where the real needs of the market are. They think their project has so-called “positive externalities”, so they start to make a big deal about incentives, but end up becoming worse because of the “magnification effect” of tokenomics.

Therefore, exploring positive externalities is the most worthwhile and valuable thing for current token project entrepreneurship, and projects without positive externalities will be nothing but “empty shells”. How to find market pain points and lock in positive externalities? This is a deep and grand topic, and its related theories, methods, and practices exceed the scope of this article. We will discuss this with you in our original series in the future.

In addition to the core driving force, a well-adapted business model, incentive mechanism, and governance system will also greatly reduce the resistance of the “value gear” in the process of moving forward, allowing the “project snowball” to roll quickly and smoothly. The importance of the business and governance is no less than the design of the basic tokenomics (incentive). You may be able to start a project by designing a token incentive mechanism carefully, but without a long-term profitable business model and a stable governance system to optimize the system, your project will soon fall into a “death spiral”.

Token projects are neither sprints nor marathons, they are more like orienteering: to realize the expected goals step-by-step through repeated experiments. The key to their success is the ability to create sustained value and income growth. In other words, “creating value” is the goal or core of token projects, and business, incentives, and governance are the basic elements of a project’s ability to create value, or the three pillars of trust that make up a token project, indispensable.

▶️ For a token project,

· A well-planned business model can avoid the project becoming a “building in the air”. A well-planned business layer can create a new attention black hole, which has positive externalities to ensure that the project can truly take root and grow in the cryptographic world;

· A well-designed incentive mechanism can help the project maximize its future. A well-designed incentive layer can provide a stable supply and demand mechanism for tokens, help the community to actively hold and use tokens, maximize consensus, and amplify the influence of the project;

· A carefully-crafted governance mechanism can continuously optimize and antifragile. A carefully-crafted governance layer can make the project evolve autonomously and sustainably, and a continuously optimized business layer and incentive layer can make the project have stronger “toughness” and adapt to the unpredictable market environment and cross longer market cycles.

Thus, token dynamics believe that projects with positive externalities can grow quickly like “rolling snowballs” under the protection of business, incentives, and governance.

The three elements are indispensable, and they are the necessary conditions for the project’s value to grow smoothly and steadily. “Before deciding to participate, understand the sources of power for the project, and analyze and evaluate the three key elements of the project, which are crucial for both investors and project organizers.”

4. Token dynamics: empty talk or real value?

As we previously discussed, token-based economic and financial systems are a type of dynamic open-game chaotic system that requires interdisciplinary cooperation to address their economic security issues. Therefore, we propose “token dynamics” from a multi-field integration perspective, which allows business, incentive, and governance to have mature disciplines to guide them specifically.

▶️ Robust business logic — optimization and control theory are guiding.

A business logic (or business scenario) is the foundation for a token project’s incentive mechanism and governance. If the business logic is sound, the profit model is promising, and the system mechanisms are reliable, the project is likely to have sustained users and avoid being Ponzi. We need to ensure that the business logic can support the project development throughout its life cycle.

During the operation of the business, parameters and mechanisms of the project’s smart contract need to be carefully designed.

The English auction, also known as the increment auction, has a starting price that is the minimum expected price. The price is called from low to high, and can be bid multiple times. The winner is the one with the highest price before the countdown ends.The Dutch auction, also known as the decrement auction, has a starting price that is the maximum expected price, and the price is called from high to low. The first bidder wins and pays the price called at that time.

For MakerDAO, the English auction rules are simple, and there may be a very high auction price. The Dutch auction can trade instantly, without locking a large amount of funds for a long time. Both auction methods have their own advantages and disadvantages, and different mechanism choices correspond to different project ecosystems, which effectively affect MakerDAO’s final value realization path. In terms of liquidation parameters, there are also key liquidation variables such as step, cut, buf, cusp, tail, etc. How to adjust and adapt to MakerDAO’s value capture is also critical.

As a result, it’s essential to incorporate optimization and control theory. This interdisciplinary field focuses on the iteration and optimization of systems, taking into account learning, cognition, adaptation, social control, emergence, aggregation, communication, efficiency, effectiveness, and connectivity. For projects like MakerDAO, optimization and control theory provides a scientific design and verification method for improving the business logic and analyzing and adjusting internal mechanism parameters. Compared to “brainstorming” decision-making, business plans that are iterated under the guidance of optimization and control theory are theoretically less risky, more robust, and more likely to be accepted by the community.

▶️ Effective incentive mechanism — game theory is guiding.

In addition to reviewing the whitepaper, founding team profile, roadmap, and community development, the incentive mechanism is also a crucial aspect to consider when evaluating the future potential of a token project. Token projects design their token incentive mechanisms to encourage or discourage certain user behaviors, aligning them with their business and governance frameworks. Different users have different goals and expectations, so the same incentive parameters may result in vastly different outcomes for different groups of users. Therefore, it is necessary to find a balance that maximizes the accumulated incentive utility, similar to how a central bank manages monetary policy to regulate the macro economy by encouraging or discouraging spending, lending, saving, and money flow.

Currently, token projects’ incentives still heavily rely on tokens, and game theory has been a key part of the token economy for some time.

For example, Olympus DAO (OHM) is trying to create a global stablecoin asset supported by crypto rather than the US dollar, and uses staking as the primary way to increase the value of its token, OHM, and achieve value storage status. This strategy, known as (3, 3), is inspired by game theory.

In the Olympus system, you can stake, bond, sell, or combine these strategies. The numbers in the chart are just a visual representation of how beneficial each strategy is for the Olympus protocol, with stake being +3, bond being +1, and sell being -1. The (3, 3) represents Olympus’s view that pure staking is the most advantageous strategy for the project, so users using this strategy have the highest returns. Combinations of stake and bond (3, 1) or sell and bond (-1, 1) have overall lower returns.

The use of (3,3) game theory is important. Currently, 91.5% of the OHM supply is pledged — one of the highest numbers among all cryptocurrencies. Game theory is an economic concept that assumes that traders are rational actors who will ultimately make the best choices given certain incentives, such as pledging for high returns or mining Bitcoin. The case of OHM shows us that game theory provides a more scientific and comprehensive methodology for designing incentive mechanisms, bringing system objectives and Nash equilibria closer together. Token dynamics will also explore more applications of game theory and tap into its greater potential when combined with tokens.

▶️ Complete governance plan — institutional economics is guiding.

In many token projects, token holders are able to change the rules of the project through voting. DAOs can change the amount of token rewards given to stakers, or modify the risk parameters in their business logic, through voting.

For example, 1HiveDAO, which is dedicated to the development of public goods, decided to use belief voting to decide whether to distribute HNY tokens to reward contributors who bring value to the community.

Belief voting is a novel decision-making process in which voters support the proposal they want to be approved by staking tokens, constantly expressing their preferences. As time goes on, collective beliefs accumulate until they reach the threshold set by the proposal. When the belief accumulates beyond the threshold, the proposal is passed and funds are released.

It is clear that the setting of governance parameters — thresholds — has a huge impact on the passage of proposals and even determines the development of projects and communities. In the face of complex community networks, communities need better perception and response to the belief voting network in order to make more scientific decisions.

In this case, institutional economics can be applied. It is a branch of economics that focuses on the role of formal or informal institutions, which are sets of rules, norms, procedures, customs, arrangements, or traditions — that guide social and economic interactions and enable individuals’ decisions to be incorporated into organizational decisions. They then allow the system to be coordinated towards a common goal.

This is highly consistent with the governance paradigm of token projects, and it can be said that the introduction of institutional economics is a necessary step in optimizing governance models.

Each discipline demonstrates their unique abilities, providing a more universal and diverse theoretical foundation for token dynamics.

5. The theoretical upgrade is only the first step.

In order to embrace a more healthy, free, and active crypto world, there are still two problems to be addressed：

▶️ First, open source data in the crypto world is not truly “open”.

“Code is law” is a fundamental principle in the crypto world, and project parties often make their running code available on GitHub. However, few people outside of hackers and professional developers take the time and effort to study this code, resulting in a significant information asymmetry and making it difficult for users to trust projects. By using tools to convert code logic into visual models and presenting the macro data as well as patterns generated by code execution in the form of charts and graphs, we can transform “Code is law” into “Model is law”. This would make all projects easily readable, usable, and verifiable by the general public, bringing us closer to a true open source world.

▶️ Second, while project teams typically design token-based economic and financial systems based on scientific guidance, a wealth of market data shows that users’ actual behavior often diverges significantly from expectation.

This is due to a lack of a universal validation framework for evaluating token system design in the market, as well as the high level of uncertainty brought about by the involvement of “people”. Uncertainty cannot be completely eliminated, but it can be minimized through the use of tools to iteratively optimize and narrow the gap between the expected behavior of project teams and the actual behavior of users.

“Token Dynamics” is dedicated to providing a profound theoretical guide for the value growth of cryptographic projects. Only when the public’s cognitive foundation is enhanced can the practical level take a more solid step. To solve the problems of token projects such as “non-transparent” and “high uncertainty,” we need to introduce more reliable methods and tools into the conception, design, development, and deployment stages. We will also continue to introduce relevant concepts such as “Model is law” and “Token Engineering” in subsequent posts, in the hope of contributing to the healthy development of the crypto market.

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