Since the summer of 2020, the DeFi ecosystem has been experimenting with progressive decentralization – that is, the process by which founding teams of token-based startups relinquish control of their networks over time. Of course, crucial to that process is the distribution of tokens. In this piece, we’ll be diving into three of the key trends we are seeing in token distribution, with some actionable guidance for early stage teams.
Until recently in DeFi, token distribution usually occurred through liquidity mining (LM) incentives and public sales. But that convention is changing – and quickly. TVL in DeFi has exploded ~5x over the past year and traditional LM programs have fallen out of favor, largely due to the abundance of capital and many LPs having dumped their token rewards.
Instead of solely bootstrapping initial liquidity, many newer projects have used tokens to acquire long-term community members. With this increasing liquidity, protocols are able to be more selective and better attract long-term stakeholders.
We’ve tracked three key developments in token distribution over the last year:
One notable shift is that token distribution is becoming a more bottoms-up process that actively involves a project’s contributor community. It wasn’t always this way. Early DeFi token distributions – such as MakerDAO’s and Compound’s – were created almost entirely by the initial team. These frameworks were then applied to the network with little opportunity for alteration; the default was to not change anything, although alterations could be proposed through governance.
Beginning in 2018, we started to see hints of token design being more inclusive of a project’s larger community. Early tokens from this era had parameters that could be set by governance; for example, Uniswap contains a fee switch for protocol revenue that can be turned on and set to different percentages through voting processes. This flexibility proved helpful for future growth – for example, Yearn actually minted ~$200m of additional tokens in early 2021. This less rigid design transferred more power to the project's community of long-term stakeholders and governance participants.
This process continued with entire token distribution models voted on by contributors. For example, Gro’s “DAO first” approach was to launch the DAO before the token, which enabled contributors to finalize its design and distribution. Interestingly, despite having the allocation decided by the community, only 1% went to airdrops – far less than many protocols. In other words, this process did not attract speculators looking to distribute tokens to themselves, but rather long-term stakeholders supporting the DAO and protocol. Established protocols also adopted similar approaches, most notably Yearn’s recent tokenomics overhaul, where a Curve-like model was proposed and revised by the community.
This more inclusive and democratic process cultivates a stronger community of stakeholders more aligned with a protocol’s long-term success. It also introduces additional layers of scrutiny and review for token distribution. Over the next year, we expect the responsibility of token distribution and design to partially shift to the community from the founding team; while both will certainly play key roles, project contributors and governance participants will serve as reviewers and a source of new ideas to ensure more sustainable token value accrual. External parties could even be brought into the design process; communities like Fire Eyes or the Token Engineering Commons (TEC) specialize in tokenomics, and could propose designs voted on by DAOs for a bounty. Importantly, this process also gives more responsibility to DAO contributors by allowing them to impact the protocol’s long-term vision. Rather than feeling like passive supporters, they will gain a sense of ownership and fulfillment, further strengthening the community.
In the past year, a number of novel auction mechanisms were used to assist with price discovery and make for a more equitable distribution of tokens. Many tokens in the ICO wave of 2017-2018 were famously scooped up by large whales able to manipulate prices given weak secondary market liquidity. This severely hurt a few parties, notably contributors paid in a project’s native token and long-term investors – groups that should ideally be rewarded the most.
In light of the chaos of that ICO era, a few new types of auctions have emerged in the last year. Liquidity Bootstrapping Pools (LBPs) auction tokens over a set period of time according to demand; the price is initially set to decrease at a given rate, but if the token sees high demand, the price increases. LBPs aim to capture each investor’s willingness to pay and prevent whales from scooping up large quantities of the token, as doing so would cause the price to skyrocket. (Tokens can also only be purchased in small amounts). However, LBPs also make it difficult to attract a wide base of stakeholders since inexperienced investors are less willing to underwrite complicated price risk over the time period.
Tokemak’s “Degenesis” sought to correct this shortcoming by having all investors pay the same price at the auction’s conclusion. The event set an initial price range to be decided over a period of days. Investors could withdraw their funds if they felt the price became too high, and the tokens weren’t distributed until a final price was determined at the end of the event, where everyone paid the same price. There was no “guessing” for price movements, encouraging a broader base of investors to participate. However, the event may have raised less funds than a potential LBP since some investors may have been willing to purchase tokens at a higher price.
More recently, Locke Protocol introduced streaming auctions to distribute tokens. This mechanism distributes tokens to stakers over a set period with participants able to move in or out of the auction as the price moves. When there is a net inflow of staked tokens, the price increases, and when there is a net outflow, the price decreases. The ability to move in and out with price changes makes for a friendlier UX for less experienced participants and prevents whales from taking large quantities of the tokens since the price would jump.
Unlike traditional ICOs, these more innovative mechanisms can be used for greater price stability through more equitable initial token distributions. They cleverly utilize programmability – a feature not available for TradFi products – to distribute tokens in ways that make it difficult for speculative whales to pump and dump the token, and, at the same time, provide a better experience for smaller participants.
Over the next year, we expect these auctions and new mechanisms to become the standard for initial token distributions in DeFi. Using the more bottoms-up process detailed above, teams can propose auctions to the community through forum discussions and customize the model to meet the different goals of individual protocols.
In the last year, many protocols have experimented with lockups that changed the secondary market structure for their native tokens by decreasing circulating supply. The purpose of these lockups is to force participants to align themselves with a protocol’s long-term success (or at least until the lockup ends).
OlympusDAO pioneered the concept of protocol owned liquidity (POL) through a bonding mechanism. Users would deposit stables or blue chips and receive OHM at a discount a few days later – a mechanism like discounted zero-coupon bonds, so not analogous to locking but quite similar. Olympus also famously offered seemingly impossibly high APYs to incentive holders to stake their tokens, reducing circulating supply. Then, OHM in pairs with assets from bonding would be deposited in liquidity pools on leading DEXs, allowing the protocol to “own its liquidity.” The model became so popular that it saw the second largest number of forks (after Uniswap) at about 109 protocols. While the mechanism performed quite well during bull runs, it also proved somewhat disastrous in poor market conditions when investors were unwilling to accept price and market risk over the bonding period. Token prices crashed as OHM was unstaked and sold; the model’s popularity declined quickly.
Released in mid-2020, Curve introduced voting escrow (ve) contracts, and ve tokenomics have become one of the most popular frameworks in DeFi. The model allows CRV holders to lock their tokens for various periods of time, with longer lockups receiving higher reward boosts (multiples). veCRV holders also vote on gauge weights that determine CRV emissions to Curve’s LPs, leading to the “Curve Wars” where other protocols “bribe” veCRV holders to direct reward emissions to their pools. Many other protocols are adopting ve tokenomics, including major projects like Ribbon and Balancer. While young, the model seems to be limiting volatility.
Other lockup mechanisms became more common over the past year. Gro introduced token vesting schedules for emissions, where holders could increase their GRO rewards by lengthening the vesting period. Lockups can also be applied to initial distributions. For example, some airdrops, such as a recent announcement from Mars Protocol, introduced lockups to prevent recipients from immediately dumping the token; these distributions are sometimes explicitly called “lockdrops.”
Opinions on lockups are mixed. Supporters argue that they lower short-term volatility and reward long-term holders, while discouraging speculative, high frequency traders from claiming large portions of rewards. Conversely, critics believe that retail users – unwilling to accept lockups due to financial constraints and less experience underwriting market risk – avoid investing and interacting with the protocol; they can sometimes place artificial upward pressure on the price in bull runs with large drawdowns from exits in bear markets. Nevertheless, projects can still consider lockups broadly so long as they also understand the specific drawbacks and limitations of the model they’re implementing, particularly the types of people that are attracted to or deterred from participating.
The purpose of this article is not to provide “copy & paste” models for token distribution, but instead to provide a high-level overview of the experimental frontier of the space. The growing popularity of ve tokenomics, Olympus-style PCA bonding, and other mechanisms has led to a highly standardized landscape. As the field becomes more homogenous, it seems to have broadly turned into a yield competition, with projects introducing more and more inflationary rewards. This trend is not sustainable.
Instead, early-stage projects can consider bottoms-up token design, new auction mechanisms, and lockups as a means of cultivating a community of long-term stakeholders through token distribution. Broadly speaking, innovation in token design has lagged the larger ecosystem; the emphasis for researchers has been on scaling, smart contract optimization, and other more technical topics, with token design seeming like a bit of an afterthought. But founders are becoming increasingly aware of its importance and are pouring substantial resources into designing their tokens. 2022 will be a fascinating year across the crypto ecosystem, and we’ll be eagerly watching as innovations in token distribution continue to evolve.
If you’ve been experimenting with any of the above, have ideas on what we’ve missed, or just want to chat about token distribution, don’t hesitate to reach out.