Laundry list of Tokenomics
0x8f7A
April 26th, 2022

This is an effort to collect information for my own learning and references about economics around a token. It covers various good examples to provide better understanding of a token. This article is for web3 people looking to design a token and liquidity pools.

In recent years, "Tokenomics" has become a popular phrase to explain the logic and incentives that control crypto assets. It comprises all aspects of the asset's operation, as well as any psychological or behavioral factors that may have an impact on its long-term worth.

This is a laundry list of things to know about a token. Let’s start with the basic terminologies on what exactly supply and demand actually means.

Supply

When there are fewer tokens available, the value of a token rises—this is known as deflation. Inflation is the loss of value of a token as more of them are produced.

Think about the supply alone, and how it will evolve over time, rather than the utility or profits it will bring to the holders.

Questions to ponder include:

  • How many of these tokens are now in circulation?
  • How many will there ever be?
  • What is the rate at which new ones are released?

Allocation is the last thing you want to think about when it comes to supply. Do a few investors own a large number of the tokens that will be freed soon? Is it true that the protocol distributed the majority of its tokens to the community? How equitable does the distribution appear to be? You might be hesitant to get in if a group of investors owns 25% of the supply and the tokens will be released in a month.

Demand

ROI: The return on investment is not determined by how much you believe the token price will rise. It's the amount of revenue or cash flow the token can earn for you merely by holding it through staking, rebasing, and other methods. It's crucial to think about ROI because if a token doesn't have any intrinsic value or cash flows, it's difficult to justify owning it.

Game Theory: Consider what extra components in the tokenomics design might assist enhance token demand, as suggested by Game Theory. Lockups, on the other hand, are a popular variant of good tokenomic game theory. The protocol incentivizes you to lock your tokens in a contract, usually through higher incentives. Curve is a great example of this.

Meme: The assumption that other people want the token and will want it in the future is another reason people could want it. How is the atmosphere in their Discord? What is their Twitter activity like? Do individuals consider this token or protocol to be a part of their persona? How long have members of the community been involved?

Evaluating Convex finance (CVX)

Convex has a set maximum supply of 100 million coins, which will be released at a decreasing pace over time based on CRV deposits. According to Coingecko, 78.5 million of the 100 million have already been generated, implying that the current supply will increase by 33%.

The great bulk of the tokens will be distributed to Convex users. As a result, this is a very equitable token distribution, with just a little portion remaining for the team and investors. Consider what would happen if Amazon handed away 75% of its merchandise to Amazon customers.

Curve token distribution
Curve token distribution

To assess demand, consider why you would hold the CVX coin.

You earn a piece of Convex Finance's revenue if you possess the CVX token. That's not a lot of money, but it earns around 4% right now. However, it isn't all. You can also lock your CVX tokens for up to 16 weeks at a time, earning bonus incentives from a variety of protocols that seek to reward Convex stakers.

The APR is still only 5% here, but that doesn't include any bonus rewards you may receive from other platforms. Furthermore, you can use the Votium service to delegate your Convex to other voters in exchange for "bribes."

As a result, Convex has a fixed supply that is largely distributed to the community. The majority of the tokens have already been distributed, and there won't be much further inflation. Holding CVX is rewarded substantially through protocol fees and other token-holder perks, so there's less incentive to sell if the price drops.This in my opinion, is one of the good tokenomics model.

Monetary policy

Cryptocurrencies, like fiat currencies like the dollar, have monetary rules that govern specific features of the token, such as supply, inflation, and so on. This can be used as a technique to raise, lower, or keep the price stable. The supply schedule for tokens might be either fixed or flexible.

Bitcoin is an example of a cryptocurrency with a predetermined supply. Currently, 6.25 new bitcoins are mined per block, and this will continue until the maximum quantity of Bitcoin is achieved, at which point block rewards will be halved every four years.

Ethereum is an example of a token with a variable monetary policy, which means it can be modified at any time. Block rewards on Ethereum began with 5 ETH each block and have since seen two revisions. This has reduced block rewards to 2 ETH, creating a supply schedule similar to Bitcoin's, in which block rewards have fallen over time, effectively lowering the inflation rate - see graph below.

BTC inflation vs time
BTC inflation vs time
ETH issuance rate
ETH issuance rate

Token Distributions

When it comes to launching a token, a team has two options: a fair launch or a pre-mine. A fair launch is one in which everyone has an equal opportunity to acquire a token. A pre-mine is a token launch in which the token's supply is partially or completely created. Before going on sale to the general public, it is first dispersed to a mix of founders, private investors, development treasuries, and others with access.

Bitcoin is an example of a fair launch because everyone who wanted to obtain Bitcoin had to follow the same steps. To get BTC, everyone had to mine.

When establishing a coin and the ecosystem surrounding it, for example, there are costs to be paid, such as labor and other development overhead. It is reasonable to assume that the development team will require funding to fund future development.

Token distribution
Token distribution

UNI allocation as an example

With a four-year vesting period, 60 percent of UNI is distributed to the general public and 40 percent to the team and private investors. 15 percent of the UNI supply was immediately available for claim by anyone using the platform, trading, or providing liquidity at the introduction of UNI in September 2020. Liquidity providers received 49,000 UNI, or 4.9 percent of the total UNI, with the awards favored for those that participated early on the platform when liquidity was low. A total of 10% of total UNI was distributed evenly across all 251,500 historical user addresses, with an airdrop of 400 UNI available to claim.

The governance treasury holds 43% of UNI, which will be released into the community over time through grants, community initiatives, liquidity mining, and other programs. After four years, 2% of UNI per year will be utilized to keep the platform's participation and contribution going. In essence, they will allocate funding to activities that encourage user growth. This can be extremely beneficial to a platform that implements it since, if done right, it can lead to long-term growth, which is critical for tokenomics.

UNI allocation
UNI allocation

Framework to analyze a token

We should be asking these questions when we are analyzing any new tokens.

Reason to exist

  • Why is a token required for this protocol?
  • Is it useful as a source of information?
  • Is there a return for the holders?
  • Is it for the farm and the dump?
  • Exit liquidity for insiders?
  • What part of the ecosystem does the token play?

Reasons to hold

  • Why should anyone hold this?
  • Who are the target buyers?
  • Will they buy and hold more tokens or is it purely reliant on hype and narrative?
  • If inflationary, as most tokens are, are there good reasons for stakers and LPs to hold rewards?

Supply dynamics

  • What is the supply schedule of the token and what does it imply for selling pressure?
  • What creates and removes supply?
  • Who has most of it?
  • When are they likely to sell?
  • When do they *have* to sell (e.g. VC fund unlocks)?

Value accrual mechanisms

  • How does the token benefit when the protocol benefits?
  • How do the various interactions within the protocol impact the price (buying/selling/minting/burning) of a token?

Let’s consider few examples

Perp Protocol V1: Perp V1 is a derivatives exchange. People trade on their platform, half of the trading fees go into a pool which is then paid out to stakers. Protocol value capture and token value capture.

Luna: The Terra blockchain's native token is LUNA. Burning 1 LUNA will produce UST, a stablecoin. When there is a higher demand for UST, more LUNA is burned, reducing the supply and raising the price.

CVX: CVX is an excellent example of tokenomics, since it employs game theory, supply curve management, and revenue sharing while also being built on top of a protocol with a strong economic moat (Curve = best-in-class stablecoin DEX). When CVX reaches its maximum supply of 100 million coins, each CVX will represent more CRV, which means more incentives and, as a result, more revenue split with investors.

Investor’s perspective

It is always good to get investors point of view about a token. This helps in stabilizing the token value.

Market cap and FDV

A crypto asset's market cap is calculated by multiplying its price by the number of coins/tokens in circulation. Another valuation indicator is FDV, which stands for "fully diluted valuation." The FDV is the price multiplied by the total number of coins/tokens ever created (for that asset). The market capitalization is either less than or equal to the FDV.

Market cap = measure of demand, FDV = measure of supply. FDV increases 1:1 with market cap

Scenario

Consider a scenario in which a project holds a fundraising round in January, raising $2.5 million at a $50 million valuation for private investors. Private investors can purchase tokens for $0.01 each, but their tokens will be frozen for a year. In March, the token's market cap is $5 million.

The airdrop, however, was only for 1% of the overall supplies. The market cap is $5 million, and the FDV is $5 million multiplied by 100 to equal $500 million (because the $5 million market cap equals 1% of the total). The price of a token is now $0.10. Seed investors have made a tenfold profit.

Imagine more hype if FAANG announced a merger, or if youtubers picked up on the news. The amount of public money willing to be allocated to this coin has increased 20-fold from $5 million to $100 million. Because team and seed tokens are held for a year, no fresh currencies have been unlocked. The market capitalization has risen to $100 million. The cost is $2. The FDV is now $10 billion, and seed investors have made a 200-fold profit.

Seed investors with locked tokens are willing to sell for much to $5 billion, netting them a 100-fold return. That means they'll be happy sellers even if their tokens are released at a 75 percent discount from present pricing.

Token unlock

Locked tokens, on the other hand, can have their own active market. Professional and sophisticated investors trade locked coins with the assurances of trust and legal enforcement. Essentially, they acquire or sell locked coins at a lower price than the market price and enter into contractual agreements with their counterparty to send the coins as they become unlocked. During this OTC sale, the locks on these locked coins are sometimes extended (particularly if the team is the seller).

This is similar to what happened with Solana, where SOL SAFTs were sold at a discount of 66-80% in the run-up to the unlock in December 2020. If there is no OTC market and no demand for the locked coins, the only option for locked investors to benefit is to dump them into AMMs or on Binance when they get unlocked, which can be a bit of a chicken game among seed investors.

Is the unlock bullish ?

To assess "how well is this project?" Active users, TVL, and product-market fit are all good proxies. If a cryptocurrency attracts institutional interest, it's likely that funds have attempted to purchase any locked tokens that exist. Long-term investors also have more complex valuation models, so consider them to be more like "smart money."

Unlock schedules

Bitcoin presently has a market capitalization of $970 billion dollars and a fully diluted valuation of roughly $1.07 billion dollars. However, as part of the ever-decreasing block reward, this additional $100 billion will be unlocked over the following 100 years.

BTC unlock over time
BTC unlock over time

Projects that generated funds through private fundraising and distributed tokens to investors with locked vesting may have a different supply schedule as show below. In this case, the coin supply begins above 0 (maybe through a public auction or an airdrop), and insider tokens are unlocked in significant chunks every year. The most typical vesting schedules seen for team or investor tokens in crypto are of the format X years locked, Y years unlocking linearly, where 0.5<x<1 and 1<y<3.

RIDE unlock over time
RIDE unlock over time

Science behind token liquidity

Liquidity pools are collections of crypto tokens locked in smart contracts. The liquidity pools help in carrying out trades between assets on a decentralized exchange, with the assurance of liquidity.

Ways to incentivize native token liquidity

Pool 2s are decentralized liquidity pools for a project's native token, they exist on decentralized exchanges (DEXs) and are artificially bootstrapped by rewarding liquidity providers (LPs) with the native token for which they offer liquidity.

Pool 2's APY could be used as the primary marketing tool to draw attention to a project's protocol. Pool 2s are poor marketing tools because they attract liquidity that exists only to farm incentives. Almost every historical pool 2 had a 50%+ reduction in liquidity just 30 days after the incentives ended.

This is a delicate balance because LPs are effectively shorting big price moves and are only encouraged to LP if they believe the token will trade within a certain range. If they predict the token price to rise soon, it becomes more profitable to stop LPing and keep the token. On the other hand, if they expect the token price to fall, they will rush to sell. If a token is newer, price discovery could be dramatic in either direction, highlighting the concept of impermanent loss. The primary problem with pool 2s is determining the proper cost and paying for the right quantity of liquidity.

Here are three suggestions if a project decides that pool 2 is the best way for them:

  • To allow for re-configuration and empirical testing, run shorter programs (30–90 days) (Interesting case studies to look into include PancakeSwap, 1inch and CREAM.)
  • Experiment with strategies like lower APYs (<100%), vested block rewards and non-transferable tokens to ensure alignment with long-term participants. (Aside from Aave's pool 2, Ribbon Finance experimented with withdrawal fees, non-transferable tokens, and capped TVL for their early liquidity pool.)
  • To avoid overpaying for liquidity, set a liquidity cap target:

Finding a liquidity cap target is as simple as determining the smallest permissible trade size for larger investors and ensuring the pool has sufficient liquidity to support it within a 2 % slippage range.

Liquid cap target
Liquid cap target

One way to think about a liquidity cap target is to consider liquidity depth in relation to market capitalization.Determine which market cap category the project belongs to and use the lower bound of the nominal trade sizes as a guideline.Calculate how much liquidity is required to facilitate those trade sizes for various levels of slippage using this equation/spreadsheet.

Liquidity depth
Liquidity depth

Example: I'm the founder of a $50 million project with a low-mid market cap. At most, I'd like to let large investors to trade 0.1% to 0.3% of my protocol at a 2% slippage rate. This leads to trade volumes ranging from $50,000 to $150,000 (50m * 0.1% and 50m * 0.3%). According to the spreadsheet's logic, a $5 million pool (50/50 weight) can accommodate $50k trade sizes with 2% slippage. This means I don't need more than $5 million in my pool to accommodate huge investors, and I just need $2.5 million in my own token and $2.5 million in USDC/ETH in the pool.

Power of uneven pools

The biggest advantage is that uneven pools has less impermanent loss. Because the risk of impermanent loss has decreased, LPs are more ready to offer liquidity in exchange for lower yields. This lowers the amount that a protocol must reward in terms of cost.

Impermanent loss vs Relative price
Impermanent loss vs Relative price

While unevenly weighted pools are more LP-friendly, it comes with a tradeoff. The main drawback is that a higher TVL is required to achieve the same slippage environments. As seen in the graph below, 50/50 pools are the most efficient in terms of slippage.

Slippage
Slippage

Uneven incur in more slippage, thus resulting in less trading volume and APR. Uneven pools affect token upside as the project evolves since the pool requires more stablecoins/ETH to increase the price (relative to a 50/50 pool).

Leveraging idle treasury for liquidity

To provide double-sided liquidity, established projects should consider fronting all or a portion of their original liquidity using their treasury and converting a piece of it to ETH/USDC. This has a slew of advantages, including:

  • Allowing the project to make more money through trading fees.
  • The ability to have more control over liquidity and isn't exclusively determined by the APR.
  • If the price of a token declines, an automatic "buy back" mechanism will be activated.
  • Increasing the treasury's diversification (with other pairs like ETH/USDC)

One caution is that projects are subject to the possibility of being lost. Here are some creative ways protocols can use a pool 2 to achieve a hybrid strategy:

  • Employ idle treasury to provide 50-80% of their liquidity needs, then use protocol tokens to incentivize further liquidity if needed.
  • Use treasury to provide liquidity and trading fees to entice more LPs to join.
  • For the first 6 months to a year, use the idle long-term treasury to supply liquidity while conducting short tests with liquidity incentives.
  • Alternatively, simply remove a liquidity cap objective and front liquidity with the idle treasury without incentivizing any further LPs.

Pool research

Nansen's research looked at all token transfers from 400 farms and discovered that 36.4% of farmers left within the first five days of entering, while just 13% of all addresses are still farming today.

Analyzing a dozen previous pool 2s also reveals that while most incentivized pools experienced transient liquidity boosts, most of those liquidity levels plummeted by more than half after 30 days of the awards ending. Badger's pool 2, which was launched at the peak of the bull market, is one (of many) examples.

Liquidity pool on badger
Liquidity pool on badger

Governance

Protocols adopt the ve token model. ve stands for vote escrowed. Let’s look at how Curve implements ve token model.

Escrowed: Users can pick how long they want their tokens to be locked up for (e.g. CRV). Early unstaking is impossible. Tokens are unlocked in a linear fashion over the time period chosen. Users can keep their tokens locked indefinitely to maximize their voting privileges and benefits.

Vote: Users earn a quantity of ve tokens (e.g. veCRV) proportional to their lockup period. Because ve tokens are used for governance, community members who lock their tokens for a longer period of time have more clout. The same is typically true when it comes to rewards. Locking CRV for a maximum of 4 years, for example, gives users a 2.5x bump in LP rewards.

To summarize, stakers lock their tokens for a set length of time and gain proportional voting (and reward) rights.

Benefits of ve token

Stakeholders' long-term commitment is demonstrated via locking. In exchange for voting rights and benefits, they are willing to make their stake illiquid (opportunity cost). Because dedicated members have more clout in decision-making, this should strengthen governance. These individuals of the community are more useful to a protocol than others, and as a result, they are rewarded more.

Downside of ve token

Lower-than-expected incentive alignment

Building a community of bag-holders: The lockup can be used in either way. While removing tokens from circulation reduces sell pressure, it also makes the token less appealing to buy. Will I truly buy it if I have to lock it up for four years to get the most out of it? In a volatile environment like bitcoin, the opportunity costs are enormous. Liquid wrappers, on the other hand, deal with this problem by tokenizing locked stakes. However, as previously stated, this reduces long-term alignment. There is also the problem of the tokenized position becoming disconnected from the underlying ve token. The major pool is the "tokenized ve token / ve token" pair, and exit liquidity is frequently poor.

Governance halt: Stakeholders who have lost motivation desire to leave but are unable to do so. They have been locked. They still have ve tokens, which they use to vote on governance. It's unlikely that they'll be interested in any governance decisions that aren't focused on short-term profit. This makes governance difficult at a time when it is most needed, and it may even bring it to a standstill.

Summarizing ve token

It's challenging to find long-term dedicated stakeholders and contributions. While a rigid lock-in ensures people's financial commitment, it may not be the ideal strategy to encourage behavioral commitment. Protocols should conduct more testing, particularly with soft lock-ins like as time-based tokenomics. Of course, these token dynamics can be designed to promote long-term sustainability or to accelerate the ponzi, as is always the case. It's beneficial to look at the design space and trade-offs as a builder or researcher to arrive to your own conclusions. Remember that tokenomics is only one piece of the equation when it comes to long-term community retention.

Conclusion

There are multiple factors which affect a token value. Creating a token is simple but adding value to the token and stabilizing its price is a huge task. There is no one equation which fits all for tokenomics. It hugely depends on the demand for the token and how organic the adoption for the token is established. Providing a well oiled liquidity pool becomes the core strength for a token’s success. How well the system is gamified also helps in a cold start problem and results in organic growth.

References

Arweave TX
rJ-8dnywxifyHYxJXjUvTVSnEmWffYPxxsfJjagqb4s
Ethereum Address
0x8f7A8e158186e14b335A26a4E9422735b5afE6c7
Content Digest
qADne8Ryea2CeQb6W0cvBzuICfmNj3YyJFIvm-WTYSM