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Guide: How to Design Web3 Tokenomics

tokenomics

Almost all of the crypto-assets currently being launched by web3 companies have poor tokenomics design. This is the first in a series of blog posts that will attempt to share insights on best practices in tokenomics design and where the future is headed. This series of blog posts should be useful to Web3 entrepreneurs as well as investors looking to better understand what they are investing in. A proper understanding of tokenomics is one of the most critical aspects needed for analyzing the financial value and sustainability of crypto-assets.

Evaluation of assets can be decomposed into 1) supply management and 2) incentive-boosting demand. While most of the topics in this blog post can be found elsewhere, the topic of network effects applied to crypto-assets has not been overly discussed and may come as new critical information to most in how to design or assess tokenomics. Additional blog posts will be published directed at Web3 ventures in order to design their tokenomics using the latest best practices. Let’s first do a review of the micro-economics of supply and demand and its effect on prices.

Micro-Economics of Supply & Demand

Many factors come into play when markets adjust the price of an asset. When it comes to the crypto-industry, prices of assets are adjusted by two mechanisms, typically speaking, which are through a bounding curve (often used by Decentralized Exchanges (DEX) such as Uniswap) and through order books (the standard for Centralized Exchanges (CEX) such as Binance).

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In both of these cases, the balance between selling volume and buying volume causes the price to shift downward or upward, respectively. More precisely, buying volume reduces the available supply of an asset available on an exchange, resulting in a lower ratio of token A versus token B, such that now token A is more expensive compared to token B. Therefore, increasing the demand for an asset reduces its supply from an exchange and results in a price increase. Meanwhile, a reduction in demand (selling volume) does the opposite by increasing the supply available on the exchange and consequently reducing its price.

law of supply & demand              bounding curve

[Figure 1: Supply and Demand]                                   [Figure 2. Bounding Curve]

Note that the value of capital is obtained by multiplying the quantity of an asset by its price. Further, should we assess the value by comparing it to US currency or comparing it to other assets? I would argue that in some cases comparing to US currency may not be the most logical. For example, as a crypto trader, I often lose value of my assets when compared to US currency, but the quantity of tokens I have often increases while the market is going down, and therefore, when the market goes back to its original price, my total capital has increased significantly, so the loss is only temporary and somewhat fictional. In which case I sometimes prefer to assess the value of my assets and return on investment (ROI) in terms of the quantity of tokens (for example, how many Ethereum I have while trading).

Regardless, it becomes critical for successful crypto ventures to properly incentivize demand while reducing supply in a sustainable manner.

Minting, Burning, and Fixed Supply Mechanisms

The first two mechanisms to manipulate the supply of a token economy are to encode a burning mechanism that will reduce the supply of a token over time in order to increase scarcity. This method is believed to incentivize a long term increase in the value of a project, and while in theory it is true, it is often done in a way that has no short term effect on the price because market participants evaluate the value emotionally without quantitative assessment.

Minting is the opposite process of burning tokens; this is often used to slowly release additional tokens into the supply and is primarily used to incentivize adoption (demand). Ideally, the minting process can be significant in the early life of a project until a reversal occurs and the burning mechanism starts to become greater, which is the case for Ethereum at the moment[1]. Some projects, such as Bitcoin, have a fixed supply (no minting and no burning).

However, not all Bitcoins are currently on the market, and in this case, new tokens are obtained through the process of mining to support the network’s operations. Fortunately, the release of these mined tokens is slow and hopefully inferior to the adoption rate of the network, leading to price appreciation. Regardless of the fixed supply, minting, and burning mechanisms of a project, it is important to attempt to understand the future action of these mechanisms on the supply. Many projects reward users with free tokens for their involvement in a project, and while this creates an incentive for adoption, it has to be done in a way that prevents a significant increase in supply that would reverse the financial incentive of existing users to remain part of the community.

Overall, minting to incentivize users during phases of large adoption is acceptable as it slows down excessive price appreciation; however, it is not sustainable when a network reaches a plateau and starts decreasing in value.

Staking

Staking is the process of locking tokens on a platform for a certain amount of time in order to receive additional financial rewards. Since the tokens are then locked, the participants are unable to sell their tokens in the event of a rapid downturn, which slows down the selling pressure. Since the staking process offers additional financial incentives, the demand for the token also increases; therefore, it is usually a good way to increase demand while reducing supply.

Unfortunately, many projects offer these rewards out of the token supply and, as such, just push problems down the road, making the projects unsustainable. Ideally, one would have to make investments with the liquidities that have been locked into staking, and if these investments generate additional revenues, a portion of these revenues is then used to provide the financial reward to the stakers. Unfortunately, very few projects manage their staking this way, and staking then becomes a financial loss.

Bank-Run Risk & Pre-Minted Token Allocation

In a process called “pre-mined token allocation,” the vast majority of crypto ventures allocate some of their token supply to early investors and to their team, their foundation, and their advisors before even the token gets launched on an exchange. The tokens allocated can eventually make their way to the exchanges, which will result in selling volume.

Considering the money raised from these private investors has often been used to develop the project, this implies the money is no longer available when investors sell their tokens, in which case, if the project has not generated outside revenue, it’s almost like a ponzi scheme where new investors money is used to pay returns to earlier investors without real value creation. Regardless, the price of the asset on a DEX is entirely calculated from the ratio of the tokens in the pair, such that only a small fraction of the token supply is kept in the liquidity pool on the DEX (even worse if the token is traded on multiple DEX and CEX). The liquidity pool (essentially similar to a bank) is composed of a portion of the token’s supply and usually a portion of stablecoin such as USDT. More often than not, the liquidity available on the DEX is lower than what was previously allocated to the early investors, team, etc. Overall, this implies that a “bank run” is very much a possibility.

A bank run is when too many people withdraw their money from the bank while the bank doesn’t have enough liquidity on hand to give to everyone requesting their withdrawals. In the case of crypto, if there is not enough liquidity available in the bank (liquidity pool), the ratio of tokens to stablecoins can become exponentially costly, resulting in a massive drop in price. What is important to note here is that liquidity on any exchange is typically much smaller than the overall amount of tokens in circulation, so bank runs frequently result in tokens losing more than 90% of their value. Fortunately, the bounding curve mechanism prevents the token supply from reaching 0, which would be a complete collapse of the token price; instead, the ratio becomes exponentially small, resulting in massive price swings.

Given that liquidity is often small, the mathematical result of the bounding curve is that a $1 of buying volume often leads to value creation for the entire pool of investors being much greater than $1, hence the value is entirely fictitious and only possible as long as most investors do not sell their assets.

Projects typically request vesting periods for those pre-allocated tokens; however, the vesting is often short, such as 1 or 2 years. This means a massive increase in supply of the token will enter circulation in the first few years of the project, and this is a lot of potential selling volume. What’s worse is that often the project vesting occurs at a specific time point instead of having daily vesting, and as such, investors receive a large amount of tokens to sell at the same time as other investors instead of spreading the vesting.

Given this potential selling volume, adoption consequently needs to be massive in order to have more buying volume than selling volume, and this is where the problem is: more crypto-assets become pure pump and dump, unable to sustain the selling pressure within the first few years. It becomes very risky to invest in such projects in their early stages after their initial launch on the market. Lots of projects end up just spending insane amounts of money on marketing and publicity, which boost buying volume but most often have no effect on real value creation for the ecosystem.

Overall, when evaluating crypto-assets, it is critical to look at the fully diluted market capitalization (FDMC) versus the market capitalization in circulation (MCIC) (FDMC minus MCIC = unallocated supply). As well as the vesting period of pre-allocated tokens and the distribution strategy of the remaining unallocated token supply. If the total market capitalization in circulation is, let’s say, $1B USD, but the sum of all liquidity available on exchanges (both CEX and DEX) is only $100M, this means if everyone withdraws their money, the price could collapse to the point that most investors would suffer significant financial losses (a “bank run scenario).

Therefore, there needs to be an incentive for users to remain part of the economy when adoption starts plateauing or worse, decreasing.

Network Effects for Crypto-Assets

Network Effects have been identified as one of the best mechanisms for maintaining competitive advantages for businesses. For example, Facebook benefited from massive network effects as it reached critical mass adoption. Typically, network effects are when the added benefit of adding an additional user increases the value for all participants exponentially. For example, 4 users in a network effect have more value together than 2 groups of 2 users taken separately. In the case of Facebook, if someone has 100 friends, then the cost of transitioning to Google Plus and starting with only 2 friends would be a significant reason to remain on the Facebook platform, because it becomes impossible to transition all users at once, and people want to remain connected. The more friends you have, the more benefit and inertia you associate with the platform.

When it comes to crypto-assets, the network effect is associated with financial value; the more new users join, the more wealth is accrued and reflected in the price of the asset. This network effect creates an incredible fear of missing out, as being early in a project can lead to a 1000%+ return on your investment often within just a few months. Unfortunately, in the case of Facebook, when users start moving to other platforms, there is no financial loss to the remaining participants, which is not the case for crypto-assets.

Instead, the loss of participants leads to a loss of financial wealth for the remaining participants, which can lead to negative network effects. Negative network effects are when there is a significant incentive to abandon a crypto asset before it starts collapsing. Overall, this often ends up being called a pump (positive network effect) followed by a dump (negative network effect).

To this day, we have seen very few cases of crypto-assets that have built-in network effects to incentivize participants to remain in the economy during a collapse. Which is one important reason why crypto-assets are known to often lose more than 90% of their value during a market downturn.

Speculators versus Real Users

For any crypto project, the community is composed of both real users and speculators. More often than not, successful crypto projects can have massive growth due to speculators buying the tokens only for the wealth generation potential. Compared to any other industry, the crypto industry is mostly driven by speculators’ behaviors. For example, metaverse projects such as Decentraland have less than 100 players on any given day, yet have a market cap of more than $1 billion USD, which has been accrued mostly by speculators.

Meanwhile, real successful games can often have more than 100 million players daily and have a lower market cap than Decentraland. All of these insane metrics show how the economy of crypto-assets can be driven by speculators. At the same time, this is a real danger for crypto-projects given that at any time these speculators may choose to sell their tokens, triggering a negative network effect for real users. Reaching a plateau of adoption is often enough to trigger these speculators to move on to the next project, resulting in a price collapse. Unlike real users, speculators have no loyalty to a project and will simply follow the financial incentive, which makes the negative network effect so impactful in a period of collapse.

Revenue Model… not just Tokenomics

The crypto-industry was built on pure tokenomics alone, and unlike publicly listed companies on the stock market, which typically generate revenues for their products and services, crypto ventures often generate no revenues at all. This is a massive problem for sustainability because it implies that once mass adoption for a crypto project starts to saturate, then it becomes very hard to maintain the price, and even considering the burning mechanism, the financial incentives become oriented more toward selling than remaining a holder.

While this will raise eyebrows in the crypto-community, Bitcoin’s value is entirely dependent on scarcity and market adoption. If adoption disappears, the financial incentive to remain part of the network vanishes regardless if there is scarcity or not. Sure, some collectors may want to buy their own Bitcoin as a collector’s item in the future if there is a total collapse, but the whole point of Bitcoin was to be a digital currency, and it is now used more as a long-term store of value. Overall, these philosophical debates may have worked in the past and made Bitcoin the king of crypto, but in 2023, tokenomics alone is no longer enough.

The future of crypto-assets has to be built on real revenue-generation potential that grows alongside real users, not speculators. There are an increasing number of web3 ventures now incorporating revenue streams supporting their tokenomics, and it needs to become the majority for real sustainability. For examples of revenue models integrated into tokenomics, you may look into a DEX called GMX, where a portion of revenue generated by the exchange is used to financially sustain demand for their token.

Unsustainable Growth

Too many times in the past, successful crypto projects grew at breakneck speed. In some cases, it even went past 10,000% in a year. This implies that early adopters with an investment of $1,000 were rewarded with more than $100,000 a year later, making a lot of overnight millionaires.

Unfortunately, this creates fear of missing out (FOMO) and also becomes financially unsustainable when early participants start selling their tokens, since the liquidity pool (bank) did not grow at 10,000% for the reasons described above. This means the likelihood of a bank run increases, and the negative network effect becomes larger. All of which makes pump and dumps inevitable and leaves late-entry participants in ruins. Overall, this leads to high volatility, which prevents real utility and long-term user adoption for the industry.

Meanwhile, more than $180 trillion (180 times the current size of the crypto market) is held by businesses across the world in traditional banking. Very little of this money will transition to crypto as long as the volatility remains what it is, since these businesses cannot afford to see their treasury shrink by 30% or more in a given month when they need to pay their employees, suppliers, etc. So, what makes the crypto-industry great also makes it impossible to grow much further unless new mechanisms are introduced to support and sustain long-lasting lower volatility tokenomics. Long-term, sustained growth is more important than overnight success.

Conclusion

We explained the various forces and tokenomics principles mediating price movements for crypto-assets; however, the industry is still in its early stages, and additional mechanisms need to be introduced to enhance the long-term sustainability of crypto-assets as well as attract new participants, such as businesses. In the next blog post, we will theorize such new potential mechanisms to help web3 builders design better economies for themselves and their communities.

[1] https://bit.ly/3ZzKFbR

Written by: Patrick Poirier

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