Category: Tokenomics 101

Tokenomics 101: The Principles of Tokenomics

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Ray Dalio, Principles

Tokenomics describe the relationship between a token’s use and its price. Done right, tokenomics can align the interests of protocol participants, leading to a valuable token, and securing the protocol from economic exploits.

Designing a protocol requires keeping track of many moving parts – to this end, it is helpful to have a framework.

Enter demand-side tokenomics.

The demand-side tokenomics framework can be distilled in three principles: utility, value capture, and economic security.

There are tradeoffs between each of them, so the goal of tokenomics, according to the framework is to maximize the aggregate of these three.

Utility

Utility is the usefulness of a protocol to all participants.

There can be multiple groups of participants in a protocol. To maximize utility, these groups’ interests should be synchronized.

This can be done by matching demands of each group.

For example, MakerDAO matches the wider market’s demand for stablecoins with degens’ demand for leverage.

Value Capture

The second principle of tokenomics is value capture.

Many protocols create value – utility, but fail to capture any of the created value to a token.

For example, Uniswap has $1.2 trillion in all-time trade volume, but UNI sees none of it. Uniswap has never charged, and plans never to distribute fees.

Use of the Uniswap protocol is completely uncorrelated with the value of its token.

Because they didn’t capture value initially, Uniswap can’t capture value from the utility it creates.

Value capture comes from the strategic inclusion of tokenomic mechanisms – ways a token is used in a protocol.

Value captured through tokenomic mechanisms (e.g. staking, collateralization, buyback-and-burn) varies.

Value captured by a protocol can be modeled, and mechanisms compared based on value capture and economic security.

Economic Security

Economic security is the third principle of tokenomics.

Economic security is distinct from technical security – technical security comes from an absence of bugs in the code; economic security entails a lack of vulnerabilities in the incentives.

Vulnerabilities in the incentives enabled three major exploits in 2022 – the collapse of Terra, the Mango Markets exploit, and the Aave liquidity exploit were all economic, rather than technical security issues.

Conclusion

There are tradeoffs between each of these principle, and successful protocols maximize the aggregate of the three.

Tokenomics is challenging to get right, especially because of the associated technical complexity of writing smart contracts.

It’s helpful to have a framework when designing the tokenomics of your protocol.

The demand-side tokenomics framework is what Eat Sleep Crypto uses to teach tokenomics to developers in the Tokenomics For Founders 6-week intensive course.

Space is limited, so apply now to be a part of the next cohort.

Tokenomics 101: Tokenomic Levers

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Tokenomic levers are features of a protocol which capture value.

The degree to which a tokenomic lever affects value capture is called tokenomic leverage.

The three types of tokenomic levers act on corresponding components of the equation of exchange.

  • Supply levers capture value by decreasing circulating supply.
  • Demand levers increase demand for tokens, raising PQ, Total Purchase Amount in the equation of exchange.
  • Velocity levers capture value by decreasing a token’s velocity.
    • Velocity levers are only hypothetical. Discerning coins based on velocity (e.g. coin age) would destroy a their fungibility, one of the key properties of money.

Tokenomic levers’ effects on value capture are proportional to their input.

Supply-side tokenomic levers

Supply-side tokenomic levers are one of two types. They decrease circulating supply of a token, which increases its value according to the cryptocurency valuation framework.

Examples

A cryptocurrency’s utility value or price floor is proportional to its use as a medium of exchange. The total value of all circulating coins, called monetary base, M is solved for in the equation of exchange.

All else equal, less coins circulating makes each one more valuable.

Tokenomic mechanisms which decrease circulating supply in this way include:

  • Burns
  • Collateralization
  • Staking
  • Lockups

Demand-side tokenomic levers

Demand levers, or mechanisms are another type.

Demand levers increase demand for a token, reflected as an increase in PQ, Total Purchase Amount in the equation of exchange.

Examples

Cryptocurrencies capture value through use as a medium of exchange.

Other kinds of tokens capture value differently.

Examples of demand levers include:

  • Fees
  • Collateral
  • Dividends

Velocity Levers

Velocity levers must be hard coded into the protocol, which affects user experience, but limited examples exist.

Velocity levers can be justifiably imposed when gas costs are a concern – e.g. implementing a bi-weekly “paycheck” in a protocol where payments are accrued, in order to distribute tokens, rather than forcing users to pay for their own withdrawals.

A slowing of velocity can be measured in other components of the equation of exchange.

For example, a coin age scheme which incentivizes holders of a token to hold funds for longer periods of time will tend to split their coins between “old” and “new,” increasing the velocity of “new” coins and taking the “old” coins out of circulating supply. [[Valuation Methods; Determining Coin Age]] schemes are one example of tokenomic mechanisms which affect velocity.

Tokenomics 101: Tokenomic Leverage

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“Give me a lever long enough, and a place to stand, and I will move the Earth.” – Archimedes

In the physical world, mechanical leverage multiplies the force of a given input. Similarly, tokenomic leverage multiplies value capture by affecting supply and demand.

Currency-like tokens capture value when used as a medium of exchange.

Adding leverage through tokenomic mechanisms in a protocol increases supply and/or demand pressure for a token, specific to the type of mechanism in use, by increasing the value exchanged through that token.

For example, staking decreases circulating supply by the amount staked; fee increases for an application increase the demand for the token used to pay fees.

Illustrating Tokenomic Leverage

first-class lever

Tokenomic leverage mirrors mechanical leverage. Using the analogy of a first-class lever, we can say that:

  • Value being exchanged in a mechanism is the force applied to end of the lever.
  • Value captured is the output of force from on the other end.
  • Tokenomic leverage is the ratio of the distances of each force from the fulcrum.

Tokenomic leverage example

The ratio of value captured to value created or transferred is called tokenomic leverage.

Higher tokenomic leverage in a mechanism or protocol overall is analogous to higher profit margins in a traditional business.

Tokenomic mechanisms further up the hierarchy of value capture have higher leverage. And it’s possible to have a tokenomic leverage greater than 1 – indicating more value is being captured than created.

Synthetix’s tokenomics are an example of high tokenomic leverage.

Users of Synthetix can create sAssets – synthetic TradFi assets collateralized by several times their dollar value in SNX tokens.

Synthetix governance decides this collateralization requirement, but it generally stays between 300% and 500%.

This means that SNX will necessarily be worth 3-5 times the value of all necessary sAssets.

So the tokenomic leverage of this mechanism in the protocol is between 3 and 5, depending on the current collateral requirement.

This is only possible because the protocol has a monopoly; higher tokenomic leverage requires extreme defensibility.

Synthetix’s collateralization mechanism introduces economic security issues only mitigated by active management of the c-ratio, and heavy inflation. As a result, Synthetix has begun to pivot its design toward other tokenomic mechanisms with lower value capture, illustrating tradeoffs between the principles of tokenomics.

Conclusion

Archimedes’s assertion – that simple mechanical leverage at scale was sufficient to move the Earth – was a bold and groundbreaking claim.

Tokenomic leverage is just as powerful, yet it’s highly underappreciated. It’s a key component of value capture – one of the three principles of tokenomics.

Even those with a deep understanding of tokenomics miss opportunities to apply leverage to their token. Others go But adding leverage to a token is one of the simplest, yet most effective ways to increase its price floor.

If you or a project you support is in need of tweaks to its design to increase leverage and maximize its value, reach out to us for a free consult.

Tokenomics 101: Value Capture

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In a talk at Stanford, Peter Thiel called value capture the “most important, yet least understood” aspect of business.

Value is captured by a business by taking profit. Value captured is the percentage of a product’s total value taken as profit.

In his book Zero to One, Thiel describes the problem of inadequate value capture.

Examples of inadequate value capture include a business selling widgets valued at $10 for $5 (undercharging), or another business selling a widget for $10 which costs them $5.

A business may have inadequate value capture because either it doesn’t charge enough, or costs incurred are too great a percentage of revenue.

In both cases, less value is captured than is created, and at a certain point, inadequate value capture leaves a business economically unviable.

Similarly, inadequate tokenomic value capture allows price to stagnate with adoption and leaves a blockchain vulnerable to economic exploits.

Value capture in tokenomics

Tokens and cryptocurrencies miss opportunities to capture value when they are either not used in ways that raise their price floors, or used in insufficient quantities.

Cryptocurrencies primarily derive value proportional to their use as a medium of exchange (see How to Value Cryptocurrency).

So, a currency that is used to pay fees in a protocol is valuable proportional to the value of fees paid. If such a currency is only used for fees, it is only as valuable as the total amount paid in fees.

Inadequate tokenomic value capture becomes a security problem when a blockchain’s native asset (e.g. Ethereum’s ETH) is used exclusively for paying fees when that chain is securing other valuable assets.

For more on blockchains’ economic security:

Valuing cryptocurrencies is much different than valuing companies, but the concept is the same – inadequate value capture dampens the value proposition of a business; ditto for a token or cryptocurrency.

Why value capture matters

Without adequate value capture, cryptocurrencies and tokens are vulnerable to massive price crashes, and if the tokenomics of a blockchain’s native asset is not considered by developers of token protocols, those protocols may incentivize economic exploits through perverse incentives.

When a token’s value capture and other tokenomic components are properly considered, a token’s price increases steadily with its use in applications, and it strengthens the blockchain network on which it’s built.

If you or a project you know need help designing a protocol or would like input on your project’s tokenomics, reach out to us for a free consult.

Tokenomics 101: What Are Tokenomics?

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Tokenomics describe how a token’s use affects its price.

Good tokenomics increase a cryptocurrency or token’s price and prevent bad actors from destroying or weakening a network.

Poor tokenomics leave tokens and blockchain networks vulnerable to economic exploits which arise from a lower-than-possible price of a token, disappointing users and investors.

When considering tokenomics, incentives are everything.

Charlie Munger is Warren Buffett’s business partner.

Munger also famously said in regards to management practices: “show me the incentives, and I will show you the outcome.”

What you incentivize is what will happen – even more so for blockchains.

In management, incentives are malleable. In decentralized protocols, changing analogous incentives requires a complete overhaul. Changing tokenomics requires consensus to avoid fracturing network effects.

Token economists design protocols to be maximally secure, and maximize token value by applying tokenomic leverage and value capture according to the principles of tokenomics.

Many projects leave tokenomics to chance, relying on speculation to create price support. This leaves them vulnerable and all but ensures 95% drawdowns, and subsequent abandonment by users.

Good tokenomics give cryptocurrencies and tokens a price floor – a price at which they can’t sustainably trade below.

For more on price floors, follow Eat Sleep Crypto on Twitter, and stay tuned for the release of Cryptocurrency Price Floors.