What is Tokenomics? Ultimate Investor's Guide - Part 2
What is Tokenomics?
In the first part, of “What is Tokenomics” we made significant headway into understanding what tokenomics is and how it works. Towards the end, we had explained how the underlying blockchain or the layer-1 protocol deals with its tokenomics. So, in this part, we are going to look deep into the tokenomics of the layer 2 protocol aka the applications built on top of the layer 1.
Tokenomics design goals of Layer 2 applications
The developers of the project will need to have a source of funding to get their projects up and running. The way they do that is by holding a public sale (ICO, STO, IEO). During this sale, the interested investors can buy the native tokens of the application and give the developers funding in the form of the layer-1 token (mostly). Accomplishing these goals means answering several relevant questions.
- How does the application carry out its ICO responsibly?
- How are the early adopters getting rewarded?
- Who are application creators responsible for?
For a public sale to be deemed a success, the tokens should be widely distributed among the ecosystem. Since the main aim to make a decentralized environment, a wide token distribution is extremely desirable. The way they can make it happen is:
- Make sure that the tokens are distributed widely and don’t end up belonging to few whales. Whales are wealthy crypto investors who tend to hoard up vast amounts of tokens.
- Crypto whales often pay a premium gas fee to put themselves in front of the line. The ICO must find a way to work around that.
To promote a state of token flow in the ecosystem, people are rewarded for actions which increase the engagement within the project. To do so, the following must happen:
- The team behind the project have to be paid for their time, talents, and commitment to the ecosystem.
- Having said that, there should be certain constraints so that they don’t just cash out the tokens straightaway. To do so, there must be a “waiting period” before they can convert the tokens to cash.
- Early adopters in the ecosystem must be rewarded for their faith with some reward system.
How should an ICO be designed?
So, we know that a lot of things need to be considered to understand how an ICO should be designed. With that in mind, let’s look at some general ICO design principles:
- A reasonable enough funding must be acquired during the ICO. The company must specify a cap which will help in funding the company and paying the salaries of its employees.
- Early adopters get the first bite of the ICO pie.
As you may have probably guessed, it is critical for the success of an ICO that the valuation of their tokens goes up. This is important because of several reasons:
- Increases the credibility of the company and brings more eyeballs to the product.
- Rewards the investors with profits.
- Brings in more investors into the ecosystem. These investors are usually of two types. The ones who suffer from FOMO and want to get their hands on the tokens. The others are the more experienced traders who buy the tokens after careful technical and fundamental analysis.
Now, this brings us to the next section.
What makes up a token’s value?
So, how does a token get its value? Well, there are two parts to it. A token’s value is made up of its:
- Intrinsic value: The value that the token gains from the credibility and utility of its project.
- Speculative value: The value that the token gains from speculative traders who expect its price to fluctuate in the near future.
Speculative investors are a valuable part of any ecosystem. However, it is hazardous for a token to be priced purely on its speculative value. For real sustenance, a token needs to be heavily dependant on its intrinsic value. So, how does a token gets its intrinsic value? The intrinsic value is created by the underlying project and how much percentage of this value is captured by the token.
This is one of the primary functions of tokenomics or “token economics.” William Mougayar came up with the term and he also came up with the three tenets behind a token’s value.
According to Mougayar, there are three tenets to token value and they are:
These three are locked up in a triangle and they look like this:
Each token role has its own set of features and purpose which are detailed in the following table:
Let’s examine each of the roles that a token can take up:
By taking possession of a particular token, the holder gets a certain amount of rights within the ecosystem. Eg. By having DAO coins in your possession, you could have had voting rights inside the DAO to decide which projects get funding and which don’t.
The tokens create an internal economic system within the confines of the project itself. This helps the buyers and sellers to trade value within the ecosystem. This creation and maintenance of individual, internal economies are one of the most critical tasks of tokens.
It can also act as a toll gateway for you to use certain functionalities of a particular system. Eg. in Golem, you need to have GNT (golem tokens) to gain access to the benefits of the Golem supercomputer.
The token can also enable the holders to enrich the user experience inside the confines of the particular environment. Eg. In Brave (a web browser), holders of BAT (tokens used in Brave) will get the rights to enrich the customer experience by using their tokens to add advertisements or other attention based services on the Brave platform.
Can be used as a store of value which can be used to conduct transactions both inside and outside the given ecosystem.
Helps in the equitable distribution of profits or other related financial benefits among investors in a particular project.
So, how does this all help in token valuation? A token must fulfill more than one of these properties to become more valuable. More properties that a token can have, higher its valuation
Alright, so now we know what a token is, how a company distributes token and where a token can gain value from.
Single Token vs. Double Token
The next hurdle that you will need to consider to understand a project’s token system is whether they are opting for a single token model or a dual token model. When you are researching the project, really ask yourself if the token(s) and the goal of the project are in alignment. Does it make sense for the project to have more than one tokens?
More often than not, Occam’s Razor comes true. Occam’s Razor means that the simplest solution to a problem is most often the correct one. In this context, a simple single-token structure will perfectly suit a project to a T.
So, this begs the question, why are startups looking into dual-token models? Simply put, compliance issues. Over the last couple of years, ICOs have, in general, come under a lot of scrutiny from regulatory bodies. Prior to this, there was no proper distinction between security and utility tokens. Now, several projects have started offering two tokens, one security token is sold to an accredited investor and the second token is a utility token sold to a user/customer.
Three models are used to create dual token offerings (content for this part has been taken from this article):
RATE : Real Agreement for Tokens and Equity
In this model, the company issues two tokens, one as equity compliant with securities laws and the second token is offered to the investors as a bonus.
DATE: Debt Agreement for Tokens and Equity
This model will allow for a convertible note (bond) or straight debt token with the utility token as a perk.
This model uses both a security and a utility token. The security token is first offered through a crowdsale to accredited investors. The utility token is distributed after the crowdsale in the form of a property dividend to investors. The utility tokens are generated per the number of security tokens issued.
Examples of single token and dual token systems
Single Token – ethereum
Ethereum plans on becoming a decentralized supercomputer for developers around the world. Anyone can build their decentralized applications on top of the blockchain. Ethereum’s consensus model is currently proof-of-work, however, they are going to be moving onto the proof-of-stake consensus model utilizing the Casper protocol. Ethereum’s token is ether and this token is used to power up the entire ecosystem.
Dual Token – Neo
Neo has often been called China’s Ethereum. Neo emphasizes scalability and hence uses a delegated byzantine fault tolerance consensus model. The Neo ecosystem has two tokens: NEO – formerly known as Antshares (ANS) and GAS – formerly known as Antcoins (ANC).
There is a total of 100 million NEO tokens.
Ownership of the NEO gives the holder rights to manage and make decisions for the network. These rights include bookkeeping, NEO network parameter changes, etc.
The NEO token can’t be subdivided into decimals with the least possible unit being 1.
If NEO is the token that gives you voting and decision making rights in the community, then GAS is what fuels smart contracts and get things done. It is, as the name states, the fuel of the network. GAS is what will be exchanged as currency inside the ecosystem and it is what is going to incentivize the various projects taking place in it economically.
Quite like NEO, it has a total limit of 100 million tokens, however, unlike NEO it is divisible. The minimum unit of GAS is 0.00000001.
There is another major point of difference between the two.
The 100 million NEOs have already been generated in the genesis block, i.e. the first block of the blockchain, of the NEO network. The 100 million GAS has not yet been generated. They will be generated corresponding to the 100 million NEO via a decay algorithm in about 22 years time to the address holding the NEO. If the NEO is transferred to a new address, the GAS generated will be credited to the new address.
Two million blocks will be generated each year with a downtime of around 15-20 seconds between consecutive blocks. The initial GAS generation is going to be 8 GAS per block and that is going to reduce by 1 GAS per year or 1 GAS per two million blocks till only 1 GAS is produced per block. At the 44 millionth block, the total GAS generated will reach 100 million after which there will be no GAS generation.
According to the algorithm:
- 16% of the GAS will be created in the first year.
- 52% will be created in the first four years.
- 80% of GAS will be created in the first 12 years.
The GAS tokens are released proportionally in accordance with the NEO holding ratio to the corresponding addresses. The NEO holders can claim these GAS tokens anytime they want.
Triple Token – Steem
There are also triple-token models out there. Steem, a blockchain-based blogging and social media website, actually utilizes a triple token system.
Steem has three cryptocurrencies:
- Steem Power.
- Steem Dollars.
STEEM: STEEM is the primary cryptocurrency of the Steemit network. STEEM can be exchanged for Bitcoin, Ethereum and other cryptocurrencies in several exchanges. If you want to have some say in the governance of the ecosystem and cast votes, you will need to convert your STEEM into Steem Power tokens. This method is called “powering up.” You can also convert your STEEM into Steem Dollars.
Steem Power (SP): The Steem Power tokens act as equity within the network. As we have said above, you can turn your STEEM tokens into SP. One unit of STEEM, vested as SP, equates to one vote. More SP tokens you have, more your influence in the ecosystem will be:
- The upvotes and downvotes, or “flags,” from users holding large amounts of SP are worth more than users with less SP. Because of these factors, the users with the most SP have the greatest influence over which content gets elevated to the top.
- 90% of new STEEM that is created goes to users who hold a lot of SP. This adds another layer to the system’s tokenomics, where the participants have a real incentive to hold to their tokens. The process of converting SP back into STEEM is called “powering down.”
Steem Dollars: These are the stablecoins in the ecosystem which are valued 1:1 with the US dollars. They are a unit used to represent a short-term debt. According to Steem’s whitepaper, holding Steem Dollars is a way of lending the community the value of one US dollar, which is designed to foster growth.
The next thing that must be integrated into a solid tokenomics model is a stabilizing mechanism. Like we have said before, most ICOs tend to reward their early investors with some bonuses. However, in many cases, this bonus gets out of control. This is also true for ICOs where whales have hoarded the majority of the tokens. In cases like these, there can be scenarios where a single investor can have too much influence on the price stability of an entire ecosystem!
To avoid scenarios like these, a strong monetary policy is needed.
The central bank utilizes three methods to achieve currency stability:
- Changing the money supply by buying or selling government bonds and foreign currencies.
- Changing credit policy towards other banks.
- Changing the reserve ratio for banks.
Changing the money supply seems like a pretty attractive option. However, how does that work?
For that, let’s take a look into Economics 101.
Supply and Demand
The idea of supply and demand is pretty simple to understand:
- More the supply and less the demand for a product, the lower will be its price.
- Lesser the supply and more the demand, the higher will be the price of a product.
The sweet spot where both the curves intersect is the equilibrium. The pricing of an asset can often depend on simple supply and demand manipulation. So, having said that, how does that factor into tokenomics?
Turns out, many projects utilize an inflation and deflation mechanism to doctor the supply and demand of their asset.
- Many projects increase their overall supply by injecting new tokens into the ecosystem. Eg. EOS has an annual 5% inflation rate where the new tokens are used to reward their block producers and increase token flow within the ecosystem.
- On the other hand, many projects utilize a token burn function to remove coins from their ecosystem permanently. Binance famously uses the token burn function to keep their token supply under check. In fact, let’s take a brief look into what Binance does to understand their model.
Binance Coin Token Burning
Binance performs periodic Coin Burn events through the use of a smart contract function known as “burn function.” There will be a total of 200 million BNB (Binance coin) tokens which will be ever issued. The burning will happen every quarter until 100,000,000 BNB are finally destroyed.
The amount of BNB coins to be burned is based on the number of trades performed on the exchange within a three-month period. So after each quarter, Binance burns BNB according to the overall trading volume.
How Does Burning Work?
Token burning happens according to the following order:
- A coin holder will call the burn function, stating that they want to burn a certain amount of BNB.
- The contract will then check if the users have more than the stated number of coins they want to burn in their wallet.
- If they don’t have the required number of BNB, the burn function doesn’t execute.
- If they do have enough, then the coins will be subtracted from that wallet. The total supply of that coin will then be updated, and the coins will be burned.
- Once the coins have been burnt, they will be destroyed forever and will never be recovered.
NOTE: Burning a cryptocurrency is not a guarantee that the value of the remaining tokens will increase. Just because there are less in circulation does not mean that potential buyers will be willing to pay more for those that still exist.
Token distribution and velocity
We have touched on the topic of token distribution here. However, let’s look into the matter a little more in this section. The articles we have for our research have been both written by Kyle Samani and can be found here
Like we have said before, a successful decentralized model needs to have a wide distribution of tokens within the ecosystem. The last thing they want is a higher concentration of wealth among certain members. The concentration of wealth in a given ecosystem can be quantified using the Gini coefficient. The higher the Gini coefficient, the more concentrated the wealth.
When compared to FIAT currencies, the Gini coefficient is significantly higher in cryptocurrencies since the number of investors is less.
The graph above shows the amount of each cryptocurrency held by the top 500 wallets. The interesting thing is that the more established cryptocurrencies like BTC, BCH, ETH, and LTC have far less Gini coeffecient than their peers. The reason for this could be two-fold:
- The established cryptocurrencies are all comparatively older. So, the early holders may have slowly sold their holdings over time.
- BTC, BCH, ETH, and LTC all use proof of work (POW) consensus mechanism. Since POW is expensive to maintain, the miners will have to sell their block rewards to pay for system maintenance.
Nowadays, a lot of cryptos are preferring to the proof-of-stake mechanism which doesn’t require hardware maintenance and encourages validators to hold a stake within the system. Now, this has its benefits which we will discuss in the token velocity section, however, it leads to higher concentrations of wealth and a higher Gini coefficient. The layer-2 tokens are also mostly POS, so they don’t require their validators to sell off their tokens for maintenance either.
So, what can be done to enable higher distribution? Well, let’s look at some attempts at token distribution that have already been made.
Previous Attempts At Token Distribution
#1 Crowd Sales
ICOs are the most commonly used distribution mechanisms. While they were helpful in the beginning, they haven’t really been that effective. Let’s take a look at the infamous BAT ICO.
The BAT ICO raised a staggering $35 million…..in 30 seconds. Just think about that for a second. The amount of time we took to write this paragraph was enough for BAT to raise their required capital.
One buyer paid $4.7 million worth of Ether to buy the tokens. Another user paid $6000 worth of mining fees to virtually guarantee their spot at the top of the pile. Only 130 people purchased the tokens with five people buying half of the supply. You can look at the pie chart here to see the token distribution:
Obviously, this clearly means that the BAT tokens are not exactly decentralized and evenly distributed…to put it very mildly.
Airdrops are a process by which a company distributes its tokens to the wallets of specific users, completely free of charge. Layer 2 tokens can be airdropped to users in proportionate to their existing holdings of the layer 1 tokens. As we have seen with the Gini coefficient graphs well-established layer 1 blockchains like EOS, Ethereum, etc. are relatively well distributed. Companies can take advantage of that distribution by airdropping their tokens to the holders of the parent blockchain token.
#3 Merkle Mining
Livepeer (LPT) is an open protocol that facilitates permissionless, decentralized video transcoding. The Livepeer network went live in May of 2018 and utilizes a method called Merkle mining.
As per Kyle Samani:
“Merkle mining is similar to mining, but instead of running hashes to find a hash value that’s below some threshold, Merkle mining requires Merkle miners to generate Merkle proofs demonstrating that a specific ethereum address was in the set of accounts that had at least X ETH at some block height.”
Merkle proof computation is deterministic and can be calculated ahead of time and doesn’t need intensive calculations like POS. Merkle mining forces Merkle miners to incur ETH-denominated costs because the Merkle miners must pay for gas on the Ethereum network to store the proofs.
The advantages of this method are:
- Doesn’t have an ICO’s regulatory constraints.
- It is permissionless, global, and can be executed anywhere.
- Doesn’t need special hardware like POW or a huge amount of initial capital like POS.
This is the other side of the argument we have been having so far.
Till now, we have told you the importance of creating token flows and establishing a wide distribution network. But, a multi-layered and robust tokenomics model needs to address different sides of the equation. In the case of tokens, they need to consider token velocity.
Most of the tokens out there in the market as simple “medium-of-exchange” tokens, i.e., they don’t have any utility outside of being a simple payment token. As such, these tokens change hands and get transacted very frequently. In other words, they have high velocity.
If you were to define Token Velocity in strictly mathematical terms, then it would look like this:
Token Velocity = Total Transactional Volume / Average Network Value.
If we were to flip the formula then:
Average Network Value = Total Transactional Volume / Token Velocity.
Now, that leads to two conclusions:
- More the token velocity, less the average network value.
- More the transactional volume, more the token velocity.
How to Reduce Token Velocity?
A project can use one of the following methods to reduce the velocity of their tokens:
- Profit-share model: The users of a particular network may be rewarded with its native token for performing some work for them. For example, the Augur ($REP) network pays REP holders for performing work for the network. So, why does a profit-share model work in reducing velocity?
Since the tokens are generated from the profits made, if the value of tokens is low, the profit made will be low and vice-versa.
- Proof-of-Stake Protocol: In a proof-of-stake (POS) protocol, users are supposed to lock up some of their tokens as a stake to gain governance rights in the ecosystem. As the tokens are locked up, it will be impossible to spend them. This dramatically reduces the velocity of the tokens.
- Token Burning: We have already explained how token burning works above. The way burning helps with velocity is that since the supply of the tokens will decrease, the holders will think twice about spending them frivolously.
- Gamification: Gamification can encourage users to hold on to their tokens for various perks. Eg. The native tokens of YouNow are called PROPS. The idea is that users can tip content creators with PROPS. The creators then have the choice to sell them off or hold onto them. Holding on to the tokens will improve the ranking of the content created and make the creators more discoverable.
- Store of value: This is extremely rare and only the most prominent of cryptocurrencies have managed to become a real store of value. There are two kinds of tokens which have the potential of being true store-of-value:
Firstly, projects with strong fundamentals and robust token design. The value of these tokens will appreciate with time. Bitcoin is an excellent example of store-of-value token which will appreciate with time.
Secondly, we have stablecoins. Dai, for example, is a stablecoin. Users can convert their crypto holdings/profits to Dai and keep the price stable regardless of market behavior.
In both these cases, users have the incentive to hold on to their tokens instead of just selling them off.
So, there you have it. Our two-part mega-crash course on ” What is Tokenomics ? ” is over. This subject is so vast that we are sure we must have missed out on some elements. However, whatever we have covered thus far should be enough to clear your basics. We hope that the lessons you have learned in these guides will inspire you to create tokens with solid tokenomics fundamentals which are going to bring more value into the ecosystem.
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