Original article: "To achieve both short-term returns and long-term development, token design should be based on basic principles"

Author: Dust Technology

In the past two years, many protocols have established token economic models. In order to get investors to put their money in, many project parties who are only interested in making money have designed economic models that consider short-term returns more and sacrifice long-term sustainability.

But we all know that we won’t survive until the next wave of cryptocurrencies. The winter season is a good time for builders to calm down and carefully design well-founded tokens that can provide sustainable results for the next generation of protocols.

In today’s content, we provide a new perspective for builders, starting with the two basic design principles that we believe protocol tokens should follow.

Token economics should coordinate public benefits that are difficult for participants to provide effectively and economically on their own. Token economics should direct value to those who create value, prioritizing the distribution of value to high-utility groups rather than value transfer between participants.

Similar to the "liquidity mining" framework, these design principles are based on the fundamental idea of ​​rational and value-maximizing economic exchange. There is no free lunch in the world, and short-term gimmicks often come at the expense of lasting value. Both the project owners and us participants should look for designs that clearly create and distribute fundamental value, and be skeptical of those that do not.

The Importance of Good Economic Models

The term “token economics” is both vague and fascinating. It is an all-encompassing term that includes all of the following design categories:

Initial supply and allocation to the team, investors, community, and other stakeholders Allocation methods including token purchases, airdrops, grants, and partnerships Revenue distribution between users, service providers, and the protocol Fund size, structure, and intended use Issuance schedule including inflation, minting/burning rights, and supply cap Token governance including voting, custody, stake weighting, vesting, and metrics Miner and validator compensation such as fees, penalties, etc. Use of protocol native tokens vs. external tokens (e.g., ETH, USDC)

In this article, we will consider “token economics” to be the allocation of incentives based on tokens. Rather than focusing on individual and operational issues, we will focus on defining first principles. Based on these principles, protocol designers can answer each question based on the most pressing tradeoffs and concerns for their specific product.

Principle 1: Providing public benefit

The first core principle of a strong token economics model is the ability to provide public benefits. A good design should solve collective action problems, organizing and incentivizing participants to collectively provide services that cannot be generated by individual actions.

Without a reward system, no participant would be willing to stake the network. But with a reward system, this decision changes. Participants stake for individually rational reasons, but collectively they provide benefits that everyone can enjoy.

The public interest in crypto is motivated by the same principles as taxpayer-funded goods and services such as public transportation, national defense, or public schools. In both cases, a well-designed public interest typically has the following properties:

Positive Net Utility: Total benefits to the entire community exceed total costs. Unprivatizable: Providing the good is uneconomical for individuals due to direct and coordination costs. Principle 2: Align Rewards with Value Creation

The second core principle of a sound token model is the ability to compensate individuals based on the value created (and destroyed). In other words, a good design creates clear and significant connections between actions and rewards, thereby maximizing incentives to create value.

At a high level, compensation (and punishment) for any participant in the system can theoretically be divided into two components: consistent (what they gain by providing value) and inconsistent (anything else). For example, slashing a dishonest validator would be consistent because the cost is associated with a change in value (a loss, in this case). In contrast, giving a random validator a high token bonus would be inconsistent because there is no value to justify that reward.

While this is simple in theory, it is much more complicated in practice. First, any interaction within the system is often shared by multiple parties, and attribution is not always measurable. Second, the rewards for many key actions are far away (e.g., allocating community grants, building long-term partnerships, etc.), making it difficult to establish clear incentives up front. Nonetheless, we believe this is a key principle that protocol builders should strive to achieve.

Furthermore, there is a close connection between consistent compensation and long-term value maximization. When protocol designers make a choice between optimizing short-term target metrics and long-term utility, two trends emerge in practice:

“Aligned” health: Aligned compensation incentivizes risk- or cost-bearing commitments and other forms of long-term investment. In contrast, inconsistent compensation incentivizes employed capital, which tends to preserve maximum exit freedom. For example, “farm-dumping” (i.e., selling reward tokens immediately) demonstrates asymmetric liquidity mining. “Distorted” costly: Design mechanisms that do not adjust compensation often destroy long-term value, especially when interacting with feedback loops. For example, artificially giving NFT collectible holders higher rewards can induce speculative behavior, followed by a brutal reversal once the rewards are exhausted — which can destroy the perceived value of the collectible.

 

Evaluate the current design

So far, we have defined our principles in the abstract, but how do we apply them to real-world examples? We examine a range of common and specific token economics designs.

Gas Fee:

Gas fees perfectly embody our two principles. Follow me as I imagine a blockchain without gas fees. In this case, it costs nothing for participants to submit low-quality transactions (pure spam in the extreme case), which crowd out high-quality and high-priority transactions. At the same time, miners and validators are not rewarded for the computational effort of processing transactions.

So, as we would expect, gas costs are critical. Evaluate this against our core principles:

Public Good: Gas fees protect the system from low-quality or resource-intensive transactions, which would otherwise make the blockchain slow or unusable for high-quality transactions. Additionally, fees act as a coordination mechanism that allows participants to coordinate on relative transaction priority by default.

Value Alignment: Compensation is consistent because fees are paid directly by participants who impose computational costs on the system, in addition to miners who provide the necessary computing power for the operation of the blockchain.

Fees can be distributed and optimized in a variety of ways. For example, Ethereum's EIP-1559 reduces deadweight loss by introducing a base/priority system that allows users to compete for relative priority within a block while minimizing the impact on the price of the lowest priority transaction. Ethereum has historically had high and variable gas fees, which complicates user decision making. However, all reasonable variations of the gas system achieve the key goals of providing public benefit and aligning rewards with value creation.

Validator Staking

In a proof-of-stake system, validator staking (and slashing) is another classic example of good token economics design. As before, imagine a blockchain with no staking. In this case, validators are not penalized for compromising the security of the chain. With security weakened, users won’t use the network — and the blockchain becomes useless.

Therefore, staking is equally important and can be analyzed based on two core principles:

Public Good: Staking provides security to the chain, making it available to the community. Without such a mechanism, private actors would not be incentivized to provide security, as the costs are immediate and the benefits are dispersed. Additionally, staking is a coordination mechanism for the network to agree on the relative importance of validators. Value Alignment: As mentioned above, compensation for good actors is aligned. Additionally, incompetent or malicious validators lose their stake to the rest of the community as a penalty for weakening security.

Delegated staking has the same properties. For example, a user staking Solana on a centralized exchange still contributes to the security of the chain because the exchange still has an incentive to direct its tokens to high-quality validators who will preserve capital.

While staking remains an effective mechanism, there is room for improvement. In particular, staking is often done entirely in the native token on the chain. In extreme cases, a drop in token price will lead to a reduction in security, which in turn will cause token price to drop further. In this case, staking will not be able to provide a public benefit and properly adjust value.

(3,3) and unrestricted pledge

Gas fees and validator staking successfully align value between the two parties, reward good behavior, and impose costs on unproductive or malicious behavior. In contrast, many of the non-restricted staking rewards currently offered by DeFi protocols require neither direct value from users nor any form of behavioral commitment from them. The most prominent example is OlympusDAO (and its many imitators), which introduces a "rebase" every 8 hours to issue more OHM tokens to staked OHM tokens (sOHM). While technically locked, sOHM can be unlocked at any time by giving up rewards for a single rebase value, making it effectively "OHM with an interest rate."

Olympus rose to fame in late 2021 with staggering APYs (sometimes exceeding 8,000%), attracting nearly $5 billion in capital investment at its peak. The surge and fall in the price of its tokens — from $200 to $1,300 to $17 — is astonishing even for cryptocurrencies. Are these dynamics just the inevitable result of a speculative environment?

Maybe, but we propose an alternative hypothesis: the staking mechanism does not focus sufficiently on public interest and value alignment. Instead, the mechanism focuses on value transfer from non-stakeholders to stakeholders. Let's see how it performs in terms of design principles:

Public Benefit: Minimal. Arguably, this form of staking creates two public benefits — liquidity and marketing — but at levels that are too high and unsustainable. On the liquidity side, staking contributes to “protocol-owned liquidity,” which allows the protocol to earn fees by providing liquidity to AMM pools. However, the need for this public resource is questionable, as users can provide liquidity directly to the pools. On the marketing side, high rewards attract a lot of attention, which is valuable to a certain extent because attention translates into continued activity that increases the long-term value of the protocol. However, the protocol’s high rewards crowd out all other initiatives, making it harmful overall. Value Alignment: While modest rewards can be used to provide liquidity and marketing, the rewards are high. As a result, this mechanism mostly results in a redistribution of value from non-stakeholders to stakeholders in practice.

We can also use this lens to understand Cobie's criticism of Bored Ape Yacht Club for rewarding unproductive staking. The rewards it provides are unlikely to stimulate any real, value-providing use cases, and primarily look like a way for early investors to cash out. In prioritizing value transfer over value creation, this mechanism weakens the long-term foundation of the protocol.

Governance

Given the importance of decentralization and broad participation in cryptocurrencies, governance should be a rich design space, but the governance models of most protocols are both simple and highly similar. In fact, most protocol governance can be explained as a combination of two key design choices. First, almost all protocols follow the "one coin, one vote" rule. Second, the "ve" (voting escrow) model, which gives locked tokens more voting power than unlocked tokens, has become increasingly popular as a means of empowering long-term holders. How do these models score on our design principles?

Public Good: It is undeniable that governance models create powerful public benefits. First, governance models serve as coordination mechanisms that enable decentralized communities to commit to clear actions. Second, community-driven models allow protocols to be more flexible and adaptable to changing conditions than hard-coded rules. Finally, community-driven governance can reliably reduce the risk of builders being expropriated relative to centralized governance. Value Alignment: Despite creating huge common benefits, most governance models are surprisingly poor at returning value to those who produce it. For example, voters are generally not rewarded for good decisions or punished for bad decisions; in fact, voters are not even rewarded more than non-voters for participating. As long as reward markets (aka bribes) exist, they will incentivize the success of any proposal, whether beneficial or harmful.

On the topic of value alignment, we also note that those who create, research, and guide successful governance proposals are generally not rewarded for their efforts. While there are some innovations (e.g., Vitalik discussed a “skin in the game” system that ties long-term outcomes to votes), these are mostly hypothetical. The rare exception is the VE model, which better ties long-term rewards to current governance choices.

Despite voting escrow, token governance as a whole should innovate. There are indeed some efforts making progress in mitigating Sybil attacks and better tying voting to identity, such as identity proof systems (discussed by Fred Ehrsam), pseudonymous political parties (discussed by Siddarth et al. 2020), and “web of trust” solutions (ibid.). There are also efforts to strengthen voting escrow models to more effectively tie voting power to long-term staking (as discussed by Ong and Reucassel). Future protocol designers should consider this expanded arsenal when designing governance and experiment with more powerful token economics designs.

Play-to-Earn

Play-to-earn is the combination of tokenized ownership and game mechanics, which at first glance should be a natural fit for value alignment, but the reality is much more complicated. Compared to traditional games, crypto game protocols offer the potential for more complex in-game economies, with a wide range of liquid and tradable assets. Play-to-earn is a way to distribute economic ownership through token-denominated participation rewards. Leaving aside the token value, how does the Play-to-earn model perform on our two key principles?

Public Good: In theory, the Play-to-earn model can help games solve the "cold start" problem. Without incentives, games such as MMOs may fail to attract initial participants, and even good games will fail. However, the ideal model only rewards early players before reaching critical mass. In practice, as momentum builds and prices rise (usually driven by asset scarcity), the Play-to-earn model often distributes more valuable rewards. At this point, rewards simply transfer value from the protocol to players, promoting short-term use at the expense of long-term sustainability. Value Alignment: In theory, the Play-to-earn model shares rewards with early participants, who provide value by playing the game before the game itself is attractive enough. However, most Play-to-earn games transfer value to early participants regardless of whether they contribute to the game community. This lack of alignment benefits short-term participants and distorts community development.

Currently, the main problem with Play-to-earn is the efficiency of value distribution. Broadly speaking, the ideal mechanism for rewarding early community builders should be to reward only those actions that make the game more enjoyable for everyone, only reward when it is necessary to build critical mass, and only reward for sustained contributions.

Of course, the actual problem may be more subtle, but the same principles still apply. For example, if the game's current mechanics primarily attract low-skilled players, the designers could focus on rewarding skill per match (e.g., beating better players would give a larger reward) rather than rewarding the number of matches. If the problem is that early stakeholders are taking a disproportionate share of the rewards when the token price rises, the designers could tie the reward to some global activity metric.

Finally, if the cold start problem is the most critical, then rewards can be gradually reduced. More specifically, web3 game developers can allow the first 1,000 players of a new game to receive a higher reward rate in the first few weeks, and players in the following weeks or later to receive smaller rewards.

While play-to-earn is the most obvious example of the value alignment challenge, the previous discussion also applies to any “X-to-earn”. For example, Stepn, a pioneer in the “move-to-earn” model. We recommend that these protocols carefully consider the type of value they want their token economics to incentivize and reward.

Some future ideas for the token economy

So far, we have applied our principles retroactively and graded existing models based on their performance. How else can we provide direct and targeted incentives to individual supporters of the public good?

Decentralization: Miner honesty is highly incentivized in practice, but miner diversity is rarely considered. In theory, miner diversity is widely understood as a form of public good. Would it make sense to impose a progressive tax on validator rewards above a certain stake size?

Marketing: Name recognition is critical to the survival of a protocol, so there is value in being first in the sense of providing initial liquidity or usage to the network. Participation driven by artificial incentives may be non-incremental or detrimental once a protocol reaches critical mass. Could the protocol reward early backers by offering larger rewards to the first $X million of TVL, then amortizing those rewards as total liquidity increases? (APY is already falling as TVL rises, so this would be a more dramatic drawdown above some desired liquidity level.)

Grants and Partnerships: Token cap tables often include large, open allocations for developers building on the protocol and partners integrating with it. However, these rewards can be quite fragmented and actionable. Is it possible to tie grant-based token rewards to on-chain metrics in a way that is not exploitable?

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in conclusion

Token design is difficult because it requires answering a highly abstract, open-ended question: What is worth incentivizing? It would be ideal if protocols could try different models, solicit early feedback, and iterate. But most teams only have one chance to set up the dynamics of the system and must provide a solid foundation on the first try. We believe that following these two core principles — creating a public good and aligning rewards — will give these teams the best chance for long-term success.

The burden also falls on the broader community. Early investors, retail participants, and protocol users should all push for strong and principled token economics — now more than ever. Many of the momentum-driven designs of the last crypto bull run could only last in such a booming market. Despite its shortcomings, bear markets demand real utility from the outset.