Original title: "Tokenomics 101 - valuable knowledge before the 2024-2025 bullrun"
Original author: Route 2 FI
Original translation: Lucy, BlockBeats
Editor’s Note:
In this article, crypto researcher Route 2 FI explores the basic concepts of token economics and some reference standards. From the perspective of supply and demand, it deeply analyzes the issuance, distribution and market performance of tokens. By comparing different scenarios of tokens such as Bitcoin and Ethereum, as well as considerations of governance, returns and expectations, it comprehensively explains the mechanisms and drivers behind tokens. BlockBeats translated the original text as follows:
Today’s article is about token economics, which may be valuable to you when you are looking for new projects to determine if they are worth buying.
Many people talk about token economics, but only a few actually understand it.
If you’re considering whether to buy a crypto asset, understanding token economics is one of the most useful first steps you can take to make an informed decision. This newsletter will cover the basics and help you learn how to analyze projects on your own.
In order to understand whether a coin is going up or down, we have to understand supply and demand. To better understand this, let’s take BTC as an example and start with the supply side.
supply
How many BTC tokens are there?
Answer: 19.2 million BTC
How many tokens will there be in total?
Answer: 21 million BTC
How often are new tokens released to the market?
Answer: The increase in token supply over time is called “emission”, and the rate of emission is important. You can find information about this in the token’s whitepaper.
Every 10 minutes, BTC miners verify a BTC transaction. The current reward for each verified BTC block is 6.25 BTC. Therefore, approximately 900 BTC are released to the market every day.
On average, the rate at which blocks are created will “halve” every four years (called a “halving”), until eventually in 2140 the reward for each mined block will be just 0.000000001 BTC.
In other words, nearly 97% of all BTC are expected to be mined by early 2030. The remaining 3% will be generated over the next century, until 2140.
BTC’s inflation rate is currently 1.6% and will gradually trend towards zero.
This means that if fewer tokens exist, the token price should increase, and vice versa, if more tokens exist, the price should decrease.
For BTC, this is easy to understand, but when we look at other tokens, such as ETH, the situation is a bit more complicated because there is no upper limit on the amount of Ethereum. However, as long as Ethereum's gas fees remain at a reasonable level, it is actually a net tightening asset.
Important Metrics
Circulating Supply: The number of tokens in existence today
Total supply: On-chain supply minus burned tokens
Max Supply: The maximum number of tokens that can exist
Market Cap: Today’s Token Price x Circulating Supply
Fully diluted market cap: Today’s token price x max supply
Another important thing to consider on the supply side is token distribution. This isn’t as big of an issue when it comes to BTC, but it’s something to consider when evaluating a new token you’re considering buying.
in addition:
Are there large holders who own the majority of tokens?
What is the unlocking plan?
Did the protocol distribute the majority of tokens among early investors in the seed round?
My point is: don't invest in shitcoins like KASTA created by The Moon Carl without studying the token economics and end up losing money. In my opinion, @UnlocksCalendar and @VestLab are good resources to check the unlocking schedule.
For a quick summary of what’s important on the supply side, check out:
Circulation Supply
Total supply and maximum supply
Token distribution
Unlock plan.
That being said, supply alone is not enough to decide whether a token is worth buying. So let’s talk about demand.
need
OK, we know that the supply of BTC is 21 million tokens, and the inflation rate of BTC is about 1.6% and is decreasing every year. So why is the price of BTC not $100,000 yet? Why only "40K" dollars?
Well, the simple answer is that just having a fixed supply doesn’t make BTC valuable. People also need to believe that BTC has value and that it will have value in the future.
Let's break down the requirements into 3 components:
Financial utility (return on investment of the token)
Actual utility (value)
Speculation
Financial utility: How much income or cash flow can be generated by holding the token. For proof-of-stake tokens, you can stake your tokens to generate pass yield.
This is not possible with BTC unless you wrap it in WBTC, but then it is no longer regular BTC. If holding a token benefits holders by rewarding staking yields or providing LP in liquidity mining, then demand will naturally increase.
But remember, the yield has to come from somewhere (token inflation), so when you see these really high APR projects (think OHM-fork season in 2021), be a little skeptical.
Actual Utility: For many projects, the fact is that they have no value. This can be debated, but BTC has value because it can be used as a store of value and unit of exchange. BTC is known as a digital currency that is an alternative to fiat currencies controlled by central banks. Ethereum is a digital currency that has multiple uses through decentralized financial applications (dApps).
You can actually do something with ETH other than just hold, send or receive it. To decide if there is actual utility, you have to consider who the team members are, what advisors they have, and their background. What companies are backing them, what are they building, are they solving a real problem, etc.
Speculation: This includes narratives, memes, and beliefs. Basically, it’s a future belief that someone else will want to buy it after you do.
The speculative aspect of the demand side is difficult to analyze and predict. BTC has no ROI and no staking opportunities, but it has a super strong narrative. People believe it could be a long-term store of value. BTC also has a huge advantage in that it is the first cryptocurrency.
When you hear people talking about cryptocurrencies, the first thing they’ll mention is BTC. Strong communities drive demand, so always remember to research the community on Twitter and Discord before investing.
The speculative aspect is one of the biggest drivers in crypto in my opinion. Don’t underestimate how far a coin can go with the right narrative, memes, and followers. Think DOGE, SHIB, ADA, and XRP.
Most crypto tokens are highly correlated and move together. If you hold anything other than BTC and ETH, it should make you think it will outperform based on the supply and demand side of the token economics.
Another important aspect when valuing a token is the token economics trilemma: the balance between yield, inflation, and lock-up period: Proof-of-Stake projects want to give their tokens high staking yields to attract users, but high annualized percentages may lead to inflation and selling pressure. On the other hand, if the staking yield is not attractive enough, it may be difficult to acquire users.
The way to get people to hold tokens is to offer higher yields the longer the lockup period, the downside is that if the lockup period is too long, people will simply avoid participating in the project. Another thing is that the day of unlocking will happen, which will lead to a huge sell-off as investors want to extract their profits.
If you think supply/demand is hard to understand, just try thinking about it in a simpler way:
What would happen if the Ethereum Foundation decided to print 100 million new ETH tokens tomorrow? Answer: The price would collapse due to increased supply and decreased demand.
What would happen if Michael Saylor announced that he wanted to buy 100,000 BTC in the next 6 months? Answer: The price would go up because supply would decrease and demand would increase.
Just consider the following model:
Prices will always tend to equilibrium based on the supply and demand curve.
Is ETH worth $100 or $10,000? Is BTC completely worthless or $300,000?
No one really knows, and since cryptocurrencies have no underlying value compared to, say, stocks, it remains very difficult for investors to determine the price.
This makes crypto assets extremely volatile and speculative. But it also presents a huge opportunity for the few who actually take the time to participate in cryptocurrencies.
What should a new project or protocol focus on?
Let’s take a look at the structure of Curve (CRV).
In essence, Curve provides incentives for LPs to participate in governance through their token economics. For Convex, the ultimate goal here is to get as much veCRV as possible to maximize CRV rewards.
After clearly setting the goal, the founder of the project should further study the actual value proposition of the token. What value can participants who hold the token gain from it? For example:
Staking
Governance
Store of Value
There are many more. Today, it is common to see founders come up with tokens that are made up of multiple value propositions. This, of course, can lead to higher demand for the token.
A perfect example is GMX, a token that has multiple value propositions such as governance (the ability to elicit the true preferences of participants), claiming (the ability to convert escrowed GMX into GMX over a period of time), and holding (receiving protocol revenue).
Along with these value propositions, there are also functional parameters, which are related to variables that determine the literal functionality of the token, the simplest example being transfer or destruction. It is absolutely critical for the team to ensure that the functional parameters of the token do not conflict with its value proposition. For example, the goal and value proposition of a token for value transfer should have functionality that ensures its fungibility. Here are some functional parameters for tokens:
· Transferability (transferable + non-transferable): GMX and esGMX respectively.
Destroyability (destroyable + non-destroyable): BNB and SBTs respectively.
Fungibility (Fungible + Non-Fungible): ERC20 and ERC721 (NFT), respectively.
Exchange rates (floating + fixed): MKR and DAI respectively.
Sometimes, teams intentionally decide that a token is assigned conflicting value propositions or functionality. In such cases, tokens can be split into two or more types. The famous case of AXS is a prime example of this, moving from an initial single-token model to a multi-token model.
Initially, AXS had 3 value attributes: value transfer, governance, and holding. The conflict here stems from the fact that if a participant decides to transfer the value of AXS within the game, it means giving up the rights of governance and holding, which causes problems for the game economy. To solve this problem, they released a "new" token SLP, which then became the preferred value transfer tool within the game. You may remember this same dual system in STEPN's GMT and GST.
However, implementing a dual-token system may make the token economics design too complicated, and sometimes it may be important to consider external tokens as auxiliary tokens to ensure smoother interactions. A typical example is ARB, which is mainly used for governance.
To ensure smoother interactions, ARB uses ETH as a means of paying transaction fees, as transactions occurring on L2 are bundled together and sent to the L1 state. If this external token (ETH) was not introduced as a means of paying transaction fees, the following would happen: ARB is used to pay transaction fees (gas fees), operators then have to redeem ARB for ETH to validate on L1 and lose in further gas fees, creating a contradiction for the growth of ARB.
In the above section, I have introduced the general dynamics of token economics and the various drivers that teams should consider. Now let’s take a look at the token supply. Because this directly affects the token price (which is what degens want). The structure of the token supply is as follows:
Maximum supply
Distribution percentages (sales, investors, team, marketing, treasury, etc.)
· Distributions allocated: Allocated to initial, vesting, and bonus issuances.
Max supply is important because it determines the maximum cap on how many tokens a team can issue, and uncapped tokens may not have great price distribution. This does not directly affect price, but factors such as the issuance rate, and whether a token is deflationary or inflationary are factors that affect price.
For a limited maximum supply, such as CRV (3 billion tokens), the price can rise because as the network grows, the demand for the token increases, creating a high demand zone with a limited supply. The problem with this type of maximum supply is that it is difficult to provide incentives for new future contributors if the tokens are not distributed quickly.
On the other hand, having an infinite maximum supply avoids questions about future incentive exhaustion. Of course, the downside here is that there may be a drop in token prices in the long run, because there is essentially an infinite supply, and unless external models are used to reduce circulation (e.g. staking, destruction, etc.), there can only be a downward trend in the long run, regardless of its growth.
In terms of allocation, it is usually based on a percentage of the maximum supply, which actually determines the percentage of the maximum supply that should be allocated to each category. The main categories are: Team (including founders, developers, marketing, etc., who are actually the individuals responsible for building the project), Investors (people involved in early/seed/private rounds), Treasury (operating costs, such as R&D, reserves, etc.), Community (airdrops, LP rewards, mining rewards, etc.), Public Sales (ICO, IDO, IEO, LBP, etc.) and Marketing (including consultants, opinion leaders, agents, etc.).
These are some of the key elements for a project to consider, however these are largely unique to each project and can be simplified or further broken down into categories based on their “strategy”.
Notably, during the rise of DeFi in 2020-21, teams realized that by allowing higher rewards to their community, or increasing float for initial holders through airdrops, it could lead to a boom in network growth and sustainable token economies.
Finally, distribution. Initial supply is the initial float that is released to the open market immediately upon “launch,” or what some call the TGE. Allocations that go into this category are usually percentages from treasuries, public sales, and the infamous airdrops we see everywhere.
For tokens to be unlocked, these are usually locked for x months/years, usually for investors, treasury, team tokens, they can decide the duration and when to start unlocking, usually unlocking prevents large-scale token sell-offs, especially because participants in this section are usually investors who bought at a valuation below the listing price.
So why does all this matter?
Simply put, token demand and value capture mean that market participants should theoretically gain value by holding tokens.
Let's take CRV as an example again. We need to identify and understand the meta-demand of CRV. Let's break down its value proposition: It is a governance token. Participants can use their CRV to vote on how much CRV to issue each week. Why is this important? How does it capture value? Because market participants who hold CRV are eligible for 50% of the project's fees. Therefore, the more CRV they hold, the more income they receive. This makes the ultimate meta-demand of CRV the ability to maximize user profits while encouraging them to hold, a good mechanism to induce positive behavior (users hold) and capture value (get rewards).
Back at the beginning, many tokens struggled to recover their value. This sparked interest in projects to capture value by holding on to generate profits for market participants.
There are a lot of creative token models in the space today. I think another great example is Cosmos successfully addressing the craze about airdrops.
I’ve discussed this before, but you may remember that staking ATOM, OSMO, KUJI, INJ, and TIA may qualify you to participate in most airdrops in the Cosmos ecosystem today.
This has resulted in a significant increase in the number of stakers in the Cosmos ecosystem. With the promise of more airdrops in the future, they will not stop staking. This incentive encourages people to hold onto the token rather than sell. Since there is a 21-day unstaking period, unstaking becomes quite cumbersome, so people prefer to hold.
One DeFi Degen described the Cosmos ecosystem’s practices as (3,3) (OHM Ponzi Scheme), and to some extent he is right.
Want to learn more about token economics?
Here are 4 great threads that dive deeper into token economics:
