Academy Series #11: Tokenomics & Incentivization Strategies
As many of you know, tokens (whether fungible or non-fungible) are digital assets issued and living on a blockchain. At first, tokens were only issued as a native currency of a blockchain and were only used as a means of exchange, but, later on, with the appearance of Ethereum, we started seeing tokens that could have multiple utilities and could interact in many different ways with smart contracts.
This possibility to issue programmatically-defined tokens allowed for an entirely new field of study to appear where individuals and entities can somehow create their micro-economies and manage behaviors in their ecosystems.
Today, our article will briefly cover this phenomenon, called tokenomics, and how you should think about it (whether you are evaluating a protocol or starting your project). We’ll also try to provide a couple of examples in the end.
The word ‘tokenomics’ is a blend of two words: token and economics. In short, it is the study of the economics of a crypto token — It covers all aspects involving a coin’s creation, issuance, management, utility, and sometimes removal from a network.
The most significant point regarding tokenomics is that they allow Blockchain-based protocols, services, and applications to design an economy that incentivizes the main players and agents to participate positively and constructively in the ecosystem.
The reality is that much of what we see worldwide runs on incentives. Incentive structures are present in every business, institution, and framework, which also happens to be the case in most crypto/web3 related projects and protocols.
In the case of public and mostly decentralized protocols, there is usually a need to create proper incentive mechanisms to drive viral adoption and growth. And this is where tokenomics play a critical role.
Do all blockchain-related projects need Tokenomics?
A common misconception about tokenomics is that all blockchain-related projects need tokens to run. That’s not necessarily true.
A blockchain is a distributed ledger, and tokens are used mainly by public chains where the nodes have no knowledge of each other, and tokens are used to incentivize participants to join the protocol and build a consensus mechanism in a trustless manner. Additionally, since crypto-tokens often have economic value, they can be used to protect the network by making it prohibitively expensive to attack the network, as in proof-of-stake systems.
Private and enterprise-level blockchains, like R3 Corda or IBM Hyperledger, are deployed among multiple entities with another type of corporate or legal agreement. As a result, they don’t necessarily need to use tokens to incentivize behavior.
This way, tokenomics are naturally more relevant for public blockchains since they are open to everyone (whether good or bad actors), and tokenomics allow the aligning of behavior of each actor towards the growth and strengthening of the protocol.
Main factors to consider when building Tokenomics
Now that we understand what tokenomics mean and why they are important, let’s go over the main aspects of building tokenomics for a project.
(Note: building a Token-based economy is challenging and not an easy task. There’s also a lot to learn about the topic. Our goal here is simply to give you some initial pointers and guidance to go further in your studies! This is NOT “financial advice”!)
1. Designing & aligning incentives
The first thing you need to think about for your project is incentives and alignment between all participants. Every project is unique, so simply copying and pasting tokenomics from another project will likely go wrong.
We won’t go into much detail in this article since it’s a dense topic, and a lot of incentive design can be learned by studying a field called Mechanism Design and Game Theory. There are, however, a few things you can consider and answer to design your mechanism.
When starting to design your system, think about the following questions:
- What’s the goal of the ecosystem or the protocol?
- Who are the primary agents/actors of the system?
- What type of behaviors do you want to instill?
- What positive incentives can you create to reward good behavior?
- What negative incentives can you create to punish bad behavior?
If you manage to answer all these questions, you’re already halfway through your token design. These answers will work as your anchor throughout the procedure. It’s essential to take time here, and there’s no need to start thinking about going any further in the process until you have a sufficiently satisfactory answer to all these questions.
It looks easy, but soon enough, you’ll start to find complexities you haven’t thought about before, and going through this process will help you better understand your project and what you wish to achieve.
2. The Supply of the Token: Inflationary vs Deflationary
Another component to consider of a crypto’s tokenomics is the token supply. There are two broad approaches you can use: inflationary and deflationary tokens.
Inflationary currencies have no limit to how many units are in circulation. Tokens are created over time based on specific parameters of the protocol, and there’s never a fixed cap for them. Inflationary measures are particularly useful if you want your token to be regularly used and distributed as a means of exchange. Because the tokens are inflationary, they won’t likely increase in price over time, as there are a constant influx of coins into the market.
Deflationary currencies have a max supply. The supply of the token is decided on the genesis phase or as a parameter of the protocol, and it can only be changed by achieving consensus between all participants of the economy. Therefore, these tokens are handy to incentivize early adoption and holding of the tokens.
As the buying power of deflationary currencies increases with time, the currency becomes ever more scarce.
3. The Allocation and Distribution of Tokens:
Finally, after understanding the behaviors you want to instill and deciding how to deal with supply, the next step is to plan how to distribute the token over time.
One way to approach distribution is through a fully automated and decentralized process where there is no early access to the token, or private allocations, before making the token public. Bitcoin, Dogecoin, Ravencoin, and YFI are good examples of this as there was no pre-allocation of tokens to any actor or investor in the protocol. Instead, these networks simply distributed them based on parameters defined at the core protocol level and open to any participant.
Another approach is to pre-mine tokens (the entire set, or a part of it) from the start and then create distribution rules embedded on a smart contract. In these situations, the crypto tokens are generated and distributed among some exclusive addresses (usually project developers, other team members, and early investors) before going public. For example, Ethereum was released this way, and most of the subsequent crypto projects follow the approach with pre-mining activity.
Either way, the most important is to define how the tokens are distributed via the platform’s usage. Distributing rewards to early adopters, users, and actors of the protocol based on activity will create network effects of adoption, and this is where incentive design and game theory come into play.
Finally, an alternative option to token launch is an approach called “Build First, Token Later”. This means that you bootstrap your project or protocol using other means, and then eventually launch the token, which will be used primarily for governance and decentralization purposes. Uniswap and ENS are good examples of this.
At this point, you’re probably thinking: so, and what’s the best approach for tokenomics? Deflationary or Inflationary? Full distribution or pre-mine? More significant allocation to a set of agents or others? Token first or build first?
The answer is always: it depends! And depends on what? On the incentives and behaviors you want to create in all ecosystem actors. It all ties back to that.That’s why having a clear idea of these incentives will always help you a lot when moving the different levers needed to build tokenomics.
Examples of Tokenomic Models & Usages
As I said, there are no right or wrong answers, and one of the best ways to learn about tokenomics is to learn from different projects and how they are using tokens on their end.
Many intelligent solutions were built previously based on the goals of each specific project, and you can learn a lot from them.
Below, I share some excellent examples with you, and I hope you can take some time to analyze and get ideas for your project.
a. Bitcoin & Proof-of-Work — Bitcoin (BTC) is the original cryptocurrency, blockchain, and tokenomics. It uses a consensus mechanism called Proof-of-Work. It has a fixed supply and uses things like difficulty adjustment, hash rates, and halvings to incentivize more participants to join the network.
Bitcoin is the perfect example of a fully decentralized network that bootstrapped itself uniquely based on the token economy and distribution model. It’s certainly worthwhile to read its WhitePaper to understand where everything started and how one can build a beautifully designed incentive system.
b. Smart-Contract Layer-1 tokens — The primary purpose of Layer-1 Tokens is that they are used as means of exchange and payment on specific Blockchains. These tokens have a clear and direct utility: pay for transactions within the network. They might have different ways to distribute the token and various forms to achieve consensus and security of the network, but in the end, their final goal is usually the same.
c. Governance tokens — Governance tokens grant voting and management power to their users. Governance tokens allow for a power balance between users and holders of these tokens for semi- or fully decentralized environments. Using governance tokens, holders can vote on proposals related to a specific Protocol, DAO or Blockchain. In addition, they allow users to be actively involved in discussions and evolutions of a protocol or product.
d. Work/Stake Token — On the work token model, a service provider stakes the token of the protocol to earn the right to perform work or services within the context of the protocol. These Service Providers will then receive rewards for providing services and holding the coins. Theoretically, a work token model, with the absence of speculators, will allow that when you have increased usage of the network, that will cause a natural increase in the token price. This way, as demand for the service grows, more revenue will flow to service providers.
e. Multi-Token Economies — Multi-token economies (usually two tokens) are a term used for crypto-projects that use multiple tokens with different types of utilities, but where the tokens are somehow related to each other. Common examples include using one of the tokens for governance and the other for payments. Another example is mixing two tokens with inflationary and deflationary mechanisms.
Creativity is the limit here, but some projects found that a single token was insufficient for the incentives mechanisms they wanted to create. Hence, they moved further with a multi-token economy.
f. Burn-n-Mint — Burn and Mint tokenomies are subsets of Multi-Token where the primary token is minted and burned continuously to find balance and equilibrium in the economy. The secondary token works as a proxy for payments in the protocol.
On these tokenomies, there is usually a clear distinction in the protocol regarding who are Service Providers and who are Users of the protocol. On one side, Service Providers are continuously rewarded with newly minted tokens. On the other side, instead of paying the tokens directly to the providers, users simply burn the tokens whenever they use the protocol.
This model can be very interesting for tokenizing existing businesses and updating their business model.
Also, Burn-n-Mint encourages circulation and usage of the crypto assets while avoiding a continuous drop of the value of the assets of the protocol.Examples of Burn-and-Mint tokens are Helium (HNT) and Factom (FCT).
I hope that this article has been helpful for you to start understanding tokenomics and how they can be a critical piece for the adoption and growth of any project in the crypto space.
You can now use this knowledge every time you look at a new crypto project. And now, instead of just asking about the token, you can critically evaluate the real incentives behind the existence of a specific token.
Finally, tokenomics is a fascinating field of studies with roots in Game Theory and Mechanism Design. As crypto goes mainstream, we’ll see more and more developments in this area. Of course, there’s a lot more to learn, but I hope the explanations and examples provided are a good first step for you to dig deeper into the topic and learn more.
If you have questions or ideas around the topic, feel free to reach out directly to us, and we’ll be happy to help! Just ping us directly at firstname.lastname@example.org!
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