The word tokenomics has become trendy these recent years in the blockchain space despite an often misunderstanding and a weak implementation in the ecosystem. Although it is a crucial step for web3 projects, many do not understand what makes an efficient token-design, and what made the success of the previous ones.
As founders & advisors of 30+ start-ups in Web3, including notably Equisafe (security tokens), Dogami (GameFi), Securd (Defi Protocols) & Lezar House (NFTs launchpad), we want to share how tokenomics can vary considering your project nature in Web3, and to share the common best practices.
For the first article, we will remain high level and will enter in detail in further articles
What is a token or a NFT ?
Before diving into tokenomics, let's take a look at what a token or a NFT means. A token is a digital unit of a cryptocurrency that is used as a specific asset or to represent a particular use on the blockchain. Tokens have multiple use cases, but the most common are security, utility and governance tokens. They can be considered as fungible, which means that all tokens of the collection has the same value (like BTC, ETH and ERC-20 tokens), or as non fungible which means that each token of the same collection is unique (NFTs collections such as BAYC or Dogami).
While BTC (2009), ETH (2014) and other fungible tokens are well-known for many years, NFTs are more recent (the most well-know “historical” NFT is CryptoPunks created in 2017) and its adoption took off in 2021 with the “Play & Own” and metaverse hype.
What are tokenomics ?
Tokenomics is the contraction of the words "token" and "economics". It involves different fields of application and domains like game theory, finance, behavioral psychology, computer science and so on. To make it simple, tokenomics are to Web3 projects what central banks are to monetary policies.** These policies are the core of a currency. Without carefully thinking through the rules, the currency is likely to fail. The rules of tokenomics are implemented through code and are quite difficult to alter as they require agreement from many network participants.
Token engineering is one of the most important aspects of a Web3 project. Even a good product based on tokens cannot succeed if its tokenomics aren’t well designed. Of course, well-designed tokenomics cannot sustain a project that do not create sustainable value.
This discipline can have different objectives depending on the project and its utility. It must incentivize investors, users community, contributors, devs and so on, so that they act for the greater good of the project.
As a project creator, you have 5 main phases for designing & managing tokenomics, each steps being more or less difficult to setup as shown in the graph below:
The first crucial step is to make sure the token has a clear & powerful utility for the solution.
The purpose of non-security tokens : Utility first, & align interests
When the bull run comes up and the hype around cryptocurrencies is in full swing, a lot of entrepreneurs ask themselves suddenly : How could I introduce a token into my project ?
Indeed, the token model is often seen by entrepreneurs as a way to raise non-dilutive funds more easily and to embellish a “Web2” project that would have difficult times to gain traction & visibility at an early stage. They often spend a lot of time on token supply and issuance strategies (explained below) but without clear utility of the token.
Even though supply and issuance mechanics are an important part of tokenomics, 80% of its relevance relies on the purpose of the token. A well-engineered token is first and foremost a token that has a real utility into the project, often by decentralizing the solution (protocol DAO “decentralized autonomous organization”) or creating a circular economy with active participants being rewarded with token projects that “consumers” need to use the protocol.
Centralized company powered by equity vs. crypto network powered by tokens
Equity versus token
Why tokenomics are a big deal ? Because it is a massive disruption of corporate finance. During the last centuries, businesses acted as centralized companies with a few shareholders sharing the profits of their consumers paying in “fiat” money (euro, dollar, …).
Equity is a simple financial tool: through ownership, you can vote and receive dividends. And we have a valuation model for assessing the equity value of a company: the “DCF” or Discounted Cash flow model.
Token is way more complex than equity:
It incentivizes many stakeholders as it often transform the “consumer” into an “investor” and / or a “contributor / validator”
It combines many utilities and is not yet worldwide regulated
It is often listed & publicly exchanged in early stage of the project, hence its price is very volatile & hugely impacted by market sentiment due to the lack of maturity of the project
We don’t really have yet performing token valuation models, except maybe the one from Chris Burniske (https://medium.com/@cburniske/cryptoasset-valuations-ac83479ffca7) derived from the MV=PQ model. Today, tokens are mainly valued through market valuation models where you just apply ratios from your competitors (network value / daily trx volume, …)
History of token utilities
Why is tokenomics so complex and cannot be resumed in one article? Because, as you see in the table below, there are different kinds of projects in different sectors that all have different utilities, and each one has its own complex dynamic. But to make it short, if you introduce a token mainly to fundraise or use it as a short term reward for participants without real long term utility, your project will rapidly fail like 99% of tokens that were already launched.
With way more complexity compared to traditionnel equity, token utility can be multiple, and depends on the project type. For example, Bitcoin as a currency have a worldwide payment utility but also can be used as the “new digital gold”, whereas BNB token as an exchange token is used to obtain discounts on their solution, but also grant access to their launchpad feature (privileged access to token investments) & is also the currency / gas payment of their BNB chain.
We can see on the table below how tokenomics are sector dependent and in constant evolution:
After you made sure your token had a good utility, it needs a relevant supply and issuance strategy to stay consistent with the business plan, the adoption curve of the product/service and the global market situation.
Supply strategy and specific mechanisms
6.1 Allocation & vesting
Allocations of tokens and their issuance schedule are often represented through the issuance schedule chart. It gives information about the allocation of tokens for each contributor and details such as cliffs (the time before the token release starts) or vestings (the duration of the token distribution). Here is a quick overview of some allocation charts for Layer 1 (blockchain), DeFi and Gamefi tokens :
Supply allocation & schedule depending on the project type
Still in comparison with a central bank, a token follows a kind of monetary policy, which we define as what is planned for a token after the Token Generation Event (TGE). It is an important step of tokenomics design as it tells if the token has a maximum cap of issuance, if it is deflationary or inflationary or if the founders could change the rules during the token’s lifespan for example. Today, the dominant model is to have a coded capped supply like Bitcoin.
Since the 2020 bull market, we have seen many projects that designed what we call “Ponzinomics”, which are tokenomics that prioritize fast speculation on the token over sustainability. This way to proceed has been widely used by decentralized exchanges forks and by play to earn projects. If you took a look at their token issuance schedule, you could have seen that the majority of the tokens are planned to be issued in few weeks after the TGE and that the project couldn’t be sustainable, which is why the supply and issuance metrics are also important for projects and their community.
Today, the main best practices on token supply are the following:
Don’t distribute too much to “insiders” (team & private sales) (<40%) if you really want a long-term decentralized protocol
Condition some allocation according to some KPIs, that can be linked to on-chain events like TVL in Defi. It is already done with companies equity when you vest warrants for your team or advisors based on KPIs to reach
Have long cliffs & vesting (in years) to let the protocol create enough value to absorb selling pressure.
After the adequate monetary policy is set, you can use specific mechanisms on your token such as staking, periodical or automated burns, buy backs & airdrops in order to manage the supply after the token issuance. Tokenomics are alive and can be updated even after the token emission, that’s why biggest Web3 projects dedicate a team on the tokenomics monitoring & strategy.
6.2 Public sale & / or airdrop ?
Vast majority of Web3 projects made a public sale of their token, but we had some innovation these recent years with increased Private sale amounts and sometimes airdrop replacing public sale, like uniswap did.
Also, an interesting practice would be to drop your tokens based on the usage of your protocol (requiring that your solution is already live like Blur) or usage of a competitor (like Looksrare that airdropped their tokens based on your Opensea usage - “vampire attack”) rather than a public sale that will bring a lot of speculation into the project.
Best practice: Require some actions to claim your airdrop, and try to introduce a vesting system of the airdrop with some actions / KPIs to reach
If you go for a Public sale that can bring a lot of visibility to your project but also a lot of speculators (and legal constraints), you may wonder how to determine the price of your token ? It is often determined by the market conditions, as the % of tokens sold & its price is the result of a targeted marketcap at listing.
In recent years, it is rare to be attractive with a fully diluted market cap at listing above 100m$, or a circulating market cap above 10m$. Circulating market cap at listing is often really low compared to FDV (<10%) as only the public sale tokens are in circulation (liquidity ones are “locked” into liquidity pools & exchanges).
FDV (fully diluted value) check based on different round prices
Of course, your market cap target depends on the “hype of the project”, the maturity of the project at listing, the exchanges you will be listed on and the market conditions. Basically, you need to fix a price that makes the circulating market cap at listing attractive, where investors can expect a quick return. Hence, it must be well designed as it will attract a lot of speculators & you risk a massive pump & dump.
6.3 Buy-back & burn
Buy-back of tokens by the company to burn them can really help to sustain token price, but this practice can qualify your token as a security token in some legislation, hence you need to be really backed in legal terms for this feature.
Also, the problem of this practice is that the company becomes too impactful on the price, hence you can easily lose confidence of your community if you make bad decisions. The goal of a project is not to speculate or spend a lot on time on token price manipulation, but rather building a great product or service!
You can try to “program” or “code” the buyback based on on-chain datas - like your TVL for a Defi protocol - but it can also be easily played / cheated (like temporarily / artificially boosting some KPIs just to pump tokens, then sell & leave the project).
Major flaw of this mechanism is to have the company needing to buy a lot of tokens to support the price if there is a massive crash (specific to scandal or market black swan), hence weakening the company (or the protocol treasury) through a “death-spiral”.
To make it simple, buy-back & burn (or even resell to the market later) can be a nice short-term booster of token value, but it is not sustainable as the main way to increase token value, especially as it can be considered as a security token practice.
Staking is one the most known & used features for tokenomics: it requires users to lock an amount of tokens for a determined period of time, and they are rewarded with added utility, exclusive access, native tokens and / or NFTs rewards as they secure the network and / or demonstrate their long-term commitment to the project. On the team side, it is an important strategic marketing tool to engage the community or to reduce the selling pressure on the token for example.
Some of the best practices for staking incentives are the following:
Try to offer long locking (3 months +) staking services with high APY, and less attractive APY for flexible ones where you can unstake at any time.
Implement active staking, like the “ve” model (vote escrow) common in Defi, that give more voting power when you stake since a long time.
Some Staking rewards should be under conditions of some on-chain metrics
Again, like Buy back & burn, staking helps in sustaining token price, but it cannot be the only feature or utility of the token.
As a Web3 project creator involving a token, you will need to go through the following phases - more or less difficult & time consuming - in order to create & sustain performing tokenomics:
Define clear utility(ies)of the token - Very challenging
Consistency with Equity & NFTs (if any) - Challenging
Allocation & vesting - Easy
Listing strategy (private & / or public sale, airdrop, CEX & DEX setup, …) - Challenging
Post-listing management (liquidity, market-making, staking pools, …) - Very challenging
Defining clear utilities for the token, that make sense compared to an equity model, is the crucial phase that will decide 80% of the tokenomics relevance. Staking & buy-back cannot be the only features of a utility token to make it sustainable, except if you assume that you are a security token and that regulation could then be a massive threat.
Remaining 20% will be the result of the supply strategy, that need to match the demand (weak at the beginning, especially if you have no live utility or not enough users) with the offer of the tokens that will keep increasing every day, for years. Especially, if you have big unlocks scheduled at certain dates (even if a hourly daily vesting is highly recommended for a smooth release of tokens), try to make big announcements (with true value) or launch new features at these unlock dates to sustain the token price.
Tokenomics is a young science that will still profoundly evolve through innovations (like we saw with the NFT boom of 2021 / 2022) & regulation to come. Hence, you need to stay flexible in the conception and understand that managing your token post-TGE will be as challenging and time-consuming as the conception.