What is Tokenomics?

Like many concepts in the crypto world, Tokenomics is an ambiguous concept with different interpretations, depending on whom you ask. In this series of “essays”, we will try to demystify, explain and present (as simply as possible) a framework for understanding and designing an optimal Tokenomics model. We’ll examine the many filters we use, when assessing a project’s prospect, to better understand what are the building blocks. Finally, we will show how we bring together these blocks, to build and optimize an ecosystem’s Tokenomics.

A Solid Foundation Starts with the Fundamentals

One reason for the confusion around Tokenomics is that it’s a cross-breeding of multiple scientific disciplines. To name just a few: economics, psychology, game theory, behavioral economics, engineering optimization and more. In order to minimize the confusion, let’s start with a few definitions so that we have a common language.

A token or crypto token is a digital asset that represents fungible/non-fungible, tradable assets that reside on their own blockchains.

A dollar bill is a token. A gold-gym membership card is a token. A game-7 Chicago Bulls vs Utah Jazz ticket is a token. The same ticket signed by Michael Jordan is also a token (but probably a more valuable one). And of course, Bitcoin, Ethereum (Ether) and Dogecoin are also tokens.

Economics is a social science concerned with the production, distribution and consumption of goods and services. It studies how individuals and organizations make choices about the allocation of resources. Token economics, or Tokenomics, is the economic mechanism for incentivizing/motivating and aligning multi-sided platform participants in order to achieve an optimal outcome for all parties involved.

First-principle thinking is an effective strategy for stripping down complicated problems into their basic components to generate broad understanding. Once we have understood the atoms and axioms of a system, we can learn and anticipate their interactions (and even create original solutions). 

The first first-principle of all economics is Supply and Demand which are the manifestation of these incentive mechanisms. 

Expanding the Scope of Tokenomics

Contrary to popular opinion, Tokenomics is not the customary, oversimplified view of pie chart distribution.  Rather, it’s the small and simpler part of building a healthy token-economics. Before we go any further, we should differentiate between token metrics and token economics. Token metrics are the variables and aspects by which we analyze and evaluate projects. Each is (somewhat) necessary, and has its function (no pun intended), but is not a sufficient signal on its own. We filter these multiple wave functions through them, as we try to estimate the magnitude and influence of each. 

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Tokenomics refers to the broader, all-encompassing, incentive mechanism and functions written into code AKA smart contract. Thus the one is contained within the other.

Common and valuable token-metrics are market cap, total and circulating supply, total value locked (TVL), token distribution & allocation, and more. 

Let’s observe some of them while being cognizant of nuances.

Token Distribution & Allocation Filters

The great team at Messari created the chart below, which demonstrates the wide-ranging distribution among leading blockchains.

It is easy to see the stark difference in token allocation among the Public Blockchains, but only upon careful examination do these hidden factors emerge. For example, Ethereum and EOS are heavily skewed in favor of public investors, in comparison to Binance or Solana. Still, distribution alone only paints a vague picture. 

Today, Solana, Polkadot, and Cardano have a comparable market cap, but when we drill down into the investor allocation the hidden selling pressure becomes visible. 

More prominent metrics to keep in mind are the entry prices for each investor and their return expectation, which in part depend on the investor type and their risk tolerance. A retail investor may be content with a return of 50 percent on his investment, but for an institutional investor, this ROI may be unsatisfactory. 

Solana’s seed sale, which constitutes ⅙ of all market tokens, was at $0.04 and at its ATH it surged to $260 (x65 relative return).

We also inspect some additional metrics: do the tokens have a cap (BTC)? Are they inflationary (SOL), deflationary or a combination of the two (ETH)?

Bringing all these metrics together paints a more wholesome picture, but we have other, superior filters ahead.

From Users to Partners

Web2 brought us centralized platforms on which the users were the product. The users on diverse social media platforms were the ones creating the content and value, and were compensated with “likes”, hearts, and various emojis (instead of a piece of the pie). Thus almost 100% of revenues generated went to shareholders. Web3 flipped this pie on its head and now users are the stakeholders, and the platform's partners have to get an equitable and more satisfying chunk of the pie, one that ensures a sustainable product and platform. In this scenario, everybody wins.

When legacy equity stakeholders and investors came to crypto, they viewed tokens through the old equity model, whereby investors were looking to achieve the same token percentage that they were used to holding in equity. 

Henry Ford famously said, “If I had asked people what they wanted, they would have said faster horses”. A new technology calls for a new infrastructure and a new infrastructure necessitates a different outlook. Soon enough, these legacy folk started to learn that the token model should be examined through a new lens.

While equity-based deals meant founders and investors were diluted with each round of funding, the Web3 model usually offers investors and founders a non-dilutive structure. This means they can own fewer tokens (than required by equity-based investments) and enjoy a comparable – or even better – potential upside. 

Web3 has also driven the trend towards DAOs (Decentralized Autonomous Organizations), which adds a new layer of active participation in, and governance of, the product. Community engagement and evangelism happen when users have skin in the game and/or are so impressed by the product that they “have to share it with their friend”. This, if sustained, can create organic-viral growth. 

In other words, if a  network is to be owned by the community (token holders), the piece of the pie that is distributed to investors/founders/team must be smaller than it was, in the old days of 2018. This growing movement shrank the percentage distributed to the team and investors, and in some cases has even fallen to 25% in total. 

Who Doesn’t Like a Bigger Pizza Pie?

Tokenomics lies at the heart of the product and platform. The token allocation, or the way the pie is sliced, is only secondary when judging the Tokenomic merits of a platform. 

Striving to grow the pie chart is much more important than how you initially divide it.

The Good, The Bad And The Unbalanced

Two of the prime metrics when assessing a project are Value Creation and Value Exchange (and Value Capture, but we’ll leave that for later). Value is created when one side (the supply side) produces something that is perceived as valuable to the other side (the consumer). Two clichéd rules of thumb to remember: there are no free lunches, and if you’re not paying for it, you are the product. A Token is a medium of exchange and in order for a rational person to exchange value, they need to get a slightly greater value in return (to be worthy of his effort), hence Value Exchange. 

Crypto gets a bad reputation in respect of fraud (largely inflated by today’s clickbait news environment). Yet if we are honest, some of this is deserved. First we look for the value creators or producers in a project. If they aren’t immediately obvious, that’s a red flag.

Projects whose Tokenomics are based on others buying, holding, and encouraging others to do the same in a pyramid structure, create no value thus aren’t sustainable. 

Olympus DAO (OHM), is a (somewhat contentious) project which has the merit of trying to be the crypto world’s reserve currency, but some criticize its structure. OHM offers extraordinary APYs (which fluctuate) reaching into 5 digits at times.

OHM's “motto” (3,3) comes from game theory, meaning it is in the best interest of all players to keep on holding. As a result of OHM’s success, hundreds of projects have been forking its code and a shortlist of projects illustrating the phenomena can be found here. 

Lending and borrowing services are of the simplest barter mechanism. There is the supplier, i.e lender who creates value in proportion to the demand of the borrower. But what is the underlying product here? Only time (and the market) will tell.

Trust Me, I’m a (Crypto) Engineer

The primordial, most basic human emotion, and the strongest driver of behavior are fear and the avoidance of pain. Most people need to avoid pain more than they need to gain pleasure. Behavioral economists call this risk aversion and that’s why,  when introducing a new product, there’s always a slide of “what pain does it alleviate?” 

People think that the groundbreaking invention of Satoshi Nakamoto, the godfather of Bitcoin and DLT, is digital money but this is a somewhat one-dimensional perspective. Nakamoto invented a technology of decentralized trust. A mechanism for certainty. 

Good Tokenomics design is very similar to good product design – which starts with the end-users in mind. People crave certainty and comfort, and products that are transparent and trustworthy are more aligned with customers' inner incentive mechanism.

Forta is the first decentralized, community-based, security platform to prevent/ mitigate smart contract exploits as they occur. This real-time, smart contract threat detection is created by a community of “agent writers”, whose scripts look for suspicious transactions, provides scanners and alert nodes which are responsible for running agents. 

Forta's product provides certainty and safety for smart contract developers. In other words, it’s built for a multi-sided market comprising smart-contract-based protocols, detection agent developers, node operators, and validators – each with their own set of incentives. Here’s an explanation of how Forta could have prevented PolyNetwork’s $600M hack (which is quite an incentive).

Subquery is another great example of good token design with regard to a clear supply-side and demand-side. In short, Subquery is a marketplace for data indexing and provisioning where consumers, i.e. app developers, make requests to the Subquery network for data and Indexers, who supply relevant transformed data.

The clear value proposition of quality data is well known, but the linked list structure of block-chains makes extracting and traversing data much more complex. In addition, Subquery provides an infrastructure solution for project deployment. In essence, Subquery creates a faster, safer, and cheaper solution for projects to meet their goals, where each protocol contributor is rewarded for their contribution. 

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Consumers make requests to the network for specific data and pay an advertised amount of SQT in return.

Indexers (i.e. producers) host Subquery projects on their infrastructure, running both the node and query service to index data and answer GraphQL requests.

Delegators participate in the network by supporting their favorite Indexers to earn rewards.

Why are Tokenomics So Important?

First and foremost, good Tokenomics are the flywheel that brings new users to platforms. They are also the reason they keep using the platform. 

Another reason Tokenomics are so important relates to the nature of decentralized organizations and the immutability of smart contracts. Once a Tokenomic model has been implemented and agreed upon, it is harder to fix (when compared to a centralized product with quick product interactions and a “move fast and break things” culture).

There are many examples of great crypto projects that failed, purely because they used a “bad” model.

Different people need different amounts of motivation to behave in a certain way, and it’s the same with products. There isn’t a one-size-fits-all model. Planning, designing, and creating a proper token mechanism is a difficult balancing act, and it requires many iterations of trial, error and communication.

Win-Win-Win

In order for people to invest/spend money, there needs to be Value Creation – which in turn enables Value Exchange among its counterparts. But Value Creation is not enough. History is full of one-hit wonders, but a platform or product that aspires to be sustainable has to devise a Value Capturing plan, and that has to start with the users in mind.

For a Poly Victorious ecosystem to thrive it needs to provide its users with clear shared goals and facilitate cooperation among its members.

Platforms create value for their users by facilitating interactions between their different stakeholders. The type, frequency, and density of these interactions can lead to one of the buzziest of buzzwords in the crypto-verse which is…network effects. 

In the next blog post, we’ll dive deeper into the “how”, and introduce a myriad of strategies, approaches and tactics we employ to empower and grow platforms. From a winner-takes-all market to an all-winners market. And reaching this Holy Grail starts with an aligned incentives token mechanism at the center.

Want to share thoughts?

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This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice