BuidlersTribe Research

Throughout history, businesses have operated within existing economic frameworks and regulations set up by governments of various countries. The microeconomics of these businesses had a close correlation to the macroeconomic framework because of the boundaries they set. 

Web3 changed everything. The mechanics of ownership of assets, spending of currencies, and distribution of power have changed. Every single project can have an economy of its own completely independent of the economy of another. 

With this great power comes great responsibility. You are not just a founder anymore running product, tech, ops, HR, etc. You are now responsible for a whole decentralized economy, which clearly means that you have both a fiduciary and moral responsibility to the people who believe in your project.

This concept is extremely new to the world of tech, and tokenomics design as a concept is still in its very early stages and everyone is learning. As a responsible founder, it is important that you do your best when you are designing the economy of a decentralized project, and this guide is here to help you do just that.

To design the tokenomics of your project, you will need to know certain fundamental concepts of economics. This should take approximately 30 minutes of your time to complete.

Fundamentals

Supply

Supply simply means how much of a resource it is available. It is an equation of abundance. If something is abundant you will not pay a good price for it. Take oxygen for example. If there was someone on the street selling cylinders of breathing oxygen (assuming you are hale and healthy) you would not buy it because there is enough in the atmosphere.

Similarly, scarcity of a resource drives the price up. Ex. Devs in the Web3 ecosystem are scarce (low on supply) and they are very expensive to acquire.

A fashion season at a “Supreme” store sees people standing in queues and pitching tents outside for >24 hours to buy virtually anything they can get their hands on at the store because every single item is a limited drop. Supreme will never create that item ever again. Folks who stand in the queues are all there to buy an item and flip it at a higher price.

The same principle applies to tokens too.

We will see more on factors that affect supply later in the piece.

Demand

The other side of the same coin is demand. Demand is a measure of how much people want a resource. Basically, when demand is high the price is high, and when demand is low, the price is low.

When we looked at supply, we saw that scarcity drives the price up. But scarcity alone is not enough. There has to be demand for a scarce resource’s price to go up. The best example was given by Nat Eliason in his “Tokenomics 101” piece:

“I could go into my backyard, break a few rocks, and then say they’re the only rocks I’m ever going to break and put up for sale. I have a fixed supply of 10 rocks. 0 inflation rate. So they should be worth millions, right? 

Well, no, because no one wants my broken rocks.”

Demand is generated only if the resource has utility or if it may hold a higher value in the future.

To piece the concepts together: High demand and low supply will increase the price of a resource, and high supply and low demand will pull the price down.

Demand and supply work together to decide the “price” of a token. When both the supply and demand sides agree upon a price for a resource, it is called Equilibrium.

Many different factors affect the supply and demand and we will see these later in the piece.

Inflation and Deflation

Inflation is the decrease in purchasing power of a currency (or token in this case). An increase in supply can cause inflation. Let’s understand this with an example:

There is a Village with 100 people who on average have about $100 in their bank account. The government gives a stimulus check of $100 to each villager. Now every Villager is $100 “richer”. The local shoemaker now notices this and increases the price of his shoes from $5 to $10, now that people can afford them. Soon, the grocer, the blacksmith, and the goldsmith increase their prices too.

A shoe that cost $5 before the stimulus, now costs $10. So resources/goods just got more expensive. The cost of living also went up. This is inflation.

This happens at a macro scale when more money is printed by Central Banks and the same thing can also happen when your token supply increases.

In simple words, inflation is when the price of goods rises and the value of the currency/token drops (because now you can do less with the same).

Deflation is the exact opposite of inflation. This happens when there generally is a crunch in supply. If there is a crunch in supply, people will wait for the prices of goods to go down, and this results in more goods that can be bought with the same amount of currency/tokens. This means that the value of the currency/token is high. 

Basics of Token Economics

What does a token mean/ represent?

Besides the tech, tokenization separates web3 projects from web2 projects. Most tokens have governance rights which allow holders to participate in the governance of projects by voting on key decisions on the project and the treasury. The token is what allows for the decentralization of a project. Token holders have equal rights irrespective of their status. Ex. Advisory and public tokens hold the same amount of value and power.

Maximum Supply

The total amount of tokens that can ever exist is the maximum supply. Many projects keep a fixed max supply because it may deflate due to scarcity in the future. It is generally advised for governance tokens to have a fixed maximum supply. Keeping a fixed max supply allows for the token holders to share incentives provided amongst themselves because if there is an unlimited supply the incentives distributed will be ~0. 

Circulating Supply

By definition, Circulating Supply is the total number of coins or tokens that are actively available for trade and are being used in the market and in the general public. Circulating supply is a good measure of how liquid the token is in the market. Momentary abundance and scarcity can be measured by looking at the circulating supply of the tokens in the markets. If there is an increase in the circulating supply of a token, it indicates abundance and typically moves the price of a token down, while the opposite indicates scarcity and can move the price of a token upwards.

Allocation

Among the maximum supply of tokens, certain tranches can be created. These tranches are created for various reasons:

1. Raising money from investors of the project’s choice
2. Controlling the centralization of power and the incentives
3. Controlling the usage of tokens for various purposes Ex. Community, Marketing, etc.

Allocation design has to be done very carefully. We will talk more about it in the next section: Mechanism Design.

From deep research done by Lauren Stephanian and Cooper Turley in their piece “Optimizing Token Distribution”, it was observed that most of the popular projects allocated governance tokens in the following buckets:

1. Community Treasury
2. Core Team
3. Private Investors
4. Ecosystem Incentives
5. Airdrops
6. Public Sale

Lock-ups, Cliffs, Vesting

Allocating tokens is one thing, but controlling the circulating supply of these tokens is another. The circulating supply needs to be controlled for the following reasons:

1. Stop pumping-and-dumping from early investors
2. Control sudden inflation in the token economy

Let us now look at each term and what it specifically means:

Lock-Ups

A lock-up is used to define all the tokens removed from the circulating supply, which prevents token holders from selling tokens and creating selling pressure. Lock-ups are most popularly implemented via “Staking” mechanisms where token owners can lock up their tokens in exchange for incentives.
An important metric to pay attention to is Total Value Locked (TVL). TVL is the sum of all staked crypto assets that are earning incentives. A higher TVL indicates that there are enough long-term positive speculators in the platform because they have “given up” their right to sell the tokens in the near future. But this doesn’t necessarily always mean that higher the TVL the price will always go up.

Cliff

A cliff is a mechanism built-in that locks up tokens of the core team/ early investors and prevents the tokens from entering circulation in the first place. Cliffs ensure:

1. A longer-term commitment toward the project
2. Prevents the possibility of a pump-and-dump

Let us assume you as a founder have built up a team, and have allocated 0.5% of the max token supply to your Head of Marketing. Due to unforeseen circumstances, within the first month, she has to move away from the company. The investors, core team, or the community wouldn’t be happy with someone just walking away with 0.5% of the max supply. A Cliff reduces the risk of these tokens getting allocated to the individual or circulated in the market.

Vesting

In simple words, Vesting is the unlocking of allocated tokens that move into circulation. Vesting can be of two types:

1. Cliff Vesting: All allocated tokens get unlocked as soon as the Cliff period ends
2. Graded Vesting: Tokens get vested in a graded manner over time
3. Hybrid Vesting: A combination of the two

Let us understand the above with examples:

You have hired a Head of Marketing with a Cliff Vesting period of 1 year that ends on 18th April 2023. If she exits the project at any period until the 17th of April, she will walk home with 0 tokens to her name, but if she exits on the 19th of April, she walks home with 100% of the tokens allocated to her. This is Cliff vesting.

Graded vesting is when tokens vest with time. You can have daily, monthly, quarterly, or yearly vesting. Let’s assume this very same Head of Marketing had graded vesting of tokens where 120 tokens vest monthly over a period of 2 years. This means that every month she works on the project, she is going to earn 5 tokens. If she plans to leave in 5 months, she can go home with 5*5=25 tokens of the project.

Hybrid vesting is the most popular method we have observed across all the web3 projects. There is an initial cliff period where there are zero tokens vested and a vesting period initiates as soon as the cliff is complete. Ex. There is daily vesting of 1 token per day for 3 years after a 1-year cliff period. If the Head of Marketing leaves the project within a year, she gets 0 tokens. If she leaves any time after the end of the year, she will walk home with the number of tokens she was allotted every single day that she has worked on the project.

Such models are called “Linear” Vesting models. This means the tokens vest linearly over time, and the unit of time can be determined in days, months, or years. 

Total Supply

Total supply is the sum of the circulating supply and the total value locked (TVL).

Factors that Govern Token Value

The contents of this section have been collated from the model described by Nat Eliason in his piece Tokenomics 101.

Once the tokens are out in public circulation, it is the market that determines the price (a representation of value) of a token. These factors are reverse engineered from user behavior that the market has seen over time. 

Supply-Side Factors

Circulation

The question the market wants to be answered here is: “How many tokens exist now and how many will ever exist?”

From the first principles of Supply, we understood that the abundance of a resource will make people want it less, and rarity will make people want it more. A higher circulating supply of your tokens will create a notion of “abundance” in the minds of your token holders. True believers might hodl your token, but there will be many sellers. When more people sell your tokens it will decrease the price of your tokens.

To avoid tokens being in open circulation, systems like staking have been introduced where a holder can lock up their tokens for a certain period of time (hence preventing it from entering circulation) in exchange for future rewards, incentives, and/or utilities. Ex. Locking up $CRV tokens for a minimum of 4 years gave a staker access to $veCRV which gave them voting rights on directing the revenue and rewards generated on the platform (a very powerful utility with incentive)

Emissions

The question the market wants to be answered here is: “How quickly are the tokens being released?”

If you are releasing a high number of tokens at a rapid velocity, the tokens will be abundant. So it is important to control token emissions. If a founder is in a hurry to decentralize a project too early, it will be pretty evident from a steep slope in the token emission schedule of the project.

If the tokens are getting released over a longer period of time, inflationary effects won’t kick in as hard. Ex. Bitcoin emissions were set over a period of 131 years, which is why we might never get to see an inflationary effect on Bitcoin based on emissions only.

Distribution

The question the market wants to be answered here is: “How much of the total supply is controlled by a select few?”

The market is generally worried about whether a select few holders of the tokens control a large portion of the total supply. If investors are holding a large portion, say 30% of the Total supply, and their tokens become liquid within a coming couple of months, then the public stops positively speculating the token because they expect future “abundance” in the token.

This is precisely why vesting needs to be planned out well, where there aren’t too many tokens getting vested immediately thus causing a spike in the circulating supply. 

Another trust factor that comes into play is the governance portion. If you are giving voting rights to token holders on governance proposals, then people will be wary of holding the token if the distribution is unfair. Ex. Compound Proposal #86. A proposal was made to support $MATIC on Compound, and about 35 different addresses staked many $COMP tokens to vote for the proposal (~125k votes). It was not until the last moment that A16Z which controls 9.66% of all the voting rights on Compound came in and voted against the proposal with ~321k votes, outclassing the rest of the voters by more than a collective 2.5X.

Such incidents in governance make token holders feel helpless and give up the token itself. This particular problem is actually a governance problem but is a second-order effect related to allocation and supply.

Demand-Side Factors

Supply factors aren’t the only things that govern the value of the token, demand factors are equally important if not more.

Incentives

Speculation drives buying decisions, but to hold a token, speculation alone is not a sustainable motivator for a token holder. There has to be an additional reason to hold a particular token. This is where incentives come in. There are many ways to incentivize your token holders:

1. Monetary incentives
2. Staking
3. Combos of the above methods

DEX’s like Sushiswap distribute a portion of the revenue to $SUSHI holders. $CRV token holders earn a share of the trading fees earned by the protocol. This is one way of incentivizing the holders. The other way is by providing discounts on various activities in the project/protocol  Ex. Low/No transaction fees,

Staking is another method that allows 2 things, cutting the circulating supply (thus causing a scarcity effect) and another is providing and giving the stakers more tokens as a reward. This shows the market that there are many long-term believers in the project.

A combination of the above methods coupled with a solid concept of Game Theory has been implemented in many projects.

Again let’s take the example of Curve Finance, where they introduced an incentive to users to participate in specialized governance. This is precisely what started the “Curve Wars”. Essentially, $CRV holders could stake $CRV for a minimum of 4 years in order to earn veCRV which gave them the right to decide the distribution of revenue to specific liquidity pools.

This led to many wallets hoarding curve and staking it to get veCRV that allowed them to divert rewards to LPs they were a part of.
Here is a deeper dive on the Curve Wars in case you are interested: https://every.to/almanack/curve-wars

Memes

As much as it doesn’t make sense, meme values can make or break the value of a token. Meme values are just pure beliefs that a token’s value is going to go up or down in the future. This belief can be generated in many ways by external factors such as influencer endorsements and news.

Ex. Dogecoin. If one evaluates $DOGE based on the factors before Meme value, nobody would buy it. No utility, no incentives, perpetually inflating, zero control on emissions. An economist’s nightmare, but it yet has survived. Celebrity influencers like Elon Musk mention it in a tweet (jokingly or otherwise) and the price just shot up. 

Other meme values include judgments and speculations based on things like street cred of the founders, activity on discord and socials, the brand value of the token, etc. Ex. Nobody outside of Solana core knows what xNFT is, but there are about a 1000 Twitter handles with xNFT as a prefix to their name. Pure meme. I’m pretty sure whenever this project comes out, there is going to be a major sellout effect.

Things to Keep in Mind when you are Designing the Tokenomics of your Project

Allocations

There is no one right way to design the allocation of a project. Allocations are a function of the utility of the token in the project or protocol. If you are designing an L1 chain with a POS consensus mechanism, there has to be a large number of tokens allocated to community rewards and to the public, whereas if you are building a DEX, you will need a good amount in the treasury to provide liquidity.This article will give you a good understanding of ideal allocations based on data crunched from the tokenomics of 60 dApps.

Incentives and Utilities

Incentives and utilities. Game theory can be used to make a robust incentive to hold structure for your token. Game theory is a whole other specialization course on its own. My favorite material on Game theory is the class taught by Prof. Ben Polak at Yale. The course is completely free of cost and available here .

Before that, let’s see what is not an incentive. Governance is not an incentive because it does not bring any value to the individual (unless it is a rare proposal deciding on what to do with the treasury or revenue). So the ability to vote is not an incentive.

It can be considered a utility. Again when it comes to utilities, the ability to spend the token on the platform is not a utility. The utility comes when you can only buy a particular item/resource/asset with only that token. The utility lies in the underlying value that can be obtained by spending the token.

As Alexander Bulkin mentions in his piece “Cryptoeconomics is Hard”:

“If you can exchange a bitcoin for something valuable (a dollar) then the bitcoin has the same value as its dollar price. If you can exchange Filecoin for a decentralized storage service, its value is the value of that storage service.”

Emissions

When you are designing the emission schedule for each of your allocated tokens in the project, be mindful of a few things:

The founders must have the longest vesting period as compared to the investors and the public. This gives the token holders the confidence that the founders and the team are committed to the project for the long term and cannot pump and dump their tokens while the others’ tokens are locked up on a cliff or have not yet vested.

The same principle applies to early vs late investors. Early investors of the project must have a longer or the same end of vesting period as the later investors. As a founder, you will have raised money from early investors say at $1 per token, and from later investors at $2.5 per token. The early investors must not be able to dump their position at TGE.

More on designing your TGE in the next piece. Until then use the tokenomics simulator below to generate an emission schedule for the model you’ve designed!

Tokenomics Simulator

Steps to use:

1. Create a Copy of the Sheet
2. Do change anything in the second and third sheet
3. Enter the values of your choice in the cells highlighted Yellow
4. Make sure that the slope of each allocation is not too high (this means that you are releasing too many tokens into circulation too fast!)
5. Spread the word on Twitter. Don’t forget to tag @BuidlersTribe!

Link to the Simulator

References

1. Tokenomics 101, Nat Eliason
2. Optimizing your Token Distribution, Lauren Stephanian and Cooper Turley
3. Cryptoeconomics is Hard, Aleksandr Bulkin
4. Creating a Cryptoeconomic Protocol from Scratch, Vlad Zamfir
5. $BICO Token Economics, Biconomy Team
6. Field Guide to the Curve Wars, Nat Eliason
7. Evaluating Tokenomics, Tokenomics DAO

And about 50 more articles I can’t remember!