Primer Token Economics: The Basics of Valuing Cryptocurrencies
Original title: Tokenomics 101: The Basics of Evaluating Cryptocurrencies
Author: Nat Eliason
Original compilation: Lu, WhoKnows DAO
In the Web3 era, evaluating a project's token economic model is an essential link.
introduction
#01
introduction
Tokenomics has become a popular term over the past few years to describe the mathematical models and incentives of cryptoassets. It covers the mechanics of how an asset works, as well as the psychological or behavioral factors that affect the value of a cryptoasset over long-term time frames.
A project with well-designed token economics will have more long-term value because buying and holding tokens will be effectively incentivized. Projects with poorly designed tokenomics are doomed to failure, as people are quick to dump assets at the first sign of risk.
If you are considering whether to acquire crypto assets, understanding token economics is the most effective way to help you as the first step in a good decision.
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#02
Token Supply: Release, Inflation and Distribution
Let's start from the supply point of view, because this will be easier to understand. Now, we have to figure out an important question:
Unilaterally based on the perspective of supply, should we maintain or increase expectations for the value of tokens? Or will there be inflation in the value of tokens?
On the supply side, if there are fewer tokens in existence, the value of the token increases—we call this deflation. If more and more tokens exist, their value will drop - we call this inflation. When you evaluate a project from the perspective of the supply side, you don't need to think about whether the token has actual utility, or how much income it will generate for the holder. Just focus on one point, the token supply and how it will change over time.
There are a few questions we need to figure out:
How many tokens currently exist?
How many tokens will be generated in the future?
How fast are new tokens released (increased)?
Bitcoins follow a simple and straightforward supply curve as they are produced, and they will be released over approximately 140 years.
This means that 90% of bitcoins are already in circulation, and 100 years from now, the overall total will only increase by 10.5%. Therefore, the expectation of bitcoin depreciation due to the inflation mechanism is not strong.
What about Ethereum? The circulating supply is approximately 1.1 billion, and there is no upper limit to the circulating supply of Ethereum. However, the supply of Ethereum has recently been adjusted with a burning mechanism to maintain a constant number of tokens, and there may even be deflation, resulting in a total supply of tokens between 100 and 120 million. With this in mind, we should also not expect too much inflationary pressure on Ethereum. It can even be deflationary.
Dogecoin also has no supply cap and currently has an annual inflation rate of around 5%. Therefore, among the three tokens, we expect the inflationary mechanism to bring depreciation pressure on Dogecoin, which will be stronger than that faced by Bitcoin or Ethereum.
The final issue to consider is supply allocation. Are some investors holding large amounts of soon-to-be-unlocked tokens? Does the protocol provide a significant amount of tokens to the community? Is the distribution mechanism fair? If some investors own 25% of the tokens that will be unlocked within a month, you should be careful when buying.
What about DeFi tokens? Yearn, the first DeFi protocol I introduced, already has a fixed supply of 36,666 YFI. There is no release and inflation mechanism, so the value of YFI will not depreciate due to inflationary pressure.
Meanwhile, Olympus, a DeFi protocol I recently covered, has an insanely deflationary timeline, with tons of OHM tokens being minted every day. In theory, holding OHM is a bad bet. However, we will soon discover that supply logic alone is not enough to understand whether a token is worth buying or holding.
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#03
Token Needs: ROI, Memes, and Game Theory
Let's say, I go into my backyard, break some rocks, and declare those rocks to be the only ones I want to sell. And their supply is only 10 blocks, which is not inflationary, so they are worth millions, right?
But no, because no one wants my shattered stones.
At this level of supply magnitude, there is not much difference between my stone and Bitcoin in essence. Just having a fixed supply doesn't make something valuable. People also need to believe that these objects will have value now and in the future.
If you want to understand whether a token will have demand-side value in the future, you will want to think in terms of ROI, Memes and game theory.
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ROI (Return on Investment)
In the case we’re discussing, ROI isn’t what you think it is — the gain from shipping after the tokens go up. It is the process of holding this token that brings you income or cash flow.
For example, after the launch of Ethereum POS, if you are a holder of Ethereum, you can pledge ETH to verify network security. In return for staking, you will be paid in Ethereum at an interest rate of around 5%.
Some tokens allow you to earn a portion of the income of the protocol they represent by holding them. For example, if you are a Sushi Holder, you can pledge their tokens to get rewards from the Sushi protocol, the current annual interest rate is about 10.5%.
Another form of ROI can be reflected in "Rebasing", which is very similar to a stock split. This will be reflected when you hold or pledge tokens. When the protocol increases the token supply, you will get more tokens. This is how Olympus works. This means that a high inflation rate is sometimes not a bad thing for the agreement, because the shares you hold will not change.
ROI is one of the key points of the research. When a token does not have the characteristics of generating return on investment or cash flow, it is even more difficult to prove that it is meaningful to hold them. You have to trust that other people's belief in the token's rising price is strong enough to maintain its price.
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Memes
The reason people want to acquire tokens is simply the belief that other people also want to acquire it and will hold it in the future.
You can call it beliefs, beliefs, or memes, but whatever you want to call it. This mechanism for generating belief in future value growth is always an important consideration.
How would you evaluate it? Other factors that constitute token economics can be clearly quantified. How is this reflected in Memes? To understand it, you need to go to the community to be rooted in the feelings.
What does the project’s Discord ethos look like? How active are they on Twitter? Are people using their tokens or protocols as a form of identity? How long have people been active in the community?
Belief in future value is often the strongest motivator on the demand side. Bitcoin has no cash flow, no staking returns, nothing. People just believe that his long-term store of value can compete with gold. Or more ambitious beliefs like decentralized finance and hyperbitcoinization.
So, while rational analysis can be compelling, one cannot underestimate the beliefs, interesting memes, and cult following that a token can garner.
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game theory
Game theory requires you to think about what additional factors in the design of token economics can increase the demand for tokens. This is where token economics can get complicated. It is also the key issue that I will focus on in the follow-up article "102".
One common good tokenomics game theory use case though is locking. This protocol creates an incentive mechanism for locking tokens in contracts, usually in the form of higher rewards. The classic case for this is Curve.
It's a bit like Sushi, where you can lock up your CRV tokens and earn a portion of the protocol's revenue. In addition, the longer you lock in, the greater your benefits, up to a maximum of 4 years.
In addition, the more CRV tokens are locked and the longer the lock time, the lower the rate of using other functions of Curve.
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#04
Token Economics in Practice - Evaluating a Project
Now that you have a clear idea of the problem to be solved, let's walk through the project evaluation process.
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Convex Finance
Convex is a platform built on Curve, which helps you get higher returns by aggregating many investors. If you have locked up thousands of CRV tokens for 4 years, it allows you to earn most of the high yield you get on Curve without having to lock it up yourself.
By accessing their documentation, we can address the issues listed in the text.
token supply
The supply of Convex is fixed at 100 million. This will be released at a decreasing rate over time, depending on the amount of CRV tokens deposited.
According to Coningecko, 78.5 million of the 100 million have already been produced, which means that the current supply will increase by 33%.
Most of these tokens will be distributed to people using Convex. This is a very fair distribution method, and only relatively small chips are allocated to the team and investors. Imagine if Amazon distributed 75% of its shares to the people who use Amazon:
So, there is a fixed supply of tokens, the remaining tokens are being released at a decreasing rate, most of the tokens are allocated to the community, and there will only be a maximum of 33% dilution. In terms of token supply, it is very good.
What about token demand?
token demand
To assess token demand, you need to address a question: why would you hold CVX tokens?
By holding CVX tokens, you can earn a share of Convex revenue. That's not a huge gain, currently only 4%.
On top of that, you can lock up CVX tokens for 16 weeks, and when you do, you'll earn various rewards from a number of protocols, all in return for Convex stakers.
On top of that, you can become a voting representative of Convex and in return for a “bribe” get access to Votium services.
Therefore, even if there is no change in the value of CVX tokens, staking CVX tokens will have a considerable ROI. Moreover, he has a very powerful game mechanism to support holding tokens, because you can only get these benefits after locking the position for 16 weeks.
Convex's Memes is not powerful, because it is a relatively boring Defi protocol background. They don't need to because it's a cash flow machine;
So, Convex has a fixed supply that is mostly allocated to the community, most of the tokens are in circulation, and there is not much inflationary pressure. In the process of holding positions, CVX holders will receive considerable dividends from protocol usage fees and other rewards, which reduces the incentive to sell when the token price falls.
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#05
self assessment
This will give you a good basis for evaluating new projects. By reading the documentation and white paper, you should have a good understanding of how token supply should be managed and how the demand for tokens and cryptocurrencies is driven by what forces.
The question that should be kept in the back of your mind should not be "Will these assets appreciate against the USD" but "Will this thing appreciate against a range of cryptocurrencies (ETH/SOL/BTC, etc.)". Most cryptoassets are highly correlated and affected at the same time, and if you are holding assets other than large public chain tokens, it should be based on a belief that token economics and incentives will make it Outperforms the coin that built it.
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