Understanding Token Economics

Introduction

The study of economic models and token distributions in the cryptocurrency market has become known as token economics in recent years. For any crypto to have value, it needs some incentive for users to hold that token. This in turn incentivizes demand for the token which leads to an increase in price.  There are many different ways to incentivize users to hold tokens, but for this paper, we will be taking a look at some of the main token economic models seen in the crypto market today. 

Economic Models of the Top 100 Tokens:

Deflationary Model (Currency)- Example BTC, LTC, BCH

In a deflationary token economic model, there is a hard cap on the number of tokens created which acts as a deflationary mechanism as demand increases over time but supply does not.

Inflationary Model (Utility)- Example ETH, DOT, SOL

In an inflationary token economic model, there is no hard cap on the number of tokens created. There are various iterations of the inflationary token model with some token issuers limiting token creation to a yearly basis, others going off of a set schedule, and some opting to determine supply based on-demand data. 

Duel-Token Model (Other)- Example VET & VTHO, NEO & GAS, ONT & ONG

In a dual-token economic model, two distinct tokens are used in combination on a single blockchain. This generally includes a store of value token as well as a utility token. The purpose of this model is to incentivize users to hold the store of value token to receive returns in the form of the utility token which can be used for transactions on-chain.

Asset-backed Model (Stablecoins) – Example PAXG, USDT, USDC

In an asset-backed token economic model, an issuer pegs the value of an asset to the token’s underlying assets, similar to an Asset-Backed Security in traditional finance markets. Asset-backed models can rely on assets with fluctuating valuations such as gold or fixed assets such as the US Dollar.

From the above graphic, we can see that the majority of the top 100 coins by market cap follow a deflationary utility token model, with the second most popular option being an inflationary token model.

Returns by Economic Model: 

Over the last year inflationary token models such as ETH, DOT and SOL have done very well, returning 2392% in aggregate. In fact, inflationary models have had the best returns over the last year by a narrow margin, beating the returns of deflationary models (2067%), Dual-Token Models(2084%), and Asset-Backed Models (116%). Despite the lack of systemic scarcity, the data shows that inflationary tokens without a hard cap have been able to appreciate the most in value in recent years. The relatively small difference in returns between deflationary, inflationary, and dual token models indicates that the economic model may not be a defining factor in a token’s success.


Proof of What?:

Next, we are going to take a deeper dive into the underlying consensus mechanism behind these token economic models. While there are several different ways to get consensus, we are going to be taking a look at the mechanisms behind the top 100 coins. In order to do this, we first need to understand a few key definitions.

Reference: https://medium.com/@Telosfeed_en/the-blockchain-ecosystem-273544192b7c

Of the top 100 coins, the most common consensus mechanism is PoS, with over 55% of projects utilizing this method.

Taking a look at returns by consensus mechanism over the last 1 year we can see that Pow tokens have outperformed the rest of the categories, followed by DPoS 

Moreover, the top returning coins by consensus mechanism can be broken down further by economic model and consensus mechanism 

As we can see from the graph above, Deflationary PoS has seen the best performance over the past year, seeing over 6000% growth on average, while Inflationary PoW tokens have done the second-best over the past year, seeing over 4000% growth on average. In the case of Deflationary PoS tokens, investors are attracted to token models where they can earn a yield on their assets while still having a hard cap on the total supply. While in the case of inflationary PoW tokens, investors are once again incentivized by cash flow, but this time through mining rather than staking. For mining rewards to be high on new platforms, token issuers must use an inflationary model which allows them to offer a high yield for early miners.

Funding Methods: ICO vs Private Sale vs Airdrop vs “Mining”?

There are multiple ways for token issuers to circulate their tokens when they first launch. There are funded options, such as an ICO (or IDO) or a Private Sale which allow the token issuer to sell tokens directly at a fixed price to select individuals or the general public. There are also non-funded options such as distributing tokens to existing holders of another crypto or allowing users to signup to receive tokens via an airdrop. Tokens can also be released only through PoW or PoS where the tokens serve as a reward for miners or token holders who chose to stake on the network. Each of these distribution methods serves a different purpose and has varying effects on the performance of a token. 

Below we see a breakdown of the distribution style of the top 100 coins, as well as an analysis of each distribution’s style’s return over the last year.

One thing to note when looking at this breakdown: deflationary currencies like bitcoin often have only one method of distribution, i.e. mining only. On the other hand, inflationary currencies like Luna usually have multiple methods of distribution, including but not limited to: 

  • Inflationary Rewards- ie Staking or Mining 
  • Fundraising Events – ie ICOs and Presales
  • Airdrops

Interestingly, the majority of protocols that distribute rewards based on platform usage are deflationary by nature and have a fixed hard cap. This suggests that those who receive the highest rewards are always early users, which helps speed adoption by incentivizing token discovery.


Case Studies:

VGX (Voyager Token)

VGX (Voyager Digital) is a lending platform similar to Blockfi or Celsius allowing users to earn yield, trade, and take out loans backed by crypto. VGX is the utility token behind the platform, allowing users to get discounted services as well as higher yields and earn cashback rewards based on the amount of VGX in the user’s wallet. VGX token merged with LGO, (a France-regulated AMF entity) in 2020. The swap included a 1:1 swap for existing VGX token holders and a 1:6.536 ratio for existing LGO token holders, resulting in 255,491,293 tokens being distributed at the launch of the new VGX token. Existing holders were given one year to swap their tokens, with any remaining legacy VGX and LGO to be burned after the end of the one year. 

Along with the token upgrade came the creation of an annual allocation pool to grow the community and encourage the staking of VGX. The initial staking rate was fixed at a solid 7% annually for the first three years, with the community being allowed to vote on the staking rate after this period. The strategy paid off, with VGX’s number of unique senders increasing nearly 4x between 2020 and 2021 with cumulative transfer count also increasing by just under 4x according to cryptorank.io. Along with this increase in on-chain activity, the token price increased by over 150x over the year making VGX one of the best performing tokens on the market and outperforming BTC by more than 14,000%

BNB (Binance Token)

Binance issued its BNB token alongside the launch of its next-generation crypto exchange in 2017. BNB entitles holders to fee discounts on the Binance exchange and serves as a deflationary token that was one of the first examples of a successful buy and burn program.  Buy and burns are one of the ways in which inflationary (or deflationary) cryptos can encourage price appreciation. By intentionally decreasing the number of tokens in circulation token issuers can limit the market supply creating a supply/demand imbalance that often results in consistent price appreciation.

In BNB’s whitepaper, the plan outlined was for a hard cap of 200 million BNB with the plan of burning a total of 50% of it, or 100 million BNB through buy and burns over time using 20% of Binance’s profit for each quarter. The results of this program were clear, especially in 2018/2019 when many tokens experienced a bear market, BNB was able to outperform Bitcoin by conducting multi-million dollar buy and burns. Other notable buy-and-burn programs include FTT (FTX), OKB (OKex), HT (Huobi). 

XDC (XINFIN TOKEN)

XDC (XinFin) token is a utility token based on Ethereum and JP Morgan’s Quorum technology.  XDC incentivizes users to purchase XDC by offering three different membership tiers based on the amount of XDC in your wallet. The first tier includes anyone that owns XDC tokens (which could be purchased through the crowd sale), the second and third-tier are obtained by holding a predetermined amount of XDC tokens which allows institutions to participate in the XDC consensus mechanism, and gain the ability to create private sub-networks. 

One interesting thing to note about XDC is its token release schedule. The XDC blockchain has a maximum supply of 100 billion XDC tokens that were 100% premined. Although there are 100 billion tokens, less than 13% of the tokens circulate within the market, with the rest being dedicated to founders, ecosystem development, allocations for the hedge pool, contingency funds, and philanthropic causes. Additionally, XDC locked in these pools is released slowly, with only 1-10% of the amount locked released each year. This artificial scarcity, despite the large number of tokens minted, has helped XDC outperform the market through strong price action. XDC is up over 12,000% over the one-year period.

(Xinfin Medium)

SUSHISWAP vs UNISWAP

Uniswap was released during the crypto bear market of 2018 during which it struggled to find volume. After the re-emergence of the crypto bull market in 2020, Uniswap began to gain serious traction with the Ethereum community doing billions of dollars in trades by mid-2020and Uniswap offered their UNI token to the public. Sushiswap was forked from Uniswap’s UNI token and offers many of the same features with a few critical differences in Tokeneconomics:

First, Sushiswap was created with no pre-mine, no VC investors, and no presale. Uniswap, on the other hand, was first created from a$100,000 grant from the Ethereum foundation and then did a seed round in April 2019 where they raised funds from notable VCs such as Paradigm Capital in exchange for roughly 18% of the 1 Billion UNI supply.

(Uni Blog)

Uniswap claims that their team and investor tokens would be vested over a multi-year period but never made the vesting schedule public. Despite strong VC backing at launch, very few labeled VC wallets appear to be holding UNI, suggesting many may, in fact, have sold early on. Additionally, Uniswap opted to distribute transaction fees to liquidity providers only, while SushiSwap distributes transaction fees to BOTH liquidity providers and token holders. The community impact of this difference was massive, allowing Sushiswap to surpass Uniswap in TVL in less than six months despite being launched nearly two years later. 

According to data from Nansen, Alameda staked xSushi in January and February of 2021 when rates topped out at just under 20% APY but stopped staking once yields dipped too low (10-12% APY). From February until May of 2021 Alameda held no xSushi in their wallet, but began to buy back in Mid-April when rewards started picking up before upping their stake significantly on May 9 to take advantage of high incentive rewards (20% APY which has since gone as high as 80% APY). This data shows that funds are willing to chase yield, and will move assets around to ensure they can generate the highest ROI.  Framework Ventures, which entered Sushi in September of 2020 was likely one of the Sushi launch partners. Framework sold their entire holding in Uniswap on September 16 (launch day) when the price of UNI spiked more than 50x from its presale prices. Framework has never repurchased sushi to their wallet. The selling that Framework did on September 16 had very little effect on price in the short run as investor demand was able to take on the additional supply. 3AC first entered Sushi in September of 2020 as one of Uniswap’s VC partners but sold all of their Sushi within 3 days after launch. 3AC has since sold and reacquired their position multiple times. Similar to Alameda, 3AC increased their sushi position in January of 2021 when staking yields were higher and decreased their position in February of 2021 when staking yields decreased. 

What’s more, roughly 70% of the UNI tokens have remained within wallets for greater than 90 days while 58% of addresses are older than 90 days old. Contrasting that versus Sushi, where 84% of Sushi tokens have remained within wallets for greater than 90 days and only 54% of wallets are older than 90 days, we can see that large token holders have been holding Sushi at a more consistent rate than UNI, perhaps due to its staking rewards and lack of pre-launch VC investment. Despite these differences, according to on-chain data from Nansen,  firms like Alameda were able to stake their UNI for cUNI on Compound finance, allowing them to earn yield on their tokens despite UNI not distributing rewards to token holders. This effectively bypasses one of the key differences between the two coins, allowing UNI token holders to earn rewards similar to how Sushi stakers earn rewards which has led firms like Alameda to continue holding UNI despite the lack of native staking rewards.

YFI (YEARN.FINANCE)

In contrast to many other tokens, Yearn Finance’s YFI token had no pre-mine, no investor allocation, and no founder allocation.  YFI was launched with a supply of 0, with the 30,000 total YFI tokens instead being distributed to users of the platform and liquidity providers. Despite the lack of a pre-sale, many institutional investors still entered YFI including 3AC, Spartan Group, Framework ventures, Polychain, and Alameda.

According to data from Nansen, institutional investors have not held YFI tokens for long periods of time, but rather have traded in and out of their positions. Polychain, for example, first bought YFI in October of 2020. After increasing their stake in YFI in November of 2020, Polychain held all of their YFI until January of 2021 when they sold all of their holdings as price and TVL had climbed significantly. Polychain then purchased back their YFI at the end of January 2021, holding for months before finally reducing their position in May of 2021 as staking rewards went to single digits (as low as 2% in May Similarly, Alameda also first purchased YFI in the third quarter of 2020, entering in the start of November before selling all of their holdings by the end of the month. Alameda repurchased YFI in late December 2020 and sold their position over time until they had almost zero YFI by late February of 2021. The lack of long-term institutional holders of YFI comes from their pre-mine free launch which led many institutional investors to wait for buying and selling opportunities rather than holding long term. Despite the lack of strong institutional backing, YFI has been able to outperform the market via its deflationary model. With 30,000 YFI outstanding and only 36% of the supply on exchanges according to Nansen, there are less than 11,000 YFI in circulation which has allowed prices to continue moving up despite slow growth in the number of token holders.

SNX (SYNTHETIX)

SNX or Synthetix token is a derivative liquidity protocol built on Ethereum allowing users to get on-chain derivative exposure to crypto-assets. On the SNX platform, users can create synthetic assets based on smart contracts allowing users to get exposure to the returns of an asset without physically holding it. The SNX token is used as collateral against synthetic assets issued on the platform and staking these assets allows you to receive rewards if you maintain a collateralization ratio above 600%. Users who stake their assets can receive rewards in SNX as well as a portion of exchange fees from all Synth trades in the minted asset. By linking the collateralization ratio to the rewards Synthetix can always ensure synthetic assets are sufficiently backed and can incentivize SNX holding by requiring users to use SNX to collateralize assets.

source: @deltatiger

SNX is able to distribute healthy rewards to users in the first few years due to its unique supply curve. The Synthetix team speculated that strong rewards early on would help incentivize user growth, raising the price of the token. Their assumptions were correct, as Synthetix saw strong price performance over the past year, earning a return of over 2000% in the one-year period from April 28, 2020-April 28, 2021. 

Frameworks Ventures made a significant investment in the (presale) of Synthetix token SNX in July of 2020 when they purchased over 5 million SNX from the Synthetic treasury. Frameworks has not sold a single unit of SNX since. This suggests that Synthetic has done a good job incentivizing investors to support the project. SNX has done this, in part, by providing high interest rates (currently 30% APY) on SNX staking which allows institutions like Frameworks to earn a strong yield on their assets. Staking rates on Synthetix have gone as high as 100% over the past year, making staking very attractive. Jump Trading on the other hand first got into Synthetix in October 2020 and has since moved in and out of the market. Jump sold SNX in December of 2020 and bought it back at the end of February 2020 before selling again at the start of April and rebuying mid-April. This pattern suggests that Jump was trading SNX token to take advantage of price action, rather than staking rewards.

While institutions like Jump have opted to trade the price movements in SNX, many have opted to simply hold due to the high staking rewards. Despite listings on major exchanges like Coinbase and Binance, only 13% of the outstanding SNX supply remains on exchanges suggesting that users are taking advantage of SNX’s yield. 

BADGER (Badger DAO)- 

BadgerDao is an Ethereum token dedicated to building the infrastructure that bridges the gap between Bitcoin and Defi. Badger rewards its users for staking tokens via their PoS mechanism. While staking rewards for Badger started strong, rates are now just 4.51% per annum, down from over 200% per annum in January.  Rewards were highest January-February of 2021, this is also when the price peaked at around $84. Badger has since fallen as low as $16 as staking rewards tapered off due to more people entering the pool as TVL increased, and price, in turn, went down as the yield became less attractive and holding the tokens yields less utility. In this way, we can see that staking rewards and prices correlate, as yields go down, token price growth slows. We can also see this by analyzing wallet growth on-chain. As yields go down and prices stop going up, wallet growth also stagnates. As we see in late January and early February of 2021 wallet growth accelerated as staking rewards remained high and the number of unique addresses grew by over 200 a day. When yield started to level off in March due to a large number of people having entered the pool and the TVL having increased dramatically, the number of unique addresses grew by as little as 25 users a day as the yield became less attractive to investors.

According to data from Nansen, addresses associated with Alameda first bought Badger in February of 2020 and accumulated more Badger until they sold nearly their entire position around mid-April. It seems that Alameda made this sale as TVL on the platform fell and yield went down for staking and the number of new unique addresses began to level off.

Summary & Conclusion:

Overall, there are a few notable takeaways that can be made from these case studies:

  1. Users search for yield and look to take advantage of high yield rewards, when rewards drop, demand drops, and thus price drops.
  2. Buy and burns put upward pressure on asset prices and create an artificial sense of demand
  3. Institutional investors are more likely to hold onto tokens that generate large amounts of yield or that they were able to buy at presale prices
  4. Premines, as well as founder and team allocations, do not appear to affect price performance as long as they face lockup periods
  5. Tokens with very little outstanding circulating supply do better than those with a large outstanding circulating supply (in % terms), 
  6. Fixed yield rewards (inflation) can actually promote long-term growth by incentivizing users to continue holding despite the lack of a hard cap.