Token Economics 🎲
Understand the fundamentals to avoid getting rekt
Hello friends!👋
You might have come across the term ‘tokenomics’ thrown around in crypto conversations. Even if you haven’t, you’ve probably been impacted by it almost always so it helps to know what exactly token economics is and how it impacts your returns. The current cycle had plenty of ponzis but sooner or later the fundamentals do catch up with valuations and it’s safe to say we’re in the midst of it. Does this mean we’re never going to see such projects prop up again? I doubt so. Each new cycle brings with it a new set of users who fall for scams over and over again. In this post, we’ll perform a dissection on one of the crucial topics in the crypto economy - tokenomics, to avoid and steer clear of scams🚨🚨. But before that, we’ll cover macros.
Celsius Insolvent? + Large scale liquidations
Primer: Celsius is a crypto-focused fintech company that offers services similar to Coinbase in addition to offering high yields on stablecoins (remember LUNA/UST?). It offers loans backed by crypto assets and manages all the on-chain activity for the users providing them the benefits of DeFi and charging them a small fee in return. In simpler words, Celsius manages clients’ money.
Setting false narrative: Celsius for the large part promotes itself as a crypto-native company when in fact, it’s more like a bank. The founder talks about unbanking yourself, fighting traditional finance, and promising all-time accessibility to token owners. Up until a few days back, all of these held true but now users are scrambling to get their funds out after they froze withdrawals.
Problem: To offer high yields and loans to its customers, Celsius needs to be making money so it turns to Aave and Curve Finance. Celsius staked millions in $ETH in exchange for $stETH that can only be redeemed for $ETH about 12-18 months later. However, a lot of users on Celsius wanted to withdraw their funds so Celsius had to sell $stETH on the secondary market since it cannot be redeemed yet. Due to a liquidity crunch, the price of 1 $stETH started trading at a discount of 0.9 ETH. This meant Celsius was selling at a loss. They have no one but themselves to blame for poor financial decisions and in a bizarre turn of events, people found out that the Head of Lending at Celsius is a former porn actress. To put someone in charge of billions who has no financial background is a poor decision.
In the midst of all this, Celsius faced liquidations on Aave and other platforms due to the crypto carnage, owing to global macro conditions. Once users found out, they went to withdraw their funds, and fearing a shortage of funds, Celsius blocked withdrawals which left 2 options for its customers - add more collateral or get liquidated. Pretty awful! It is yet to be confirmed if they’re insolvent or not but seems like they might be. Their competitor, Nexo even offered to buy them out, in public.
Not your keys, not your coins!
- probably Buddha
What this means for traders is more incoming pain for the next few weeks/months. The bear market is expected to be a prolonged one implying a lot of projects are going to go bust. For optimists, this is the accumulation phase of fundamentally strong coins! No one knows for sure if this is the bottom yet but definitely close to it.
Tokenomics 101
If you ever wondered why some tokens go up in price, while others get instantly dumped, why even good projects don’t fetch returns, tokenomics is behind all of it. Let’s begin 🚀
The top 5 factors that determine the success of a token in a vertical (DeFi, gaming, or social) include:
Supply and Demand of tokens
Emission rate of tokens
Token Distribution
Utility and Value Accrual
Game Theory
1. Supply side of tokens
If other factors other than supply had no effect on the price, would you gain from owning this token or not? This is a logical place to start from. We know that holding fiat money (cash) is not a good idea as it loses its purchasing power over time. The reason being the supply keeps increasing (money printing!). Similarly, other factors kept aside, increasing supply could be a net negative for the price action of a token.
Let’s look at some key metrics that provide a nuanced view of the supply side of coins.
Circulating Supply: Total number of tokens tradable on the market; doesn’t include lockups by insiders or team.
Total Supply: The total number of tokens ever created until that point in time minus the tokens burned (if any).
Max Supply: The maximum number of tokens that can ever exist. This is either hard coded into the system otherwise the token is inflationary (in most cases).
Market Cap (MCap/MC): Price of token x Circulating supply
Fully Diluted Value (FDV): Price of token x Max Supply
You can access this data for any token on the CoinGecko or CoinMarketCap website. Now the ratio of circulating supply/max supply tells us what amount of tokens are yet to come into the markets. In simple words, it tells us about the inflation of a token. It is important to note that VCs and teams hold lots of tokens in most projects which unlock after a certain time period and a dump on the market can nuke the price so this metric comes in handy.
The ratio of market cap/FDV tells us what kind of growth is required from the project to sustain the price of the token at the same level. For example, a project with a 10% MCap/FDV ratio tells us the project needs to grow 10x over a certain time period (defined by emission rate) to maintain the same price otherwise price would drop significantly once more tokens get unlocked.
Using BTC as an example, it famously has a fixed (max) supply of 21 million, no more, no less. That makes it a scarce resource and couple it with the network effects and we have the most valuable asset in the crypto ecosystem.
That’s the supply side of things. What you stand to gain from holding these tokens constitutes the demand side of things. And that depends largely on the value accrual mechanism of a token, utility, and game theory. We’ll cover these topics independently in the following sections.
2. Emission rate
Knowing how many tokens exist and will come into the supply is one part of the equation. The other part is to know at what rate they’ll come into the supply. If 90% of the tokens of a project unlock and flood the market over the next 6 months, you’re pretty much guaranteed to get rekt. To check the emission rate, you can either check the docs of the project or visit the profile page of an asset on Messari and look into the tokenomics section. See the screenshot below for Solana.
Bitcoin, for example, has over 19M coins in circulation already and there are only <2M coins yet to come but that’ll be over a period of 100 years so inflation won’t really affect the price of BTC. On top of that, BTC emissions (as mining rewards) get halved every 4 years so we’ve seen the worst of inflation for BTC already. The next halving is in 2024.
With Ethereum’s POS merge set to take place in the next 6-12 months, ETH could turn deflationary at best. If that doesn’t happen, the inflation rate is well under control, credit to the implementation of EIP-1559 that went live in August last year. EIP-1559 changed the structure for gas fees and started burning (removing from the supply) ETH. You can watch the burn here.
On the other hand, some tokens such as Dogecoin are inflationary (~4%) and will reduce over time but this will impact the price of the token when compared to ETH or BTC. Some would argue this is healthy when it comes to using such coins as a medium of exchange since people won’t hoard them expecting the value to rise. Elon Musk certainly aligns with this ideology.
3. Token Distribution
A project can distribute tokens in mainly 2 ways or a combination of both.
Pre-mined: Distributed internally amongst team members, treasury and investors.
Fair Launch: Open the sale to the community so everyone has equal access to buy at the launch price.
This is crucial to know since investors get to unlock their tokens after a predetermined period of time. It is important to know when they unlock and in what amounts. Since they hold millions of it, a sudden dump (although unlikely) could tank the price. This information is usually made public by the project or you can view it on the Messari asset profile page. Here’s a cool graphic showing the token distribution for major public blockchains.
There is nothing wrong with teams or VCs owning tokens since they make their fair share of contributions and end of the day people want to create wealth for themselves. It’s just that one must be aware of it in order to plan for the worst case. A project claiming to be community-owned with 50% or more tokens sold to insiders is simply lying to the public and it helps to know that.
4. Utility and Value Accrual
A common misconception amongst newbies is that if a token exists there must be a utility. Not always true. A good question to ask is - does this project need to have a token? Even when there’s utility, the cases may differ. $ETH, $SOL, or $MATIC, for example, are used as currency in their respective ecosystems. One cannot use USDT or other currencies to perform transactions. These tokens are also staked to secure the blockchain and stakers earn staking rewards (dividends). With more network usage, the token price is expected to appreciate so simply holding such tokens can result in gains since more users would drive revenue and adoption leading to increased demand for the coin.
On the other hand, there exist governance tokens too whose purpose is to participate in the governance of the protocol. Whoever wishes to have a say in the execution of proposals, needs to hold the token to be able to vote on decisions. An example would be the $AAVE token. It can also be staked to earn yields but the primary purpose is to participate in governance. The AAVE team periodically burns tokens from the supply to drive the price up.
There exists another kind of token that earns dividends just like stocks do. $xSUSHI is an example of that. If you stake your $SUSHI token on the sushi bar, you get $xSUSHI in return which earns a part of the protocol revenue. It can later be redeemed for $SUSHI along with the additional rewards you accumulated. In this example, $SUSHI essentially serves as a cash flow token that earns you money as long as people use the sushi protocol.
Make sure you know what you’re getting into. There is no right/wrong approach here. Teams design their tokens for various purposes but an investor must know how the token accrues value otherwise one could be left holding sushi tokens in hopes of expecting a price rise when it should have ideally been staked to earn dividends.
5. Game Theory
This is the most interesting part of all the 5 factors. Most ponzis are able to garner interest solely based on exciting game theory albeit at the cost of sustainability. One interesting example was that of Ohm finance. The project offered unreal staking APY, as high as 8000%. The high APY would draw investors towards the project and as more people got in, the APY dropped. But if people decided to get out, they would increase the APY again. This was automated and had a wildly successful run before coming to a halt.
Another example is that of Convex Finance, a successful DeFi project. Not only does it offer sustainable yields on deposits that are a part of the protocol revenues but offers boosted rewards if you lock up the token for a limited time period. Furthermore, other projects that build on top of Convex award users in their own tokens as well for locking up the CVX (Convex) token. This way Convex gains by getting more users hooked to its platform which drives its revenues and users earn enough rewards to stay on the protocol.
Wrap Up
There’s a lot that goes behind designing a successful token but these are pretty solid fundamentals to start from. In order to make the best decisions, it is imperative to get your hands dirty. So the next time you think of making an investment (long term), don’t forget to ask yourself the following crucial questions, otherwise, rekt soon!
How many of these tokens exist now and how many will in total?
How does this token accrue value?
Who are the whales holding this token and can they dump it in the near future?
Will the price outperform BTC/ETH or am I better off holding BTC/ETH?
Can I expect the price to go up or is this a cash flow machine?
Use this checklist and you’ll be better off than 99% of retail investors.
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