Tokenomics Design Fundamentals for Dummies: Part 1
Tokenization has always existed, directly or indirectly, but Crypto puts it on steroids with this sector's permissionless values.
Creating a token on any chain might be easy, but making a great token on any chain requires a great product and then a tightly coupled tokenomics design for the product’s flywheel.
The Fundamentals of Tokenomics Design
You’ll need to understand how to knit fundamentals from demand drivers to network effects and speculative value.
Demand Drivers
Demand drivers are the core mechanisms/reasons for users to acquire tokens. Usually, the demand driver would be the product’s growth and futuristic value that aligns with the user’s interest.
The demand driver of a dApp Aerodome is that the platform accrues trading fees that will be distributed to token holders. The demand drivers for L1 projects like Ethereum are gas fees and governance.
Network Effects
As the dApp grows, demand for tokens is likely to increase, especially if the dApp offers a token-based subscription service.
More stakers means more liquidity, especially on proof of liquidity chains; higher liquidity improves yields and strengthens the ecosystem.
On Ethereum, primarily through liquid staking, there’s more liquidity and stakers are incentivised to stay for the juicy yield.
Speculative Value
Speculations aren’t sustainable in the long term. They’re usually high initially and must ride narratives to be sustained. You’ll see this in NFTs and memes; they’re a big deal.
Speculative value is excellent, but you must build a great product that gains adoption to sustain the hype.
Value Capture
Value capture aligns the incentives of all participants (users, investors, and the protocol) to create a sustainable economic model that ensures everyone stays and plays their part correctly.
Protocols use mechanisms like burning, fee redistribution, and lockup smart contracts to capture value, depending on the participants they’re trying to capture value.
Business Model Integration
Unless you’re building a memecoin, you’ll want to interweave the tokenomics with the project’s business model tightly.
For business model integration, Most DEX projects that generate revenue via trading fees distribute a portion of those to token holders and have proposals to fund their projects.
Game Theory in Tokenomics
You’ll need to implement some game theory to keep participants in check, incentivise normal behaviour and deter occurrences that may harm the product.
You must analyze the participants' behaviours and scenarios and offer incentives or punishments to keep them from misbehaving.
Mechanisms like bonding curves or quadratic voting can balance resource allocation and prevent a few players from dominating.
Understanding Supply Mechanics
Supply mechanics are the cartilage of tokenized systems. Your supply mechanisms dictate how your tokens are created, allocated and introduced over time.
Your supply mechanics configurations (supply distribution and inflation) influence everything from user participation to long-term value accrual.
Supply Distribution
Token allocation is the most basic form of supply distribution. It determines incentive alignment across stakeholders and the community.
Poorly designed token allocations can introduce centralization among sects of stakeholders, induce rapid price crashes, and quickly disengage the community.
Here’s an intuitive table that overviews a chic supply distribution model:
| Stakeholder | Purpose/Role | Typical Share | Mechanisms | Best Practices |
|---|---|---|---|---|
| Founders & Team | Drive project vision and execution, ensuring long-term success. | 10-20% | - Linear Vesting: Tokens released over 4+ years. - Cliffs: 1-year lock-up before vesting begins. | Avoid excessive allocation to build trust and reduce centralization concerns. |
| Early Investors | Provide early-stage capital and take on higher financial risk. | 10-15% | - Discounted tokens (20-50% off). - Lock-up periods: 6-24 months with gradual unlocking to prevent pump-and-dump. | Ensure transparency in lock-up terms and align incentives with long-term project goals. |
| Community Incentives | Foster user engagement and decentralization through staking, airdrops, and rewards. | Up to 50% or more | - Airdrops for early adopters. - Learn-to-Earn and Participate-to-Earn programs to incentivize engagement. | Prioritize mechanisms that ensure wide distribution and encourage active participation in the ecosystem. |
This table isn’t a one-size-fits-all. You’ll need to approach considerations based on what you’re building.
Supply Inflation
Inflation mechanisms determine a token’s circulating supply. They influence factors like token scarcity, ecosystem incentives, and the currency's long-term value.
With suitable inflation mechanisms, you’ll need to strike the right balance between incentives and value. Here are some great inflation models.
| Model | Description | Advantages | Challenges/Risks | Use Cases |
|---|---|---|---|---|
| Fixed Supply | Total token supply is capped (e.g., Bitcoin's 21 million tokens). | - Creates scarcity, driving long-term demand. - Predictable supply maintains value stability. | - Deflationary pressures from lost tokens. - May discourage spending over time. | Scarcity-focused projects or digital gold analogs like Bitcoin. |
| Controlled Inflation | A steady issuance of new tokens rewards participants and validators (e.g., Ethereum). | - Incentivizes active network participation. - Mitigates deflation by replacing lost tokens. | Oversupply risks if issuance exceeds demand. | Projects emphasizing sustained incentives and network security. |
| Exponential Inflation | High early token issuance to bootstrap network activity. | - Encourages rapid adoption in the early stages. | - Risk of oversaturation if not tapered effectively. | Early-stage DeFi projects seeking quick user acquisition. |
| Linear Inflation | Tokens issued at a constant rate over time. | - Ensures predictable, steady growth. - Minimizes risks of economic shocks due to abrupt changes. | Less flexible to dynamic market conditions. | Mature ecosystems aiming for long-term stability. |
Your business model integration and use case should help you decide on the supply inflation mechanism you choose
Consider these principles part of your mechanisms to adapt effectively to changing conditions.
| Principle | Description | Objective | Example/Best Practice |
|---|---|---|---|
| Vesting and Lock-Ups | Vesting schedules ensure gradual token release for founders and investors. | Prevent market manipulation and align incentives with long-term project success. | 4-year vesting with a 1-year cliff for team tokens to foster commitment. |
| Dynamic Adjustments | Community governance mechanisms to modify inflation rates or supply dynamics as needed. | Ensure adaptability to changing market conditions and network needs. | Allow token holders to vote on inflation rate changes via decentralized governance proposals. |
| Incentive Alignment | Allocate sufficient tokens for ecosystem participation without excessive centralization. | Foster decentralized engagement and prevent network stagnation or over-concentration of power. | Reserve 50%+ of supply for community rewards like staking, liquidity mining, or airdrops. |
| Burn Mechanisms | Reduce supply by burning tokens, often sourced from transaction fees or penalties. | Counter inflation and maintain token value stability. | Ethereum’s EIP-1559 burns a portion of transaction fees to create a deflationary effect. |
These principles help balance out some of the challenges with supply inflation mechanisms.
Token LifeCycle Management
Throughout your token's lifecycle, you and your stakeholders must manage multiple aspects based on the project's milestones and supply dynamics.
In the early stages, you’ll set the initial token supply and issuance rates to balance short-term growth objectives with long-term sustainability goals. Your cliff schedules should align early backers with the project’s roadmap without creating centralization through any means.
You’ll also have to make some adjustments post-TGE (token generation event), like campaigns to retain users or buyback tokens to stabilize market value and reduce volatility.
Once you’ve found a stance in the market, you can control market dynamics as you deem fit, from high inflation to low-emission or deflationary models to preserve token value as the ecosystem matures.
Your Project Probably Doesn’t Need a Token
Pay attention to the intensity of demand drivers and your business integration; from a user experience standpoint, does your project need a token? Remember that launching a token incorrectly or treating it as a separate product could cascade on the product.
You can always try out alternatives, like using the token of the underlying chain you’re building on and using external governance providers instead.