Alex Fatuliaj
August 9, 2023
Tokenomics Tuesday

TLDR: it’s crucial to recognise that token economies are fundamentally more complex than fiat economies. You can design a token economy using the step by step process outlined below.

Intro


Token economies are the same as standard Web2 economies in the sense that they represent how value flows between different entities.

However, the key difference is that cryptocurrencies / tokens have more utility to them than a fiat currency, as we discuss in our post on token utilities. This means that a token economy generally needs to factor in interactions that its fiat counterpart doesn't.

Economies


First, let's establish what an economy is.

An economy is a system of exchange and production that enables participants to obtain goods and services that they need or want. A normal economy, like that of a country, is based on a medium of exchange (usually fiat currency), and various financial instruments like stocks, bonds, and derivatives.

However, in a token economy, we have a unique situation where the token not only facilitates monetary exchange but can also grant ownership, access, the ability to share data, and perform many other functions that each project has the autonomy to include.

Therefore, a token economy will be structured differently from a traditional economy, with new roles and opportunities for participants creating new interactions between all parties.

How to create a token economy


To design a token economy we do the following steps:

1. Map out the actors:
Identify all the actors who will participate in the token economy, including users, developers, miners, investors, and other stakeholders.

2. Map out the protocol/company elements:
Identify all features within the ecosystem that participants can engage with, such as marketplaces, nodes, wallets, exchanges, smart contracts, and any other technical infrastructure.

3. Map out the flow of value between all elements:
Chart out the flow of monetary, social, political, and informational value within the economy, including the flow of different currencies (tokens, fiat, others) and all possible interactions between actors and protocol elements.

4. Assess where the demand and supply will stem from:
Identify the sources of demand and supply for the token, with reference to its use cases, utility, and value proposition.

5. Work out where the sinks and injections are:
Identify the mechanisms that remove or add tokens to the economy, such as rewards, burns, airdrops, vagrants, and so on.

6. Estimate velocity:
Estimate the velocity of token circulation to approximate potential value accrual (velocity is the frequency of token exchange between actors and protocol/company elements).

7. Calculate the balance
Work out the monetary balance between the expected demand (based on financial projections, utilities, and velocity) and potential supply that would come from tokenomics, to see how demand and supply are balanced.

8. Work out where to implement fiscal and monetary policies:
Calculate the rates of inflation, interest, taxes, and other economic policies that will affect the token economy most sustainably. This is best done via tools such as Machinations that allow one to visualise how these inputs will affect the price.

Note: modelling to see future price is unreliable. Only use modelling to visualise impacts on price.

Example economy designed by Simplicity Group

What are some key things to consider when designing a token economy?


When designing a token economy, several factors are often overlooked, these include:

1. Network effects:
The value of a token is often dependent on the size and activity of the network that supports it. A token economy should facilitate network growth and adoption to create stronger network effects.

2. Game theory:
A token economy is a complex system of incentives and disincentives that can be analysed through game theory. Designers should consider the strategic behaviour of actors and how it can affect the stability and security of the economy.

3. Community building:
A token economy is not just a technical system but also a social one. Web3 is about shared ownership and decentralisation, meaning that there should be an inherent focus on the users. Building a strong community of users, developers, and stakeholders is critical to the success and longevity of the economy.

4. Token value stability:
Will the value of tokens be stable, or will it fluctuate significantly? How will stability be maintained? Read more about token value here: https://www.simplicitygroup.xyz/blog/how-to-correctly-value-tokens

5. Incentive alignment:
Will the incentives of actors be aligned with the goals of the economy? For example, will miners be incentivized to secure the network, or will they be incentivized to act in self-interest? Are governance token holders aligned with utility token holders?

How to create a stable token economy and token price?


There are various mechanisms that architects can consider to ensure the economy is sustainable with regard to the token and overall network health:

1. Functions:
It is possible to program money supply policies into smart contracts to create dynamic vesting schedules which unlock tokens in direct relation to particular market conditions, such as price or trade volume thresholds. Variable vesting schedules, which unlock tokens based on certain conditions being met (like roadmap milestones), are also something that a project can look into programming into the smart contract via oracles. These functions allow for greater stability in supply and demand on an infrastructure level, but are only effective whilst tokens are still undergoing vesting.

2. Barriers:
On a higher level, projects can ensure the token price is kept within a particular price range by implementing external barriers that help stabilise the price via extra demand or supply. For instance, adapting fiscal and monetary policies, implementing token burns or buybacks, utilising treasuries (for example for airdrops), or even pre-planned marketing campaigns, can all serve to keep the economy in balance.

3. Governance & sovereignty:
Architects can create governance structures that grant the community the ability to make decisions and implement changes, as well as an inherent sharing of sovereignty; this helps ensure the community is aligned and works together for the benefit of each other.

4. Positive and negative reinforcement:
Architects can create incentives that encourage desirable, and discourage undesirable, behaviour - i.e. rewards for beneficial behaviour or penalties for malicious behaviour. Infrastructure projects do this very well with certain consensus mechanisms that force users to put up collateral in order to earn from the protocol.

Conclusion


Designing a cryptocurrency token economy requires a different approach to designing a traditional economy. By mapping out actors, protocol elements, and value flow, assessing demand and supply, and calculating fiscal and monetary policies, architects can create a robust and sustainable token economy.

By addressing issues such as token distribution, value stability, and incentive alignment internally within the economy, architects can ensure that their economy is sustainable inherently, prior to being released into the open market.


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