‘Deflation’ is a dumb way to approach tokenomics… and other sacred cows

Having taught and studied token economics at the University of Nicosia, Ive found that students often have some decidedly muddled beliefs about how what tokens are and how business and token economies work.

Unlike microeconomics and macroeconomics which are based on decades of research, debate and inquiry that have produced some commonly accepted principles tokenomics is a much newer field of study full of people without economics experience.

There are many self-professed experts who provide advice that sounds fine and is often even sensible in theory but that fails in practice.

When designing a token economy, what you really want to focus on is:

• Is the economic strategy repeatable?
• Is there some way of diagnosing when and how to deploy the strategy for your token and the estimated value of doing so?
• Is there research that validates the strategy so you can talk about it more credibly?

Deflationary tokens

Take, for instance, the idea held dear by many that deflationary tokens have an absolute advantage. Deflationary means an ever decreasing supply of tokens, which in theory increases the purchasing power and value of each remaining token. Inflationary means the opposite: an ever increasing supply which, in theory, reduces the value of each token.

Youll hear commentary along the lines of how deflationary tokens empower a crypto projects value from blockchain pundits such as Tanvir Zafar celebrating the limited supply of Bitcoin and the deflationary supply of Ether following the Merge.

Its an idea even propagated by a widely recognized community for tokenomics best practices, the Tokenomics DAO, which has a Tokenomics 101 page that states:

People who understand Bitcoin will see great value in the fact that it is so simple, elegant and has a limited total supply. Bitcoins tokenomics have created digital scarcity that is enforced (through token incentives) by the network.

But while many token designs emphasize deflation, they are not optimally designed, according to Will Cong, the Rudd family professor of management and faculty director of the FinTech at Cornell initiative at Cornell University.

Taking their cues instead from tweets and community ideologies, many platforms also cant even write down a logical objective for their token supply and allocation policy, Cong continues.

Focusing on whether a token is inflationary or deflationary shifts attention to second-order issues. The price of a token can always adjust to meet supply, and each token can be arbitrarily fractionalized, so a fixed supply is a moot point if the token does not provide value to end-users.

Is SOL inflationary, deflationary or both?

In fact, some inflationary coins with robust burn rates may regularly switch between being inflationary or deflationary, like Solana, explains Eloisa Marchesoni, a tokenomics consultant. The inflation rate started at 10% and will reach its final rate of 1.5% in about 10 years, but there are also deflationary features, like a percentage of each transaction fee getting burned.

With enough transactions per second, the transaction fees that are burned could be even higher than 1.5% per year if many transactions occur, which would bring Solanas inflation rate to 0% and make it deflationary in the long run.

Token price falls and deflation

Although cryptocurrencies behave very differently than traditional asset classes according to research by professors Yukun Liu and Aleh Tsyvinski they are heavily influenced by momentum and market size. In other words, investor sentiment and the number of users on a platform are significant predictors of cryptocurrency returns and volatility.

Fluctuations in the valuation of traditional asset classes may not have a direct effect on crypto, but they can indirectly affect it through spillover effects. For example, changes in interest rates will dampen the risk appetite of investors who are heavily exposed to sectors like real estate.

In this sense, even if a token has deflationary properties, a common macro shock that stifles aggregate demand renders these deflationary properties less useful since the decline in demand lowers the price of the tokens, and as a result, they cannot buy as much.

That said, in general, the cryptocurrencies with the highest market cap are also the most resilient to the current global recession, so we are mainly talking about Bitcoin and Ether.

Novelty tokenomics

Many tokens with novel tokenomics have risen with transient social media momentum but subsequently collapsed as the fads passed.

SafeMoon relied on heavy selling fees and deflationary mechanics to convince holders that the price would go up endlessly even though the protocol never actually identified the problem it was actually solving, says Eric Waisanen, chief financial officer of Phi Labs Global.

Similarly, Olympus DAO inflated their OHM token in accordance with its price, even advertising (3,3), a misrepresentation of simple game theory, which told holders that if none of them sold, theyd all get rich.”

Is SafeMoon safe? Is it smart? (Source: SafeMoon)

Another big shortcoming of tokenomics strategies is their emphasis on holders staking their tokens to earn a high yield. A large yield that lasts for a day, or even a month, is not helpful for consumers and investors who take the long view. Instead, it attracts the wrong crowd.

The use of staking options to lure extractive users into the project usually does not end up well, causing volatility or the risk of market prices and token price fluctuations, which will stress the whole tokenomics and may end up breaking it if not adequately tested already with simulations under extreme conditions, Marchesoni explains.

Take, for instance, Helium, a project that uses open-source technologies to create a decentralized and trustless wireless infrastructure. Its tokenomics strategy offers people the possibility of becoming a validator by staking at least 10,000 of its native HNT token, but those who do risk significant volatility by locking up their tokens for months perfectly demonstrated by the fact its price went from over $50 to $2 within the space of approximately one year.

Other projects such as the business-focused VeChain ecosystem, which specializes in supply chain tracking have endeavored to address the volatility in token prices by creating two separate tokens. The first, VTHO, is used to pay for network access and deals with the predictable component of supply and demand for the product or service. The other, VET, serves as a value-transfer medium, with VET stakers generating VTHO.

What APR is too high?

While proof-of-stake protocols such as Ethereum rightly incentivize staking because it secures the network, the emphasis can get misplaced the further down the line you go.

Now were seeing inflation rates well over 20%. Evmos, an EVM-compatible chain in the Cosmos ecosystem, currently has a 158% APR for staking. Similarly, layer-2s are giving staking rewards just for holding a token without having a blockchain to secure, Waisanen says.

Headline APR for Evmos and adjusted reward. Source: Staking Rewards

These APRs for holders are misleading because the supply of the tokens continues to grow, but the liquidity of the token is constant, so these APRs are not sustainable.

Moreover, when you see high yields, you have to ask yourself how they are sustainable. Ethereum co-founder Vitalik Buterin summed it up best on Twitter during 2020s DeFi yield farming craze, stating:

Honestly I think we emphasize flashy DeFi things that give you fancy high interest rates way too much. Interest rates significantly higher than what you can get in traditional finance are inherently either temporary arbitrage opportunities or come with unstated risks attached.

While these incentives have been abused, staking can be important for securing a network and ensuring price stability.

Too much emphasis on tokenomics has been placed on generating returns for early adopters and users of tokens rather than driving utility values, says Gordon Liao, chief economist at Circle.

In this deep crypto winter, the sentiments around tokens have entirely shifted. Even VCs are starting to place more weight on the equity components rather than the token component when considering new investments. Some protocols have even opted to airdrop USDC instead of their protocol-specific tokens.

Crypto airdrops

Some projects have turned to airdropping users with tokens for marketing purposes. And while my research suggests that airdrops, on average, have a positive effect on market capitalization and volume growth, how the airdrop is done also matters.

For example, those that use bounties or establish requirements that involve boosting and posting on social media to claim the airdrop tend to perform worse. Airdrops on decentralized exchanges and those that involve governance tokens tend to perform better.

Uniswap and Ethereum Name Service launched successful airdrops where the greedy users were converted into active members of the community, thanks to the great game-theoretic model that these projects had put in place, says Marchesoni.

There was great turmoil on Sept. 17, 2020 when Uniswap airdropped its UNI token, but it was also only a matter of time until most users cashed out. But over two years later, there is still a group of dedicated UNI holders, and tokens are still being claimed today.

Airdrops can be a great way to build communities.

Uniswap remains the leading decentralized exchange, and its UNI token provides governance rights to those willing to get involved. The Ethereum Name Service airdrop was also fairly successful, turning many recipients into active members of the community thanks to its game-theoretic approach to the airdrop.

Admittedly, however, there have also been many failed attempts at airdrops, including the most recent APT airdrop by buzzy project Aptos, set up by some of Metas former Diem team. It airdropped between $200 million and $260 million in tokens, but when news of FTX hit with FTX Ventures co-leading its round of funding the momentum dried up, and people began to sell the token while they had a chance. As in comedy, good timing is essential, and projects need to recognize the broader economic environment that theyre operating under, who they accept capital from, and which blockchain they build on.

Are crypto tokens like stocks?

A final misconception is that tokens are equivalent to stocks. While governance tokens or even NFTs can appear to inherit similar features as stocks such as governance rights or dividends most have not.

The vast majority of NFT art projects […] convey no actual ownership for the underlying content, according to Alex Thorn, Galaxy Digitals head of research. There is nothing stopping nonfungible tokens from conferring greater rights and benefits, but collections have historically not been designed as such. Similarly, DAO governance tokens can provide dividends from project revenue, but many tokens, including Uniswaps and Optimisms, do not.

Professors Cong, Ye Li, and Wang have shown in their research how tokens can solve important principal-agent problems, particularly for startups, but the reality remains that many tokens are receiving valuations commensurate with corporate stocks, which is not sustainable.

Token utility

Many projects should ask whether they need a token in the first place. Even if they do, they often struggle to articulate why. Indeed, a Web3 organization can easily exist without a token. For example, OpenSea and Rarible are both NFT marketplaces, but Rarible has a token and OpenSea does not. The answer really depends on the organizational objectives and strategy.

Because the incentives for launching a new token are so high, there has been a proliferation of tokens. If they were to take a step back, most founders would quickly realize that they do not actually need a new token and that building on an existing crypto ecosystem would be a much more sustainable choice in the long run, says Christian Catalini, founder of the MIT Cryptoeconomics Lab. To date, only a handful of networks like Bitcoin and Ethereum have proven the value and usefulness of their native token.

Projects that have a native token need to be thoughtful about anchoring its price in real assets. Some stablecoins, for example, hold reserves in fiat currency to hedge against the volatility of other crypto assets. While there is an active debate about the composition of reserves and how to signal proof of reserves, some collateralization is important for token price stability. In the absence of some stable collateral, a shock to the system can lead to the collapse of a token. The collapse of the Terra ecosystem and the role that FTT played in the fall of FTX are instructive.

Catalini commented that: In the summer of 2021, we wrote a paper outlining the key weaknesses of algorithmic stablecoins, and how they inevitably lead to death spirals. The paper and insights were widely shared with regulators, academics, & industry participants well before the Terra/Luna meltdown. Sadly, the structure of the FTT token and how it was used as collateral suffered from the same fatal flaws. Here, the collateral for both Terra and FTX was tied up in their own native tokens, which collapsed in price too.

Using volatile tokens as collateral was a big part of the downfall of both FTX and Terra.

Why tokenomics is important

To be sure, tokens provide a handful of advantages that traditional systems do not provide, but it is important to know when and why. First, having a token that is native to a blockchain provides a common system of account that reduces the probability that assets and liabilities will be mismatched in different units of account. And since native tokens can be linked directly to the history of activity on a blockchain, they provide a trustless mechanism for facilitating exchange that is insulated from the fluctuations in other asset prices in the economy.

Such benefits are especially important for creating markets over areas that may not have had a price mechanism rationing supply and demand. For example, there is a lot of optimism that tokens could help create a market for credibly trading energy or emissions credits. Existing implementations of emissions trading have been challenged by compliance costs and liquidity, which tokens could help counteract by providing a common and credible unit of account.

Second, tokens can help secure credible commitments on both sides of a trade. Although the use cases of smart contracts are still limited and complex rules and contingencies have yet to be fully implemented, they reduce the risk of either side reneging, according to Cong, Li and Wang.

Consider an entrepreneur who distributes tokens to investors for an innovative new blockchain. Insofar as the founder succeeds, there is much less chance to cheat or mislead the investors since the tokens are fundamentally tied to the intellectual property and technology stack of the blockchain.

Third, tokens can reduce transaction costs and bring together heterogeneous buyers and sellers on a platform built around a specific economic transaction, according to additional research by Cong, Li and Wang. In other words, they provide a measurement tool for differentiated buyers and sellers to coordinate around shared perceptions of value.

For example, consider the Akash Network in the Cosmos ecosystem a cloud computing provider with a live service offering a decentralized alternative to Amazon Web Services and Google Cloud. Even in a declining market, demand for Akash services is growing because of the security and price advantages decentralized compute offers, says Lex Avellino, founder and chief marketing officer of Passage a metaverse platform thats also on Cosmos.

Thats where the value comes from, regardless of token sentiment [] Web3 builders need to address traditional market concerns of value and demand before speculative tokenomic systems, he says. Although transactions could be completed with fiat currency, tokens provide a platform-specific tool to conduct economic activity.

Further study

Academic institutions are beginning to offer curricula on the economics of distributed ledger technologies, including crypto, although the curricula are still extremely nascent. The University of Nicosia, for example, was one of the leaders in the launch of a masters program on blockchain and digital currency. Select classes at other leading institutions exist, including Decentralized Finance: The Future of Finance a set of four courses taught by professor Campbell Harvey at Duke University and a digital finance seminar series led by Agostino Capponi at the Columbia University Center for Digital Finance and Technologies.

Much more work remains to be done in educating people about the economics of tokens. Crucially, entrepreneurs and participants in the sector should view tokenomics as a mixture of economics, finance and marketing, drawing on established best practices and theories, rather than trying to invent new ones that have already been shown risky or ineffective.

Source