What Are Tokenomics and Why Do They Matter for All Web3 Protocols?
Have you heard anything about “Tokenomics” yet? Tokenomics is an emerging concept and catch-all term that refers to the key features of a digital token’s economics.
Tokenomics is core to the design of a digital token and typically a key determinant of sustainability for a web3 project. Keep reading to learn more about Tokenomics and understand what makes for an attractive token design.
What is Tokenomics?
In web3, Tokenomics (short for Token Economics) is the study of how value is distributed, shared, and moved among different users engaged with a decentralized protocol. To understand Tokenomics, it’s important to understand why various blockchain projects have native cryptocurrencies. All cryptocurrencies are created to enable some decentralized application or protocol, which is a service that no single individual or entity operates. Rather than relying on a centralized organization, such as a corporation, to oversee day-to-day operations, a decentralized application or protocol is governed by a community of individuals with aligned interests.
The native cryptocurrency token of a decentralized protocol exists for two reasons:
- First, to access and operate the blockchain project and enable it to uniquely achieve its business goals
- Second, to incentivize individuals to contribute the time, energy, and resources necessary for the blockchain project to function—essentially a means to convert customers to stakeholders
Tokenomics addresses a few key questions related to any blockchain project. For example:
- What drives demand for the token?
- What is the utility of the token and how is the token used in the protocol?
- How does the token capture value created by the protocol?
- How are tokens distributed to various stakeholders aligned to the project?
The Tokenomics of any protocol describe how value flows throughout the protocol and assigns a set of rules to govern these value flows. Tokenomics are significant in the web3 ecosystem and can have substantial influence on the success (or lack thereof) of protocols that choose to issue a native token.
What makes for a robust token design?
Effective Tokenomics design is crucial across all web3 projects. The design must address a wide range of needs in order for the token to be adopted and grow in value. A well-designed token is integral to the product, enhancing the user experience without adding unnecessary complexity which may otherwise alienate users.
Token design should foster rapid network growth, outpacing centralized counterparts. Versatility is key; the token must be effective as an incentive mechanism during both the project's early phases and later stages of protocol maturity.
A thoughtful Tokenomics design should encourage decentralized development and collaboration on the protocol rather than competition. A token should capture value from a protocol’s end users without extracting exploitative value, striking a balance between “business sustainability” and user friendliness. Finally, the token's complexity should be manageable for the average person, ensuring wide accessibility and adoption.
Four key characteristics of Tokenomics design
You can assess a token’s design by analyzing its utility, demand drivers, value capture, and supply-side tendencies. If the token and protocol has been thoughtfully designed across each category, it likely displays strong Tokenomics which may catalyze a flywheel effect for protocol growth. Keep reading to wrap your head around these four important design aspects.
1. Token utility
How is the token used in the protocol? The utility of a token is directly related to its usefulness and is often associated with spending, consuming, or holding tokens to accomplish some core activity within the blockchain project. Simply put, if a blockchain project provides a meaningful service and its native token is essential for users to operate within that project, then that token likely has value and demand.
A strong token design means that the protocol cannot function without the token. It has to provide some sort of utility for both the protocol and its user. While most protocols do their best to accomplish this, some do it better than others. Individuals tend to have strong alignment with tokens that have high utility, because they need to spend or hold them to access the products or services offered by the protocol.
In the web3 space, the more access that tokens offer to a user, the greater the perceived token value. As an illustrative example, consider an Automated Market-Maker (AMM) protocol and Decentralized Exchange (DEX) project that facilitates cross-chain transactions and enables developers to create customized AMM products.
In this ecosystem, the native token can play a dual role. It can be instrumental in generating revenue and may concurrently add value for its holders and stakers, demonstrating how tokens can provide tangible utility to both users and the protocol itself.
A closer look at how token utility can create ecosystem alignment:
- A project’s tokens can be staked by any individual, offering rewards from transaction fees, which are distributed in kind (i.e. in the project’s tokens).
- The protocol generates its revenue through trade fees, encompassing DEX trades and contributions from liquidity providers, with payments made with the project’s token.
- Network validators are remunerated with a share of these transaction fees, also paid in kind, aligning their incentives with the protocol's success.
2. Demand drivers
Where does demand for a token come from? Why would someone want to purchase it and hold onto it? A token requires demand drivers or mechanisms to ensure its necessity among both the protocol's users and speculative traders. A mechanism is a method, process, or requirement that encourages users to buy a token, thus creating demand. For example, suppose a blockchain project offers a revenue-share mechanism to token holders. Protocol users may be incentivized to buy and “stake” the token to receive a portion of the total revenue generated by the protocol.
Demand mechanisms are closely linked to utility but do not always mirror it. A revenue-share mechanism may stimulate demand for a token for users wanting to generate yield on their tokens—especially if the protocol generates significant revenue and therefore offers an attractive yield—but holding those tokens may not be essential to access a protocol. Token ownership in this scenario is a “nice to have” but not a “need to have.” If the yield and revenue potential are high enough, holding tokens may seem like the obvious choice, but still may not be required for protocol access.
Examining the same AMM/DEX project once more provides a clear illustration of effective demand mechanisms. For example:
- The token is needed for developers to set up new custom Automated Market-Makers
- The token is needed to earn fees from staking
- The token is needed to perform swaps on the DEX itself
This Tokenomics design generates demand from multiple mechanisms both inside and outside the protocol, while keeping it simple for anyone to participate and extract value from the token. This approach also ensures that developers are not motivated to fork the project and build on their own, since significant value is created by the protocol and the native token introduces a high degree of alignment between users and the ecosystem. Developers are instead empowered to build within the project’s ecosystem in an efficient and value-driven way.
3. Value capture
How can a token capture the value of a protocol for its stakeholders? Value capture is composed of two types of value accrual:
- Value accrual to the protocol via the protocol’s main stream of monetizing activity (example: network fees)
- Value accrual to the token via supply and demand dynamics—including demand due to utility and demand mechanisms
Continuing with the example of the AMM/DEX project’s token, the token design supports the creation of value through strategic alignment and collaboration. The design tightly aligns the incentives of all stakeholders by ensuring that users, developers, and validators are all working towards common goals, fostering a cooperative and productive ecosystem.
A project can capture value through its protocol treasury, which receives a portion of all transaction fees that occur on the network. The treasury can then use these funds for various purposes, such as development, marketing, and community building. Decentralized governance then dictates the allocation of pooled community funds, giving stakeholders a say in how protocol treasuries are used.
The token captures this value and accrues it back to token holders by distributing yield to staked assets that secure the network. Earning yield incentivizes users to stake additional tokens, reducing supply and increasing demand, which potentially increases the token's value.
4. Token distribution and emission schedule
How are tokens distributed to various stakeholders aligned to a project, and at what rate do these tokens enter the circulating supply?
Tokens can be emitted via a linear or log-based release:
- Linear token release: A linear release—also referred to as “lock & vest”—dictates that tokens are released at some predetermined frequency over a set period of time. For example, tokens may be released on a daily, weekly, or monthly schedule for a period of two years following an initial unlock. The same quantity of tokens is unlocked or "vested" at each interval.
- Log-based token release: A log-based release—also referred to as epoch-based emissions—releases tokens at some predetermined milestone over a set amount of milestones. These milestones are referred to as "epochs'' and generally represent some type of on-chain activity. The amount of tokens unlocked or "vested" at each epoch varies based on the methodology used by a project but typically decreases over time. For example, Bitcoin's block rewards follow a log-based emissions schedule with the quantity of BTC distributed to miners halving every four years. This log-based emissions schedule will continue until approximately the year 2140 when all 21,000,000 BTC are mined.
A thoughtful distribution and emissions schedule ensures that tokens are allocated to the right groups of end users who intend to promote further decentralization of the protocol. Distribution is performed in a manner that does not flood the market with an inordinate amount of inflation, without adequate demand to ensure market stability.
Tokenomics and a sustainable web3
Tokenomics are an essential component of the web3 ecosystem. Intelligently designed Tokenomics support individual web3 projects—and also the decentralized cryptocurrency ecosystem. Tokenomics that are both comprehensive and align user incentives are best positioned to drive widespread adoption of web3.
If you’re a developer who needs to make some Tokenomics design decisions, then you’re already on the right track by learning everything that you can about Tokenomics. The sustainability of any web3 project is never guaranteed—gulp!—but projects with robust Tokenomics may be more likely to flourish.
Stay tuned in the coming weeks to get more details on the Tokenomics of tea—the ranking and incentives protocol that’s enabling open-source software developers everywhere to capture the value of their software contributions. TEA will ultimately serve as the access key to the tea Protocol, and value captured by the protocol will accrue back to token holders in novel ways that further enhance the sustainability of the open-source software ecosystem.