AL #52: Logical Token Design
Starting a $MEMECOIN counter-movement
Author's Note: Tokenomics is far from a subject that I'm an expert on but I've been excited about the idea of framing token design as a non-speculative beneficial product feature and seeing how that can work from first principles. I hope you enjoy this exploration.
Following the launch of Olympus and the (3, 3) meme, tokenomics became a dirty word.
The idea that a token could sustain a monetary premium independent of value accruing activity around it was quickly disproven.
Even memecoins have meaningful activity to support their monetary premiums in the form of community gameplay. From Vitalik:
…don't just make a coin, make a game. But make an actually meaningful and fun game. Don't think Candy Crush on the blockchain; think World of Warcraft on the blockchain.
Tokens can meaningful value to a protocol if designed carefully.
MakerDAO's recent moves have been a masterclass of continuing to iterate holistically on the integrated token-protocol equation.
However, the problem with token design, is that it's not obvious at all where to start especially if your name isn't Rune or Tarun.
Unlike when designing a product or protocol, there is no underlying user need to branch out from. The question of constructing a token with a monetary premium is a lot harder to unravel. Here’s one way of thinking about it…
1. Incentive Alignment
The reason to launch a token shouldn't be raising capital. It should be to create incentive alignment around your protocol in a way that improves it.
Opensea and Zora are simple marketplaces. As long as they are valuable to buyers and sellers, they don't need tokens. And so they haven't launched them.
But there are protocols that can benefit from additional sustainable inflation alignment and my thesis is that this is the best place to begin.
Inflation
Corporations wield the ability to issue more equity and dilute existing holders. While there exist fixed supply tokens, some of them still use controlled emissions of circulating supply as a form of inflation (e.g., Chainlink).
Fiat economies are characterized by their power to print money. It effectively allows for arbitrary real-time taxation or wealth transfer from the owners to the treasury and is used for to plug short-term liabilities like debt payments.
It’s no surprise that while used much more delicately, tokens are somewhere in between governments and corporations. Inflation is a cornerstone feature of any token economy.
For inflation to be meaningful it needs to serve an important incentive alignment purpose that needs to be continually and sustainably funded and is difficult to incentivize from the protocol itself.
Risk management
One such idea is risk management. Inflation may exist to incentivize people to backstop a lending protocol (e.g., AAVE safety module) or ensure network integrity (Ethereum).
Other forms
Maker’s endgame economics are more creative, using the MKR token as a form of incentive alignment between Maker Core and the SubDAOs.
Ultimately, the inflation is the “why”, not speculation.
This approach is a notable deviation from the “utility first” approach. Utility if singularly used, can just become a a way to create a demand floor of a token in the spirit of justifying a valuation.
It's not what we want to advocate here.
2. Stability
Inflation is the thing you get for “free” by introducing tokenomics. But its ability to drive impact is driven by some notion of monetary premium, price floor, asset backing or other pressure that prevents an inflationary spiral.
Treasury Inflows
A fundamental factor is treasury inflows. Treasury inflows guarantee that real underlying value continues to accrue to the protocol. This could be in the form of protocol fees, sequencer revenues and could have a variety of denominations.
Burning Tokens
One purely tokenomic solution to create upward price pressure is the idea of burning tokens. A direct reduction in token supply will result in a corresponding price increase all things being equal. Common sources of that capital are tokens that are consumed on a utility basis or perhaps as a result of slashing stakers.
Token Buybacks/Diversification
A third factor here is token buybacks and token diversification. Both of these support monetary premium and stability.
Token buybacks create positive price pressure by creating a supply/demand imbalance while simultaneously giving the treasury more ownership to redistribute tokens. Having an automated buyback mechanism also serves to incentivize onchain liquidity by providing it with a guaranteed order flow source.
Diversification helps stability too but it could also be seen as leading to capital reinvestment (next section). We place it here due to its effects on the underlying asset base.
Token Inflows
Finally, token inflows can contribute here more subtly as a way of returning “ammunition” to the treasury. They can arise in slashing as well as utility based transactions,
3. Reinvestment
Treasury Outflows
For a token to be able to be sustainable and evolve in a competitive market, it needs some way of being reallocated in the form of grants and contributor rewards. Hence we need treasury outflows.
Token Outflows
Token outflows fit a similar purpose with perhaps greater power to incentivize future contribution and alignment and are used for example in Optimism Retroactive Funding rounds or Liquidity Mining.
Finally, token liquidity is another “magic” factor as pointed out by blockrotator that can serve to accelerate the “velocity of money” in the ecosystem and improves the efficiency of all the above mechanisms.
When liquidity is low, the threshold of action becomes harder and harder to exceed for any ecosystem participant resulting in network scale inactivity.
A more symmetric way of looking at these is realizing that they come in pairs:
Ultimately, there’s no automated framework for designing a token model but my theory is that approaching it in this sequence allows each element to be considered with the proper context instead of simply copy & pasting the latest prevalent tokenomics design trend.