Evaluating the Basics of Cryptocurrency

NatEliason
2022-11-01 14:00:20
Collection

Original Title: “Tokenomics 101: The Basics of Evaluating Cryptocurrencies

Author: Nat Eliason

Compiled by: Lu, WhoKnows DAO

#01 Introduction

In the past few years, Tokenomics has become a popular term used to describe the mathematical models and incentives behind crypto assets. It encompasses the mechanisms by which assets operate, as well as the psychological or behavioral factors that influence the value of crypto assets over the long term.

A project with well-designed tokenomics is likely to have long-term value, as the purchase and holding of tokens will be effectively incentivized. Projects with poorly designed tokenomics are destined to fail, as people will quickly sell off assets at the first sign of risk.

If you are considering whether to acquire crypto assets, understanding tokenomics is one of the most effective ways to help you make informed decisions.

So, as someone who has been writing articles on DeFi topics for nearly a year and has designed tokenomics for a popular crypto video game, I will focus on several aspects when evaluating the tokenomics of a new project.

#02 Token Supply: Release, Inflation, and Distribution

Let’s start from the perspective of supply, as it is relatively easier to understand. Now, we need to clarify an important question:

Based solely on the supply perspective, should we expect the token value to hold or increase? Or will the token value experience inflation?

From the supply side, if the number of existing tokens is low, the value of the tokens will increase—we call this deflation. If the number of existing tokens becomes increasingly large, their value will decrease—we call this inflation. When evaluating a project from the supply side, there is no need to consider whether the token has actual utility or how much yield it generates for holders. Just focus on one point: the token supply and how it will change over time.

There are several questions we need to clarify:

  1. What is the current number of existing tokens?
  2. How many tokens will be generated in the future?
  3. What is the rate of release (increase) of new tokens?

Bitcoin follows a straightforward supply curve during its production, with tokens being released over approximately 140 years.

Only 21 million bitcoins will ever be produced, and their production rate will halve every four years. Currently, about 19 million bitcoins have been mined, meaning that only 2 million bitcoins will be released over the next 120 years;

This means that 90% of bitcoins are already in circulation, and over the next 100 years, the total supply will only increase by 10.5%, so the expectation of Bitcoin depreciating due to inflation is not strong.

What about Ethereum? The circulating supply is about 1.1 billion, and there is no cap on Ethereum's supply. However, Ethereum's supply has recently adapted a burning mechanism to maintain a constant token quantity, potentially leading to deflation, with the total supply possibly ranging between 100 million to 120 million. Considering this, we should not expect Ethereum to face significant inflation pressure. It could even experience deflation.

Dogecoin also has no supply cap, with an annual inflation rate of about 5%. Therefore, among these three tokens, we expect the inflation mechanism to exert depreciation pressure on Dogecoin, which will be stronger than the pressures faced by Bitcoin or Ethereum.

The final consideration is supply distribution. Do some investors hold a large amount of tokens that are about to be unlocked? Does the protocol provide a significant number of tokens to the community? Is the distribution mechanism fair? If a portion of investors holds 25% of the tokens that will unlock within a month, you should be cautious when buying.

What about DeFi tokens? Yearn, the first DeFi protocol I introduced, has a fixed supply of 36,666 YFI tokens. There is no release or inflation mechanism, so the value of YFI will not depreciate due to inflation pressure.

Meanwhile, Olympus, a DeFi protocol I recently introduced, has a crazy deflationary timeline, with a large number of OHM tokens produced daily. Theoretically, holding OHM is a bad bet. However, we will soon find that supply logic alone is insufficient to understand whether a token is worth buying or holding.

These are the main considerations regarding token supply. Now, the demand-side perspective will make the evaluation more interesting.

#03 Token Demand: ROI, Memes, and Game Theory

Let’s assume I walk into my backyard, smash some rocks, and then claim that these rocks are the only ones I want to sell. And there are only 10 of them, so they must be worth millions, right?

However, that’s not the case, because no one would want my smashed rocks.

At this level of supply, my rocks and Bitcoin are essentially not that different. A fixed supply alone does not make something valuable. People also need to believe that these items will have value now and in the future.

If you want to understand whether a token will have demand-side value in the future, you need to consider ROI, Memes, and Game Theory.

Let’s start with ROI, as it is the simplest.

ROI (Return on Investment)

In the context we are discussing, ROI is not the kind you might imagine—profits from selling tokens after their price rises. Instead, it refers to the income or cash flow that the token generates while you hold it.

For example, after Ethereum's POS launch, if you are an Ethereum holder, you can stake ETH to validate network security. As a staking reward, you will receive returns paid in Ethereum, with an interest rate of about 5%.

Some tokens allow you to earn a portion of the income generated by the protocol they represent simply by holding them. For instance, if you are a Sushi Holder, you can stake their tokens to earn returns from the Sushi protocol, with an annual interest rate of about 10.5%.

Another form of ROI can be reflected in "Rebasing," which is similar to a stock split. This occurs when you hold or stake tokens, and when the protocol increases the token supply, you receive more tokens. Olympus operates this way. This means that high inflation rates are not always bad for the protocol, as your share will not change.

ROI is one of the focal points of study; when a token lacks the ability to generate investment returns or cash flow, it becomes very difficult to justify holding it. You must believe that others' faith in the token price rising is strong enough to sustain its price.

Alternatively, you must believe in the token's Memes.

Memes

The reason people want to acquire tokens is simply that they believe others also want to acquire them and will hold them in the future.

You can call it faith, belief, or Memes, but whatever you call it, this mechanism of belief in future value growth is always an important consideration.

How do you evaluate it? Other factors that constitute tokenomics can be clearly quantified, but how does this manifest in Memes? To understand it, you need to root yourself in the community.

What is the spirit of the project's Discord like? How active are they on Twitter? Do people view their tokens or protocols as a symbol of identity? How long have people been active in the community?

Belief in future value is often the strongest driver on the demand side. Bitcoin has no cash flow, no staking rewards, nothing. People simply believe its long-term store of value can compete with gold. Or more ambitious beliefs, such as decentralization and super Bitcoinization.

Therefore, while rational analysis can be convincing, one should not underestimate the faith a token can inspire, the interesting Memes, and the fervent followers.

On the demand side, there is a third factor that can combine with some aspects of ROI and Memes. We call it Game Theory.

Game Theory

Game Theory requires you to think about what additional factors in the design of tokenomics can enhance demand for the token. This is where tokenomics can become quite complex, and it is a key issue I will focus on in the subsequent article "102."

However, a common excellent use case of Game Theory in tokenomics is locking. The protocol creates an incentive mechanism that locks tokens in contracts, usually in the form of higher rewards. A classic example of this is Curve.

It’s somewhat similar to Sushi; you can lock your CRV tokens to earn a portion of the protocol's income. Additionally, the longer you lock, the greater your rewards, up to a maximum of 4 years.

Moreover, the more CRV tokens you lock and the longer the locking period, the lower the fees for using other features of Curve.

Thus, there is a strong incentive and game mechanism for holding Curve tokens. You can achieve a good ROI through staking and also gain higher ROI from other features of the application. The highest yield comes from locking the tokens for 4 years, which greatly reduces the motivation to sell CRV.

#04 Practical Tokenomics - Evaluating a Project

Now that you are clear about the questions to address, let’s walk through the project evaluation process.

We will start with one of my favorite projects: Convex Finance.

Convex Finance

Convex is a platform built on Curve that aggregates many investors to help you earn higher yields. If you have locked thousands of CRV tokens for 4 years, it allows you to earn most of the high yields you would get on Curve without having to lock them yourself.

By accessing their documentation, we can address the questions listed in the text.

Token Supply

Convex has a fixed supply of 100 million tokens. This will be released at a decreasing rate over time, depending on the amount of CRV tokens deposited.

According to CoinGecko, 78.5 million of the 100 million have already been minted, meaning the current supply will increase by 33%.

Most of these tokens will be allocated to users of Convex. This is a very fair distribution method, with only a relatively small portion allocated to the team and investors. Imagine if Amazon allocated 75% of its shares to its users:

So, here we have a portion of fixed supply tokens, with the remaining tokens being released at a decreasing rate, most of the tokens allocated to the community, and a maximum dilution of only 33%. From the perspective of token supply, this is excellent.

What about token demand?

Token Demand

To evaluate token demand, you need to address one question: why would you hold CVX tokens?

By holding CVX tokens, you can earn a share of Convex's income. This is not a significant yield, currently only 4%.

In addition, you can lock CVX tokens for 16 weeks, and when you do so, you will receive various rewards from many protocols, all aimed at rewarding Convex stakers.

The annual interest rate here is still only 5%, but does not include the bonuses you earn from other platforms.

Most importantly, you can become a voting representative for Convex, and as a "bribe" in return, you can use the Votium service.

Therefore, even if the value of CVX tokens does not change, staking CVX tokens will yield a considerable ROI. Additionally, it has a very strong game mechanism to support holding the tokens, as you can only earn these rewards after locking for 16 weeks.

Convex's Memes are not strong, as it is a relatively dull DeFi protocol backend. They don’t need to be, as it is a cash flow machine;

Thus, Convex has a fixed supply, primarily allocated to the community, with most tokens in circulation and not facing significant inflation pressure. CVX holders will receive considerable dividends from protocol usage fees and other rewards during their holding period, which significantly reduces the motivation to sell when the token price drops.

For me, this is one of the best tokenomics designs and a well-crafted project. All the factors come together to create a sound financial incentive system that does not solely rely on confidence to support its value.

#05 Self-Assessment

This will lay a good foundation for you to evaluate new projects. By reading the documentation and whitepapers, you should have a good understanding of how token supply should be managed and what forces drive the demand for tokens and cryptocurrencies.

Deep down in your mind, the question should not be "Will these assets appreciate against the dollar?" but rather "Will this thing appreciate against a range of cryptocurrencies (ETH/SOL/BTC, etc.)?" Most crypto assets are highly correlated and will be affected simultaneously, and if you are holding assets outside of major public chain tokens, it should be based on some belief that the tokenomics and incentives will allow it to perform better than the token that created it.

In the next part of the tokenomics series, I will delve deeper into a series of game theory strategies that protocols use to drive token demand.

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