Tokenomics Design Fundamentals for Dummies

Creating a token on any chain might be easy but a great token? we'll see about that!

Tokenization has always existed, directly or indirectly, but Crypto puts it on steroids with this sector's permissionless values.

Creating a token on any chain might be easy, but making a great token on any chain requires a great product and then a tightly coupled tokenomics design for the product’s flywheel.

The Fundamentals of Tokenomics Design

You’ll need to understand how to knit fundamentals from demand drivers to network effects and speculative value.

Demand Drivers

Demand drivers are the core mechanisms/reasons for users to acquire tokens. Usually, the demand driver would be the product’s growth and futuristic value that aligns with the user’s interest.

The demand driver of a dApp Aerodome is that the platform accrues trading fees that will be distributed to token holders. The demand drivers for L1 projects like Ethereum are gas fees and governance.

Network Effects

As the dApp grows, demand for tokens is likely to increase, especially if the dApp offers a token-based subscription service.

More stakers means more liquidity, especially on proof of liquidity chains; higher liquidity improves yields and strengthens the ecosystem.

On Ethereum, primarily through liquid staking, there’s more liquidity and stakers are incentivised to stay for the juicy yield.

Speculative Value

Speculations aren’t sustainable in the long term. They’re usually high initially and must ride narratives to be sustained. You’ll see this in NFTs and memes; they’re a big deal.

Speculative value is excellent, but you must build a great product that gains adoption to sustain the hype.

Value Capture

Value capture aligns the incentives of all participants (users, investors, and the protocol) to create a sustainable economic model that ensures everyone stays and plays their part correctly.

Protocols use mechanisms like burning, fee redistribution, and lockup smart contracts to capture value, depending on the participants they’re trying to capture value.

Business Model Integration

Unless you’re building a memecoin, you’ll want to interweave the tokenomics with the project’s business model tightly.

For business model integration, Most DEX projects that generate revenue via trading fees distribute a portion of those to token holders and have proposals to fund their projects.

Game Theory in Tokenomics

You’ll need to implement some game theory to keep participants in check, incentivise normal behaviour and deter occurrences that may harm the product.

You must analyze the participants' behaviours and scenarios and offer incentives or punishments to keep them from misbehaving.

Mechanisms like bonding curves or quadratic voting can balance resource allocation and prevent a few players from dominating.

Understanding Supply Mechanics

Supply mechanics are the cartilage of tokenized systems. Your supply mechanisms dictate how your tokens are created, allocated and introduced over time.

Your supply mechanics configurations (supply distribution and inflation) influence everything from user participation to long-term value accrual.

Supply Distribution

Token allocation is the most basic form of supply distribution. It determines incentive alignment across stakeholders and the community.

Poorly designed token allocations can introduce centralization among sects of stakeholders, induce rapid price crashes, and quickly disengage the community.

Here’s an intuitive table that overviews a chic supply distribution model:

This table isn’t a one-size-fits-all. You’ll need to approach considerations based on what you’re building.

Supply Inflation

Inflation mechanisms determine a token’s circulating supply. They influence factors like token scarcity, ecosystem incentives, and the currency's long-term value.

With suitable inflation mechanisms, you’ll need to strike the right balance between incentives and value. Here are some great inflation models.

Your business model integration and use case should help you decide on the supply inflation mechanism you choose

Consider these principles part of your mechanisms to adapt effectively to changing conditions.

These principles help balance out some of the challenges with supply inflation mechanisms.

Token LifeCycle Management

Throughout your token's lifecycle, you and your stakeholders must manage multiple aspects based on the project's milestones and supply dynamics.

In the early stages, you’ll set the initial token supply and issuance rates to balance short-term growth objectives with long-term sustainability goals. Your cliff schedules should align early backers with the project’s roadmap without creating centralization through any means.

You’ll also have to make some adjustments post-TGE (token generation event), like campaigns to retain users or buyback tokens to stabilize market value and reduce volatility.

Once you’ve found a stance in the market, you can control market dynamics as you deem fit, from high inflation to low-emission or deflationary models to preserve token value as the ecosystem matures.

Your Project Probably Doesn’t Need a Token

Pay attention to the intensity of demand drivers and your business integration; from a user experience standpoint, does your project need a token? Remember that launching a token incorrectly or treating it as a separate product could cascade on the product.

You can always try out alternatives, like using the token of the underlying chain you’re building on and using external governance providers instead.