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A Primer on Token Economics and Incentivized Mechanism Design

A Primer on Token Economics and Incentivized Mechanism Design

Disclaimer: These are my own thoughts and opinions.

This article is not intended to represent an academic paper but rather more practical ideas on architecting token economic systems. My assumption is that one is familiar with the concepts and economics of PoW, PoS, DeFi, Slashing, Burning, Uniswap, etc. This topic could be an entire Ph.D. thesis, but I will try to keep it high level.  

If you want to discuss the ethics, theoretical and academic approach of these economic systems please send me a message as I will be leaving these out of this post. I wrote this article in a single 10 hour session, as a result, lacks references.

The rapid development of emerging crypto-economic systems is an arena that I believe deserves more coverage. I like to think that Web3 represents the Internet of Value – not in terms of the exchange of value but rather an entirely new approach to value creation. Whereas Web2 companies are revenue driven, Web3 companies are value-driven by stakeholders. 

Web3 is a whole new economic system with an innovative approach to value and incentives. 

In my opinion, previous academic research on traditional economic topics like valuations, stocks, levers, and pricing theory fall short when applied to new token economic systems. Traditional economic theories fail to capture the full value created by Web3 ecosystems. Papers like this research from Columbia Business School is one of the best out there using traditional approach.

Part 1: The Four Generations of Token Economics

Looking at all of the crypto projects building right now, I see four generations of token economic frameworks. Each generation builds on the characteristics of the previous one and the line between them can be grey at times, but please keep in mind these are generalizations. They ignore the nuances and intricacies in order to take a high-level view of the token mechanism design. 

First-generation:

This economic framework is characterized by a simple, straightforward S-curve driven by speculation and transaction volume. Protocols of this type include Bitcoin, Litecoin, Dogecoin, and others that use a proof-of-work (PoW) consensus mechanism. This framework has high token velocity and very little incentives to “hold” beyond speculation value. High token velocity is due to miners having to sell tokens to recuperate costs.

This results in arguably a zero-sum for this type of economic system: the inflow of value (for things like mining equipment, operating costs, etc.) is equal to the output value of the minted tokens (derived from speculation). Token supply can be restricted by holding the tokens, decreasing token velocity. Transaction fees are arguably small enough for the overall design to be considered part of the zero-sum. For example, Ethereum’s current total daily average transaction fee is $97,433 resulting in $35.56 million annually. With a current market cap of $20.66 billion, transaction fees represent 0.17% of the network value on an annual basis. I am sure many people will try to debate the intricacies of this, but from a high level view, it should be positioned as near negligible impact.   

Second-generation:

Second-generation frameworks introduce new mechanisms that attempt to create more stickiness (less churn) and greater stakeholder interactions. Smart contract protocols like Ethereum (currently PoW), EOS (Proof-of-stake, PoS) and hybrids use mechanisms like governance and staking rewards to reduce token velocity.

Protocols of this generation usually only utilize one or two levers to influence token economics, the most common being governance and fluctuating block rewards.

Example: Decred has arguably two economic levers  – a predictable inflationary supply curve along and a governance structure. The supply curve shares a lot of similarities with Bitcoin with the added features of PoS mining, voting and a rewards treasury.

“The hard cap with no “tail emissions” beyond the scheduled ~21M is designed to provide certainty in the monetary policy and prevent existing holders from being diluted by future manipulation of the monetary supply.”

Ethereum started out at second-generation and is evolving towards third-generation.

Third-generation:

I think we are just starting to see the next generation of protocol economic systems. Token economic models of this generation makes use of two or more of the following attributes:

  • Type of Token Supply – Inflationary vs. Deflationary vs. Fixed
  • Perks & Incentive Pools
  • Burning & Decay
  • Liquidity pool – Lending and Market Making
  • Insurance Pool
  • Penalties, Edge Cases and Slashing
  • Inter-blockchain Communication (IBC) / Inter-Chain Messaging among Parachains (ICMP)
  • Foundation Economics
  • Governance

The focus of the second part of this article will dive deeper into these economic mechanisms. Ethereum would be considered third-generation as a result of projects building on top of it that create some of the above mechanisms. 

Fourth-generation:

Fourth-generation token economic frameworks are purely a thought exercise. I think fourth-generation mechanisms represent both an expansion and optimization of factors from the third-generation mechanisms as well as a bridge for traditional equity and assets into the ecosystem (not security tokens).

Currently, there is little to no leverage in crypto. What leverage does exist tends to be over-collateralized, which is a joke compared to how traditional capital markets work in developed nations. 

In my opinion, there are two primary goals of fourth-generation frameworks:

  1. To create leverage of similar scale to the real estate industry – for example 30 to 1 leverage (buying a home on a 3.5% FHA loan)
  2. To allow the collateralization (even multi-collateralization), leverage and claim on real-world assets (bringing in identities) – for example, tying the equity in your home to a legally enforceable smart contract and getting leverage to lend out DAI

These are just two things I think the ecosystem needs to really drive value creation similar to how real estate and derivatives have led financial engineering in the traditional markets.

Part 2: Overview of Economic Mechanism Design

The goal of this section is to dive a bit deeper into the economic mechanisms that characterize third-generation token economic frameworks. Some of these are already being used in practice while others are still theoretical. And like the sometimes blurred lines between generations, some of these mechanisms depend on another to create an outcome while others can operate completely independent of the others.  

1. Time Scale

One of the first and most common questions I ask projects about their token economics is “what is the time scale you are designing the economics for?”

Most of the time, leading projects are designing for something similar to the length of Bitcoin (~20 years). The lesser known projects have little idea and often follow other projects or simply have a fixed supply and proportionally allocate them to various stakeholders. 

I think that due to the rapidly evolving nature of crypto, projects should focus their design economics for a five to seven-year time frame with a longer tail end type design (just in case it somehow goes for 20+ years).

This could elicit the following response: “But what if our token 1000x in price in the first 5 years? And people can no longer afford using our chain/service?” However, this can be addressed simply by having the right governance controls in place, like issuing another token or creating or leveraging other economic mechanisms.

The goal of using time as an economic mechanism is to focus the largest incentives during the early years of a protocol to attract developers, investors, and users.

2. Inflationary vs. Deflationary vs. Fixed Supply

Most projects use some form of an inflationary or fixed supply model. Inflationary models involve an increasing supply of tokens and are based upon the assumption that inflation is needed for support and to keep costs low as more users join the network. It is also used as a lever to back the consensus systems (ex. PoS) while  variable inflation is used to incentivize staking participation. Fixed supply is pretty straight forward, there will only ever be a certain amount of tokens. 

Deflationary models are less popular because I think they are less understood. Current deflationary models mainly utilize a burn mechanism.

When we look at Bitcoin and traditional markets, we can draw conclusions about how inflationary and fixed-supply models have worked out over time. Deflationary models are still being explored, but I’m a fan of MakerDAO (MKR) for creating such a strict and laser focused incentivized deflationary model. I’m surprised there has not been more discussion around this or more projects imitating their approach. 

There could be multiple papers written about which model to use, why, short and long-term effects as well as edge cases and shocks to the system. Research the various models and then determine which is best suited for your project’s needs. 

 3. Monetary Flow

I think a great starting point of token economic framework design is to understand how capital flows in and out of the system. In each system, I think there should be more capital flowing into the system than out; this requires a deep understanding of the underlying mechanics. A great comparison is video games with large in-game economies. 

When too much in-game currency is generated, an alternative trading asset becomes the standard as a result of its ability to reflect value. In Diablo 2, it was the Stone of Jordan. Eve Online mimics real-world economies so well because they employ full-time economists to examine and model how the in-game currency is flowing in and out of the system. Here is an example from WSJ. Eve’s in-game economy is very well balanced and has the right incentives to support a wide variety of stakeholders. You can see these trends in this report analyzing the Eve economy in September 2019

What makes the Eve Online economies even more interesting is not just how the developers leverage various mechanisms but also how they incorporate community input via an election based representative system called CSM.

CSM gives the system the ability to swiftly respond and address any shocks in the system. This same methodology could be applied to cryptocurrency projects.

To start, projects need to understand how capital flows in and out and who is behind these movements. Many projects currently depend solely on “buyers” to bring capital in and do not have alternative streams or incentives to keep that capital in their ecosystem. This is comparable to a Web2 company that only has a single revenue stream and focusing all of its attention on acquiring customers while having no mechanism for retention. Normally it’s called CAC (customer acquisition cost) but I joke that in crypto it’s called SAC (shill acquisition cost – coined by me).

Personally, I think the best approach is to design a system where there are multiple inflows and as little of outflows as possible. In other terms, create multiple ways for capital, assets, tokens, etc. to move into your ecosystem, implement the right incentives to have them stay there while minimizing the amount that leaves. 

We have seen this really take off in the decentralized finance (DeFi) realm where there is a constant influx of both USD and other assets into Ethereum DeFi products.

With the coming interoperability capabilities that connect multiple chains, understanding the game theory behind this will be critical for projects. Additionally, “robo” advisors, exchange staking, wrapped tokens, and potential derivatives will play into this market and need to be addressed. 

Example 1: Convert cash into crypto via USDC and building a USDC bridge into your token so users do not have to hold your native token to utilize your chain/service. Abstract away all the complexities and make the user experience great while providing an easy way for capital to flow into your ecosystem. 

Example 2: Assume two highly liquid, high market cap projects with a diverse investor base and basically building a similar chain. Project 1 offers an inflation rate of 8%, while Project 2 offers an inflation rate of 6.5%. 

There is a group of investors and users that are yield seeking along with the automated solutions like “robo” advisors. With a 1.5% difference in yield (for simplicity sake let’s just say yield and not anti-dilution), people will move their assets to the more profitable and higher yield project. We have seen this in practice already, and it is debatable whether they care about supporting and using the project as opposed to focusing only on maximizing yield. 

Example 3: Creating mechanisms to reduce outflows of capital. Currently there are very few mechanisms for reducing the outflow of capital, it’s pretty much just staking and governance. An emerging mechanism is liquidity providing on Uniswap. I am a huge fan of how it works, and I believe it solves many issues with low liquidity tokens (analyzing Uniswap’s innovative architecture and the impact could be an entire paper on its own).

Example 4: Ethereum’s ability to create DeFi products incentivizes cash flows into the ecosystems while disincentivizing cash flows out of the system. One can earn yield when exchanging cash for USDC, converting USDC to ETH and finally to DAI/cDAI. What is interesting about this system is learning exactly how this yield is achieved – arguably a new form of financial engineering.

If you take the current state of Ethereum and stop all cash flows in and out, it is possible for DeFi protocols to create value on paper out of thin air, similar to financial engineering techniques in traditional markets.

A top priority should be to understand and structure capital/asset/token flow into your ecosystem. Instead of being solely dependent on buyers, explore how to take advantage of products or services from other projects/chains to bring capital into your ecosystem. Lastly, control outflows and creative incentives to reduce churn.

4. Perks and Incentive Pools

Take a look at Blockstacks App Mining, where $200,000 in rewards are given to apps/their development team every 30 days.

These rewards are given out on a distribution curve to incentivize developers to build the best and most usable apps to capture the lucrative portions of the curve on a continuous basis. 

Compare this to a traditional application platforms like Salesforce, where third party developers are incentivized to building applications that focus on generating revenue as opposed to applications that benefit the ecosystem. 

Blockstack’s approach shares similarities with the open source community, think of it as an incentivized open source community. Instead of relying on grants which are fixed and last only a certain time frame, development can become more sustainable from the rewards. Their app mining approach is one of the most unique I have seen and is one representation of how your project could approach building these new types of incentivization programs.  

Certus One is currently working on SignOS, software for PoS validators. We thought about creating an incentive pool where we would place a portion of the subscription fee into a pool. This pool would then be used to incentivize the development of the software, applications, and products on top of SignOS – similar to blockstack app mining to a certain extent. It can also be used to increase the size of the bounty and grant pool.  

This creates a positive feedback loop, as the user base grows, so does the size and monetary value of the bug bounty and/or grant pool. As a result, there is more incentive to further secure and develop on the network. Imagine if Cosmos, Tezos, Tron, etc had multimillion dollar (or tens of millions of dollars) bounties for catastrophic exploits! Some projects already implement this, but generally have poor governance system to enforce, distribute and prevent abuse. 

What has not been explored too deeply is perks and gamification. Binance token (BNB) does this to an extent because if one has a certain number of tokens (on Binance), they are allocated tickets in a raffle system that allows them to participate in initial exchange offerings (IEOs). Buyback and burn creates upside potential in this application as well. Binance has many more use cases and covers them on their website.

I think perks and gamification will be a new economic mechanism category in itself. It could be considered a strategy to decrease the outflow of capital. These mechanisms depend on time and potentially other mechanisms depending on what is required to receive the perk. For example, a token holder will be rewarded if they hold a minimum amount of tokens for a specified time frame. Perks were explored in the early development stage of Certus One: retail users who stake a certain amount of their tokens to Certus for a certain amount of time will receive financial or non-financial perks (like Netflix or Spotify subscription). 

5. Token Burning and Decay Mechanism

Define it how you like, but burning is basically a dividend to all existing token holders. I am a fan of burn mechanisms like Maker’s but other approaches do exist. It is a pretty straight forward mechanism in terms of economic impact. 

Decay has only been mentioned by a few projects with very little to no practical implementation. One of the most basic forms of decay is a decrease in block rewards (such as Bitcoin) after a predetermined amount of time, mined blocks or minted tokens. 

Decay can be expressed as a function of time and place: a decrease will occur at a certain time when a certain action occurs (optional). In the case of Bitcoin, block reward decay is purely a function of time: it halves after every 210,000 blocks. In the Dash ecosystem, masternodes are used to keep copies of the entire Dash blockchain and require ownership of 1,000 Dash tokens to run. At the height of Dash, this translated to about $1,500,000. A Dash holder could utilize an oracle with a stipulation that if the USD cost exceeded $500,000 for more than 60 days then the masternode requirements would decrease by 50%. This would attract more users to create and maintain masternodes, increasing capital flow into the system and minimizing capital flow out. 

Another use case (just an idea that no one has implemented yet) could be a decay of the self staking requirements PoS chains. For example, Tezos has 8.25% self-bond requirement that could be decreased by 50% every 2 years. 

Decay can be implemented in many forms – inflation rate, staking requirements, rewards, liquidity/insurance pool, etc. Burning and decay mechanisms can be leveraged to reduce the amount of tokens being sold and act as tools for governance mechanisms to balance long term economic design. They can also be used to react to specific supply and demand shocks. Get creative and really think about how you might implement these ideas and tools. 

 6. Insurance & Liquidity Pools 

This is where new economic mechanisms get interesting. 

Insurance pools can be designed to hedge against risk from edge case scenarios like hacking, 51% attack, catastrophic exploit, etc. Their main purpose is to move tokens on a continuous, scalable basis and can be managed by the foundation, a council or the company itself. These mechanisms decrease token velocity and capital flows out of the system. An example is Nexus Mutual who is focused on insurance for smart contract failures. As the value these smart contracts hold increases, it will further incentivize more sophisticated hackers such as state sponsored teams to find exploits. 

“Smart contracts on Ethereum are worse than even non-financial commercial code; as of May 2016, Ethereum contracts averaged 100 obvious bugs (so obvious a machine could spot them) per 1000 lines of code. (For comparison, Microsoft code averages 15 bugs per 1000 lines, NASA code around 0 per 500,000 lines.)” – Vessenes

Certus One also thought about including an insurance pool in it’s staking design. This insurance pool would keep 10-25% of commissions generated daily in the event of a slashing or other major financial impact on the delegators. 

Liquidity pools are an up and coming economic mechanism in the blockchain ecosystem. Specifically, creating incentives for users to create permanent or semipermanent liquidity for tokens and products. Token liquidity in this regard is not the same as traditional financial liquidity, and it’s a good idea to become familiar with Kyber, Uniswap, Compound and all the companies listed on DefiPulse.

Liquidity pools offer a much better user experience, price discovery and deeper order books for tokens that are thinly traded. The user experience is akin to using Robinhood vs Interactive Brokers. These pools also provide a much more fair execution price and fee sharing with liquidity providers similar to methods in traditional markets.

The community touts crypto as a more fair, transparent, and cutting edge technology, yet the main exchanges have been PILLAGING us in terms of trading fees. The fees have been absolutely absurd over the last 10 years: Coinbase 1.49%, Gemini 1.49%, Binance 0.1% (0.02% maker for >150,000 BTC per month). Compare this to Robinhood and Etrade (who offer FREE trades) and you can quickly identify the problem. 

In traditional markets, traders make money by offering liquidity. It depends on the exchange but for example, NYSE Arca charges $0.00275 per share for taking liquidity and pays $.00120 for providing liquidity. So if you provide liquidity, the exchange PAYS YOU, unlike crypto exchanges where they charge you pretty much the same fees for taking or providing liquidity. This maker/taker difference is $0.00155 on Arca (and much narrower for high volume first) and according to reports, accounts for 63% of their total revenue – they make $2.4B off this small difference in 2012. 

To create an example. I buy bitcoin at $7,500 and sell at $10,000. 

Coinbase charges a spread of about one-half of one percent (0.50%) for purchases and sales on their exchange on top of the 1.49% fee they already charge. We are not taking into account the 0.50% spread fee.

  • Coinbase 1.49%: $111.75 + $149 =  $260.75 in fees to execute two trades 
  • Gemini 1.49%:  $111.75 + $149 = $260.75 in fees to execute two trades 
  • Binance 0.1%: $7.50 + $10 = $17.50 in fees to execute two trades

Binance is somewhat reasonable while the other two are just insane. 

Comparing this to traditional markets using the most expensive stock – Berkshire Hathaway class A that is currently trading at $317,495 per share. 

If you provide liquidity for 100 shares (worth $3.17 million) your trading fees would be $-0.12. If you provide liquidity and sell those same 100 shares for the exact same price it would be $-0.275. You would actually get paid $0.395 if you provide liquidity and get filled. If you take liquidity both times, it would cost you a measly $0.55. This is why I strongly support any new types of liquidity pools that provide better mechanics that charge a fraction of the fees. 

Uniswap is a new form of exchange and its structured as a liquidity pool. Fee structure: “Whenever someone trades on the exchange, the trader pays a 0.3% fee which is added to the liquidity pool. Since no new liquidity tokens are minted, this has the effect of splitting the transaction fee proportionally between all existing liquidity providers.”

For the same two denominated value of trades above, the fees would be $52.50 on Uniswap. However, this fee goes to the other liquidity providers that are providing a deeper order book for the token, drawing parallels to how the NYSE Arca system is setup. Uniswap compensates users for providing liquidity. This framework provides a more fair pricing model and incentivizes participation. 

Dex.blue takes this a step further by giving users access to liquidity pools through their exchange interface (massive UX improvement as liquidity pools appear in the order book similar to ordinary trades). They can also do ring trades by matching multiple pools, like LINK to ETH to DAI in one atomic operation giving you the best possible rate. 

Going forward, we think Dex.Blue, Kyber and Uniswap style exchanges will become the dominating forms of exchanges for sophisticated retail. 

7. Interoperability

Interoperability is one of the most important mechanisms that projects should familiarize themselves with. Building apps on one chain and having the ability to interact with them on a completely different chain unlocks tremendous amounts of value.

Uniswap style exchange on Cosmos or Polkadot anyone?

Will your chain or project be able to be compatible with these two? How will the interaction work? What bridge and who is building/maintaining the bridge? And lastly, of course, think about how capital will flow once the bridges are built. 

Will you airdrop equivalent tokens on the other chain? Or have the ability to convert your tokens to the other chains native tokens and vice versa? I think these economic mechanisms are important to explore early on and at least develop a mental approach model. 

Random example: Can I wrap Tezes on Ethereum, Stake it for a month (earn more tezes) then sell it anonymously on a DEX using anonymous transaction like Tari (or Monero style chain) – and have it automatically converted to Libra. I believe a scenario like this will be likely in the future. 

8. Governance

I recommend studying the various governance models that the large layer ones currently use as well as the more obscure ones because each has its own unique eccentricities. Specifically: Decred, Maker, Lisk, and Cosmos, just to name a few. Learn about their approaches with respect to on and off-chain governance. 

One thing to note is that governance generally plays a critical role in token economics. Fred Ehrsam and Vitalik Buterin have written excellent articles about the role governance plays in deciding things like inflation, burn, block rewards, validators, and more.  Both argue that adaptability is one of, if not the most important characteristic of a blockchain that determines success. While it’s important to think about how each of the economic mechanisms described in this article will impact a blockchain project, governance structures that enable users and contributors to change with their needs are more important. 

For example, who gets to propose and vote on these changes? Is it dependent on the amount of tokens you hold or is it a select group? For example, is PoS networks validators can vote on these changes. Because token holders can decide who to stake their tokens to, the weight of the validator’s vote can change. Token holders can move their tokens based on whether they agree with how their chosen validator is voting or behaving. 

Personally, I think governance is critical for using the right mechanisms that anticipate and react to changes in the underlying technology, economics or ideologies (like DAO’s). 

Foundation setup is an issue that is rarely discussed and I am not sure why. The Foundation is one of the most important stakeholders in a given ecosystem. They are responsible for capital collection and distribution, governance, strategy, community leadership and more. Tezos is a great example of what could happen. 

9. Foundation Economics

As previously mentioned Foundations are responsible for some of the most fundamental activities in an ecosystem, so the size of their token allocation needs to be given careful consideration. If their allocation is too large token supply can become constricted and over incentivization can occur. If their allocation is too small the economic frameworks might not be sustainable or offer enough incentives to keep value in the ecosystem. 

In my opinion, Foundations should be able to use mechanisms described above to manage value flow in and out of the system in a sustainable way. For example, part of the transaction or usage fees go the foundation. 

Projects from a previous time did not design their Foundation as robust as some are doing today, which is expected as these economic frameworks and technology is new and constantly evolving. An example of an unsustainable model can be seen in Litecoin. Litecoin was founded by Charlie Lee as a fork from the Bitcoin core protocol. A Foundation was created to advance the use of Litecoin and it’s principles. According to a recent CoinDesk article, the Litecoin Foundation has historically been funded by Charlie himself – accounting for ~80% of total funding. They also have cash inflows from merchandise, donations, and partnerships but relying mainly on a single individual donor is not sustainable. 

Implementing mechanisms like allocating a percentage of transaction fees, staking rewards and mining rewards to the Foundation’s token pool have been proposed to fix this issue.

A Foundation’s allocated token supply is not the only parameter that needs to be considered. The token structure of the Foundation relative to the token structure of the protocol, who has control (is it a single individual or multiple and how are these people chosen), and identifying potential conflicts of interest are all important questions to ask. 

Previously, foundations did not have a lock-up period on tokens but we have seen more recent examples of protocols implementing long vesting schedules for their Foundations. These lock-up periods are often time or event/milestone drive, for example after one year or a certain number of blocks have been created.

A very common theme is that most foundations lack transparency and communication. they tend to preach decentralization and transparency yet rarely are open about their finances, initiatives and operations. I have only seen a small handful of foundations operating with the integrity and transparency that would be aligned with the values of crypto / open source community.

Interchain Foundation, Web3 and Tezos foundations are great case studies. Tezos, in particular, has an excellent bi-annual transparency report that can be found here.  

A common practice of Foundations is to hand out grants to projects building on top of their ecosystem, with the number of grants awarded tied to the value of their tokens. Price ceiling, floor and/or collar conditions can be attached to the value of a Foundations token supply stating that certain price ranges correspond to a fixed number of grants. 

Foundation grants are often not limited to only developers building apps on top of the ecosystem. There have been exciting instances of “grants” being used to throw hackathons or to incentivize test net participation (like Game of Stakes hosted by Cosmos and Tour de Sol hosted by Solana). This is a great way to draw support for a project, engage the community and get feedback for mainnet launch. 

In these examples, it is important for the projects to carefully consider the role staking plays in Foundation design. Again, who will manage the tokens, should they be staked, if so should the Foundation run its own validator or do they stake with a third party, and how do staking rewards and token supply inflation/deflation fit in.

Part 3 – Token Valuations, Libra and Other Thoughts

1. Token Valuations and Perspectives on Growth

The goal of this section is to provide some perspectives on how to approach one of the most hotly contested topics: project valuations. Valuations fluctuate with market sentiment as well as price of Bitcoin and Ethereum. They also depend on which layer you are building (Layer 1 vs Layer 2) and distribution strategy.

Generally, there are four main valuation categories in which most projects fall into:

  • Initial Exchange Offering (IEO)
  • Layer 1 
  • Layer 2 
  • Decentralized Applications (dApps, Layer 3)

IEOs are as the name implies: token launching on exchanges. Exchanges tend to set a valuation cap on IEOs and make sure investors have a lock-up so tokens cannot be dumped.  This transpires from the incentive exchanges have to list a particular token as well as the value they bring in the form of community engagement. I’m just estimating here but generally projects have been around the $40+ million range in their public sale valuation for IEOs. 

Layer 1 protocols (base-layer blockchains like Bitcoin and Ethereum in its current state) generally command the largest valuations, such as Hashgraphs $6 billion valuation during the latest funding round. For comparison, Ethereum’s valuation on the pre-mined tokens from their public sale was a little over $22 million. It is arguably justified to have large valuations for layer 1 projects due to the core principle of fat protocols: “the market cap of the protocol always grows faster than the combined value of the applications built on top, since the success of the application layer drives further speculation at the protocol layer.”

It is often debatable if layer 1’s drive enough value to justify their valuation. The current main driver of price for layer 1’s is speculation. Traditional high growth software companies are valued between 5-12x profits. If you take Ethereum’s annual transaction fees of $35.56m (consider this as profit instead of revenue), then using traditional methods the upper end of its valuation would be $426m. Even if we apply a “premium web3 multiplier” or say 50x, its market cap should be $1.77b. This is an entire topic on its own which I may do a deep analysis of in the near future but its something interesting to think about. 

We are still very early stage when it comes to Layer 2 and Layer 3 (protocols and dApps built on top of layer 1s). It is difficult to value these protocols, here is an article from Multicoin that talks more about the dynamics.

Take a look at the companies mentioned in the article and their initial valuation. Look at recent raises through crunchbase or pitchbook. Then you can prepare a mental model on the ballpark valuation for your project. If you run a public company, you can also do what this Iced Tea company did 😉.

The next time I hear a layer 2 or dApp pre-product say “we think our project is undervalued at $1b,” I am going to get an aneurysm. 

Valuation Perspective

When I look at a project, I always think about what will it look like and what will it take to 100x the valuation. Is it even possible? How does their market cap compare to other projects? Are stakeholder incentives aligned?

I personally think the goal should be to design economic systems that has the potential to 100x a project within a fair timeframe (4-8 years). This might be aggressive but a well designed economic system coupled with fair traction should have the potential to generate these types of returns. Afterall, why build a company if you are not swinging for the fences? 

Lastly, make sure to model out valuation economics based upon project specific mechanism designs for multiple outcome scenarios. It puts a smile on my face when a project presents multiple scenarios with ranges because it demonstrates that they have thought deeply about these issues.

2. Impact of Libra 

Libra will have tremendous impact on the blockchain ecosystem provided it takes off. 

Theory crafting for fun: 

  • Libra could be tied to real word assets and identities, starting the process of the fourth-generation token economic systems mentioned above and introduce serious leverage (fourth-generation mechanisms) 
  • Integrating Libra with DeFi products would be interesting. For example robo advisers automatically maximizing your return if you hold Libra, lending, margin trading (on traditional markets), market making, etc. 
  • What if Libra started to become the default currency in which people held their liquid assets? Libra acts like Google Fi, build in a credit card and you will be able to spend it in most countries of the world. If this happens the USD will dominate an even larger percentage provided it remains the dominant currency in the Libra basket. Foreign governments will dislike this. 
  • For example let’s say Australia wants their currency to be part of Libra but Libra foundation has voted against. What if you could engineer a product/smart contract that would act as a proxy (or derivative) for the AUD to be accepted? The Australian government builds their own token that might be needed as a tax for Libra transactions in Australia. 

This is just the beginning. 

As a side note: I just heard from a friend in Columbia that China built and owns 50% of a port in Columbia. In addition, they are building a free trade zone. However, in order to take advantage of this free trade zone, all trades must be done in Czar (their new government issued cryptocurrency). This is supposedly launching in the next few months, and is a new form of economic imperialism! 

Libra and Czar will introduce digital currencies to potentially billions of people. There will be many bridges into current tokens, so it’s best to keep up to date and potentially start building integrations. One example is Solana’s support for Libra Move VM. Again, the goal here is to watch and learn how capital will be flowing around the ecosystem with Libra’s integration. 

Closing thoughts

One final question for projects to ask themselves: what else do I need to get started designing my economic system?

Assuming you are familiar with the economic design of Bitcoin & Ethereum, I would recommend looking through all the companies funded by Polychain, Pantera, Paradigm, Hashed, Kenetic capital. These 5 investments firms will generally cover the leading 95% of the global blockchain projects. It is also a good idea to become familiar with the blockchain ecosystem in foreign countries, specifically South Korea and China as these countries have seen the most ICO opportunities outside of the U.S.

A common concern I encounter is how a project’s economic design will play out over 20+ years. It’s practically impossible to design the perfect system for that many years from the very start. There will be inevitable changes required, thus the best approach is to have the right architecture and governance in place to respond to changes. 

The content above generally covers the most common and generic use cases. With demand for new specific use cases, I am confident there will be many other types of mechanisms. 


Special thanks to Kelly McCoy, Hendrik Hofstadt, and Greg Osuri for the editing help!

If you found this article useful, please share! Follow me on Twitter and Medium.

Last bit: I was recently at an Andreas Antonopolis talk and this quote was memorable. “We have zero or even negative interest rates yet credit card interest rates still average 18% in the US, it’s basically the same rate across all banks, if that’s not a cartel, then I don’t know what is.”

My next two pieces of content are:

Practical Design for a Fully Fungible Staking Token

This article will cover a proposed design for a creating a staking token. Lets use sETH for example (when ETH goes full PoS). If you hold sETH in your wallet, you will automatically accumulate more sETH – it will not be staked (or locked in anyway), super liquid, and able to interact with DeFi products like Uniswap or Compound. 

Comprehensive Guide to Validator Economics

Here is a generic overview of the topics:

  • Why Recruit the Largest Validator Set as Possible
  • The 3 Groups of Validators and How they are different – Professional, Group, Hobbyist. 
  • Understanding Value Add Validators and What They Contribute
  • Costs of Running Validators and Multiple Nodes
  • Team and Technology Required to Run a Professional Validator
  • Validators are Not Investment Funds – Self Bonding Rates
  • Creating the Right Incentives for Validators
  • Understanding Validator Profitability
  • Modeling out Validator Economics
  • Tokenomics Designs from a Validators Perspective
  • Slashing / Penalty Economics and Design

Look out for these to be posted shortly!

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