Today seeing a yet another blockchain-powered project promising to change how the old world works is not a news. None of such projects fail to emphasize that “token is an essential part of the ecosystem”. Yet, a rare project convincingly explains “why it needs a token in the first place.” Often times a seemingly simple answer leads to countless nuances and triggers a lot of consequences. Take a popular answer “it’s a means of payment on our platform”. Great, but:
How do the token-based prices on such platform adjust with the token price volatility?
Will users change their behavior to buy a token first to use it on this platform after? and
The killer of all: Why can’t you use Ether/ BTC/ any of the already existing crypto to do all that?
And the answer to “why you need a token” is usually in line with the ideas of retaining users in the ecosystem. But does a token truly retain users or does it simply represent a constraint? While users on a gaming platform may be accustomed to the token-based payments, a platform selling groceries, however, may have a much tougher time convincing a consumer to buy a token to purchase bread. Given a token represents a logistical constraint for a user, do benefits of the platform outweigh the complexities a token brings?
A token is a tool that ignites and powers a “digital cooperative” around some activity. The incentives it carries determine whether the cooperative outlives its creators (the token issuers) or becomes a facade for speculative activities with no one giving a damn what the token is needed for.
A token design is not a one step action. Neither there is a formula that’s guaranteed to work.
As investors and advisors at Cyber Studio, we evaluate multiple projects to select the few ones that we eventually work with. To do that, we have our internal series of questions that we go through to see if a token is a necessity or a fashion feature in each specific project.
In this article, we attempted to assemble as many of those questions as possible in one place. We also discussed why it matters to answer those questions whenever you deal with a token-enabled ecosystem.
If you are a project that ponders token functionality, this article may provoke you into a thought process you have not necessarily given a lot of time before.
If you are a token-sale contributor / investor / researcher, taking a project through these questions would allow you to evaluate the depth of a team’s thinking and to find the places their model might crumble.
First, we’ll look at questions that are relevant to every token-powered project, regardless of what type of project that is. Then, we will review more specific token incentive questions important to new protocols and new blockchains. After, we will look at platforms and DApps that are built on top of the existing blockchains. If you are only interested in either category, feel free to jump directly to them. Finally, one could argue that some projects do not quite belong to one group only (like some stablecoins or Inter-Blockhain Communication protocols). When researching those, getting answers for both sets of questions would do no harm.
And, for those who make it to the end — there is a long cheat sheet of all the questions compiled in one place. But let’s figure why we should ask them in the first place.
Bird’s eye view:
Before diving into specifics of token (coin) incentives for a blockchain vs a DApp, every project, regardless of the type, needs to answer these three grand questions:
How do you attract the audience to participate?
How do you retain this audience?
How do you ensure a commitment of the participants?
And, of course, understanding how a token within the ecosystem helps answering these questions is the key.
Acquisition Incentives: how do you attract the audience
Nobody simply starts using a token-enabled project, just because 🤷. Does a project incorporate any audience acquisition incentives into its token design? How is the token used to make someone notice a platform at all?
A list with multiple due diligence questions that cover Acquisition Incentives built into token is at the end of this article, but a good place to start is:
Are there any airdrops / faucets / bounties that would allow users acquire tokens for free? If so, how much and how are they distributed?
The freebees by themselves, are rarely enough to attract true users. Just the opposite, they can become a target for airdrops hunters looking for free tokens of any project. To use these tools right, a project needs to make a strong effort to direct these free tokens into hands of the right holders, so called “smart community”.
Are there any token price discounts for early contributors? If so, what does it mean for the valuation of a project?
Attracting a new customer by offering them a discount might be a standard practice in the traditional business and not too bad of an idea to invite a user to try a product that may require some behavior change. Offering discounts to early contributors into blockchain projects for no apparent reason other than just coming to a platform or bringing in sufficient funds, may be a magnet scheme for a greater fool game and speculation. And the game goes like that: “buy at a discount as long as you can recoup it with a next buyer”.
Freebies, discounts, extra rights and services to early participants may work at first, but oftentimes result in users coming, taking what’s available, and leaving. It is the visibility of economic incentives that would ultimately pull the right people in. These economic incentives can translate in multiple shapes and setups. We will dive into them later in this article, but how transparent those incentives needs to be evaluated as much as what those incentives are. So the question one needs to ask is:
Is token economics of a project transparent enough and attractive enough to get anyone interested? (see Token Incentives in new Blockchains/Protocols and Token Incentives in DApps/Platforms for details about token economics)
Retention Incentives: how do you retain the audience
Retention incentives are the mirror image of the Acquisition Incentives. Token designers need to incorporate the mechanisms that may make holding a token longer more desirable.
Does a token allow influencing the ecosystem? Does holding a token give you special status over time?
Ultimately, though, just as transparency of token economics can pull the audience in, the visibility of how these perspectives may come to fruition over time is what retains the audience.
Can token economics of a project play out beneficially to make participants stay long term? Will these long-term incentives also be in the interest of a project?
There is a big difference between subsidizing a long-time user with unprofitable pricing levels and awarding a user with just enough to make them stick. The former may put a hole in the entire economic model of a project, the latter may make a user a loyal supporter with no budget sacrifice. See the questions in the cheat sheet (the link to the full list of due dil questions in the end of the article) that may allow evaluating the Retention Incentives built into a token-enabled project.
Commitment Barrier: how do you ensure the commitment of participants
Both Acquisition and Retention incentives incorporated in a token are the positive incentives. However, from simple psychology, no one values what they get for free.
What can potentially make a user stickier is having a barrier to entry, overcoming of which makes users feel like they have accomplished something or have invested their resources, but yet does not defer a desire to get in, in the first place. For example, bitcoin mining requires investment into equipment. So leaving the ecosystem would cost disposing of the equipment. That elevates the commitment of a miner into the ecosystem.
Using a token to build the endowment effect, where someone values more what they already have as opposed to what they could have was well described by Wendy Xiao Schadeck here. An escalating commitment to a project via the actions the ecosystem participants perform is the foundation of the endowment effect.
Commitments required for a participation in token economics of a project may turn that participation in somewhat of an achievement. Off-boarding, on the other hand, may become somewhat of a hustle. For example, Cosmos Hub uses DPoS (delegated proof of stake) consensus, where a validator candidate needs to acquire enough support from delegators to aggregate enough stake to deposit as a collateral to be in the top 100. The effort placed into marketing and convincing of the delegators to entrust their ATOMS (tokens on Cosmos Hub) to a validator candidate definitely makes achievement of a validator status a thing to treasure. So it’s important to investigate whether a project has created a commitment layer to make getting in more desirable and leaving the ecosystem — undesirable:
Does participation in the token economy require certain commitments form potential participants? Does leaving the ecosystem make one suffer losses?
Token acquisition / retention incentives and commitment barriers may be helpful to get people in and to hold them within an ecosystem of a project. But it does not mean that the users will be actually actively using the project’s solution. That’s where the token economics comes into play. To be viable, these economics need to work sustainably long-term or need to change over time from aggressive to attract a critical mass to well calculated in order to sustain activity.
With a short-sighted approach to token incentives, you may be shooting yourself in the foot in the long run. A good example could be the exchanges, CoinBene and Bit-Z, introducing a new model of compensating a user with tokens of “equivalent value” to the transaction fee they incur. While spurring the exchanges into the top ranks, the model begs a question “what prevents a user to infinitely transact between two accounts back and forth to get continuously remunerated”? Can these economics be sustained over time?
Here’s where we want to start differentiating between the token economics of new blockchains (or protocols) and token economics of DApps (or platforms built on top of other blockchains).
Token Incentives in New Blockchains / Protocols:
The fundamental question that a new blockchain or a protocol needs to answer with regards to the tokens (and here we use token interchangeably with coins for simplicity) is how do you use a token to ensure that someone will be always there to secure this network. How to reward for successful work and, if needed, to punish a misbehavior, of someone who dedicates resources to secure a network?
The very important property of a blockchain — token supply — may unlock the answers to this question.
Is your total token supply Fixed or Variable?
A fixed token supply means that there is a finite number of tokens right away or, eventually, in a known moment in future. A variable token supply means that the number of tokens will never reach a constant number. Why does it matter? A fixed token supply introduces scarcity, which means increase of token value with more participants of the network (more demand). However, a fixed token supply leads to multiple other questions (see many of them in the cheat sheet). Mainly, how this fixed supply is going to be achieved — immediately or over time? And how, after all supply is distributed, would a network continue to attract new participants and incentivise contributors?
Variable supply may help with these issues. But making the token supply variable requires writing into the code what makes the token supply expand or contract and how. This is tougher than making the supply simply fixed.
Fixed or variable supply decision is only the beginning.
Here are the questions that fixed or variable total token supply may introduce:
If the total supply is fixed:
a) All tokens are created at the TGE; or
b) Tokens are gradually released over time.
The answer a) begs the question how you are going to incentivize the miners/validators given no tokens are reserved? Without emission, you place it on the shoulders of blockchain users to remunerate the miners/validators with transaction fees for providing their services. Answer b) requires a justified rate at which tokens are going to be released / emitted. The rate need to make it attractive enough for validators to dedicate their resources to secure the network.
If the total supply is variable:
a) Is token supply continuously growing; or
b) Is token supply algorithmically expanding or algorithmically contracting.
Same need to justify emission applies to answer a) and the need to justify conditions of supply expansion or contraction applies to answer b.
Once the decision on the token supply behavior is made, you need to asses the transaction fees’ and block fees’ size, dynamics (or variability), and distribution, as well as their relationship with each other. High block fees will incentivize the inflow of validators, while high transaction fees will disincentivize transacting on the network. Low block fees will disincentivize securing of the network, while low transaction fees make transacting attractive for users.
See all Blockchain/Protocol-related Questions by the link in the end of the article.
Token Incentives in DApps and Platforms:
Within a blockchain, a token incentivizes the always-on status and enables the security. Within a DApp or a platform, which does not create its own blockchain, token economics evolves around maintaining the activity in the ecosystem, as the security of the underlying decentralization layer is already managed by the blockchain it is build on.
Evaluating token economics of a DApp starts with figuring:
What is blockchain needed for in this DApp or platform?
Is it used to make immutable record of transactions or data?
Does it enable disinter-mediated interactions?
Does it make micropayments economically sustainable?
Does it enable a fractional ownership of an asset?
What is the problem with the status quo that the blockchain technology alliviates?
The key here is that the answers need to make sense!
Does the data the blockchain records really need to be immutable? If immutability may work for financial transactions, recording personal data permanently may be a problem.
Where the ecosystem of a DApp or a platform touches the blockchain technology determines what rights are assigned to tokens. We described token rights in the article here. Yet simply “assigning” a function to a token is not enough to make users actively participate on a platform.
Evaluating a token-enabled economy requires understanding of which direction a token will move without the involvement of an issuer (as a centralized intermediary, a subsidizer, or an enabler). A healthy token economy stimulates the circulation of a token within the ecosystem as opposed to providing a one-directional movement. Single-directional movement would necessitate the inclusion of an exchange as the main part of ecosystem, as a token cycle would not complete without it. That elevates the speculative nature of a token.
For example, if a platform for buying groceries in a decentralized way only lets token move from a buyer to a seller, then a user needs to buy tokens on an exchange to access the platform. A seller needs to sell tokens on an exchange to cash in the revenues. An exchange opens the cycle for a buyer and closes the cycle for a seller. Volatility of a token price introduces uncertainty of goods price for a buyer and uncertainty of revenues for a seller. As the result, brought to the platform, neither buyers or sellers would see a point conducting any consistent activity.
Some platforms could design a way to grant tokens to users or let them earn the tokens while they are on the platform to reduce the need to buy tokens on an exchange first. Writing reviews on our groceries platform could be one example. Does this solve a problem? Unlikely. For one, buyers would unlikely write enough reviews to earn them enough tokens to cover all their groceries needs. A more probable behavior would be for them just to turn into sellers of their opinions — write a review, earn tokens, and leave, with fewer buyers of groceries for tokens left. So now we have a system designed to bleed tokens to the exchange from the get-go, from two places: 1) sellers of goods trying to cash their revenues; 2) reviewers trying to cash theirs. It is not hard to conclude that the model would not last.
On the other hand, the token can move in multiple directions between all the participants. A buyer and a seller can both spend and earn tokens within the ecosystem interacting with each other, their peers, and the platform itself. This way, the size of internal circulation can outweigh the exchange-driven circulation and allow the ecosystem to self-sustain.
So, evaluating a DApp or a platform’s token economy, first determine:
Who are the ecosystem participants?
a) peers that take on buyer or seller roles; or
b) users that take one role (either buyer or seller) over their life.
What is the platform role?
a) it takes the position opposite from user’s; or
b) it only enables users to form the market
Why does it matter? If the ecosystem is composed of peers who take on different roles at different times and form a market, the token will move in various directions and can potentially stay within the ecosystem instead of always circulating through the exchange.
In this case, you need to understand:
How do you maintain a healthy mix of buyers and sellers at a time?
If users take only one role over the course of their participation on the platform and the platform itself takes the opposite role, you need to figure:
What other interactions can be placed so that exchange does not become a main circulation enabler?
With the variety of token functions possible the key is to evaluate in which directions a token would move.
Can every ecosystem participant earn and spend a token within the ecosystem?
The more directions are enabled, the healthier is the ecosystem.
Creating the matrix similar to one below would allow evaluating how “essential” a token is for the ecosystem.
Well, if you made it here, you know that there is a ton of questions around token economy one needs to ask to due diligence a project.
But these are only a part of the general due diligence process. A holistic approach to evaluation of crypto projects was well described by Wendy Xiao Schadeck here. We have intentionally left out the legal, the team, and the code review questions. One could evaluate those aspects before proceeding to examining of the token economy or vice versa. A good team can launch a token-enabled economy in compliance with applicable regulations, but it’s the incentives that the economy has would make this economy sustain.
To create a full functioning economy powered by tokens, many details need to come into place. If you think of a token just like money in the economy, it may be a good start for ideas how to meaningfully engage every ecosystem participant to spend and to earn the tokens. That, however, can already be done by fiat or existing cryptocurrencies. How you uniquely regulate the money supply in your “digital cooperative” may create additional incentives that current blockchains are not tailored for. What conditions make this money supply circulate within the ecosystem determine whether tokens stay in hands of real users or leave for an exchange to be played with by speculators. Designing a token that can self-sustain means answering numerous questions, each not standing in isolation but interrelated. We hope these questions will be of help.