In our last piece, we’ve shed light on the demand side of tokenomics. We’ve looked into the buying point, meta demand, and market analysis to see what influences a token’s demand, and hence influences its price.
We want to take this a step further now by looking at tokenomics more comprehensively.
Supply and demand are often analyzed separately. This tends to overlook the connection between supply and demand, leading to an incomplete picture. We call our more comprehensive approach token flow analysis.
Apart from supply and demand, tokenomics can be seen as the design of the flow of tokens e.g. distribution determines how many tokens flow to whom. If too many tokens flow to investors, there might be selling pressure. Utility determines under which condition tokens flow from users to other parts of the ecosystem, which is key to keeping tokens within the ecosystem.
Token Flow Model
Generally, these flows can be represented as follows:
The model consists of the following components:
Flows: token inflow into the ecosystem, token outflow out of the ecosystem (to the secondary market), and the inside flow of the token within the ecosystem. If too many tokens flow out of the ecosystem, it will probably create selling pressure.
Ecosystem is where the product, stakeholders, tokens and other components of a specific project interact with each other.
Supply origin is the origin of the token and the start of the token flow. It includes the genesis release (how many tokens will flow at the beginning), periodical release and distribution (how many tokens flow to whom in a given period) etc.
Incentivization is attaching a reward to a desired behavior. The reward is the tokens and might come from supply origin or reserve or treasury.
Stakeholders include investors, advisors, users, holders and project team members. Different stakeholders tend to behave differently within the ecosystem. For example, investors are more inclined to sell tokens early rather than hold and use them, as ultimately, they need a return on their investment.
Hold can be defined as when stakeholders will not sell tokens on the secondary market. This is a favorable action for the ecosystem so it’s classified as separate behavior within the ecosystem. People hold in anticipation of price appreciation, and hold is one of the two inside flows that are initiated by stakeholders.
Utility of a token like staking, governance, payment etc. is one of the two inside flows that are initiated by stakeholders.
Analysis of the model
We will mainly use the play-to-earn game Axie Infinity’s SLP token to conduct the analysis, answering three main questions:
How to prevent token outflow?
How to generate token inflow?
How to keep tokens flowing inside the ecosystem?
Token outflow, not met by sufficient token inflow, increases selling pressure and might drop the price. The best way to prevent token outflow is to keep tokens flowing within the ecosystem.
How to keep tokens flowing within the ecosystem?
The diagram above shows that tokens have three possible destinations: outflow to the secondary market, utility and hold. For SLP, the utility of breeding in-game character Axies encourages the flow within the ecosystem.
Token inside flow: Utility & Hold
How tokens flow from stakeholders to the utility can be translated to:
Why will people use a token?
To answer this question, we look at the essence of utility first: people use a product or service because it brings them value. For example, people use ketchup to make their dishes delicious. A token can help access and capture the value created by a product or service. The value of ketchup is to some degree captured in the share price of the Kraft Heinz Company. The value of the Ethereum network is to some degree captured in the ETH token.
What value can people get using a token?
Let’s look at the SLP token. The utility of SLP is to breed Axies, the in-game character that players play with. In this case, Axies create value as they help players earn income. The SLP token helps players capture value as, without SLP, players cannot breed new Axies. Value is about return on investment so if it takes a long time to profit from investing into SLP, it might be less valuable.
A game also creates value for players if it delivers a good in-game experience. The experience of playing Axie Infinity does not seem to be that good and by that might discourage people from using the token.
If the product can create decent value, people would use the token to capture that value, that’s how tokens can flow from stakeholders to utility to keep token circulation inside the ecosystem.
Keeping tokens flowing in and preventing them from flowing out drives up the price, which influences the willingness to hold.
What will drive token inflow?
Demand for the token which comes from token utility and the product’s unique selling proposition (USP).
In our demand analysis, we concluded that a product’s competitive advantage is the main driver behind generating token demand.
For SLP, the main utility is to breed Axies to compete in battles and earn an income in SLP. People do this to receive a return on their investment and for the fun of the in-game experience. While the SLP income each player receives in the battle mode is set, the ROI is determined by the price of SLP.
The price is influenced by the not so great in-game experience, which fails to attract new players, causing the price to drop. While the price drops, it takes longer for people to start making a profit with Axies. In the long-term this could create a negative feedback loop: ROI not attractive -> fewer people buy -> price drops -> ROI decrease -> Fewer people buy…
It seems that Axie Infinity does not have a very solid USP to create token inflow, and this will also adversely affect people’s willingness to hold. If there is no SLP token inflow, holding and utility are not keeping tokens inside the ecosystem and token outflow increases, the price plummets.
While the product is the driving force of token’s demand, incentives play an important role in fulfilling the product’s USP. Incentives attach a reward to a desired behavior that could increase the product’s value.
Sameer Singh describes, in his article, how properly designed incentives can increase a product’s utility. The product can deliver its USP, increase its value, make it more attractive to new users, and ideally generate token inflow.
Compound is a decentralized lending protocol whose competitive advantage is the ease for borrowers to access funds with little background checks. Lenders are incentivised by interest and COMP tokens to provide funds into a pool. With the incentive of COMP, more and more lenders provide funds, which increases the value of Compound, attracting yet more borrowers.
However, if token incentives cannot align with increasing product utility, the product’s value might not increase. It would be hard for the product to attract new users if it can’t increase utility.
In Axie Infinity, players are incentivized with SLP if they win battles in the game. This mechanism only incentivizes players to play the game, not necessarily incentivising them to add any value to the whole ecosystem i.e. increase its utility. The value of Axie Infinity does not increase and thus it is not attracting enough token inflow.
Token flow initiation: Supply Origin
The most important thing about the supply origin is whether it can be met by a matching demand. If not, tokens will flow out of the ecosystem.
How many tokens are distributed to whom?
Distribution is not just about who gets tokens, it’s also about the allocation of value to those who might create value in the future.
Let’s say a project distributes a large percentage (e.g., 35%) of tokens to investors. Investors’ interest is to gain profit as early as possible. They are more inclined to dump tokens earlier than others as they buy tokens at much lower, pre-IDO prices. This means a huge amount of tokens will flow out of the ecosystem if too many tokens are distributed to investors.
If instead a lot of tokens are allocated to those who create value for the ecosystem, like Compound’s lenders, they are more incentivised to increase product value. As a result, more tokens will flow in.
Vesting is another option. If investors need to hold on to tokens for years, they will have skin in the game and contribute to the project.
For SLP, its distribution is quite simple: all SLPs are distributed to players via play-to-earn. If players play the game to profit rather than for the gaming experience itself, they will sell their tokens. This simple distribution inevitably causes tokens to flow out of the ecosystem.
How many new tokens emit at what time
Token emissions and vesting schedules influence token outflow. If in a given period, a lot of tokens emit and can’t be matched by demand for using and holding tokens, they will flow out of the ecosystem.
SLP doesn’t have a predetermined emission schedule and no supply cap. It flows to players at a fixed amount whenever they win battles or trigger other tipping conditions. If there are not many new users joining and playing the game, the supply exceeds token demand. Eventually, the SLP flows out and causes the price to plummet.
A better way for SLP would be to introduce a token-burn mechanism and control the emission rate. So the newly issued tokens can match the token demand.
We’ve tried to analyse tokenomics comprehensively, using Axie Infinity’s SLP token as an example.
Key takeaways are:
Supply origin will heavily affect token outflow when not met by sufficient demand.
Token inflow is mainly impacted by the competitive advantage of the product and incentive mechanisms.
Utility and hold keep tokens within the ecosystem, and they are the direct drivers of token inflow
Incentives influence a product’s value and therefore, token inflow and outflow
The above diagram is a generic framework with questions about the token flow model that people can use when evaluating tokenomics. Other components could influence token flow like market cap, which we might talk about in our next articles.