Token Economics: How to Evaluate Token Supply and Demand? Measuring Demand Momentum from ROI, Game Theory, and Memetics

"I walked into the yard and smashed a few stones, saying they are the only stones I will break and issue, with a total supply of 10 stones, zero inflation. Are these stones worth millions? No, no one wants my stones." The author uses this example to illustrate that fixed total supply alone does not give value but rather the belief that they will be valuable in the future. Whether a project token creates demand value requires observation of ROI, memes, and game theory.

Original article link: https://cryptonat.substack.com/p/tokenomics-101?s=w

Token economics has become a popular term in recent years, covering incentive measures, operational mechanisms of tokens, and the potential long-term impact on investor psychology and behavior.

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Projects that are carefully designed and incentivize investors to buy and hold are more likely to succeed in the long run. Author Nat Eliason believes that understanding token economics is the first lesson in making the right investment decisions.

It All Comes Down to Supply and Demand

Understanding token supply is a good starting point:

• Tightening supply: Decrease in circulating tokens leads to an increase in token value.
• Expanding supply: Increase in circulating tokens leads to a decrease in token value.

When evaluating supply, it is not necessary to consider whether the tokens have any utility or additional income; rather, it is important to consider how the token supply will change over time:

• What is the current circulating supply?
• How many tokens will circulate indefinitely?
• At what rate are new tokens being minted?

Bitcoin

Bitcoin is built on a simple supply curve, with all coins expected to be in circulation in approximately 140 years. Bitcoin will only ever have 21 million coins, with issuance halving approximately every four years, and around 19 million coins already in circulation. Nat Eliason explains:

Therefore, the remaining 2 million coins will be issued over the next 120 years, with 90% of the supply already circulating and only 10% left to be issued, so one should not expect significant inflationary pressure to decrease the value of Bitcoin.

Ethereum

With a supply of approximately 118 million coins and no issuance cap, Ethereum's supply tends to hover around 1-1.2 billion due to the introduction of the EIP1559 burning mechanism. Therefore, Eliason believes that one should not expect Ethereum to face significant inflationary pressure and it might even experience deflation.

Dogecoin

With no supply cap, Dogecoin experiences an inflation rate of around 5% annually.

Among the three, based on token economics theory, investors should expect Dogecoin to have a larger inflation rate compared to BTC and ETH. From a supply perspective, the last thing to care about is who holds most of these coins:

• Are there a few investors holding a large amount of soon-to-be-unlocked tokens?
• Does the protocol distribute the majority of tokens to the community?
• How fair does the token issuance appear?

If a group of investors holds 20% of the supply and the tokens are set to unlock within a month, caution should be exercised before entering the market.

Eliason also points out that YFI has a fixed total supply, and investors should not expect a decrease in the value of 1 YFI due to inflation. On the other hand, Olympus OHM, with its crazy token issuance, theoretically holding OHM should be a bad choice.

However, considering only supply is not enough to determine whether a token is worth holding. Once demand is taken into account, things become more interesting.

Demand from ROI, Memes, and Game Theory

Eliason says:

I could go into my backyard, break a few rocks, and say these are the only rocks I will ever break and issue. Total supply of 10 rocks, zero inflation. Should these rocks be worth millions? No, no one wants my rocks.

The analogy with rocks and Bitcoin is similar; having a fixed supply does not inherently give value, but rather people need to believe it has value and will be valuable in the future.

Whether a token possesses value from the demand side requires observing ROI, memes, and game theory.

1. ROI

The key consideration is not how much people think the token will appreciate but how much cash flow holding the token can generate.

For example, with ETH, the staking yield is around 5%, while SushiSwap SUSHI staking yield is about 10.5%.

Another form of ROI comes from "rebase," similar to stock splits, where holding and staking tokens will yield more tokens, as seen in the mechanism of Olympus.

Eliason concludes:

ROI is crucial; if a token cannot generate ROI or cash flow, it will be challenging to justify holding the token, making investors rely on others' beliefs to sustain the token price.

2. Memes

The reason people hold a particular token might simply be because they believe others will also join in the future, known as faith or memes. However, while everything in token economics can be quantified, memes require a deeper understanding within the community. Eliason points out:

Belief is a powerful driver of demand. Bitcoin has no cash flow, staking rewards, or anything else; people simply believe it can become a store of value comparable to gold or achieve larger goals such as replacing the financial system. However, fundamentally, it all boils down to faith, and one should not underestimate how far a project based on faith, memes, or cult-like characteristics can go.

3. Game Theory

Game theory combines aspects of ROI and memes, considering external factors that contribute to increased token demand. This complexity is what makes token economics intricate.

Lockups and staking are common in a good token economic game theory, where protocols incentivize users to lock tokens for more rewards, as seen in classic cases like Curve.

Similar to Sushi staking, locking CRV tokens can earn protocol revenue, and the longer the lockup period (up to 4 years), the higher the rewards and the lower the fees for using the protocol, significantly reducing the incentive to sell CRV.

Case Study: Project Evaluation

Using Convex Finance as one of the author's favorite projects as an example. Built on Curve, Convex simplifies the process of staking CRV for users due to the higher entry barrier on Curve, resulting in higher returns by staking on Convex than on Curve.

Supply

Convex has a total supply of 100 million tokens, and the issuance rate decreases based on the amount of CRV deposited. Currently, 78.5 million tokens have been issued, indicating that the current market circulation will experience approximately 33% inflation.

Subsequent inflation and issued tokens will flow to Convex users, making this a fairly equitable token distribution, with only a small portion reserved for the team and investors, akin to Amazon giving away 75% of its shares to users.

Demand

When it comes to demand, one must ask why hold CVX tokens?

Holding CVX allows for profit-sharing from Convex Finance, currently around 4%.

Users can also lock CVX for 16 weeks to earn additional rewards from other protocols, with an APR of only 5% shown in the image, excluding rewards from other protocols.

Most importantly, through Votium protocol, users can delegate their CVX tokens to other agents in exchange for bribes.

Even if CVX does not appreciate, staking alone can bring significant returns, supported by strong game theory, making it unnecessary to heavily rely on memes. This is a money printer. In conclusion:

• Convex CVX total supply is fixed.
• Most tokens are in circulation and distributed to the community.
• No more inflationary token issuance.
• Holding CVX offers substantial rewards.

In this scenario, even if CVX plummets, there won't be significant selling pressure. For the author, this is one of the best token designs currently and a classic case of protocol design, achieving a robust financial incentive mechanism without relying solely on faith to support value.

Self-Evaluation

The author points out that the above provides a good foundation for investors to evaluate any new projects, helping them understand the supply mechanism and what forces will drive token demand. The author emphasizes at the end:

Instead of always thinking, "Will this rise against the dollar?" think, "Will this rise against BTC, ETH, SOL, or whatever you want to compare it to?" Most cryptocurrencies are highly correlated and interconnected. If you hold altcoins, they should have some belief, token economics, incentives that make their performance better than their base currency.

In the next chapter, author Nat Eliason will present more protocols and explain how they enhance demand through various game theories.