Tokenomics 101: Demand (Part 2)
Tokenomics, or token economics, is one of the most important parts of any web3 project. Whether you’re an investor or a builder, understanding tokenomics is critical to success. In many ways the ability to add a financial incentive and layer into technology protocols (i.e tokens) is THE innovation that crypto and web3 bring to the table. Tokenomics is what enable Bitcoin to provide a decentralized store of value and Ethereum a distributed compute network.
Tokenomics is built of two key factors: understanding what purpose your token serves and the different aspects affecting the supply and demand for the token. These are the core building blocks of who uses your token and why.
Once you’ve understood the why behind using a token in a web3 project, it’s time to get a better understanding of the other key aspect of tokenomics: supply and demand. In part one of Tokenomics 101, I covered supply. In this section I’ll cover demand. This is a ‘101’ breakdown. By the end of it you’ll be able to evaluate a project from all angles — whether you’re a builder or a buyer.
- Part 1 covered core supply factors: total token supply and inflation, distribution to insiders and the public and how staking plays into it.
- In Part 2 we’ll cover core demand factors: measuring token utility, ROI, memes and governance
Token supply and demand come down to a few elements. At a high level it’s very simple, yet understanding the low level intricacies to get your tokenomics right is very hard.
What makes up token demand
Demand is composed of four things:
- Token Utility
What can people do with your token? What can they only do if they hold your token? What’s the utility your token unlocks for holders?
What people can do with your token, how much it costs them (in token terms) to do it and how many users you have that will perform that action give you your token utility TAM. As in how much economic value your token utility will drive. This is the GDP of your economy. A high GDP drives a higher token price.
Utility example #1: freelancer network
If users need to pay one token per year as a fee to use a freelance marketplace (like Braintrust), a napkin math¹ model of utility TAM would be: 1 token X 58 million users. So 58 million transactions on an annual basis.
To get the dollar GDP value of that we can compare those 58 million with the current fee market for similar services. Using Fiverr & Upworks 2022 revenue as a proxy, we get to roughly $1 billion annual revenue. If our project were to reach Upwork and Fiverr’s market share, there would be $1 billion willing to buy our token and transact with it, giving us a rough token price of ~$17. This is the buying power in dollar terms willing to purchase our token for the utility it gives.
Utility example #2: Bitcoin
To process a transaction on the Bitcoin network requires a user to pay a BTC fee. The amount of transaction fees each year is the utility GDP of the Bitcoin network. Similar to our Fiverr and Upwork example, we can use a comparison from the existing fee market and reach a TAM of $409 billion per year (if your curious to understand the napkin math you can read that here.
Understanding, in depth, the use case for a token is critical to understanding the demand curve for it. That means understanding questions like:
- Who will buy it and when?
- How many tokens is their demand for?
- How fast will those tokens change hands based on utility?
- Is there seasonality to token purchases?
Memes are the narrative that form around your token. Bitcoin is the best example of this. There’s not much utility to holding Bitcoin, but HODL is a real narrative. It’s part of the larger narrative built around Bitcoin, for example:
- Not your keys, not your coins
- Laser eyes
- Sound money
Narratives have real, tangible value. Especially when it comes to money. “Fiat” money is literally that. “Fiat” is Latin word often translated as “so it shall be”, and in the context of government money, fiat currency has value because a government decrees it so and we believe them. The narrative around the money is what gives it value. The realization that faith, or a common narrative, isn’t new. John Law, a Scottish economist, put these principles into play in the 17th century in France (to his ultimate failure, but he was just ahead of his time).
‘Memes’ can be true, false, ridiculous or smart — but their power is indisputable. As long as Bitcoin’s HODL meme holds true, the supply of Bitcoin will be artificially constrained. When the narrative around it fails, ware your Bitcoin holdings.
The third demand generator for a token is the ROI someone can expect to receive from holding the token. This is identical to TradFi markets, where one holds an asset because they’re expecting a specific ROI that fits their risk/reward appetite. Return can come from cash flows returned in the form of a dividend, capital appreciation of the token or using it for DeFi use cases like taking out leverage.
Cash flow rewards are usually generated by staking of some sort (like staking ETH as a validator) or holding a token that accrues cash flows of some sort (like holding stETH which accrues ETH staking rewards). While many in crypto measure their gains in dollar terms, others measure them in ETH or BTC terms, making generating cash flow returns very hard over the long term (since most tokens drop 90–95% over a 1–4 year time horizon and never recover in ETH and BTC terms). See for example UNI, one of the best projects in the DeFi space priced in dollar and ETH terms. While in dollar terms, UNI overall is up, in ETH terms it’s never reached anywhere near its highs of 0.02 ETH. This makes the opportunity cost for crypto natives high, and forces cash flow APYs to rise to adjust this fact.
Many protocols tie governance to owning tokens in some fashion. Governance comes in all forms: one token — one vote, staked tokens voting, time gated governance, continuous governance etc. Different forms of governance incentivize different kinds of token holding. Governance doesn’t appeal to all token holders equally — smaller holders often find it useless and even large holders can’t sway early members and holders. and it’s very dependent on the specific governance dynamics of the token. Governance can act to reduce circulating supply on the market in a similar fashion to staking. It can just as easily incentivize using tokens as collateral for flash loans.
The Supply & Demand curve
Together, these different factors create a tokens’ supply — demand curve. Supply demand curves are affected not only by price but by the nature of the demand. The more inelastic the demand, the greater the impacts less supply has on price. Each factor of supply and demand affects the other: the more utility a token offers, the more built in demand. If supply is constrained by mechanisms like staking, a slow distribution schedule or governance, each unit of incremental demand can greatly affect the curve.
Tokenomics Supply & Demand 101
Understanding what goes into a tokens’ supply and demand characteristics are the basis for evaluating the prospects of a web3 project. Once it’s clear that a token is being used for the right reason, and it has the potential to capture real world value, it’s time to understand what goes into the supply and demand of the token: the utility it delivers, to whom and how much. What reason people have for holding it and using it? How much supply is out there and at what rate is it being issued.
Each of these topics deserves a deeper dive (which you can find here), but if you’ve made it this far, you’re well on your way to being able to fully evaluate a project for yourself.
I design tokenomics for crypto protocols and am putting everything I’m learning into a super in depth Tokenomics course.
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1. Calculations are napkin math based on: Number of freelancers: https://flexiple.com/freelance/freelance-statistics-and-trends-2020/ Freelance fee market: Upwork & Fiverr 2022 revenue
Designing Tokenomics by Yosh Zlotogorski