Welcome back to the third part of our tokenomics series. This 5-part series will be published once a week and cover everything from the basics of tokenomics to the nuances of token design.
Today’s article will break down the different economic design options for your token economy and the overarching goals you should try and achieve.
Once you have determined the utility of your token, you will need to decide on the economic design features of the token ecosystem. You can design the core economics in two ways; inflationary or deflationary.
An inflationary tokenomics design is characterized by increased token supply over time. This is achieved by having no hard cap (maximum supply) and a steady supply increase over time. New tokens can be introduced into the economy in three main ways.
- Tokens are released over a fixed schedule (generally in a linear function)
- Tokens are released in non-linear functions. This can be done through token singular release events.
- Tokens are minted on demand as necessary by the stakeholders controlling the token supply.
Inflationary economics designs take more work to sustain and manage. Just like in traditional economics, you want to aim for steady inflation that does not devalue your token’s value by too much. However, high inflation is much more difficult to control once it starts than in real-world economics. Furthermore, if your token is not crucial to a larger ecosystem, users will likely dump it as it loses value, creating an inflationary spiral.
Keep in mind:
- Tokenomics allowing on-demand token minting by the team is generally seen as a red flag by investors. Therefore, you may want to shy away from implementing this feature.
- In most inflationary designs, the main driving force is minting new tokens through staking or mining. If you need clarification on what staking refers to, check out part 2.
Example of an inflationary token design – Solana
SOL, the native token of the Solana blockchain, has no hard cap and annual inflation of around 8%. Each year the level of inflation decreases to a final level of 1.5% eight years from now.
The hallmarks of a deflationary token design are a maximum supply cap with the number of tokens decreasing over time. This can be achieved by implementing token burn mechanisms such as:
- Buyback and burn mechanisms – Similar to a stock buyback, this refers to the project buying back tokens on the open market and burning them (sending them to an inaccessible burn address and removing them from the ecosystem). If the project has enough tokens, they can burn them without buying them from the market first. For example, popsicle.finance burned 64% of their ICE token supply to increase overall scarcity.
- Burn on transaction – This is when a percentage of the token supply is burned when a transaction occurs. This is done via a smart contract that sends each transaction’s designated amount to a burn address.
Deflationary tokenomics models are much easier to design and tend to increase the token value over time. This is also why it is the preferred approach for most token projects.
Example of a deflationary token design – BNB
BNB, the native token of the Binance centralized exchange, is used for transaction fees, asset transfers, and smart contracts. It is capped at 200 million to reduce the token supply Binance schedules burn BNB every quarter; how many tokens get burned precisely depends on the trading volume. The quarterly burn schedule will continue until 50% of the BNB supply has been removed.
You can also combine the two and have elements of both inflationary and deflationary models. An example of this is having a core inflationary model but implementing deflationary aspects to help you manage inflation more sustainably.
For example, Solana, which has an inherent inflationary design, incorporated transaction fees to reduce inflation. Upon each transaction, a percentage of the transaction fee is burned; the exact amount depends on the transaction throughput. This reduced the overall inflation; as of writing, the SOL inflation is at 6.3% compared to the initial inflation rate of 8%.
Whether you decide on an inflationary, deflationary, or mixed model depends on the goals you are trying to achieve. However, regardless of the economic model, your overarching aim should be to ensure the long-term sustainability of the token ecosystem. Every project wants its token to the moon; however, prolonged volatility creates an environment of uncertainty, which attracts traders and gamblers while ushering out stakeholders looking to add value. You therefore want to limit volatility, create an environment of manageable risk and make the conditions as favourable as possible for all stakeholders.
Both inflationary and deflationary models have their benefits and drawbacks. However, due to more simplicity and ease of management, deflationary token ecosystems are usually preferred by projects. Regardless of which model you implement, the overarching goal should be value stability, where uncertainty and extreme price volatility is reduced as much as possible.