Link to Part I here
Lesson 3: There’s no such thing as intrinsic value
Won’t make a lot of friends with this one I guess. I have been an active proponent of crypto since 2015. One of the most often criticisms that I have heard from people regarding Bitcoin is its lack of intrinsic value. Ie the fact that by itself, Bitcoin has no tangible benefit and if not for people wanting to buy it, its value would be zero. This comes in contrast with the feeling that most everyday people have that the value of the stuff they buy, the money they have and the services they use is somehow derived from an objective, generally applicable and all-encompassing formula or method that accurately prices things in a void. Essentially, supply and demand theory is 100% exact and accounts for all variables. Boy do I have news for you…
The investment information market is worth many many billions of dollars and is filled with quants and analysts that use complex mathematical formulas in order to derive the intrinsic value of an asset. In theory, if that can be accurately determined, the market will end up pricing an asset correctly, assuming the efficient market hypothesis. This in turn, allows banks and hedge funds to long and short assets accordingly.
The problem? Everybody is doing this and it sort of becomes a self-fulfilling prophecy. People want a certain asset, which in turn makes it more valuable, which attracts more people. One absolutely great area where we can see this phenomenon happen is in crypto. Is Ethereum an awesome feat of technology? Absolutely it is. Does its current price of roughly $1,400 account for everybody knowing that? No idea. Does Tesla make nice cars? Many people would argue yes. Is its current $1 trillion + valuation limited to only the cars, batteries and revenue? Absolutely not. It takes into consideration marketing, the almost cult-like status of Elon Musk, his Twitter shenanigans and the fact that many people either love or hate the company. To what degree and in what ratio do all of these elements comprise the “intrinsic” value of an asset? If you can answer that, I have some nice AirBnB recommendations for Stockholm when you go pick up your Nobel prize in economics.
This isn’t to say that all efforts are for naught and since we can’t accurately value anything, then everything is essentially a made up lie…sort of. The economy is a social contract and as long as there is a willing buyer and a willing seller for something, a transaction for that same thing will eventually occur. Now where does this come into play in tokenommic design? How can you really price a token or an asset in a new economy within an up and coming industry? Well I have some good news for you. You don’t really have to. Doing things as simple as setting an average market price for your weapons skin or DEX reward token is more than good enough. Market forces take it away and place it where it deems fit with the force of 1000 suns. Yes, even accounting for whales and insider trading (to a certain extent).
Ultimately, after a short while, and taking into consideration extrinsic factors such as overall market sentiment and how efficient your marketing campaign was, assets will end up simply costing as much as people are willing to buy them for. The tokenomics focus is therefore best kept on giving users as many things to do within your ecosystem. More on potential solutions to this like veTokens in a short while.
Lesson 4: Scarcity = Value until it doesn’t
Further to the point of supply and demand, a solution that many protocols are opting for is to artificially reduce the supply in order to make the price floor of a certain asset, theoretically, itself stabilizes. As a rule of thumb, groups of people value stuff that is less available differently than they do things that are abundant. Read about literally any trade routes from 1000 years ago. Vikings were paying an arm and a leg for camel hide from the Middle Eastern kingdoms while selling salmon meat back to them for a small fortune.
People want what they don’t have and this 100% applies to crypto. Limiting the number of a certain asset definitely generates attention and encourages demand. However, there are good ways and bad ways of doing it. Let’s check a bad one first.
With all responsibility, I fully stand by my point, knowing how zealous their community is, Drip is the worst version of demand through scarcity that I have seen in crypto in a while. Other models that are worse I am sure exist, however this one has become particularly successful. Here is Drip explained in a very short summary:
The project states that once users deposit an initial amount, they get 1% GUARANTEED EASY LOW RISK return on investment. Where does the money come from? You don’t need to worry about that. The platform has a very well developed community and groups of people focused on getting others into the ponzi…I mean the opportunity, through referral codes and the like. No but seriously, where does the money from the APY come from?
Ok, fine. From other users. Daily payouts are funded by new users. On any platform, if you can’t figure out where the liquidity is coming from, YOU are the liquidity. New entrants pay the rewards of those that came before and they have to focus on bringing in new people to pay off their rewards, rinse and repeat down the pyramid…I mean line. The fact that user’s CAN’T withdraw their funds before 1 year is a red so massive flag that Vladimir Lenin would rise from the grave just to shake the founder’s hands. Instead, it’s turned into an apparent feature. Marketing can do wonders.
But just because there are outright scams out there using a certain economic principle to swindle people, doesn’t mean that the principle itself is flawed. Otherwise, nobody would build anything in emerging technologies anymore. There are tokenomic models in crypto that make use of scarcity as a feature without being pyramid schemes. And as of writing this piece, I can’t think of any more successful and proven model than Curve’s vote-escrowed CRV token mechanic.
Curve Finance as a whole is one of the most successful DeFi protocols ever. Initially, the platform was thought to be a decentralized way to swap tokens, but rapidly became a beacon of liquidity mining. In order to incentivize users to use the service without falling into the farm token trap, where users are paid in a native currency only to immediately sell it for ETH, BTC or a stablecoin, Curve came up with a pretty smart model that encourages long- term participation, while remaining economically viable.
CRV is the native token on Curve and is what is rewarded to liquidity providers. Users can, of course, sell their CRV in exchange for something else. Or, they can lock their CRV rewards and receive veCRV. The lock period can be between 7 days and 4 years. By accumulating veCRV, liquidity providers are entitled to additional trading fees earned by the platform and CRV rewards emissions are boosted by up to 2.5x.
This model, of voluntarily foregoing immediate rewards in exchange for a larger payout further down the line, has been successful in encouraging both collaboration of Curve users to create pools, as well as healthy competition. By competition I am referring to the Curve wars, a topic way too vast to be covered in a short paragraph. More so, it has created a secondary market for platforms like Convex, that have made their entire business model around optimizing and boosting Curve pools and rewards.
Lesson 5: Don’t be like the Spanish! (Empire)
While there is definitely validity to the argument of slowly supplying an asset into a market that aggressively wants it, the answer is not as straightforward as we might want it. Hey, you design or read about tokenomics, it’s a new area and I know just as much as you do, we are discovering stuff together. Now that we see the limitations of a scarcity-based economy, let’s see why flooding the market with assets people want is a bad idea. And what better example to use than the absolute economic catastrophe of the Spanish Colonial Empire!
At the beginning of the 15th century, as Portugal and the Castilian empires were discovering the new world, European capitals were amazed at the riches that explorers were returning with from the Americas. Spices, weird animals, potatoes and slaves that were talking a weird language worshiping wooden gods. Everybody wanted a piece of the new continents. The soon to be Spanish empire knew this very well. Therefore, its policy of colonization can be summed up in one word: greed.
Spanish conquistadors led an extremely aggressive colony expansion policy that essentially caused mass purges to the indigenous population. But more relevant to our topic, they hoarded and hoarded and hoarded everything. Gold, silver, metals, spices, dye, literally anything. All of these goods were shipped to Spain en masse and initially used to build wealth back home for explorers.
Sounds awesome for the Spanish, right? It wasn’t. This policy has absolutely bankrupted the Spanish Crown. Soldiers were paid in gold and could come back with even more gold and gems from their conquests, flooding the market with what used to be rare materials. How did the Crown consider fixing this? In an even worse way: They kept borrowing money from Italian Republics like Genoa or Holy Roman Empire electors like Hamburg to further expand their colonial holdings. This only brought in more resources, thereby making every asset worth selling as useless as the money that Madrid was printing.
For the next centuries, up until the late 19th century, the Spanish colonial slowly crumbled, with new nations being born, while the various monarchs in Madrid were plagued with one very long inflation and horrible debt. The British, French and Dutch have learned this lesson much better than their Iberian and Lusitanian counterparts (The Portuguese had a similar problem as their neighbors but to a smaller extent). The British, for example, imposed a straight up max daily cap on how much fish could come from what is today Newfoundland in the United States.
Sure, colonists and fishermen were unhappy at the time and complained that it’s not fair, however the policy worked and turned the United Kingdom into an economic powerhouse. The Dutch had similar policies with spices from the West Indies and the French with furs from the Louisiane in North America. Yes, I have more than 1000 hours played in Europa Universalis 4, how can you tell?
In crypto, a close equivalent to this is when projects have a very low initial public float. Something like 5% of the total supply is published on exchanges, 15%-ish is for other partners and the founders and the initial team have the rest, thinking that they can better control the market by generating supply and demand at will. The absolute opposite happens, as the only thing that founders can do with most of the supply is putting it out into “nature”, so sell it on the market. This does two things:
Firstly, it generates a lot of sell pressure. If, for example, 2% of something is being bought while 8% of the same asset is being sold, it means more people want to get rid of it than want to have it. This is part of the reason why most fan tokens look like the one in the chart above.
Secondly, owning the vast majority of a token’s supply doesn’t really help you as a founder. You are not a central bank, you have a happy trigger-finger that wants to sell a token to get rich. You are no JPow you’re the baby on WallStreetBet’s logo. What constantly putting coins into the market does, is further dilute an already presumably limited market capitalization. You are not creating more of the asset at a certain price, you are “disintegrating” the total number in smaller pieces with the same max price at best. Economics is hard, tokenomics is even harder.
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