The main objective in cryptoeconomics is to design token economies that will begin and grow in utility over the long haul. Early on, when application utility is low, tokens need to secure value for the network by generating financial utility (to overcome prolonged bootstrapping) and token appreciation — low velocity helps with this. Yet, too much speculative holding leads to artificial economic gains. Without financial utility and upside appreciation, tokens risk higher velocity and being liquidated for other currency.
Therefore, a critical goal should be to create mechanisms that allow users to both use and hold tokens as the economy takes shape. Furthermore, monetary and fiscal policies should work to maintain price growth and stability of the token.
Below are three approaches that can potentially help accomplish these goals:
I. Mechanism Design
Mechanism design can be thought of as the opposite of game theory. In game theory, the game is set and we examine outcomes according to the utility of each participant. In mechanism design, we start with the desired outcome and work our way backward to design a game that will incentivize participants towards producing that outcome.
II. Fiscal Policy
It’s critical to understand the economic benefits participants gain from holding tokens, beyond appreciation related to digital scarcity. Linking economic benefits to token usage would allow for greater access to services through the token as opposed to any other currency. This is particularly true when there is a large supply of tokens and lower scarcity involved (Reference: Economics of Initial Coin Offerings by Dr. Avtar Sehra, Philip Smith and Phil Gomes).
III. Monetary Policy
Monetary policy refers to the total number of tokens issued, token supply schedule, the market cap on total supply, etc. Typically, an issuance strategy is predetermined and a fixed number of tokens are minted for specific allocation amounts to various network participants.
I. Mechanism Design
Staking is particularly useful in achieving a balance of user and holder actions. Typically, staking requires locking up tokens for a period of time, which reduces the velocity of the token. The most common use of staking mechanisms are for reputation, where a user will stake their reputation with tokens, and if they fail to perform an action, they lose their tokens. Tokens are being used, but being strategically held for non-speculative, practical purposes. A good example of the use of a staking mechanism can be seen in Numerai.
(Likewise, Outlier Ventures is assisting the Seed token to incorporate a staking mechanism for reputation of bots)
Decay mechanisms are used to decrease the value of holding the token and hence introduce the depreciation of a token to disincentivize holding onto tokens (perhaps just for specific actors at times) in an economy. This can ensure alignment between users and holders within an economy. Steem is an example of an effective decay mechanism as it dilutes on a daily basis.
The downside of implementing a decay mechanism is that you might inadvertently be creating a limited supply and actually increase the value of the token. Therefore, careful examination of the overall impact on the money supply is necessary.
Burning tokens after usage has been designed into several protocols, however, this type of deflation only seems to create low token velocity and unnecessary, artificial token price appreciation over the long run. Instead, combining minting with burning mechanisms seems optimal for creating a steady level of token velocity. If more tokens are minted than burned (used) over a period of time, token supply increases and the token value starts to drop.
Conversely, if more tokens are burned than minted over time, token supply decreases and token value increases. Designing an effective computational balance could help steady token velocity and price volatility. The ideal example of this mechanism can be found in Factom.
II. Fiscal Policy
Provide Fiscal Stimulus
The mode of distribution and/or different incentives which are used to boost the usage of a token in a certain way can be thought of as fiscal policies. Fiscal policies could be in the form of some discounts, subsidies, rewards, bounties, etc to boost the usage and utilization of the token early on.
Seed Economies Early
At Outlier, we’ve proposed that token economies should aim to launch with as many services as possible, or in other words as a community token economy. By seeding an economy with complementary services prior to launch, we believe more utility is generated to kickstart the economy. Furthermore, reserving tokens for strategic ecosystem development is an important stimulus tool. These tokens can be used to motivate developer and corporate partnerships to add more utility value.
Widely Distribute Tokens
Tokens should be spread across as many stakeholders of a network as possible. While investors play their role in helping token economies develop, it’s best not to over-allocate tokens for high net worth and institutional players. Limiting pre-sales and capping amounts will help in keeping a balanced set of users and holders. This is the key limitation of any form of a security token.
Another good strategy for spreading tokens widely involves ‘airdrops’. A token airdrop is when a cryptocurrency project distributes their currency to members of the community for free. Tokens suddenly appear in the wallets of unsuspecting users, who might then become interested (or even engaged) in the token. By distributing tokens in airdrops, the ignition of interest in an ecosystem is more evenly spread, reducing the risk of larger holders monopolizing the system.
III. Monetary Policy
Rethink Fixed Money Supply
Most tokens work under the premise of either a fixed amount of tokens like Bitcoin, or asymptotic zero inflation like Ether. Based on the cryptoasset markets, it’s clear that fixed money supply enables hyper-appreciation of tokens, outpacing the utility value by vast orders of magnitude. Developing creative hard mechanisms and artificial intelligence for variable money supply (yet still avoiding central banking) may need to be the next order of innovation for tokens 2.0.
Algorithmic Intrinsic Banking
Imagine creating a programmatic monetary policy where inflation/deflation is a function of the usage of a token. Measuring usage would include the number of independent participants in a network, network size, transaction volumes, transaction frequency, token price, etc. This type of AI driven intrinsic banking would solve the inherent hoarding problems that come with tokens while relieving the subjective decision making and limitless currency issue involved with central banking. This type of forward thinking is similar to Trent McConaghy’s (Ocean Protocol) vision for AI DAOs.
The difficulty in creating this, however, is being able to measure real usage while excluding pure financial transactions (trading). We could start by building the best approximation model and through machine learning iterate towards a best starting point model. Over time, this initial model would identify the parameters and optimize automatically.
Another issue is that this type of AI-based banking could be vulnerable to manipulation and attacks (adversarial learning) in order to inflate a digital currency. We could potentially address this by having a built-in transaction tax paid by the seller which is continuously variable, purposely arduous over short time horizons to discourage speculation and excessive trading, and asymptotic towards zero with longer holding periods.
As we collect more data and learn more about these networks, we’ll be able to better understand how to manage token velocity. At the moment, the levers we can use are rooted primarily in mechanism design and broad fiscal policies. Meanwhile, the root of velocity issues is heavily influenced by our insistence on fixed money supply. The greater solution, however, may ultimately lie in a machine learning driven monetary policy.
Thanks to Jamie Burke, Aron van Ammers and the rest of the Outlier team for assisting with this post. And special thanks to Zeynep Gurguc of Imperial College London.
Eden Dhaliwal is head of crypto-economics at Outlier Ventures, a London-based venture-capital firm.
Follow him on Twitter @edendhaliwal.
This post is not financial advice and reflects the personal views of author. The author invests in digital assets and may have positions in the aforementioned cryptocurrencies.
Disclaimer: This article should not be used as investment or financial trading advice. Please conduct careful due diligence before investing in any digital asset.