Proposed Evaluation Standards for Token Models

This article introduces an evaluation framework for token economic models, helping readers identify which models have the potential for long-term sustainable growth.

Incentive Misalignment in the Current Crypto Market

On November 7, 2024, Donald Trump won the U.S. presidential election. During his campaign, Trump had made a series of pro-cryptocurrency statements, and following his victory, Bitcoin surged past previous highs, sparking a broad rally across the crypto market. Coupled with the approval of the Bitcoin ETF in January 2024 and the Federal Reserve’s liquidity injections in September, the entire industry found itself in a euphoric atmosphere. It seemed as though the floodgates of traditional financial liquidity were about to open for the crypto market.

Amid this backdrop, a persistent issue that had plagued the market for nearly a year—the “misalignment of incentives”—was momentarily forgotten.

The Problem: Short-Term Profit Over Long-Term Value

Over the past year, the Web3 industry has faced a significant issue: project teams chasing short-term profits at the expense of long-term success. Many projects are focused solely on token issuance and executing strategies to extract value from the market, without regard for the long-term viability of their products.

The image below illustrates this issue through the candlestick charts of six recently launched Binance tokens, providing a clear representation of how this phenomenon manifests in the market.

This is almost a microcosm of all new coin issuance projects this year - the price of most coins peaks when they are listed on exchanges, and then falls all the way. As for the reason why this incentive misalignment problem occurs, we can use a simple prisoner’s dilemma model to illustrate the reason.

To put it simply, in today’s market environment, everyone is accustomed to extracting short-term benefits. If they join in the extortion, they can at least get “1” in benefits, but if they insist on long-term sustainable operation, they will only get “0” And hand over the benefits to others.

The profit-seeking behavior in the market is understandable, but what we must see is that such a profit-seeking method is not a very long-term solution. Extracting short-term profits is tantamount to drinking poison to quench thirst. In the long run, it will lead to a tragedy of the commons. The entire encryption market will gradually lose confidence, and the cake of the entire industry will become smaller and smaller and tend to disappear. On the other hand, only if everyone insists on long-term operations, sustainable development, and market maintenance can we jointly achieve “10” returns.

Propose the necessity of a standard system for sustainable development of token economic models

How to curb the occurrence of incentive misalignment in the crypto market?

First of all, it is obviously useless to rely on the constraints of morality and public opinion. Secondly, some people have suggested that the tragedy of the commons in traditional economics can be solved by clarifying property rights through the Coase theorem, but this is not feasible in the crypto market. First, there is still controversy in the economics community about the feasibility of Coase’s theorem in solving practical problems; second, Web3 is significantly different from the traditional economic market. Cryptocurrency has the triple properties of securities, commodities, and currency, and is unique. It is very strong. Directly copying the theories of the traditional economic system will only lead to dogmatism. Encryption problems must be solved through encryption. Only a sustainable token economic model can solve the problem of misaligned incentives in the encryption market.

Many people have proposed improvements to the token economic model, but they are not convincing, such as increasing the transparency of team token distribution, changing team unlocking conditions to non-time factors (such as market value), etc. Regardless of the feasibility of these plans, even if they are implemented, project parties have various ways to circumvent restrictions.

Therefore, this article proposes a standard system that is as specific and complete as possible to clarify what kind of token economic model has the potential for sustainable development. This is missing in the existing research materials and is of great significance. The significance of this standard is mainly reflected in two aspects.

First, this standard provides a reference for designing a reasonable token economic model for projects that are willing to continue operating in the long term;

Second, this standard provides users in the crypto market with a standard to judge whether a project’s token is worth holding. By analyzing according to this standard, ordinary users can also judge the sustainable development potential of the project. In this way, users have the ability to identify projects that obviously extract short-term benefits, and can choose not to invest. If things go on like this, the market will be forced to give up. short-term interests and pursue long-term interests instead.

Sustainable Development Token Economic Model

Prerequisite: business income

Whether a project can develop sustainably in the long term depends on a fundamental prerequisite: the project must have real sustainable business income.

First of all, any sustainable project must have real sustainable business income. This is nonsense in traditional industries, but it must be emphasized in Web3. The reason is that Web3 has a big economic bubble. In this environment, it is really Projects with ongoing revenue are scarce. There are countless star projects in the 2021 bull market, but only a few have survived. However, Uniswap, AAVE, MakerDAO, etc., these projects without exception have real and sustainable business income; in contrast, projects such as Axie, OlympusDAO, etc. , although it flourished for a while, it was short-lived in the end.

The goal of any project must be to make a profit. And if it cannot make a profit in terms of business income, it can only make a profit by selling the project tokens or currency rights in its hands. Then in the face of selling pressure, without external liquidity to rescue the market, a collapse is inevitable. Therefore, projects without real business income cannot develop sustainably in the long term, no matter how hot the market is and how hot the hype is.

In addition, another crucial point is that a good design economic model must be related to business revenue. Good projects may not have good economic models. The most typical example is Uniswap. Uniswap is by far the most successful project in the entire Web3 industry, but its economic model is not successful. The main reason is that its economic model is not linked to business income, so its token UNI is not an ideal investment target. Regarding this, other more complex factors are involved, which will be explained in detail later.

Basics: Staking Incentive Mechanism

If business income is the prerequisite for project sustainability, then the pledge incentive mechanism in the token economic model is the basis for its sustainability. A good Web3 project can be compared to a solid building. Business income is equivalent to the foundation of a building, and the staking incentive mechanism is like the steel frame of the building. If there is no business income, it is equivalent to no foundation, and the building cannot be erected at all; and if there is business income but lacks a pledge incentive mechanism, it is like having only a foundation without steel support. Although the building can be erected, it will not be able to stand up in the face of wind, rain and time. When faced with the test, it is inevitable to appear weak.

The so-called pledge incentive mechanism means that the project must have a mechanism that allows currency holders to pledge the native tokens of the project and receive certain rewards. Different types of projects have different pledge forms and different reward forms.

For example, for PoS public chains such as Etherum, the pledge form is to Stake to become a PoS verification node, and the reward form is to obtain additional public chain tokens; for CDP stablecoins, the pledge form is to use Token as collateral, and the reward form is to obtain Hidden rewards such as governance rights and the ability of stablecoins to withstand collateral declines. For pure Ponzi projects such as OlympusDAO mentioned above, native tokens are directly pledged into the protocol and more native tokens are obtained as rewards. The most special thing here is the economic model represented by Curve. This type of economic model can link the staking incentive mechanism with the business income of the project, which will be discussed in detail in the next section.

So specifically, why is there a staking incentive mechanism? Staking is the most important mechanism to reduce the circulation of tokens in the market. Current project tokens are basically not 100% unlocked directly upon initial issuance, which means that as time goes by, the tokens will almost certainly be in a state of inflation. If the market circulation is not reduced at this time, a deflationary mechanism or means will be formed. Its currency price will inevitably fall as it is unlocked, and users will lose confidence in holding the token for a long time.

Pledge is the purpose, and incentives are the means. The rewards after staking, on the one hand, compensate users for the opportunity cost of locking liquidity, and on the other hand, they attract users to pledge through income. Users are attracted by the reward income to pledge, and the token market liquidity decreases and the currency price rises, which in turn attracts more users to purchase and pledge, and the token will enter a virtuous cycle.

Therefore, the staking incentive mechanism is the basis of any good token economic model. Of course, there is an unavoidable topic here: Bitcoin is the most successful project in the field of cryptocurrency, but it does not have a staking incentive mechanism. Why is this?

This problem is of great particularity. Its pioneering significance in the field of blockchain, its more suitable value storage method than gold, the operating costs of PoW mining machines, etc. These more important factors have created the undisputed consensus of Bitcoin in the field of cryptocurrency. The consensus basis and the design of a fixed total amount of Bitcoin put people’s belief in the value of Bitcoin at a cliff-edge lead compared to other tokens. In other words, Bitcoin succeeds only because it is Bitcoin. Not every PoW token with a fixed total amount but no pledge mechanism can replicate the success of Bitcoin. Litecoin, BCH, FTC, there are countless counter-examples.

In the same way, because the consensus of Bitcoin has far exceeded the significance of its economic model, all subsequent discussions on the token economic model will not include Bitcoin in the scope of discussion.

The form of staking distribution incentives

At this point, a good economic model has begun to take shape. The pledge incentive mechanism of a project’s tokens can be divided into several situations according to the different forms of rewards distributed.

The first type: short-term economic model

The first is to directly preset a certain distribution ratio from the economic model of the pledged token as a reward for staking. This type of economic model is standard for short-term projects, and its currency price is often characterized by a sharp rise in the short term and then a rapid decline to a very low level. This economic model does not have the ability to self-stabilize. If there is a large amount of external liquidity to rescue the market, its currency price may fall and then be briefly pulled up, but it will not escape misfortune in the end.

The most critical point here is that the staking rewards distributed by such projects are the same tokens as those being pledged, and there is no lock-up mechanism. The representative of this type of project is the second-pool LP mining of a number of small DEXs in DeFi Summer. For example, I provide the WBTC/ETH trading pair for LP mining in a DEX named “Aswap”, and the LP reward is Aswap The native token A, users can pledge the A obtained from LP mining and obtain more A according to a certain APR. The Aswap platform reserves 20% of the total amount in A’s economic model specifically as staking rewards.

Therefore, when the user obtains A through LP mining, he will choose to pledge A to obtain more benefits. Okay, here’s the question, after I get rewards through staking, should I continue to deposit the rewards into the pledge, or should I directly “dig and sell” to make a profit? This is essentially a prisoner’s dilemma.

Of course I know that if I continue to deposit, as the principal increases, the profits will increase. And if everyone holds firmly, as more new people enter, the currency price will also rise. But the problem is that if other LPs carry out “mining, raising and selling”, the currency price will drop rapidly and my income will be quickly damaged. And I cannot be sure of the behavior of other LPs, so I can only consider the worst case scenario and negotiate with them. Let’s “dig, raise and sell” together. In this way, as the selling pressure continues and the circulation of A currency in the market becomes larger and larger, the currency price will fall and never recover.

In addition to this type of DEX second-pool mining, the pure ponzi disk represented by OlympusDAO mentioned above is also the same type of economic model.

Let’s give another example. Suppose I buy token B of a certain Ponzi project “BDAO”. B’s economic model stipulates that users can pledge B and obtain more B as rewards. The reward source is the portion reserved in B’s economic model, accounting for 20% of the total amount.

If I buy B and participate in staking, the circulation of B in the market will decrease, and the price of B and the staking yield will increase accordingly. After the increase, more people will be attracted to buy B and participate in staking. The circulation of B will be smaller and the price will be higher. , such a cycle, B’s price and pledge yield will be raised extremely high in a short period of time. The APY of OlympusDAO once exceeded 10,000%, and the currency price once exceeded US$1,000 (currently US$16.1).

But once the price of B shows a downward trend, since there is no lock-up, in order to avoid losses, I will quickly unpledge and sell B. The circulation of B increases, the price drops, more users unstake, and the currency price drops further. In such a vicious cycle, the currency price drops rapidly or even returns to zero.

This type of token economic model cannot be sustained in the long term. The key reason is that the rewarded tokens and the pledged tokens are the same tokens, which can easily interact with each other and fall into a death flywheel. In addition, there is no lock-up mechanism, and currency holders can unpledge at any time, creating a scarcity of circulation. Hard to guarantee.

Second: Long-term economic model

The second economic model uses the platform’s business income as the source of staking rewards, and the pledge tokens and reward tokens are of different currencies, and are equipped with a locking mechanism. The typical representative of this token model is Curve, one of the giants in the DeFi era.

Assume that a user provides liquidity for a trading pair consisting of C and D coins on Curve. The LP reward he receives is not Curve’s native token CRV, but C and D tokens. The platform will charge a certain handling fee for each swap between C and D tokens, and part of the handling fee will be distributed to LP, and the other part will be distributed to veCRV holders. veCRV is obtained by CRV holders in a certain proportion based on different lock-up quantities and periods. Simplifying this scenario, it is equivalent to pledging CRV to obtain C and D tokens.

This staking reward mechanism has two benefits. The first is that there is a lock-up mechanism, which ensures that when the currency price drops, there will not be a large amount of selling pressure and fall into the above-mentioned death flywheel; the second is that the pledged token and the reward token are not the same currency, even if the pledged token price drops in the short term has declined. As long as the price of reward tokens is stable, users will not lose confidence and fall into the dilemma of “dig, raise and sell”.

To sum up, long-term projects must have real and sustainable business income, and their economic models must have a staking incentive mechanism. On this basis, the incentives obtained from staking must be shared from business income, rather than being distributed in a preset proportion among the project’s native tokens. The reward tokens and pledged tokens cannot be of the same currency. Such an economic model organically combines project business income with the pledge incentive mechanism. Even if the currency price drops slightly in the short term, currency holders will not lose confidence in its long-term potential and sell tokens due to the existence of business income dividends. In addition, the lock-up mechanism adds an extra layer of insurance to this token economic model.

This can be echoed above: for a project that is confident in its long-term potential, it is necessary to integrate business income into the token economic model. The first form of staking incentives in the short-term economic model we discussed is obviously completely unrelated to business income, or the project itself may not have real business income at all.

The third type: economic model with good projects but not necessarily suitable for long-term investment

Here we have repeatedly emphasized the importance of the project’s real business income to the token economic model. However, as long as a project has real and sustainable business income, its economic model must be good? This is not the case. It also depends on whether its native token economic model has a strong correlation with business income.

Here we give two counterexamples, Uniswap and Lido. The business income of these two projects is very considerable, and both are very successful projects, but their economic model design is difficult to be considered suitable for long-term investment. Take Lido as an example, this king-level project that is currently ranked No. 1 in DeFiLlama and the leader in the LSD track. However, the currency price of its native token LDO has only been fluctuating in a range since its launch. The reason is that the economic model of LDO is not consistent with Any connection to the project’s business income.

Lido’s profit model is very simple but very successful: Ethereum PoS pledge has a minimum quantity limit of 32 ETH, which is difficult for ordinary retail investors to meet. Lido integrates retail investors’ funds and promotes retail investors’ pledges in the form of “group purchases”, and starts from PoS A certain percentage of handling fees will be charged from the staking rewards. There is no doubt that Lido’s entry point is very accurate, and its business model has also brought huge business income to Lido.

However, such a successful project may not be worthy of users holding their tokens. Why? The main rights and interests of LDO holders are only to participate in the governance of Lido DAO, including voting on key decisions such as protocol parameter adjustment and node operator selection. However, they cannot receive any dividends from staking fees.

The situation is similar with Uniswap. As the absolute leader of DEX, the business income is naturally extremely considerable, but it is also not shared with UNI currency holders. As a result, UNI was once ridiculed as the biggest “mascot” in cryptocurrency (referring to the fact that UNI holders only commemorative).

Therefore, no matter how successful a project is and how high its returns are, if some mechanism is not set up in the token economic model to share the returns with currency holders, the long-term potential of its tokens will inevitably be greatly reduced.

“Underdamping Force” in Token Economics

Some people must have questions here: Doesn’t Ethereum’s PoS additional issuance also set pledges and incentives into the same currency? Isn’t Ethereum’s token model successful? Why haven’t we seen the price of ETH collapse? First of all, we still need to emphasize that Ethereum and Bitcoin are the same. The consensus of such epoch-making products far exceeds the influence of economic models, and they can only be regarded as special cases.

Putting this factor aside, although Ethereum’s pledge and incentive are in the same currency, its token economic model has an “under-damping force” that gives currency price stability.

The concept of “underdamping” is borrowed from the concept of “underdamped system” in physics and engineering. It originally means that no matter which direction an object moves, the system can generate a force that hinders but does not prevent its movement. This is called “underdamped system”. Damping force” can adjust the return of an object to a state of equilibrium.

When an object moves forward, I apply an opposite resistance. This resistance changes with the power and is always smaller than the power. It slows down the movement of the object but does not change its direction. The most typical damping force is the elastic force of the spring. When you press the spring, you will feel the resistance getting bigger and bigger, but you will not be unable to push it. When you pull the spring, you will also feel the resistance getting bigger and bigger, but you will not be unable to pull it. . In these two processes, although you can still deform the spring if you continue to exert force, it will be more strenuous, so you don’t want to continue to exert force, and the movement trend will slowly stop.

This is another key factor in sustainable token economic models: underdamping. Specifically, whether currency prices are rising or falling, there should be mechanisms in the economic model to slow down the trend.

Ethereum has this “under-damping force”. Whenever the Ethereum ecosystem is booming and the ETH currency price rises, its Gas will also rise, inhibiting users from continuing to purchase ETH and participate in the ecosystem, thereby inhibiting the currency price from continuing to rise; when the Ethereum ecosystem is deserted, the ETH currency price drops, and Gas will also decrease. , attracting more users to participate in the ecosystem and preventing the currency price from continuing to decline. In other words, the economic model of a token with under-damping power will prevent excessive fluctuations in currency prices due to market sentiment.

So why has the price of ETH increased thousands of times even so? This is because without the entry of external funds, the lack of damping force will maintain the project currency price within a certain range. But if more and more people recognize the project’s fundamentals and potential for sustainable development, external funds will continue to come in and break through the limitations of under-damping force.

In other words, this type of token economic model relies on lack of damping force to weaken the impact of market sentiment on the one hand, and on the other hand relies on the project itself to attract more investment. This is the token economic model of sustainable development. Sustainable development The project should look like. Layer 1 projects will adjust the gas on the chain due to popularity, and often have this “under-damping force”. Therefore, the price of Layer 1 public chain coins is relatively difficult to speculate and can truly reflect the market consensus of the chain.

Looking back at the first type of short-term economic model mentioned in the previous section, the design of its staking incentive mechanism results in that it not only lacks damping force, but also has “positive driving force”. The currency price rises, and the pledge further promotes its rise, and the currency price falls. This will further promote its decline. Therefore, projects with this type of token economic model tend to have strong momentum when their currency prices rise due to market enthusiasm, but once they fall slightly, they are out of control. Unless there is huge external liquidity to rescue the market, such projects may repeat themselves. A process of rising and falling must eventually end in a collapse, because it is unrealistic to rely solely on external liquidity to rescue the market. The original sin of the economic model is doomed to the ultimate failure of such projects.

The picture above shows that OlympusDAO regained its second life due to external liquidity rescue, but in the end it still returned to zero.

The Issue of Token Use Cases

The evaluation of a project’s sustainability starts with its tokenomics model, as discussed earlier. This forms the basic framework. However, for a more thorough assessment, it is equally important to consider whether the project’s token has sufficient use cases.

These use cases can be divided into two categories: “internal use cases” and “ecosystem use cases.”

Internal use cases refer to the utility a token provides within its own protocol. This encompasses scenarios where holding a project’s token allows users to access more features or gain additional benefits within the protocol itself—a concept often referred to as “token utility.”

In this regard, tokens like UNI (Uniswap) and LDO (Lido) are relatively lacking. While they serve governance purposes, their ability to provide tangible utility or profitability opportunities to holders within their protocols is limited, which weakens their overall value proposition.

Ecosystem use cases are equally, if not more, critical. This refers to whether a project’s token can find utility in other projects within its broader ecosystem. This reflects the level of recognition other projects in the ecosystem have for the token, the project itself, and its broader market segment. It also indicates whether enabling the use of the token in other projects would bring mutual benefits to both sides.

For example, in the restaking leader Eigenlayer, tokens beyond ETH can also be used for restaking, including various LSTs (Liquid Staking Tokens) and LP tokens. This demonstrates Eigenlayer’s recognition of the LSD (Liquid Staking Derivatives) and DeFi sectors. Similarly, in the future, Eigenlayer may support stablecoins or RWA (Real-World Asset) tokens, further indicating its positive outlook on the respective projects and sectors.

The breadth and depth of a token’s use cases, both within its own protocol and across its ecosystem, serve as critical indicators of its long-term value and sustainability. A robust application landscape ensures that a token is not only integrated into its native environment but also holds relevance and utility across a broader network, enhancing its demand and supporting its economic model.

The decentralized lending protocol Compound only allows the use of certain blue-chip assets and stable coins to provide loans, which is the same reason.

For another example, EVM L2 uses ETH as Gas, which represents the recognition of ETH by the entire EVM ecosystem, so it provides “ecological application scenarios” for it. Therefore, tokens can obtain this “ecological application scenario”, which is another manifestation of the sustainable development potential of their projects and the track they are located on.

The Essence of Tokenomics: Supply, Demand, and Market Expectations

At its core, the market always adheres to the most fundamental economic principle: the relationship between supply and demand. When supply exceeds demand, prices fall; when demand exceeds supply, prices rise. The cryptocurrency market is no different. Thus, the essence of designing a tokenomics model lies in maximizing demand (attracting holders) while minimizing supply (reducing circulation).

The criteria I outlined for evaluating sustainable economic models are distilled from studying numerous tokenomics models currently employed across the crypto industry. At this point in time, they represent a relatively feasible theoretical framework for achieving the goal of “increasing demand while reducing supply.” However, these criteria should not be seen as rigid. As the crypto industry evolves, new tokenomics models will undoubtedly emerge. As long as they align with the overarching principle of increasing demand and reducing supply, they will hold potential for sustainable development. Each specific scenario should be analyzed on a case-by-case basis.

Another critical factor in a sustainable tokenomics model is the management of market expectations. In other words, you must design a mechanism that convinces market participants that, in the future, your token will face demand that exceeds its supply. Only with this expectation will users be motivated to buy and hold your token for the long term, giving your project the potential for sustainable growth. Mechanisms like Curve’s staking incentives, Ethereum’s delayed-release dynamics, and even Bitcoin’s fixed total supply serve this purpose.

This brings us to a highly discussed topic over the past year: the issue of “VC tokens with high valuations and low circulation.” These tokens often launch with extremely low initial circulation percentages, followed by periodic, large-scale unlocks that result in nearly irreversible inflation. Under such conditions, demand is almost never able to keep pace with supply. As the issuance of these tokens proliferates, users naturally form negative expectations toward these evidently “oversupplied” economic models, choosing not to buy or hold them. This is one of the key reasons why most tokens have experienced consistent price declines upon entering centralized exchanges (CEXs) this year.

Conclusion: How to Resolve the Short-Term Profit-Driven Prisoner’s Dilemma

This article has introduced a comprehensive evaluation framework for token economic models with long-term sustainability. The framework can serve as a reference for project teams designing token economic models, as well as a standard for ordinary users in the crypto market to assess such models. Regarding the prisoner’s dilemma and tragedy of the commons discussed earlier, this framework holds significant value.

The prisoner’s dilemma is challenging because, although both parties could adopt strategies beneficial to the overall system—leading to mutual gains far exceeding the benefits of betraying the other—information asymmetry prevents one party from knowing the other’s strategy. This uncertainty leads to self-serving strategies for self-preservation, ultimately creating a lose-lose outcome and resulting in a tragedy of the commons.

However, information asymmetry only exists in one-shot prisoner’s dilemma scenarios. In the case of repeated prisoner’s dilemma games, this information gap disappears. According to game theory, in repeated games, both parties are aware of the other’s strategy in the previous round and recognize that although betrayal might yield higher short-term gains, it leads to mutual losses in the long run due to system-wide harm. As a result, individuals in repeated games are less likely to blindly pursue selfish strategies. Extensive economic experiments have shown that mirroring the other party’s previous strategy is the most advantageous and dominant strategy in repeated prisoner’s dilemma games.

Currently, the misalignment of incentives in the crypto market contributes to the tragedy of the commons. However, if some project teams begin to design token economic models aimed at sustainable development and prioritize long-term gains, other projects in the market may eventually follow suit, abandoning the pursuit of short-term profits. Over time, the prisoner’s dilemma and tragedy of the commons in the crypto market could be resolved.

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