Beginner Series – Part 2 – Supply and Demand considerations for your tokenomics – Supply
Since we established the importance of tokenomics in your microeconomic structures, it is critical to understand that, for the most part, the value of your tokens is bound to the laws and principles of economics and, to a certain degree: market psychology and behavioural economics.
A basic understanding of economics goes a long way in developing an economy that’s both circular and doesn’t overload the supply side or neglect the demand side. Unbalanced economies will fail for many reasons, so it’s best to start taking a holistic approach to tokenomics development in the planning stage.
As introduced in the previous article, tokenomics are built on both: a token’s use-case and market size (that is to say, what can the token be used to accomplish and how large is the market for the particular use-case) and the circular economics around the use-case (why would anyone buy this token and either spend or sell this token while balancing the in-flows and out-flows).
Supply and Demand Economics and Price Equilibrium
In supply and demand, equilibrium is reached where the quantity demanded by consumers and the quantity supplied by producers are equal. In layman’s terms, it’s the perfect price (also referred to as the “market clearing price”) for a product where you’re able to supply the exact amount of a good being demanded by the market.
In a free market economy, the process of reaching equilibrium can be described as follows:
- At first, there will be no buyers or sellers in any given market because there are no prices for anything.
- Then some people come along who want to buy something (demand) at a certain price (the amount they’re willing to pay). These people make offers accepted by sellers who want to sell their products at this same price (and thus supply). This becomes a new market price for whatever was offered for sale in that transaction.
Regarding tokenomics, supply is defined in two ways: how many free-trading tokens are out in the market presently and how many tokens will be created over the project’s lifetime. A good way of thinking about this is to ask how plentiful or scarce the tokens are. Demand doesn’t have to be complicated either, it essentially refers to the number of people willing to pay to access some benefit or resource.
If we take a grade 1 approach. We can generate a token system for a gym we’re setting up where it costs one token to access the equipment. In this scenario, we don’t know the price of a gym membership, and we want the market to determine the price organically. If 1000 people in town are into fitness and want to access the gym 15 times a month, a good starting point for a fairly balanced system would be 15,000 tokens. If we were to generate too few tokens, only the few who can outbid the many would have access, and the price will be out of reach for those who are more price sensitive. This will leave the gym largely unavailable to most potential clients and create a market opening for another gym to set up shop and serve the market who currently can’t access the gym. If we generate too many tokens, we risk having the gym become overburdened with people who want to work out. Since the tokens are so plentiful, their value on the market will plummet, with the accompanying psychology being: I pay very little for this token: still, chances are, the gym will be so full I may not get a full workout anyways.
It’s an elementary example, but the point is that you want to ensure your demand and supply are balanced to keep everything in equilibrium to offer the best possible product experience. It helps to take a step into your client’s shoes and imagine what’s going on in their mind when they buy your token. It’s a little simpler with digital products since they’re easier to scale than a physical gym network, but the concept remains the same while outlining all your considerations.
At the right price, we’re also able to maximize revenue. Theoretically, profits are maximized at this level if we do a good job with our market research and managing costs. In retail, equilibrium is paramount since it often signifies the price where most customers have their demands fulfilled while having the least amount of inventory sitting in storage.
It helps to imagine supply and demand like a see-saw. If we have a low supply with high demand, the tokens will be sought after, and those with more money will be the ones who are willing to pay a premium to have them over all others. Likewise, when supply is too large for too little demand, people can undercut each other to trade their tokens. In a scenario where more tokens are sold than bought, outflows will be greater than inflows, creating constant downward pressure on the token price.
Provided the liquidity and sufficient volume, in a free and functional exchange, the prices would theoretically hover around the equilibrium prices barring certain market anomalies (manipulation, large buy or sell orders from an overweighted market participant, etc.) Having a keen understanding of where that price equilibrium is located is an instrumental aspect of communicating the value of your token. In my opinion, in a correct circumstance, It’s the purest expression of the free market being able to value your goods and services and, if used correctly, can be an incredible tool for business owners to obtain true and actionable insights on whether you need to add value to your token or modify the supply to achieve the ideal price point for your tokens.
What are the Supply Levers?
Supply, in a traditional economic sense, refers to the total amount of goods produced and the willingness of suppliers to sell at various prices. This is a function of your business model, so you should think about how you want your tokenomics to work in tandem with your supply curve.
Supply levers include burning and minting tokens and early-on: vesting periods. Before we get into these levers, we’ll briefly go over token supply and what it means to your project.
Your token supply structure
There are a couple of ways to look at the supply of tokens. We can start by looking at the complete picture and see how many tokens will be generated in the project’s lifetime. You should ask yourself how many tokens will be tradeable by the public at the beginning and whether the mechanics are inflationary or deflationary. We will move away from the earlier gym example and start another business project from scratch to reinforce the idea.
Let’s begin with the big picture:
The first step is figuring out a token supply that makes sense for your market. The number is arbitrarily chosen, but from a UX perspective, you should aim to go with an amount that, on a fully-diluted basis, will make sense for consumers to use. It’s not comfortable or pleasant for people to start thinking about prices in trillions of tokens, nor is it helpful to work in a system where something is a distant fraction of one unit.
For our second business idea, we are creating a token that lets you play a subset of arcade machines in a city. During our market research, we see that the market for this service is $100,000 a year. We could consider producing 100,000 tokens for this project since it might be a good fit if we want to keep the token value hovering around the $1 mark. This also fits in line with the principle of creating a circular economy (one that allows the currency to flow back and forth from vendor to consumer): people spend the tokens to play the arcade machines, and the operator sells the tokens to patrons who want to enjoy a night of video games.
I’ve seen some projects create psychological traps by having initial token distributions in the quadrillions. They pump out misleading information with the basic idea being: if the price of this token reaches even one penny, your $100 worth of tokens (which buys you trillions of tokens) may make you a billionaire. In another article, I’ll produce a short write-up on market volumes and why these ambitions may never materialize as they’re supposed to, but try not to fall to scam tokens like this.
Your project is probably bigger than an arcade, so you need to figure out what your token distribution is like by examining the goals of every stakeholder involved in the project. We live in a society where it takes money to pay employees and upkeep infrastructure to undertake initiatives, so raising funds to have the resources to do this is part of the goals the firm needs to keep in mind. A portion of the tokens should be distributed to the firm to sell on the exchanges to provide the capital to enact such measures. Likewise, it would also be a good idea to set aside tokens for influencers, marketing partners and events to give the product or service exposure, so having a marketing wallet is a forward-thinking move. This goes on (think about developers, advisors, community floats, liquidity pools, etc.) until you arrive at a balanced breakdown where all the stakeholders have the resources necessary to meet their goals.
Once a distribution is settled on, there are other questions we can ask: does the distribution seem equitable? Who are the clear winners and losers in this economy? If someone studies the tokenomics model for this business case, does it leave room for malicious actors to take advantage? Is too much power being given to any single entity? Ultimately: Does the tokenomics structure create a fair and even playing field for the participants, and is the economic microstructure seem sustainable?
Inflationary or Deflationary
This is a topic that I think most projects (and people in the crypto space) get wrong. People don’t have a good understanding of inflation or deflation and the role they play in society and economics.
Consider the economics over an indeterminate time when creating your total token supply. Are you trying to create an investment vehicle? Are you trying to create an ecosystem to facilitate trade? The common trope that I come across often is that inflation is bad, which is why most cryptocurrencies are better. Deconstructed, the argument commonly goes something like this: every year, the money in your bank account is worth a little bit less, and this is the government’s way of attacking the lower class. I would argue that inflation is mechanically a feature in modern economic systems because you want to create an environment where people can grow their savings and spend their money. After all, the flow of currencies and the borrowing and lending cycle creates prosperity. The point of using currencies and living in societies is that the net benefits far outweigh everyone doing everything themselves; by facilitating trade and exchange, we develop more innovative solutions and create a higher quality of life for all people. Having deflationary or non-changing supply, such as Bitcoin, is right for some applications. Still, not all of them, especially in instances where having people use the currency to transact, fulfill the purpose of its existence. If you choose to include inflation mechanics in your tokenomics for the purpose of spurring trade and usage, you also don’t want runaway dilution. The idea is to ride the fine line where people use their tokens to invest in the ecosystem to get a return greater than the inflation rate while still spending their tokens to encourage buying and selling your tokens. Remember, don’t look at your tokens and equate them to shares in a company trading on the public markets, but instead look at it in the same ways currencies are valued: by demand. The more demand there is for a token (due to people wanting to use it to purchase services and goods), its value will rise relative to other tokens. I’ve read other articles that state when inflationary mechanics are included, you subject your holders to “suffering” a loss through built-in mechanisms that hurt your holders. I would rephrase this to inflationary mechanics, subject holders to loss when they hold the tokens and do nothing with them. Tokens should be spent in exchange for services or goods or invested in meaningful ways to promote growth.
Burning and Minting
The most powerful tool for modifying the number of tokens circulating in a market is the ability to have the smart contract that created the tokens burn existing tokens or mint new ones.
Depending on the use case, you can choose to have an inflationary or deflationary system by either removing or adding tokens to the current supply after the smart contract creating the tokens is executed. This is a lever you can use alongside some forward thinking to control the price to meet the needs of your project. From a psychological perspective, people enjoy certainty and security, so fighting to keep a stable price point once the ecosystem is up and running should be the goal of the tokenomic system and the supply controls.
Vesting and Lockup Periods
The initial distribution is really important. Demand is purely speculative as your project takes form and milestones are set. At token launch, supply should be at its lowest, and tokenomics should be set up to favour the community to gather hype.
Keeping the supply too low, in conjunction with low trading volumes, allows you to generate “pumps and dumps.” Still, if you choose to engage in such behaviours, you’ll be selling yourself, your idea and your community short, where long-term gains and legacy will be traded for a short-term gain and the loss of your reputation, and if it matters, your conscience.
Once the tokens are out there, the idea is to hit your milestones and generate sincere and genuine goodwill to create a long-lasting environment for transacting and solving your customer’s problems.
On that note, it’s also worth understanding behavioural economics and the interplay between trading activity and vesting or lockup periods. Since we don’t want to flood the market with tokens at the outset, and it’s important to tie the long-term success of the project with economic incentives for the builders, there are a few general rules to look at.
- Longer vesting periods inspire more trust. If you are not a doxxed team, stretch them out even longer.
- There is a balance to strive for when deciding how much the founding team gets: if it is too high, the team will be seen as greedy, and the tokens appear too centralized. Too low, and there might be a chance people think the reward incentive isn’t high enough to deal with the pressures and pains of building a startup or a company. Reward yourself just enough, but try to keep your greed in check.
- If you can adjust your vesting periods, so tokens are unlocked steadily, you’ll inspire more confidence. If people can see your vesting schedules are set up to release many tokens all at once, it might cause pre-emptive selling. I plan on writing an article on game theory and cryptocurrencies to further address scenarios you need to plan for that might cause sudden volatility events.
The more equitable the distribution and the more you tie your success to long-term milestones will allow you to reap the largest rewards over time.
This is one of my favourite misunderstood topics in crypto.
Without going too deeply into why exchanges use staking incorrectly, and what it means to stake your tokens to improve the system’s integrity (think Ethereum Proof-of-Stake, vs. staking tokens on a Defi platform), the end goal remains the same. By keeping your coins frozen, the ecosystem will reward you for not participating in trading activity. It’s built on this faulty underlying theory that you’re forcing the coin value to go up if no one is selling. Essentially, you are causing supply to be artificially constrained to create an environment allowing upward price movement. Volume is lowered, and the price movement is subject to wilder price action. This is accomplished by creating pricing inefficiencies to create a higher perceived value of the token to trick people into buying in and starting a run built on FOMO.
Again, if this is the behaviour you want to engage in, you are free to do this. Still, if you’re looking to create a sustainable, real-working economy, I think there are far better ways to reward the community and people holding tokens. From the consumer standpoint, you also incur opportunity costs by staking your coins. My personal opinion is that web3 facilitates the movement of money in a way that’s never been more fluid and faster than before.
There are many factors to consider when it comes to supply and demand. Understanding these concepts is important so you can craft your tokenomics strategy accordingly. By understanding how demand and supply affect price fluctuations in the market, you’ll be able to create a sustainable crypto ecosystem for your business or project. In the next article, we will focus on the demand levers.
If you want to talk about tokenomics and your project, get in touch with us at Northman & Ponari, your leaders in web3 strategy. No one else applies both a practical and an academic lens to web3 projects in the way we do. Find us at northmanponari.ca