Fundamental Concepts of Tokenomics

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Author: Jack Lodge

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The economic value of a cryptocurrency can be as complicated as the asset itself. Tokenomics is the concept that explains how a token can create value by being integrated into a larger ecosystem. This article will explore the fundamentals of Tokenomics and its role in blockchain technology.

Cryptocurrencies require incentive-compatible mechanisms to ensure that the supply of a cryptocurrency remains consistent with the demand for it.

 

Basic Terminologies

Tokenomics is the application of economics to the cryptocurrency ecosystem, particularly regarding incentives.

Token Distribution is the method through which a protocol distributes incentive tokens.

 

ERC-20 is a technical standard/framework for Ethereum token development. It is used for all smart contracts on Ethereum blockchain.

Howey Test is a test provided by US securities laws which determines what qualifies as an investment contract. It is also an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.”

The Howey Test is important for situating blockchain and digital currency projects with investors and project backers. Certain cryptocurrencies and initial coin offerings (ICOs) may be found to meet the definition of an “investment contract” under the Howey Test.

Tokens

Coins are Cryptocurrencies that have their own standalone independent blockchain. Examples are BTC, ETH, XRP.

Tokens are assets which serve a function in addition to holding value — do not live on their own native blockchain. It is a unit of value that an organization creates to self-govern its business model, and empower its users to interact with its products, while facilitating the distribution and sharing of rewards and benefits to all of its stakeholders.

Tokens, as opposed to cryptocurrencies/coins are not necessarily created with the intent to be used as currency or represent monetary value at all. Taxonomy for tokens and cryptocurrencies/coins is still being fleshed out.

Layer 1 Tokens is native to a specific blockchain that powers all services on that blockchain. Examples are BNB, ETH.

Layer 2 Tokens or Platform Tokens is used for decentralized applications (dApps) such as Security tokens and utility tokens.

Utility Tokens Layer 2 is a initial coin offering (ICO) tokens for financing a network.

Security Tokens are investment contracts including a monetary investment, common enterprise and profitability via computation efforts from different contributors and it must pass the Howey Test.

Equity tokens is a representative of equity in an underlying company/protocol — function similarly to stock market shares.

Debt tokens is a tokenized assets that either are, or represent debt instruments such as corporate debt or government bonds.

Derivative tokens are similar to traditional financial derivatives which derive their value from underlying assets (indirect investment or contracts between parties which agree to pay one another based on movements in the underlying asset that enables participants to hedge risk.
Non PoS smart contracting platforms are Crypto value stores which do not use PoS, PoS based chains generate yield and are thus capital, non PoS do not and are thus commodities.

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Medium of Exchange tokens or payment tokens these are tokens optimized for medium of exchange (what is used as a standard of value for exchanges, such as currency) purposes, this was the initial vision of Bitcoin , these are susceptible to the ‘velocity problem’, as there is no incentive to hold a pure medium of exchange token and incur the risk that comes along with doing so.

https://medium.com/amazix/a-taxonomy-of-token-models-and-valuation-methodologies-7b6c0a1d02a9

 

Work Tokens can encapsulate the group of tokens which are distributed as reward for ‘work’, work rewards can relate to providing services to a network’s coordination and/or supply , as well as for alignment incentive, in such a way that incentivizes good work and penalizes harmful work.

Governance tokens: See governance token cell.

Service tokens: Users stake tokens to provide a given service (generally consensus mechanisms) to a network in exchange for returns — returns are not usually paid in this token as the token is what is being staked, stakes can be slashed for malicious or incorrect work.

Discount tokens: Grants user discounts on transactions performed on the network — these are work tokens as they rely on the user transacting and thus contributing to the network. Can be implemented as a ‘use’ model where users pay these discount tokens in order to receive transaction discounts — or as a ‘stake’ model where users stake these coins to receive a proportional discount on transactions.

 

Burn and mint equilibrium: Users ‘burn’ tokens to combat inflation, and are rewarded with a proportional share of monthly inflation.

Currency Tokens can be a medium of exchange, unit of account or a store of value.

 

Privacy coins are Cryptocurrencies such as Monero and ZCash which aim to further privatize information regarding transaction traceability.

Stablecoins are low volatility value stores — can be fiat collateralized, crypto collateralized seignories share (algorithmically stabilized via supply and demand manipulation).

 

Fungible Tokens are tokens which are interchangeable with one another (in the same sense that a dollar is functionally the same as every other dollar) that is not unique.

Non-Fungible Tokens are tokens which are not interchangeable with one another. It is unique. It is commonly used for collectible assets such as art.

Reward Tokens it acts as a reputation token for a specific blockchain, distributed as rewards to service providers on blockchains proportional to their performance reviews. It doesn’t necessarily have real value.

 

Asset Tokens are tokens backed by a real asset such as gold, real estate or bonds. It can be used to buy/sell the assets that they back.

Currency Tokens act as a currency and serves the same function for payment of purchases. Example is ERC-20 tokens.

PLF Interest Bearing Tokens in which lenders receive interest bearing tokens that represent their share in the pool, borrowers pay interest that flows into this pool over time, increasing the relative value of the lender’s share. This ensures that accrued interest in a market is paid out to the fund providers.

 

AMM Liquidity Provider Tokens is a liquidity tokens minted and sent to liquidity providers upon depositing liquidity into a pool, these represent a proportional share of the pool, similar to PLFIB, however, there are no borrowers, but traders who pay fees every time they trade.

Governance Tokens are tokens that represents voting power on blockchain projects, usually distributed to investors of DeFi protocols.

 

Native Tokens are tokens built on the Cardano blockchain. This is Cardano’s equivalent to Ethereum’s ERC-20 tokens.

 

Consensus Algorithm

Consensus Algorithm is a procedure through which all the peers of the Blockchain network reach a common agreement about the present state of the distributed ledger. A consensus algorithm aims at finding a common agreement that is a win for the entire network.

Proof of Work (PoW) is a consensus algorithm used to select a miner for the next block generation. Whoever solves the hash function first will be able to mine the next block. Since the hash function could only be solved by brute force, solving this equation is the proof of computation power invested.

Whoever solves the hash function first will be able to mine the next block. One of the advantages is protection from Ddos-attacks, an effective attack also requires a high computing capacity and a long calculation, so it is possible, but disadvantageous against the background of high costs. Another advantage is protection from the influence of low fractions of cryptocurrencies owned by the miner in extracting capacity and holders of large capital can not make decisions for the entire network.

Problems that can be encountered are huge costs or expenses grow unmanageable, and mining becomes possible only for large groups of miners. In addition, specialized computers consume a lot of energy, which increases costs. It is also “useless” calculations. Miners perform work on the creation of blocks, simultaneously consuming a huge amount of energy, the calculations that they do, are completely useless in themselves. Yes, they guarantee online safety, but their results cannot be used in business or science.

 

Proof of Stake (PoS) instead of investing in expensive hardware to solve a complex puzzle, validators invest in the coins of the system by locking up some of their coins as stake. After that, all the validators will start validating the blocks. Validators will validate blocks by placing a bet on it if they discover a block which they think can be added to the chain. Based on the actual blocks added in the Blockchain, all the validators get a reward proportionate to their bets and their stake increase accordingly. Thus, PoS encourages validators through an incentive mechanism to reach to an agreement.

The validators invest in the coins of the system by locking up some of their coins as stake. After that, all the validators will start validating the blocks. Validators will validate blocks by placing a bet on it if they discover a block which they think can be added to the chain. Based on the actual blocks added in the Blockchain, all the validators get a reward proportionate to their bets and their stake increase accordingly. Compared with PoW, this is better energy efficiency that you don’t need to use lots of energy mining blocks and it has lower barriers to entry, reduced hardware requirements or you don’t need elite hardware to stand a chance of creating new blocks. It also has stronger immunity to centralization which proof-of-stake should lead to more nodes in the network and stronger support for shard chains or a key upgrade in scaling the Ethereum network.

Problems such as nothing at stake. In a PoW network, there is a rare occurrence that two miners produce a block almost simultaneously as a result of a time lag. This results in a temporary mix-up in the network and nodes need to reach consensus on the valid block. Consequently, miners need to choose which version of the blockchain to spend their resources on, thus by-passing other opportunities.

However, as in the PoS system, forging of new blocks requires little resources, a validator might choose to continue working on multiple versions of the fork and forge new blocks. As there are no opportunity costs for forging in a particular blockchain, there is “nothing at stake” for users creating blocks. As a consequence, users could mine on competing branches of a blockchain to maximize the amount of transaction fees they receive. In order to address this issue, most PoS coins have additional protection mechanisms built into their protocol.

The Monopoly Problem typically, in a Proof-of-Stake system, the key stakeholder can implement modifications without taking the views of the community, enterprises, miners, and developers. This aspect contradicts the objective of creating a distributed ledger-based cryptocurrency since voting power is centralized.

The Bribe Attack in this case, a malicious actor executes a spending transaction intending to reverse it later. Once the transaction is validated, the attacker begins to secretly build a substitute chain based on the block preceding the one holding the transaction. After the attacker’s transaction receives the required proportion of confirmations and is longer than the legitimate chain, it is accepted as the new authentic chain. This aspect results in the reversal of the transaction.

Proof of Burn (PoB) instead of investing into expensive hardware equipment, validators ‘burn’ coins by sending them to an address from where they are irretrievable. By committing the coins to an unreachable address, validators earn a privilege to mine on the system based on a random selection process. Thus, burning coins here means that validators have a long-term commitment in exchange for their short-term loss. The more coins they burn, the better are their chances of being selected to mine the next block.

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Problem: While PoB is an interesting alternative to PoW, the protocol still wastes resources needlessly. And it is also questioned that mining power simply goes to those who are willing to burn more money.

Instead of investing into expensive hardware equipment, validators ‘burn’ coins by sending them to an address from where they are irretrievable. By committing the coins to an unreachable address, validators earn a privilege to mine on the system based on a random selection process. Thus, burning coins here means that validators have a long-term commitment in exchange for their short-term loss. The more coins they burn, the better are their chances of being selected to mine the next block.

This encourages a long-term commitment and time horizon for a project. This theoretically creates greater price stability for the coin as long-term investors are less likely to sell or spend their coins. Proof-of-Burn is also said to be better than proof-of-work at ensuring coins are distributed in a fair, decentralized manner. While PoB is an interesting alternative to PoW, the protocol still wastes resources needlessly. And it is also questioned that mining power simply goes to those who are willing to burn more money. It has high risk protocol, as there is no guarantee that a user will ever recover the full value of the coin being burned and rich get richer, those who have a lot of coins continue to amass an even greater number of coins.

Proof of Capacity are validators that are supposed to invest their hard drive space instead of investing in expensive hardware or burning coins. The more hard drive space validators have, the better are their chances of getting selected for mining the next block and earning the block reward.

Validators are supposed to invest their hard drive space instead of investing in expensive hardware or burning coins. The more hard drive space validators have, the better are their chances of getting selected for mining the next block and earning the block reward. PoC can use any regular hard drives including those with Android-based systems. It is reportedly up to 30-times more energy efficient than the ASIC-based mining of the bitcoin cryptocurrency. There is no need for dedicated hardware or constant upgrading of hard drives. Mining data can be easily wiped-off and the drive can be reused for any other data storage purpose. Not many developers have adopted the system and it is possible for malware to affect mining activities and widespread adoption of PoC could start an “arms race” to produce higher capacity hard drives.

Proof of Elapsed one example is TimePoET, it is one of the fairest consensus algorithms which chooses the next block. All the nodes get a fair chance of creating their own block by waiting for random amount of time, adding a proof of their wait in the block. The created blocks are broadcasted to the network for others consideration. The winner is the validator which has least timer value in the proof part. The block from the winning validator node gets appended to the Blockchain.

All the nodes get a fair chance of creating their own block by waiting for random amount of time, adding a proof of their wait in the block. The created blocks are broadcasted to the network for others consideration. The winner is the validator which has least timer value in the proof part. The block from the winning validator node gets appended to the Blockchain. Instead of being resource-intensive, it allows a miner’s processor to sleep and switch to other tasks for the specified time, thereby increasing its efficiency. PoET controls the cost of the consensus process and keeps it nimble so that the cost remains proportional to the value derived from the process, a key requirement for the cryptocurrency economy to continue flourishing. This is extremely dependent on Intel technology. Although the algorithm is free software and can be adapted to other platforms, the changes would make these networks practically incompatible or with serious incompatibility problems. There are attack vehicles on these networks that exploit the known vulnerabilities of Intel processors.

 

Byzantine Fault Tolerance(BFT) is the feature of a distributed network to reach consensus(agreement on the same value) even when some of the nodes in the network fail to respond or respond with incorrect information.

 

• Leslie Lamport proved that strictly more than two-thirds of the total number of processors should be honest. The limitations of the BFT is that 1. It is susceptible to sybil attacks, 2. It does not scale well.

 

practical Byzantine Fault Tolerance (pBFT)

The client sends to the server that I want to execute the command A then the leader distributes this command to all passive nodes. When the client receives f+1 (f is the maximum number of malicious nodes that the system can withstand, that is, the total number of nodes in the system is 3f+1), and the client considers that the consensus is complete. The Risk of Centralization of Blockchain is eliminated as the frequency of transactions are increased between each shard and energy utilization is reduced as hashing energy is not required to enter the next block. Larger scalability and lower transaction fees. It has limitation to susceptible to sybil attacks and doesn’t scale well.

Platforms using pBFT variants:
Zilliqa — pBFT in combination with PoW consensus

Hyperledger Fabric — permissioned version of pBFT

Tendermint — pBFT + DPoS(Delegated Proof-of-Stake)

Proof-of-transfer (PoX) is an extension of the proof-of-burn mechanism. PoX uses the proof-of-work cryptocurrency of an established blockchain to secure a new blockchain. However, unlike proof-of-burn, rather than burning the cryptocurrency, miners transfer the committed cryptocurrency to some other participants in the network.

Anyone who wants to mine a block simply sends any amount of Bitcoin to the address provided by the protocol. The protocol uses the amount of Bitcoin sent by each miner as an input, and combines it with a verifiable random function (VRF) in order to run the leader election and select a winning miner. The more Bitcoin a miner commits, the higher their chances of winning the leader election. It brings the properties that make true digital ownership possible to wherever developers need it. It is designed so that builders can benefit from Bitcoin’s properties without modifying Bitcoin itself.

Cryptoeconomics refers to the combinations of cryptography, computer networks and game theory which provide secured and decentralized systems which use some set of economic incentives to provide for their maintenance.

Evaluative Term

Utility is the extent of useful functionality a token has to offer.
William Mougayar suggests the following metrics for evaluating token utility.

 

1. Is the token tied to a product usage, i.e. does it give the user exclusive access to it, or provide interaction rights to the product?

2. Does the token grant a governance action, like voting on a consensus related or other decision-making factor?

3. Does the token enable the user to contribute to a value-adding action for the network or market that is being built?

4. Does the token grant an ownership of sorts, whether it is real or a proxy to a value?

5. Does the token result in a monetizable reward based on an action by the user (active work)?

6. Does the token grant the user a value based on sharing or disclosing some data about them (passive work)?

7. Is buying something part of the business model?

8. Is selling something part of the business model?

9. Can users create a new product or service?

10. Is the token required to run a smart contract or to fund an oracle? (an oracle is a source of information or data that other than a smart contract can use) ?

11. Is the token required as a security deposit to secure some aspect of the blockchain’s operation?

12. Is the token (or a derivative of it, like a stable coin or gas unit) used to pay for some usage?

13. Is the token required to join a network or other related entity?

14. Does the token enable a real connection between users?

15. Is the token given away or offered at a discount, as an incentive to encourage product trial or usage?

16. Is the token your principal payment unit, essentially functioning as an internal currency?

17. Is the token (or derivative of it) the principal accounting unit for all internal transactions?

18. Does your blockchain autonomously distribute profits to token holders?

19. Does your blockchain autonomously distribute other benefits to token holders?

20. Is there a related benefit to your users, resulting from built-in currency inflation?

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Tolls/Fees are security deposits and usage fees.

Value Exchange are tokens are also a unit of value exchange inside a particular market or application, creating an internal economy.

Layer

Network is a peer-to-peer networks sharing information about the state of the network. Privacy and security occurs at this layer.

Data manages information stored both on and off-chain.

System it contains core components for maintaining the blockchain such as consensus protocols and associated subsystems.

Contract is handling a blockchain’s contracts, this includes contract verification, security and reliability.

Modeling facilitates and manages the workflow of smart contracts.

Application focused on developing blockchain solutions for various applications.

Models

Deflationary has limited Supply and it demand increases that supply does does not. Also, tokens were removed from the market over time. This prevents market from being flooded and there is no worries about inflation. However, users are incentivized to hold and not enough spending. Examples are Bitcoin, Cardano.

In this model, tokens are removed from circulation. Strategies for doing this include token buy backs and burn on transaction. Buy Back and Burn users are able to remove a portion of the coins from the market and coins removed through a buy back process get transferred to an uncoverable wallet. It preserves the value of a token as the supply is reduced causing demand to increase or stay the same like BNB.

Burn on Transaction is integrated into smart contract that will collect tax for each transaction that’s done on-chain. Part of this gets burned or distributed to the community at the rate at which tokens are removed is dependent on trading volumes.

Inflationary is a new tokens added to the market over time and there’s no capped limit. It is the most popular and proven model but it is prone to — inflation and devaluation. One of the example is Ethereum.

It is the inverse of a deflationary model , in a way resembles our normal currency. Although there is no capped limit, there are variations to this model where there would be limits to token creation per year or they are released on a set schedule.

Dual Token is used for economic structure, two distinct tokens are used on a blockchain. The function of one token is to act as a “store of value”, in turn generating a second utility token and to fuel actions on the network or the implementation of a stable coin and staking coin. It will incentivize users to hold store of value token as the utility token will generate returns. It separates finances from utility but was not fully comprehended. One of the example is xDai.

Asset Backed (Security) are tokens backed by assets such as fiat currencies or gold. It is stable and has back and forth convertibility. It also ha transparency and legitimacy such as Tether.

Comparison