Hello readers,
We’re back for another edition of The DeFi Report. This week we’re revisiting tokenomics 101. Specifically, we're looking at the token models of the top layer 1 smart contract blockchains.
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Let’s go.
Data: Messari, Coinmarketcap, Lido, Staking Rewards, Etherscan, Solscan, Snowtrace, Nearblocks, Algoscan
We should think of layer 1 public blockchains as protocols that provide public internet infrastructure. When we look back at the early days of the internet, we can observe similar open internet protocols. TCP/IP. SMTP. HTTP. These were open systems created in the ’80s and early ’90s. TCP/IP allows computers to share information. SMTP enabled email communication. HTTP enabled the processing of data exchange and HTML.
These protocols were not monetized. They simply enabled others to build things on top of them. The result? We got applications like Google. Facebook. And Amazon.
We can think of layer 1 public blockchains similar to how we think about the base layer protocols of the internet. Imagine you’re an artist — you walk into a sunlit room with a blank canvas and a bunch of watercolors. You’re probably going to create something on that canvas.
Layer 1 blockchains provide the canvas and tools which enable developers and engineers to build new blockchain-based applications.
The difference when compared to the early internet protocols? You can own them this time.
The token is the mechanism used to bootstrap the development of open internet protocols and applications.
Tokens can be used to align incentives amongst a distributed set of developers/engineers, service providers, users, and investors.
It’s very difficult to incentivize engineers and developers to build open-source internet infrastructure. In the past, this money has typically been raised via grants or by the government.
Public blockchain infrastructure projects turned that model on its head.
If you’re a developer, would you rather receive a small grant to be involved in an internet community project? Or would you rather receive a “cryptocurrency” or a token that represents ownership in that project?
If you were to get an allocation of tokens (with a lock-up period), you would probably be pretty motivated to build something really useful. So useful that other developers might come in and build something useful on your blockchain. If lots of people build useful stuff on your blockchain, it could see lots of usage. Lots of transactions. The market might observe this. And the market may re-price your blockchain based on this usage. A network effect may take hold.
This could lead to a positive flywheel that looks like this:
Developers build base layer infrastructure since they are motivated to increase the value of the token —> which leads to more developers utilizing that base layer infrastructure to build apps —> which leads to new users —> which leads to speculation and investment from VCs —> which leads to more developers and more projects —> which leads to more users —> which leads to more speculation, etc.
This is what we are in the midst of today. And as a quick side note, VCs deployed $14b in the first half of 2022 per KPMG. This was capital that was raised during the bull run of 2021 — the speculation phase. We are now in a “crypto winter” in terms of prices.
But the next bull run has already been seeded.
Public blockchains operate on distributed networks of computers. They require validators to secure the network and approve transactions. These folks need to be compensated for their efforts. They are paid with the native token of the network. Which is priced in dollars, euros, etc.
It’s really hard to bootstrap a two-sided market. Supply and demand. Builders and users. So, if you have a group of people building something, one way to incentivize users is to give them some ownership in the network for being early adopters. This is done via “airdrops” — helicopter money distributed to wallet addresses for early interactions with protocols.
Do you think VCs and other investors would have speculated on which web1.0 protocol would prove to be most useful if they could?
Not only do we now have a way to incentivize the development of these protocols, but we also have a mechanism for financiers to seed the developers and speculate on the winners.
Someone on LinkedIn recently asked me why we can’t use a “dollar token” instead of a blockchain-native asset like ETH, SOL, or AVA. My answer was that crypto assets are priced in dollars. So, we basically already have this.
With that said, if we used dollars instead of crypto assets priced in dollars, we would not have the same incentives that crypto assets provide. Think about it. If you’re a developer or engineer, would you prefer to get some dollars or get a crypto asset that could go up in price if your goals are achieved? There is a reason that early employees typically receive equity to join start-ups rather than dollars.
It’s the same for the validators. Would you like to earn a yield in dollars to service this network that you support and believe in? Or would you rather get paid in the native token that has an economic upside? What if you could sell some of your earnings to get dollars to pay bills and keep the rest?
When done well, tokenomic structures can drive additional value back to the native token of these networks. Let’s get into some of the nuances of how it all works…
Inflation is the new issuance of the native token by the protocol — paid directly to validators for approving blocks of transactions. We should think of inflation as a blockchain network spending its equity to bootstrap in the early years. Sort of like how start-ups give away equity to early employees.
As you can see in the comparison above — each network has a slightly different inflation rate. Many have relatively high inflation in the early days and level off later as transactions ramp up.
* Inflation does not include token unlocks — which could come from early investors or the protocol treasury/foundation. We’ll cover this in more detail later.
Blockchains cannot survive long-term by inflating the supply to pay out their service providers. However, they can survive on transaction fees. Transaction fees are directly related to blockchain usage. Want to mint an NFT? Trade on Uniswap? Send a payment with USDC? Anchor some data? Play a game? Each of these actions requires a transaction fee.
Validators receive the transaction fees in addition to the inflation from block rewards. So, when transaction fees ramp up, the block rewards inflation paid to validators can come down without sacrificing the security of the network.
Circling back to the start-up analogy, we could think of this as a start-up no longer requiring investor capital to run the company. Just as a start-up becomes profitable by selling products and services that offset its expenses, blockchains become profitable when the transaction fees are enough to support their service providers — without inflating the token supply. While it may not be obvious, blockchains sell products and services. We can think of these products and services as block space (data storage), and the functionality of automation via smart contracts.
Binance Smart Chain and Ethereum are the only two chains that are self-sustaining based on usage today. They are also the two chains in our analysis that have been around the longest.
You’ll notice that Ethereum still has an annualized inflation rate of about .54%. However, on days when network activity ramps up, Ethereum becomes deflationary. How could this be?
It’s because a portion of each transaction fee is “burned.” This equates to the base fee, or the fee required to have your transaction included in a block — which averages about 70% of the fees paid out to validators. So, as transactions ramp up, the amount of ETH paid to validators (protocol inflation) is offset by the portion of the fees being burned. This results in deflation, or a reduction in the circulating supply of ETH.
[the burned ETH is sent to a wallet address that does not have a private key — locking the ETH in a “vault”]
*Quick note on Algorand. Algorand is the only L1 in our group that doesn’t burn a portion of the fees. Instead, Algorand sends the fees to a wallet held by the foundation. The community could then vote on whether to burn those fees or not.
We could think of fee burns similar to how we think of stock buybacks.
The difference is that the “buybacks” for public blockchains happen automatically, and are directly correlated to network usage. Imagine if Amazon automatically bought back its shares as it sold more products and services. That’s what’s happening here.
Here’s Ethereum’s total burn and net supply growth of ETH over the last 30 days. Based on the usage of the chain (in a bear market), we would see an annualized new issuance of -.10%. This is pretty bullish. What is this going to look like during the next bull market when the chain is being used a lot??
Source: Ultrasound.money
Binance Smart Chain is also deflationary today. Binance initially minted 200,000,000 tokens. However, the circulating supply is currently 159,979,094. BNB is a pretty centralized blockchain (only 21 validators, which are controlled by Binance). As such, Binance controls the ratio of BNB transaction fees that are burned from each transaction — which can change based on the discretion of the centralized set of validators.
If you go on a website like stakingrewards.com, you will see the current yields paid out to validators for various networks. These yields include inflation — token emissions paid out to validators — as well as transaction fees.
We think that validators should think of the *real yield* as the total yield (transaction fees + block reward inflation) less the protocol inflation. Said another way, transaction fees are the real yield. With that said, there can be some nuance here. If we look at Near, the validator stake rate is currently 10.71%. However, protocol inflation is only 5%. Does this mean that the transaction fees represent the remaining 5.71%? Not really. Near has a low stake rate of 43%. So, while the protocol inflating is growing at 5%, the low number of validators means that they get a larger yield than other protocols. Here’s the math: 5% inflation on the current supply of 816,271,873 = 40,813,593 new tokens/year paid to validators as protocol inflation. With only 43% of the float staked (approx. 350,996,905), these validators earn a yield much higher than the 5% overall dilution.
What about passive holders of the coin? We think passive holders should look at the *real yield* as the difference between the inflation rate and the rate of fee burns. The fee burn is essentially getting paid out to passive holders. Here is what that looks like for Ethereum over the last 30 days. Green = fee burns (noted as “revenue” by token terminal). Purple = token incentives (block rewards/protocol inflation paid to validators)
Source: Token Terminal
Think of it like this: you’re an employee of a start-up. You get a little equity. A year or two later the start-up has to raise more capital, diluting its existing shareholders, including you. But what if there was some mechanism where existing shares would get “burned” or bought back as more products and services are sold? That’s what is happening with the tokenomics here. Dilution is being offset by network activity, i.e. people paying for block space.
A quick note on Near. Near has a fixed protocol inflation rate of 5%, which is pretty low for a newer blockchain. They also have a fairly low stake rate compared to other new chains. The combination of low inflation rate and low stake rate allows for a positive “real yield” for validators when compared to other new chains such as Solana and Avalanche. With that said, Near could run into an issue in the coming years if they cannot scale usage. Why? 81.6% of the tokens are in circulation. So, they could run out of tokens to pay for their validators in the coming years if the transaction fees do not ramp up. The protocol used about 41 million tokens for staking rewards over the last year. By our estimation, Near has 4-5 years to ramp up their transaction fees. Currently, Near is producing about $2.5k in fees per day. This compares to $2.6m for Ethereum.
Some tokens have a max supply. Some don’t. Does it matter? Only if you run out of coins before the transaction fees can support the network. Bitcoin was the first public blockchain. One of the main value propositions was its fixed supply. But Bitcoin is different — it is trying to be a new form of money. This is different from Layer 1 smart contract platforms — which are more like venture-funded start-ups. Because of the “supply cap” culture that Bitcoin created, many of the smart contract platforms followed the same framework.
We could think of it as a start-up proclaiming that “there will only ever be so many shares of XYZ company.” If you were to look at this with a positive lens you might say “that’s great, we always know what the fully diluted value of the company is.” If you were to look at it with a negative lens, you might say “why would you do that? What if we need to issue new shares to raise capital in the future?” Near may be asking this question in a few years.
The max supply is helpful when determining the fully diluted value of the network. And to determine how much of the total equity has been “paid out” to service providers or allocated to early investors and users.
Otherwise, it’s not really that useful. What matters more is how much the network pays for security vs how much it makes from transaction fees.
Key takeaway: Blockchains that reach their max supply but have no tokens left to pay their validators for security will die. We have not seen much of this yet — primarily because these networks are young and have not yet reached their max token supply. Near is far from profitability and is closest to maxing out its supply right now. Cardano (which we did not cover in this analysis) is also very far from being profitable and has 76% of its supply in the market.
Circulating supply simply relates to the number of tokens in the market. If a network is really young, you’ll see that the circulating supply can be a low % of the projected total supply. The takeaway: focus on the fully diluted market value rather than the value based on the circulating supply.
This refers to the % of circulating supply that is locked in smart contracts, validating transactions on the network. The earlier the project is in its life cycle, typically the more tokens will be staked. The lower the % of stakers, the higher the yield can be.
As we’ve noted, inflation is the protocol emissions that are paid out to service providers for validating transactions and keeping the network secure.
But there is another sneaky form of inflation to consider in the form of insider unlocks.
When these networks are seeded, typically the early investors, advisors, and team will receive an allocation of the tokens on a vesting schedule. So, as an investor, if you only pay attention to *protocol inflation,* you could miss some big insider unlocks. These insiders may seek liquidity as their tokens are unlocked — especially if the price has risen sharply during the lock-up period.
How do you check insider unlocks?
Most vesting contracts are some variation of OpenZeppelin’s code. This gets pretty technical and requires the ability to navigate blockchain explorers.
Another way is to find the token allocation and un-lock schedule. Well-run networks make this transparent in their governance docs. You can go to the protocol documentation to find it, or check a data service provider such as Messari. Below is the unlock schedule for Solana:
Source: Messari
Note that the above visual is showing the “unlock” or allocation dates and not necessarily the dates the tokens are done vesting and subject to sale in liquid markets.
Solana allocated 12.5% of the tokens to the founding team. These had a 9-month lock-up period, and vest on a two-year schedule from there. They will become fully vested by Jan. 2023. Similarly, all tokens sold in private sales are unlocked and fully vested.
The grant and ecosystem reserve fund were allocated 38% of the token supply. The entire allocations for these categories are fully vested and subject to distribution into the market — which will impact the circulating supply, and the price.
Recently disgraced FTX and Alameda hold a lot of Solana. Below is a quick breakdown:
Source: Solana Labs
That’s about 10% of the liquid float in total. It is currently unclear how these tokens will be handled given FTX and Alameda have filed for Chapter 11 bankruptcy.
Given the connection to FTX and Alameda, we will conduct a full report on Solana in the coming weeks.
Tokenomics can play a role in value accrual, but there is no such thing as “perfect tokenomics.” We look for projects that have a positive feedback loop back to the token — such as network usage leading to token scarcity. Most projects have this now.
With that said, what really matters is that the network is being used. It is worth noting that, unlike Bitcoin, the tokenomics of these smart contract platforms can always be tweaked — as we’ve observed recently with Ethereum. The major players all have pretty similar tokenomics:
They all started with higher inflation which moves lower over time
They all burn some of the fees
They all rely on transactions and network activity in the long-run
Ethereum is in the best shape today, but this is also due to its early lead. They have become profitable first because of this. Binance Smart Chain is in the same category but is a very centralized blockchain — which could impact its security and trustworthiness. The others are behind a bit. At the end of the day, the most important KPI is network usage. Fancy tokenomics can only do so much. You have to actually sell something that people want.
I hope you got some value from this edition of The DeFi Report. Please like the post or drop a comment if you’d like to see a similar analysis for Layer 2’s or for applications such as DeFi projects — which require a very different tokenomic analysis.
If you enjoyed this week’s report, please share it with your friends, family, and social networks so that more people can learn about blockchain tokenomics.
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Individuals have unique circumstances, goals, and risk tolerances, so you should consult a certified investment professional and/or do your own diligence before making investment decisions. The author is not an investment professional and may hold positions in the assets covered. Certified professionals can provide individualized investment advice tailored to your unique situation. This research report is for general educational purposes only, is not individualized, and as such should not be construed as investment advice.