Introduction Token design can play a critical role in value capture for crypto networks. Network’s without a well designed token risk becoming unsustainable and may even be vulnerable to competitors taking a more thoughtful and direct approach to value capture. While token models can vary considerably, there are some promient models that many of the mature cashflow positive protocols are gravitating towards. This piece will take a look at some of the more prominent token models looking at the benefits and drawbacks of each approach.
Bitcoin As the one of the original and most battle tested crypto networks, Bitcoin has the original token model which most people understand. BTC’s token model centers around a fixed supply of 21 million BTC with gradual issuance over time with issuance going to the miners for the security of the network halving every four years. Today Bitcoin’s monthly inflation rate sits at 1.75% with 1.3m BTC left to be issued and the next halving in 2024.
Glassnode Bitcoin Supply Curve The benefit of the BTC token model is it’s predictability and provable scarcity with it’s fixed supply curve. Independent of activity on the Bitcoin network, BTC benefits from this scarcity. The disadvantage of this model is that as the miner subsidy issuance comes down over time, the network relies on organic demand to fill the gap in place of these subsidies. Today only 5.81% of miner revenue comes from transaction fees with the remainder coming from block subsidies. The other disadvantage with this model is that all value in the form of block subsidies and transaction fees goes to miners for security and none of this value flows back to BTC holders.
EIP-1559 Ethereum Unlike Bitcoin’s predictable issuance model, Ethereum took a more dynamic approach to issuance gradually reducing emissions over time as transaction fees rose over time. With Ethereum’s introduction of EIP-1559 and the move to Proof of Stake (PoS) Ethereum moved towards a new deflationary model. While in the past ETH gas fees went to miners like in Bitcoin, with the introduction of EIP-1559 a burn mechanism was added to the network with a portion of ETH gas fees burned allowing issuance to even become deflationary over time with growing demand for block space.
Ultra Sound Money Dashboard One of the benefit’s of the EIP-1559 ETH model is it’s dynamic approach to issuance allowing the network to adjust to changing demand for block space with issuance shifting from net inflationary to deflationary depending on demand. One of the disadvantages of this model is that token holders pay the cost of low demand through dilution in the form of additional issuance. To protect themselves from this dilution, token holders can stake their ETH to earn staking rewards to offset growing issuance and earn MEV rewards (this will be burned in the future), although this does involve taking on additional slashing risk.
Maker One of the earliest DeFi projects on Ethereum, Maker is a collateralized stablecoin which introduced an interesting buyback and burn model. Inspired by share buybacks commonly utilized by publicly listed companies, Maker dedicates excess profits above the system surplus to MKR buybacks burning MKR supply. This mechanism makes MKR supply deflationary over time with Maker today estimating around $100m in annual profits and 10% of the supply which has been burned through buybacks. Make recently unveiled their new end game roadmap in which a new stablecoin token and governance token will be launched and this model will be subject to change.
Maker Burn The benefits to Maker’s current model is that profits for the protocol very directly result in the reduction in total supply of the token aiming to increase price per token over time. While Maker could instead pay out distributions, in most jurisdictions buybacks are more tax beneficial for token holders over income given the preferential tax treatment of capital gains. In addition to the tax benefits, token buybacks also benefit all token holders equally, not just those who stake or participate in governance. It’s important to note that MKR holders do take dilution risk in the event of significant losses to the system like those realized in the sharp downturn of 2020 in which DAI broke it’s peg.
Lido Lido the largest protocols by TVL on Ethereum, Lido is a liquid staking protocol. Lido has a governance token model which allows token holders to participate in the governance of the protocol. The protocol takes a 10% fee on staking rewards which is split 5% to node operators and 5% to the Lido DAO. These funds from the protocol accrue to the treasury to pay for the operational expenses of the project. Community members have made proposals in the past to implement buybacks and/or pay out distributions for stakers of Lido, which the community has voted down in favor of waiting until the protocol economics are long term sustainable before committing to returning value to token holders.
Lido Governance Forum Lido’s approach is a more conservative approach and is in many ways that of a more traditional technology company, aiming to hold off returning value to token holders until the network is long term self-sustainable. The benefit to this approach is that the project can build up cash reserves and scale it’s team from organic revenue helping to ensure the project remains a going concern independent of token price and the market environment. The disadvantage to this approach is that without a framework in place for how value will begin to be returned to token holders, some may lose faith in the project. The longer the team does not implement some framework for value capture, the token may continue to decay in value over time as the community loses faith, leaving the project with a less valuable native token treasury over time.
Uniswap Uniswap the largest protocol by users on Ethereum, Uniswap is a decentralised exchange protocol. Uniswap similarly to Lido has a governance token model which allows token holders to participate in the governance of the protocol. The protocol charges a 0.3% swap fee which today entirely goes to liquidity providers (LPs) of the protocol. Today the entirety of the 0.3% swap fee goes to LP providers, but the protocol has a fee switch which when activated will redirect 0.05% of the total 0.3% swap fee to token holders leaving LPs with the remaining 0.25%. While there have been proposals put forward in the past to activate the protocol switch, it has still not been activated due to regulatory concerns about implementing this change. Recently the Uniswap foundation put forward a governance proposal which aims to upgrade the governance to incentivize governance delegation by rewarding UNI token holders that are staking and delegating their tokens.
Uniswap Explore Dashboard The advantage of Uniswap’s initial governance token design is that it has allowed the protocol time to establish itself before beginning to monetise while putting early mechanism in place showing the path for the protocol to return value to token holders over time. Uniswap’s fee switch when activated directs revenue directly to token holders as opposed to a buyback model which is focused on driving value back to token holders by reducing supply. One of the key disadvantages to Uniswap’s model has been it’s largely hands off approach to governance, leaving the question of when the fee switch could be activated largely up in the air until recently.
Conclusions Token design has gone through an evolution over time, from a focus on utility in the early ICO days, to a focus on more traditional cash flows today. With this shift, the question of value capture and what to do with cashflows for decentralized protocols starts to look a lot more like the decisions made by traditional tech companies. How aggressively to monetize the product, should cashflows be reinvested in the business, put towards acquisitions or returned to token holders.
Two important factors for token networks to consider is:
1. Token Networks in many cases have an upfront fixed token supply as opposed to the ability to issue new equity in the future.
2. Token treasuries and protocol revenue today remain very exposed to the broader crypto cycle.
With these factors in mind, teams should plan for worst case scenarios when making decisions around returning value to token holders. Project teams must carefully consider their free cash flow (net of token incentives and token compensation), budget, protocol revenue projections and token treasury before committing to returning value to token holders.
As an investor in early stage networks, I am excited to see more mature revenue generating protocols thinking deeply about long term value capture and making a commitment to return value to token holders over time.
Regards Thanks to Eden Block team members Daniel , Sergey and Rafael who’s discussion and feedback helped shape this piece.
Resources https://studio.glassnode.com/dashboards/3daa3cb1-8dbe-4ad8-718d-35a7f4faa8c2?referrer=use_case
https://ultrasound.money/ https://makerburn.com/?continueFlag=22783de146e77a59faa4664ef13ba7a0#/
https://research.lido.fi/t/activate-lido-protocol-governance-with-revenue-share-staking/6738/3
https://app.uniswap.org/explore/tokens?chain=mainnet
https://gov.uniswap.org/t/temperature-check-activate-uniswap-protocol-governance/22936
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