Token economic model research is an important section in fundamental analysis. Simply put, tokenomics research can help you better understand the monetary “policy” behind a project.
Few of the risk factors to consider when conducting token economics analysis are mentioned. For this reason, the DAOrayaki community compiled this article with a list of nine related red flags.
- Unlimited supply
- unfair release mechanism
- unfair distribution
- inflation token
- “Black Swan” Event
- Non-transparent token economics
- Centralized mechanism
- Suboptimal Token Offering
- lack of use cases
In this article (Part 1), I will address the first four first.
We love “infinite” things, human beings are born to seek the infinite source of all things, and that’s even more true when we talk about money. Because, more money = more freedom
At the end of the day, money rules the world these days.
But now let’s talk about a related misconception in token economics, where many novice investors think that an “unlimited supply” of tokens also means more freedom, but that’s not the case.
Unlimited supply is the poison that can kill a project and its investors. Because: Infinite supply means there is no chance of a shortage of tokens at any time. As a result, supply and demand will be disrupted.
For example, there may well be times when supply is too high and demand is too low. As a result, the price of the asset fell sharply.
A large number of tokens can also lead to inflation, or hyperinflation. This is similar to reality:
More money in hand = more buying/selling pressure = more inflation
But “unlimited supply” isn’t always a bad thing, right now, both Ethereum ( ETH ) and Dogecoin (DOGE) have unlimited supply.
ETH is the native currency of the Ethereum system, and it has many usage scenarios in dApps, smart contracts, etc. Therefore, under such a high demand for use, the limited supply cannot meet the market. At the same time ETH has a burn mechanism (EIP-1559), so over time this makes ETH a deflationary asset – even if the maximum supply is unlimited.
unfair release mechanism
The Vesting period, also known as the token lock-up period, refers to the time period during which tokens sold during the pre-ICO stage are blocked from being sold for a specific period of time.
There was a time when projects would ask for some funding from investors before launching or listing on an exchange. In return, these early investors can get crazy returns once the project gets off the ground. In most of these ICOs, investors are required to lock up their initial investment for a period of time (e.g. 1 year), this interval is called the “lockup period”.
Today, many projects still have a token-locking schedule. Mainly to prevent early investors from selling their assets early in the project. It protects investors from early price volatility. At the same time, the possibility of “surge and crash” caused by factors such as large whales will be minimized.
Uniswap (UNI) token vesting schedule
But in reality, there are serious problems with these mechanisms.
For example: first year: all tokens are locked. Year 2: 70% of locked tokens will be unlocked. Year 3: 30% of locked tokens will be unlocked.
This means that from the second year onwards, you will see significant selling pressure.
But there are also some tokens that have a very loose periodic table of releases. For example, about 0.5-1% of the locked tokens are released every year. At the same time, if these tokens are well empowered and used in many scenarios, then this will lead to scarcity and ultimately lead to price increases. At the same time, this will also lead to the loss of users, and users will want to join a project with a more stable and fair price.
Finally, opaque scheduling can also be a problem. For example, some projects mentioned in their white papers that they locked X% of tokens for project developers, major investors, etc. But they did not provide further explanation on the unlocking plan of these tokens. This means that at any point in time, you are under selling pressure.
Under the current system, the rich get richer and the poor get poorer without equal access to wealth.
There are technical and political institutional reasons behind the large gap between the rich and the poor. However, what we’re really interested in is allocation.
In traditional finance, the government, central bank or financial institution formulates policy, then prints money and distributes it. In many cases, these centralized entities prioritize their own interests and they print money for themselves.
Token distribution for Uniswap, Avalanche, Solana and Elrond
Although there are no banks or governments in the cryptocurrency world, token holders still face unfair distribution due to the existence of “special groups” such as project founders.
These “special groups” include:
- ICO investors
- major investor
- pre-sale investors
- seed round
- The company behind the project
As a general rule, any portion of a sale that is not publicly allocated should be considered “unfair.” But there should be some exceptions. For example, the project party will use a part of the pledge reward for users, or use it for treasury funds. These funds will be used for the future development of the project, or to deal with possible future risk events, which are all necessary measures.
Also note the number of big players, if the top 10 holding addresses own 80% of the tokens, then the surge and sell pressure or rug are not surprising.
Chainlink’s top 10 addresses hold nearly 60% of the tokens. Source: etherscan
Inflation tokens refer to tokens that have a net increase in circulation, while tightening tokens are tokens that have a net decrease in circulation.
In the field of encryption, you will often hear these two words, and how they are generated, let’s first understand the two words:
- Supply: The amount of an asset (e.g. cryptocurrency, gold, currency) available for trading.
- Demand: The amount an investor is asking to buy an asset.
According to the law of supply and demand, the price of any asset is mainly determined by its supply and demand.
Let me give an example related to Covid19. As early as 2020, many people started wearing masks. Countries have also passed laws mandating the wearing of masks. The demand for masks has skyrocketed, and at the same time the market supply is insufficient, so the price of masks has risen.
Over time, people started getting vaccinated. At the same time, mask companies have also increased production line activities. There are enough masks on the market. Therefore, the demand for masks has dropped significantly, and the price of masks has dropped significantly.
So what does this have to do with inflation tokens?
More supply (token issuance) results in a net increase in circulation (inflation), and the token price moves in the opposite direction (downward).
And if you want to deflate tokens, there are basically two directions:
- Limit maximum supply: If the maximum supply of an asset is limited and output peaks, there will be a net decline in the supply-side market.
- Token Burn: Tokens with an infinite maximum supply typically use some mechanism to burn some existing tokens in circulation. This helps to moderate net circulation in the market. If done right, it can also lead to a net reduction.
Taking ETH as an example, we know that the supply of ETH is infinite. This means ETH is an inflation coin.
That changed after the release of EIP-1559, a feature implemented in the Ethereum blockchain in 2021 that burns some tokens on every transaction.
Daily Ether Consumption Due to EIP-1559
ETH is also deflationary due to this feature, as there are blocks where more coins are burned than mined.
When researching a project, you must pay special attention to the inflation/deflation rate of the token, or check whether the token has a maximum supply limit and burning mechanism.