The State of Cryptoeconomics

Written By Nova-Blockya .

Key Takeaways

  • Cryptoeconomic designs have often prioritised pleasing industry participants and promoting speculation over focusing on product utility.

  • There is increasing pressure, and in some cases, well-founded economic logic, to design more robust value accrual mechanisms into token design, although token valuation remains a contested subject.

  • Many projects employ unsustainable token supply and reward schedules that hinder long-term viability.

  • Governance models often struggle to balance the ideals of decentralisation with practical decision-making needs.

  • Regulatory uncertainty and failure to learn from traditional economic models continue to impede broader cryptoeconomic innovation

Introduction

This article presents the current challenges facing cryptoeconomics as a practice in a rapidly evolving industry. An effective cryptoeconomic design is intrinsically linked with the purpose of its respective product. However, in practice, speculation and social consensus often have a disproportionate influence on these designs.

The omnipresent perception of tokens as investment vehicles influences how different stakeholders view them. Projects must navigate the expectations of diverse participants, such as investors, developers, founders, partners, exchanges, and community members with varying roles and levels of involvement. Collectively, these groups represent the social consensus that shapes the industry's direction. Many of these groups are driven by speculative interests, which is not inherently problematic when balanced with other motivations. However, it risks becoming so when it gains an outsized influence.

To achieve adoption, blockchain-based projects often face pressure to compromise on product-driven cryptoeconomic design decisions in favour of designs that appeal to the most influential industry participants. New and smaller projects entering the industry often feel compelled to compete for attention and meet the expectations set by established players. While this approach is somewhat pragmatic, it has led to the widespread adoption of pre-existing cryptoeconomic models. Although understandable, this can result in an underutilisation of the transformative potential of blockchain technology and cryptoeconomics. By prioritising short-term market demands over innovative cryptoeconomic design, projects may miss opportunities to create truly groundbreaking solutions. 

This article explores the key factors shaping the current state of cryptoeconomics and together with our final article, outlines some of the necessary changes so the industry can realise the full benefits of blockchain technology and cryptoeconomics.

Opportunities and Limitations

As blockchain technology evolves rapidly, cryptoeconomics must constantly adapt to new opportunities and constraints. This technology's experimental nature allows for a wide range of deployment options, with the concept of modular versus monolithic designs exemplifying the diverse possibilities for blockchain infrastructures. However, this constant evolution also requires cryptoeconomics researchers and practitioners to continuously reassess the shifting landscape of technical capabilities and limitations.

Technical innovations can open up new avenues for cryptoeconomic design. Account abstraction, for example, has transformed how users interact with applications and the types of economic relationships they can establish. By allowing applications to customise the handling of user transactions, such as allowing the application to cover the associated costs, account abstraction offers greater flexibility than the traditional model of users always paying for on-chain interactions themselves.

Practical constraints, such as throughput and transaction handling, also influence design considerations. Most established blockchain systems face limitations stemming from how they process transactions. Block time, for instance, restricts participants from interacting with the blockchain at discrete intervals rather than continuously. Throughput and latency also impose bounds on the volume and speed of on-chain transactions. Cryptoeconomic designs must account for these realities to ensure their feasibility and effectiveness.

The emergence of Maximal Extractable Value (MEV) highlights another critical challenge arising from the discrete nature of block processing. The time gap between blocks creates arbitrage opportunities for participants positioned to influence transaction ordering, akin to the advantages of high-frequency traders in traditional finance. Developing robust solutions to MEV through cryptoeconomic incentives or cryptographic techniques is an active area of research with significant implications for the fairness and stability of blockchain economies.

However, as our understanding of these systems deepens through the maturation of existing projects and the exploration of new approaches, the potential design space for cryptoeconomics continues to expand. Legacy virtual economies, such as those found in online multiplayer games like World of Warcraft, Second Life or EVE Online, offer valuable insights into economic dynamics that have evolved over decades. These ecosystems often feature complex trading systems, supply sinks, inflation sources, and even instances of market manipulation. The industry has much to learn from further studying these established digital economies and their responses to different challenges.

Traditional economic structures, including for-profit corporations, non-profits, charities, and governments at various scales, also provide essential lessons for navigating the complexities of cryptoeconomic design. Drawing upon the wealth of knowledge accumulated in these domains can help guide the development of more resilient and equitable blockchain-based economies.

The advancement of cryptoeconomics hinges on proactively anticipating and adapting to the ever-changing technical landscape of blockchain systems. The field can unlock new opportunities without engendering undue risk by bridging the gap between innovation and more established economic principles.

Value Generation and Capture

The concept of value accrual in the current cryptoeconomics research climate remains a point of contention, with differing views stemming from varied philosophical stances, design approaches, and theories about where value should accrue.

A persistent issue plaguing the industry is the automatic conflation of an entire system's value with the overall token value, akin to how equity value is perceived in traditional finance. Tokens are often viewed as investment vehicles for speculating on the value of their associated blockchain-based projects. Broad industry expectations and non-product-related goals frequently lead to design decisions that emphasise a token's investment characteristics, typically impacting its utility, allocation, and supply.

It is worth noting that venture capital raising has become a common stage in a project's life cycle, greatly influencing how cryptoeconomic systems are designed from a value accrual perspective. Investors naturally pressure projects to drive value to their investments, whether in the form of equity or tokens.

Existing and mature projects in the current climate also face pressure from token holders to drive value to the token. Changes made to Ethereum in recent years exemplify this trend, which has seen ETH’s role change as part of the blockchain’s transition from proof of work to proof of stake, giving the token contribution utility. Furthermore, EIP-1559 has introduced changes that direct revenue generated from transactions to the token, adding a hard sink via a burning mechanism, which supports value accrual on a per-token basis. Arguably, these developments were influenced by community desires to imbue ETH with stronger value accrual properties.

In terms of valuation exercises, pursuing general models remains a complex challenge for researchers and analysts due to the diverse range of economic designs. Unlike traditional assets, where valuation models are more standardised, the unique characteristics of each design necessitate a more nuanced and tailored approach to valuation.

The difficulty of developing general valuation models for tokens is widely acknowledged. Token valuation remains a largely unsolved problem, with competing approaches and a lack of consensus in the field.

Rethinking Supply & Rewards

Many established projects are grappling with the suboptimal price performance of their native tokens and lacklustre adoption rates. This predicament often stems from their cryptoeconomic designs, which feature aggressive token supply schedules and unsustainable reward mechanisms. While low initial token liquidity and enticing short-term incentives may have proven effective for attracting initial attention and users during a project's early go-to-market phase, such designs create an artificial sense of scarcity and encourage unsustainable growth that is difficult to sustain in the long run.

Stakeholder expectations exert a significant influence on supply decision-making processes. This point is exemplified by the preference among many projects for specific fixed-supply regimes. These preferences are frequently driven more by alignment with investor expectations rather than a thorough consideration of the underlying system's associated utility and long-term sustainability. Consequently, supply decisions are often made without fully comprehending the implications for the project's overall economic viability.

While models that combine inflationary supply (perpetual rewards) with deflationary mechanisms (supply removal) offer a more nuanced approach to managing token supply and value over time, these solutions are less commonly explored. The added complexity of such models may dissuade new projects from adopting them, even though they hold the potential for more balanced and sustainable token economies. However, it is worth noting that these mechanisms come with their own trade-offs. For them to be effective, both the supply and demand sides of the economy need to be similarly well-adopted, and the inherent unpredictability of these systems can pose challenges for participants. For instance, Render's (RNDR) token supply is uncapped and relies on a mechanism called the 'Burn and Mint Equilibrium Model' to adjust supply. This model consists of predictable fiat pricing, incentivised token emissions with a predefined declining schedule, and token burns that depend on the completion of rendering jobs. While innovative, the success of this approach will hinge on the robust adoption and participation on both sides of the marketplace.

The long-term effects of unsustainable supply and reward decisions have begun to impact the cryptoeconomics of established projects. Dilutive supply decisions have affected token price performance, and aggressive reward mechanisms have resulted in temporary and exhausted growth stimulation. There is also a reluctance by the industry to innovate on supply dynamics due to pressure from investors. However, a select few projects have successfully deployed elastic token supply models.

Evolving Token Distribution Strategies

One of the primary benefits of token distribution events is the rapid decentralisation of token ownership, which has achieved varying degrees of success depending on the strategy employed. In reality, token distribution events are primarily deployed as marketing initiatives to generate project awareness. The most common forms are airdrops, public token sales, and token farming, the latter of which involves providing valuable resources such as assets for liquidity or storage space.

The emphasis on awareness stems from the necessity of competing in a highly dynamic and constantly evolving industry. Project visibility is strongly correlated with the speculative opportunity associated with projects that have not yet launched a token on secondary markets. This environment has fostered the development of platforms and strategies aimed at maximising the reach of token distribution events.

Airdrop strategies are evolving, with some projects taking a more reflective approach to optimising distribution impact. Optimism, for instance, distributed an initial airdrop partly to inform decisions for a subsequent airdrop. A recent development is the advent of airdrop points, which create a sense of certainty for participants about their relative allocation compared to other participants. The benefit for projects is that they retain the final say about the size of the allocation shared between airdrop recipients.

Interestingly, the emergence of points has led to the creation of financial instruments that trade in these points. Pendle Finance, for example, created interest rate swap-like instruments that allow for speculation on the value of points at the distribution event (floating rate) while providing certainty for others (fixed rate).

Additionally, targeting mechanisms in airdrops are becoming more prevalent, with some projects focusing on specific communities. We are also witnessing more advanced airdrop concepts like lockdrops and workdrops. The former requires participants to lock specific external tokens and forego their utility, while the latter necessitates completing valuable tasks. Ethena's airdrop exemplifies a 'lockdrop' in which participants could either receive USD yield on USDE or lock USDE for liquidity and receive the ENA airdrop. These approaches signify a more strategic and targeted distribution method that aims to minimise speculators and incentivise high-impact industry participants. Polkadot, for instance, held a lockdrop targeting ETH holders, requiring them to lock ETH for a period to engage that specific community.

Platforms like Zealy and Galxe offer token airdrops to broader industry participants who typically complete social media tasks, such as following the project on Twitter, with the intention of rapidly growing community and attention. While largely ineffective in stimulating long-term supporters, these activities are pursued by uninterested participants seeking free tokens, which has dilutive effects in the medium term.

The industry is gradually shifting towards distribution strategies with stronger vesting requirements and participation expectations, indicating a more sustainable approach to community development compared to strategies that maximise volatility. For example, while Ethereum's 2014 ICO did not implement a structured vesting schedule, with ETH released to buyers immediately after the public sale and founders receiving ETH without a formal vesting schedule, Solana's team and early investors were subject to four-year SOL vesting schedules. More recently, the Ethena airdrop only rewarded participants who participated up until the airdrop, not those who participated but unlocked assets prematurely.

The approach to token distribution is evolving towards strategies that prioritise long-term community engagement and sustainable ecosystem growth. These developments reflect a broader trend towards more thoughtful and effective economic systems that balance immediate market dynamics with strategic development to foster robust and committed communities.

Governance Complexity and Token-based Models

Decentralised governance remains one of the most complex and rapidly evolving areas within cryptoeconomics. The industry has witnessed a wide array of approaches, each with its own set of challenges and tradeoffs.

Bitcoin's community has largely opted to minimise governance decisions out of a motivation to maximise censorship resistance. Ethereum, while highly decentralised in terms of consensus participation, software client diversity, and token ownership, has fewer decentralised processes for protocol development, with ten individuals responsible for proposing 68% of all implemented core updates.

Token-based governance, where token holders collectively govern a protocol, has seen broad implementation across several projects. This approach has been partly driven by attempts to drive value to tokens and address regulatory pressures scrutinising projects' decentralisation properties. From a tactical perspective, it allows projects to potentially incorporate dividend-like utility analogous to securities. Uniswap's approach to activating fee distribution to UNI holders exemplifies this trend.

However, many projects remain hesitant to fully decentralise core governance to token holders, recognising the necessity for a central group to guide development rather than relying on a collective of community members. Simultaneously, advancements in DAO tooling have simplified and amplified the potential for facilitating decentralised governance, enabling these digital organisations to manage assets better, deploy capital, and make decisions. A few examples worth mentioning are:

The monetisation of governance utility through suffrage markets, where voters are incentivised to act in a particular manner, is a novel concept originating from the blockchain industry. These plutocratic models aim to maximise the financial impact of token-based governance. While potentially effective in certain instances, such designs can be poorly suited to others.

A significant problem in the current landscape is the incorporation of token-based governance components into cryptoeconomic designs to achieve unrelated goals, such as regulatory compliance or community satisfaction. The industry's diverse array of governance models outside the blockchain realm offers valuable lessons for crafting adaptable and unique structures that balance technical soundness with social and economic inclusivity.

Striking the right balance between decentralisation ideals and practical governance effectiveness remains a central challenge. The industry's efforts to innovate governance tools, adapt to community dynamics, and learn from diverse models are critical to realising more effective, inclusive, and responsive governance systems. As the discipline matures, bridging insights from established forms of human coordination with the potential of blockchain technology will be key to developing truly revolutionary governance structures.

Cryptoeconomics as a Practice

The term ‘cryptoeconomics’ may be less frequently used in today's industry compared to ‘tokenomics’, but the two concepts are distinct. Tokenomics primarily focuses on elements such as token allocation, supply, and utility, which are undoubtedly important aspects of a cryptoeconomic system. However, cryptoeconomics encompasses the entire economy in which a token functions, considering a broader range of economic factors beyond the token itself.

In practice, most efforts in the field have centred around token design, with these designs often developed separately from the core product and retroactively added to serve ancillary needs such as community development and capital raising. While token design is a critical component, it represents only one facet of a comprehensive cryptoeconomic system.

The development of simulation tools like Machinations and the cadCAD Python package has empowered practitioners with powerful modelling capabilities. Simulations have become a central focus in cryptoeconomics practice, but they come with inherent uncertainties akin to valuation models in traditional finance. Just as valuation models can be sensitive to input assumptions, simulation models in cryptoeconomics can be similarly limited by the assumptions that underpin them. Complex economic systems are notoriously difficult to predict, particularly in the face of rare, high-impact events.

Rather than relying on simulations as definitive predictions or deliverables for clients, they are better employed as exploratory tools to inform the design of cryptoeconomic systems. When used in conjunction with a fundamentals-based approach that carefully considers risk, these tools can offer valuable insights. In the context of complex cryptoeconomics, simulations should be viewed as a means to test various scenarios and guide decision-making. From an auditing perspective, simulations can help identify potential weaknesses and failure modes. The collapse of the Terra Luna cryptoeconomic system serves as a stark reminder of the kind of catastrophic event that rigorous cryptoeconomic auditing, leveraging simulation and modelling tools, might have helped prevent.

The evolution of cryptoeconomics as a practice is heavily influenced by the expectations of project developers. Practitioners often find themselves navigating a delicate balance between client expectations and the opportunity to develop innovative but unproven designs. Factors such as investor expectations and go-to-market pressures can significantly shape client expectations. As practitioners in the field, we have a responsibility to educate and guide other industry stakeholders, a mission we are deeply committed to at Just Cryptoeconomics.

Looking Ahead: Challenges and Opportunities

The field of cryptoeconomics is at a critical juncture in its development. As blockchain technology continues to evolve, cryptoeconomic designs must adapt to new technical limitations and capabilities. Bridging insights from traditional economic models and diverse governance systems can provide valuable guidance for addressing the unique complexities of this domain.

While the industry has witnessed a tendency towards replicating existing token models and prioritising speculation over utility, there is a growing recognition of the need for innovative, tailored designs aligned with specific project goals. Token distribution strategies are gradually shifting towards fostering committed, long-term communities rather than fuelling short-term speculation.

Addressing unsustainable token supply and reward schedules remains a pressing issue, with many projects continuing to struggle with aggressive token issuance and dilutive reward mechanisms that undermine long-term economic viability. Refining these systems to incorporate more balanced and sustainable token economies, such as models combining inflationary and deflationary mechanisms, is crucial. Additionally, governance models must be refined to strike an appropriate balance between decentralisation ideals and practical governance needs, creating effective decision-making structures that can adapt to evolving community dynamics.

Rethinking the conflation of token value with overall system value can lead to more prudent economic design decisions. The perception of tokens primarily as investment vehicles has often led to designs that emphasise speculative characteristics over utility and sustainability.

As cryptoeconomics as a practice continues to develop, practitioners must navigate client expectations while pushing for innovation. Simulations and modelling tools offer valuable insights but should be approached with caution, recognising their inherent limitations in predicting complex economic systems.

Future success hinges on an industry-wide commitment to integrating economic foresight with technological innovation. This approach will not only mitigate the risks associated with economic neglect but also unlock the full potential of blockchain technology. By doing so, cryptoeconomics can pave the way for a new era in the digital economy, marked by expansive opportunities for value creation and distribution that are both sustainable and inclusive.

Nova-Blockya .
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