What is Cryptoeconomics Part 1
Key Takeaways
The article presents the core areas that form cryptoeconomics as a field:
Value Accrual: How value is generated and captured within a system and by tokens.
Token Utility and Rights: The ways tokens are used and the benefits granted to holders.
Rewards: Incentives for participation, balancing system growth and sustainability.
Token Supply: Using token supply to shape monetary policy and participant behaviour.
Token Allocation: Setting initial token distribution to balance incentives and decentralisation.
Token Distribution: Distributing tokens to drive adoption and growth strategically.
Governance: Balancing decentralised governance benefits with efficient decision-making as projects evolve.
Cryptoeconomic Security: Combining cryptography and economic incentives optimally for system security.
Economic Assurances and Market Forces: Designing resilient systems through incentive alignment and risk management.
Network and Community: Shaping community composition and dynamics through cryptoeconomic design choices.
Introduction
In our first article in this introductory series, we argued why cryptoeconomics matters, arguing its ability to unlock the society-altering opportunities that blockchain technology offers. Having done so, we now want to delve into the specifics of the field, defining, unpacking and positioning cryptoeconomics as a distinct subject matter within the broader context of the blockchain industry.
A specific definition is necessary to avoid discussing cryptoeconomics in the abstract and conflating it with other subjects. While our definition represents our particular view, we believe it is both accurate and all-encompassing:
Cryptoeconomics is an interdisciplinary field at the intersection of technology and economics that concerns the development of economies underpinned by blockchain technology. It focuses on the use of incentive structures to align individual actions with the goals of entire systems and effectively manage digital rights and resources, all without the need for central intermediaries.
The most practical instantiation of cryptoeconomics comes from tokens, programmable economic instruments secured by blockchain technology. However, as our definition suggests, cryptoeconomics encompasses more than just tokens.
We have broken this article into two parts. In this first part, we introduce the core areas that form the foundation of cryptoeconomic systems. The second part provides an overview of cryptoeconomics' boundaries, including related peripheral areas, areas beyond its scope, and relevant fields that contribute to and inform the subject matter. This two-part article prioritises breadth over depth, providing an overview of the field's components and our foundational thinking. Future articles will offer deeper and more thorough explorations of particular areas.
The Building Blocks of Cryptoeconomics
In our work, we have scoped ten distinct building blocks of cryptoeconomics, which we classify as its core areas. We explore each one of these below.
Value Accrual
Value accrual describes how value is generated and its subsequent distribution within a system. Virtually all projects need to create value, whether they are businesses or fully decentralised public goods. Both will have overheads that must be met and growth objectives they aim to fulfil. Projects will also typically have a set of shareholders and/or token investors that expect a return on investment.
One way to visualise value accrual is through a Sankey diagram, which shows the movement and accumulation of value, specifically into tokens.
Figure: Ethereum gas fees and validator revenues flow
Token value accrual focuses on a token's ability to generate and capture value within its ecosystem:
Value generation refers to the token's design and utilities providing additional value to a system by coordinating and incentivising participation.
Value capture is the token's ability (and therefore the holders' ability) to benefit from the system's economic activity directly.
While tokens may allow for greater value generation by expanding participation, they also require value capture to keep those participants satisfied. There is a risk that value capture occurs without additional value generation, which can divert resources away from other useful expenditures. If a token fails to provide either generation or capture benefits, it jeopardises the long-term alignment with incentivised community members and investors. This can lead to an erosion of trust and support for the project.
Some key ways tokens have the capacity for value accrual stem from their defined token utilities. Designing the right utility types and combinations is crucial. It establishes a token’s value accrual potential and overall economic sustainability within its ecosystem.
Token Utility and Rights
Token utilities describe how tokens can be used within a system. They are assigned during the token design phase to create positive synergies between a token and the underlying system.
By owning certain tokens, holders will also have certain rights and responsibilities. Rights refer to what the holder receives, usually benefits or entitlements. Ascribing rights can help to keep projects accountable, which in tandem breeds trust, confidence and growth. How rights are enforceable by the holders, therefore, becomes an important lever and key consideration for projects and token designers.
For example, ETH in the Ethereum ecosystem provides the utility to pay for transactions on the blockchain, and staked ETH provides holders with the rights to participate in the consensus process.
Our taxonomy includes nine token utilities, explained below:
| Utility | Definition (adapted and paraphrased from S+C glossary) | Importance | Example |
|---|---|---|---|
| Asset Ownership | Claims over physical or other digital assets. | Can enable on-chain markets for off-chain goods. | USDC represents a claim over $1 maintained by Circle, a U.S. company. |
| Contribution | Acquire the permit to perform work. | By tying the ability to work and earn to token ownership, the system enables the formation of trustless working economies. | Staking 1INCH tokens enables stakers to participate in the process of routing transactions. |
| Commodity | Access to goods or services is attained through the consumption of the token. | Programmable scarcity that is conditional on its usage. | When users spend ETH to process transactions on Ethereum, a portion of the ETH is burned. |
| Dividend | Eligibility to a share of proceeds from the platform. | Long-term incentive alignment for token holders. | Binance had previously committed to using ~20% of its profits to buy back and burn BNB tokens until 50% of all tokens were burned. |
| Governance | Access to the decision-making process on behalf of and about the platform. | Manage centralisation vectors, permissions, and processes. | MakerDAO relies on MKR holders to stake their tokens to proposals to vote for changes to the platform and the DAO. |
| Membership | Access to platform features by holding and/or locking tokens. | Helps to define community creation and facilitate the development of exclusive access. | Holders of NFTs earn special access to certain online channels and in-person events. |
| Payments | Used as a unit of account for transfers and transactions. | Enables peer-to-peer economic activity. | BTC and Bitcoin were originally designed to provide a way to send balances between actors in a trustless and decentralised way. Paying for transactions on Bitcoin is also a payment utility since proceeds go directly to miners. |
| Store of Value | Retains purchasing power over long periods. | Can be held as a long-term hedge driving demand, and resulting in a monetary premium. | Traditional examples would include gold and US Treasuries. Some consider BTC to be a store of value. |
| Social Signaling | Convey social status, identity, reputation, and exclusivity. | Can create a strong and exclusive presence for brands and individuals. | ENS domains serve as both an on-chain identifier and a signal of the holder's integration within the industry. |
When projects design their tokens, identifying the right utilities is key. It determines where and how economic activity takes place in the ecosystem, a decision space that the project has full control over only up until the token is launched. Managing product requirements and participant expectations is often difficult for project founders during the intermediate phases of the project. Participants who are unhappy with their utilities and rights may decide against holding the token or design third-party mechanisms to bypass the shortcomings of the token.
Utilities can be adapted later, but often at some cost to the project’s credibility and participants’ confidence in it. There are instances where such changes may be necessary, and it is up to the respective decision-makers to weigh the relevant trade-offs accordingly. Ethereum’s EIP-1559 to make fee prices more predictable and burn base fees is an example of a largely positive change. That being said, even for changes like this, support was not unilateral. Though the ETH token gained a commodity utility, benefitting holders, it came at the cost of rewards for miners - prompting counter proposals such as EIP-3368 (which were unsuccessful).
Rewards
Rewards are crucial in keeping cryptoeconomic systems engaged and active over time. When projects decentralise and distribute aspects of their technology or organisational stack, such as liquidity provision, consensus, or governance, they introduce the need for economic coordination among participants. In these systems, coordination failures can threaten their trustless operation. While technical limitations can prevent participants from breaking the rules, carefully designed rewards are the primary means to ensure participants are incentivised to follow and maintain them.
Cryptoeconomic rewards can take various forms, each with distinct advantages and considerations:
Fiat rewards: These are useful for interfacing with non-crypto participants or third parties.
Exclusive rights and permissions: Projects can implement reputation systems that grant more extensive privileges to credible participants, encouraging positive behaviour.
Recognition and signalling: Non-monetary rewards, such as badges, titles, or leaderboard rankings, can help build participants' reputations and lead to other design opportunities.
Non-native token rewards: Distributing rewards in widely used tokens like stablecoins can provide participants with more immediate, stable value.
Native token rewards: Issuing a project's native token as rewards offers the most flexibility and control over the rewards process, aligning participants directly with the system's economic value.
Native token rewards, the most common type, significantly influence a project's token supply and can be the largest driver of inflation. This relationship makes reward design a critical consideration, as poorly calibrated rewards can lead to unsustainable inflation.
Creating effective rewards requires clearly defining desirable actions and behaviours, targeting key participant groups, and balancing ecosystem growth with long-term sustainability. However, changing a rewards regime once implemented can be challenging, as it will likely affect rewards and incentives for other participants, possibly eroding trust. Projects must carefully model the long-term impacts of their rewards and establish governance mechanisms for implementing necessary changes.
In summary, well-designed rewards are crucial for bootstrapping and sustaining cryptoeconomic systems by incentivising participation and coordinating behaviour. However, crafting effective, sustainable, and adaptable reward structures is a complex challenge requiring carefully balancing multiple factors.
Token Supply
A project's token supply is one of its most potent cryptoeconomic tools, enabling it to impose monetary policy and shape economic participant behaviour. Supply itself changes over time to form long-term regimes, which come in several varieties:
Fixed Supply is purposely unchanged from launch
Disinflationary Supply has a diminishing inflation regime up to some fixed point
Inflationary Supply has indefinite token growth, either constant (linear) or exponential based on a percentage rate
Deflationary Supply has a set negative growth rate
Dynamic Supply has an uncertain supply that responds to live variables
For example, Bitcoin has a disinflationary supply, with block rewards halving every four years until reaching a fixed maximum supply of 21 million BTC. In contrast, Ethereum now has a dynamic supply that varies based on network usage and fee burns.
Assessing these supply regimes allows projects to evaluate the economic viability of the collective mechanisms required to sustain themselves. Projects over-reliant on inflationary rewards may see exponential supply growth that negatively impacts value accrual to tokens.
To influence their token supply, projects use sources that increase liquidity and sinks that decrease it. Sources introduce tokens into circulating supply, typically by minting new tokens or unlocking vested or treasury tokens. Sources help projects meet their compensation obligations and can help redistribute token ownership over time. Sinks come in two forms:
Soft sinks, like staking or lending, temporarily restrict tokens' recirculation.
Hard sinks, like token burns, permanently remove tokens from the supply.
The tradeoff is that soft sinks are more flexible but may not impact supply as much as permanent hard sinks. The choice depends on project goals and incentives.
Token rewards tend to be the largest driver of sources. All else equal, fewer tokens should support price appreciation, benefiting holders. However, sinks via disincentives like slashing are rarely sufficient to decrease supply consistently.
Carefully managing token supply is crucial to a project's cryptoeconomic design. Supply regimes and sources and sinks are key levers in shaping the long-term monetary policy and sustainability of token economies.
Token Allocation
Token allocation involves all early-stage strategic decisions that affect the relative distribution of tokens to various participants at the project's inception. These initial allocations set the foundation for the token's long-term ownership and power dynamics, making them essentially irreversible once the token launches. Much like how equity distribution in an early-stage startup has lasting ramifications, token allocation decisions are critical to get right from the start.
Allocations are typically divided amongst the founding team and employees, investors and advisors, and community members. Projects must carefully balance incentives for key stakeholders with ensuring a sufficiently decentralised token distribution. Concentrated ownership can enable unilateral control and undermine the project's credibility.
Over time, the relative allocation evolves based on the initial distribution, plus rewards, minus sinks, and accounting for changes in ownership on secondary markets.
Some projects have attempted to alter their token allocation post-launch drastically, but this has often proven problematic. When Veracity burned 50% of its total supply from its treasury, it faced significant community backlash and raised questions about the project's long-term trajectory. The tradeoffs and negative reactions showcase why getting the initial token allocation right is vital.
Thoughtful initial distribution aligns incentives and sets the project on the right long-term path. While the relative allocations will evolve, the starting point is critical to establish trust and position the project for success.
Token Distribution
Token distribution events describe how tokens are allocated to their recipients. Tokens are distributed to participants both continuously through ongoing rewards and during one-off events such as vesting cliffs or, notably, at the token generation event (TGE). A TGE refers to the initial distribution of a project's tokens, often through a public sale or offering.
TGEs, similar to initial allocation events, are worthy of special note due to their ability to empower projects by providing financial capital through the token sale. Additionally, TGEs can incentivise participation and attract resources such as infrastructure and human capital. However, projects should be aware of potential risks, such as the concentration of token ownership or regulatory scrutiny, when planning their TGE.
The distribution method is also an important consideration, with implications for gas costs, smart contract complexity, and user experience. Common approaches include claims portals (where participants claim tokens), direct transfers (sending tokens to user wallets), and bonding curves (a mathematical model that determines the token price based on supply and demand). Each method has its own trade-offs regarding accessibility, security, and efficiency.
By carefully aligning their distribution strategy with project goals and considering the trade-offs of different approaches, projects can leverage their TGE to drive adoption, fund development, and foster a strong community.
Ultimately, a well-executed token distribution event can set the stage for a project's long-term success.
Governance
Governance describes the forces that drive changes in any part of a project. Blockchain-based projects face significant governance design challenges stemming from balancing growth with governance processes. Though many of the governance results can be seen on-chain, one could argue that all decisions occur primarily at the social layer.
Core areas of cryptoeconomic governance concern decision domains that have direct economic implications for the system, such as:
Token utility and rewards: Decisions around inflation rates, staking rewards, fee structures, etc.
Action incentives: Designing mechanisms to encourage desired behaviours and discourage malicious actions.
Treasury management: Allocating project funds for development, grants, liquidity provisioning, etc.
Protocol mechanisms: Adjusting block sizes, confirmation times, slashing conditions, and other protocol-level economic variables; this mostly applies to infrastructure-layer systems, such as layer one blockchains.
Changes to these parameters can significantly impact the economic incentives and overall health of the system. As such, they often utilise community input through governance processes like token-weighted voting or other mechanisms.
However, achieving effective decentralised governance over these domains is challenging, especially in a project's early stages. Agile decision-making is often necessary to iterate quickly and remain competitive. Projects may adopt a 'progressive decentralisation' approach, gradually opening up additional domains to broader input as they mature.
When deciding which economic aspects to decentralise, projects should consider:
Criticality to the system's security and value proposition
Risks associated with centralised control
The community's level of knowledge and engagement to meaningfully participate
Even if projects aim for full decentralisation, there are many ways that centralisation can persist, such as:
Coordination layers and frontends: Who owns the discussion channels?
Proposal layer: Who can submit proposals? Who owns the submission channels?
Voting: How is voting power determined?
Ratification and execution: How binding are passed votes? Are there centralised entities that still need to execute these decisions?
Thoughtful design of cryptoeconomic governance—balancing decentralisation benefits with efficient decision-making—is key to a project's long-term success. Other aspects of governance that are less tied to direct economic impact are discussed in Part 2 under related areas.
Cryptoeconomic Security
Cryptoeconomic security concerns decisions about whether certain features and mechanisms are secured by cryptographic techniques, economic incentives, or a combination of the two. Cryptographic security is generally more absolute but rigid, while economic security depends on market forces, allowing for optimisation but rarely offering guarantees.
Bitcoin demonstrates cryptoeconomic security by combining cryptographic computations performed by miners with economic incentives that encourage honest participation. The network's security is often measured by the cost of executing a 51% attack, highlighting the interplay between cryptography and economics.
The comparison between optimistic rollups and zk-rollups further illustrates the spectrum of cryptoeconomic security. Zk-rollups rely on cryptographic proofs to ensure validity, while optimistic rollups also use a form of proof but assume validity by default and use economic incentives to encourage participants to challenge fraudulent transactions. These approaches have different tradeoffs in terms of cost, complexity, and trust assumptions.
Projects must find the right balance between cryptographic guarantees and economic incentives based on their specific requirements and constraints. Understanding these tradeoffs is essential for creating secure and trustworthy decentralised systems.
Economic Assurances and Market Forces
The interaction between economic rulesets and market forces directly relates to how incentives are structured and maintained in cryptoeconomic systems. This is crucial, as the economic behaviour of actors in the system informs and is informed by market dynamics. Therefore, projects must be able to influence said behaviour effectively.
While implementing economic rulesets allows for coordination, it also introduces vulnerabilities. Features governed by market forces will inevitably experience uncertainty as individual actors' behaviours are subject to change. Systems need to be rigorously stress-tested to identify economic conditions that could enable exploitation. The impacts can range from poor user experiences to catastrophic system failures. Low-probability events become near certainties if actors stand to profit from black swan events or attack vectors, such as governance attacks, MEV, sybil attacks, or collusion.
Projects should adopt best practices to manage these risks proactively. This includes designing robust economic mechanisms, implementing comprehensive security measures, and conducting regular audits and stress tests. By carefully aligning incentives and anticipating potential failure modes, projects can create more resilient cryptoeconomic systems.
Network and Community
Cryptoeconomics plays a large part in both community composition as well as community maintenance. Similarly, the need for community generation and retention can inform where projects should index more or less into rewards and token utilities.
Conceptually, community is fairly broad and can encapsulate all stakeholders and participants, with the possible exclusion of private investors. Cryptoeconomics tends to be most interested in those who are directly involved in a project’s economy, including but not limited to token holders, active users, and other participants.
Decisions around token utilities, distribution, and rewards determine the community members who stand to benefit the most from a project and, therefore, indicate which members a project prioritises. These choices shape community composition and dynamics—for example, certain utilities and rewards may attract specific stakeholders and influence participation over time.
Managing communities also involves navigating risks like speculation, disengagement, misinformation and cultural differences. Community sentiment is deeply tied to project success. Some projects have turned around negative sentiment through cryptoeconomic changes.
Projects should strive to understand their participants and design with the community in mind from the start.
Composition: Who are the key participants, and how do they map to the share of token holders both initially and over time?
Maintenance: Do any user groups and the community as a whole grow or shrink over time?
Conclusion
Cryptoeconomics enables previously unimaginable systems. The core areas outlined in this article, with a particular focus on token design, are at the heart of unlocking these systems.
However, token design is just one aspect. Projects must also consider how value will accrue to both the token and other system participants, the distribution of rewards, and governance structures. These factors, among others, may or may not be direct extensions of the token itself.
Creating a viable cryptoeconomic system also requires zooming out and ensuring all economic security primitives can be thoroughly maintained, that the ecosystem is resilient to market forces, and that it fosters strong network effects and community.
Cryptoeconomics is an emerging field but one with important connections to other disciplines. Understanding the overlap and influences enables practitioners to benefit from a deeper pool of historical theory and lessons. Many related areas are still within the confines of cryptoeconomics, including deeper looks at participants and investors or examining actual technological choices projects make and how that may inform cryptoeconomic design considerations. This is the scope for the second part of the 'What is Cryptoeconomics' series.
