Supply and demand in token economics

Every token economics decision focuses on either the demand side for a token, or the supply side of a token.

As described by Florian Strauf:

Supply and demand play the biggest role in economics and that’s no different for tokenomics. Supply is the amount of people willing to sell their tokens and demand is who wants to buy. Supply and demand define the price. If one side gets reduced, that will change the price.

Let’s begin on the supply side.

Supply side (issuance, inflation and allocations)

The supply side of token economics focuses on where tokens come from, how many there are, and how these variables change over time. Here we explore some of those design trade-offs.

As Nat Eliason notes, to explore the supply side of a token you need to consider:

1. How many of these tokens exist right now?
2. How many will ever exist?
3. How quickly are new ones being released?

Does a token have a fixed or variable supply? Some tokens have a fixed number of tokens (e.g. 1,000,000,000 tokens), while others have a variable supply (e.g. the number of tokens might increase yearly). A fixed supply token is more rigid, but it provides certainty to investors trying to value the tokens. On the other hand, a variable token supply can provide more flexibility in terms of ongoing ecosystem incentives.

How does the supply of the token change over time? It is rare for the entire supply of a token to be circulating at launch. Rather, many projects issue or release tokens over time. The way that tokens are released includes:

• vesting schedules (e.g. where tokens are released over time according to a vesting schedule)
• staking rewards (e.g. emissions to participants that stake their tokens)
• other ecosystem incentives (e.g. liquidity mining rewards to coordinate behaviour)

These supply considerations lead to a supply schedule. You can see Uniswap’s supply schedule below (Source: https://uniswap.org/blog/uni).

When looking at supply schedules, many investors and analysts will examine whether the token supply is inflationary or deflationary. A schedule is inflationary if the number of tokens is increasing over time. This can be a concern to investors over a longer time frame: more tokens on the market means more supply which, all else being equal, might lead to a lower price.

A schedule is deflationary if the number of tokens is decreasing over time — that is, tokens are being taken out of circulation. This can occur through token ‘burning’ or ‘slashing’. Tokens can be slashed for bad behaviour (taking them out of circulation), or tokens might be bought-back by the protocol and burned (also taking them out of circulation).

Whether a token is inflationary or deflationary is not clear-cut. Some tokens will go through inflationary periods (where the circulating supply is increasing), but will eventually hit a fixed cap, and even progress into a deflationary period. Designing the supply side of tokens is complex.

The other major consideration on the supply side is how and where tokens are allocated to different stakeholders. The allocation of tokens typically falls across a range of categories including:

• Team and founders
• Private investors (e.g. venture capitalists, as we saw in Week 3).
• Public sale (e.g. in a token sale, as we saw in Week 3).
• Treasury (we’ll cover this in Step 4.5). Some of the treasury allocations might be specifically allocated to specific ways over time, such as liquidity mining rewards or funding public goods.
• Airdrops (we’ll cover this in Step 4.6)

Taking Uniswap as an example again, their allocation is outlined in a pie chart below (Source: https://uniswap.org/blog/uni). It is common for the allocation of tokens to be represented in this way. This information is typically included in a whitepaper or other early communications of a Web3 project.

The way that tokens are allocated matters because it determines which stakeholders (e.g. investors, team, users) hold your token. Each of those stakeholders have different incentives, and might respond differently to events (e.g. rapid price changes). For instance, users might be concerned that there is a large portion allocated to investors — where those investors could ‘dump’ tokens when the price of the token temporarily increases.

Demand side (staking, rewards)

Supply is just one side of the story. Token economics must also consider demand. Why would different stakeholders want (or need) to hold your token?

Different tokens have different rights attached to them. Those rights might include:

• governance rights (e.g. to vote in spending the treasury, or shifting ecosystem rewards)
• other utility (e.g. fees might be paid in the token)
• cash flow rights (e.g. the token might yield a portion of fees from some underlying business activity).

Each of these rights can provide incentives for users to hold your token, bolstering demand. Furthermore, many projects create more complex mechanisms to create demand for their token. For instance, users might need to stake the token, or lock-up the token for a period of time. Perhaps some benefits (e.g. ecosystem rewards) are only made available to those who lock-up tokens for a period of time.

These token economic incentives can be shaped to incentivise some desirable behaviour. For instance, providing ecosystem rewards to those who stake (providing security) or provide liquidity (reducing slippage) can increase those desirable behaviours. Importantly, this means token economics can power a flywheel.

Token economics must be crafted to propel your underlying flywheel and business model. Token design is not a substitute for a business model — it is a way to leverage and extend an underlying strategy for providing value to multiple sides of a market.

For a deeper dive on token economics, read Nat Eliason on Tokenomics 101 (and their follow-up essays on supply and utility and launch tokens). We have also provided some further resources below.

Want to know more?

If you would like to know more about the concepts covered in this step, check out the following links. You may also wish to explore the links in See also section at this end of this step.

Tokenomics 101: The Basics of Evaluating Cryptocurrencies

In Tokenomics 101, Nat Eliason takes us through what to consider when evaluating the tokenomics of a new project.