Explaining the Four Pillars of Token Economics and the VE Token Model

Designing Token economic models is hard

The design of the economic model of Token is crucial to the project, and it is one of the most difficult things in the project. A small mistake in the Token model design can affect the entire project, even if the rest of the project is well designed, and the tamper-evident nature of smart contracts further emphasizes the importance of the initial Token design. Once a contract is released, a fork is required to update the protocol.

Despite its complexity, Token economics is still subject to the fundamental law of economics, namely supply and demand. Simply put, Token economics models are all about designing ways to influence supply and demand in the short and long term. Ideally, the best design is to reduce supply while encouraging demand, but this is easier said than done.

Four Pillars

Before diving into the intricacies of “VE Token design”, this article will introduce the basics of Token economics. In my opinion, every cryptocurrency has four basic Token economics pillars, which are the first thing investors should analyze before delving into Token economics . Any design flaws in the pillars are hidden dangers for the Token Economics model in the future, and if the flaws are severe, they could cause the entire economic model to collapse or cause the project to slowly bleed out, like an abandoned building rusting away.

1.Supply

There is nothing more fundamental and important than Token’s volume management, and part of Token’s volume management is the Supply. We can divide the supply into:

Circulating supply.
The number of Tokens circulating in the market
Maximum supply:
The theoretical maximum number of Tokens that can be generated by the protocol
Total Supply : The number of Tokens in circulation:
The number of Tokens issued. This includes destroyed and locked Tokens, even if they are not part of the circulating supply.

The higher the supply, the lower the price. I’m sure you’ve often seen statements like “Look at ADA, it’s only $1, imagine how much money I would make if it was only 50% of the price of Bitcoin!” and so on. Because they don’t realize that ADA has a supply of 45 billion, while Bitcoin has a supply of 21 million. This is why market cap is a more accurate metric than just Token price, because it affects both price and supply.

Comparing the circulating supply to the total supply and the maximum supply reveals interesting phenomena. For example, if the circulating supply is low while the total and maximum supply is high, this is a huge red flag because the value of your Token will be diluted, as shown in the chart below:

The circulating supply of this Token is about 133M with a maximum supply of 10B. There is about an 8x dilution risk for your Token, which is a significant problem. If all Tokens were released tomorrow, your Token value would be 1/8th of yesterday’s. Assuming you buy today at a market cap of 305M, you expect to reach 100x in 5 years. This would bring the market cap to 30B (quite high, but not uncommon in cryptocurrencies), but the fully diluted valuation would be 2.3T (higher than the market cap of today’s cryptocurrencies).

Furthermore, even if the market cap increases, the regular issuance of these Tokens will increase the supply in circulation, which will put downward pressure on the price. This is not to say that everything is bad for this Token, they may even have a way to offset the supply pressure, but this is a risk factor that long-term investors should be aware of. Short-term investors are less worried about maximum supply, as they will probably be long gone by the time Token is unlocked.

Here is an example of the opposite, where the circulating supply is close to the maximum supply. This does not mean that the project is a reliable one, but it does reduce the risk for the investor.

2. Distribution

Token distribution is the next pillar of the Token economy system that investors should be aware of, and it is a very simple one. Distribution is the distribution of the percentage of specific Tokens held by each wallet. Would you want 1 person to hold 70% of the token supply? If you want to, then that project will be so concentrated that he can endlessly dump Tokens, making us retail investors poorer and destroying the future of the project.

A good distribution design is to try to distribute the token to as many people as possible. That way, if someone wants to exit, their selling won’t have much impact on the price. The best way to check Token distribution is to look at the Token allocation chart in their Whitepaper and check the distribution of token on etherscan.

3.Monetary Policy

Monetary policy determines whether Token is an inflationary or deflationary model, and also determines the degree of inflation/deflation and the overall consensus mechanism of the project. As mentioned earlier, high inflation can cause asset prices to fall over time. Low inflation combined with POW (e.g. Bitcoin) can be a good thing as it can create productivity in the ecosystem. Ether 2.0 and EIP 1559 allow for the destruction of ETH in every transaction, which in theory should make Ether deflationary.

This leads me to my next thought on how the four pillars of Token economics should be analyzed together in and their interactions. Let’s look back at the example of a highly diluted Token in the supply section of this paper. While it has a high FDV, its monetary policy is assumed to consume 7% of the circulating supply per year and 5% of the token release schedule per year, so even though 7/8 of the supply is locked in and there is inflationary pressure, this results in a 2% year-over-year reduction in deflation. Under this monetary policy, tokens would not face any locked-in inflationary pressure, but in reality, there is negative supply pressure due to the reduction in circulating supply.

4.Value Capturing

The last pillar is how much value is captured by the protocol and how that value should be distributed. In Web 2, all of the value captured went back to companies like Facebook, Google, and Twitter. They made billions of dollars from users’ data and social media interactions, while users received zero dollars in return. At most, users get a blue check mark. Web 3 turns this on its head, as the protocol captures the value they provide and distributes it to Token holders. You can become a user of the protocol and get rewarded at the same time.

Not all protocols are effective at capturing value, and I think a lot of research and experimentation is still needed before we have a Token architecture that captures 100% of the value provided by a protocol.
The easiest example to compare is the Uniswap vs. Sushiswap battle in 2020. uniswap released their AMM (automated market maker) but not their Token. sure, they offered an innovative product with a lot of value, but they captured 0% of the value for network participants. Sushiswap then forked Uniswap and with it created the SUSHI Token.

SUSHI holders can vote on governance token issues and pledge their SUSHI as xSUSHI, and receive transaction fees generated by the agreement. While this model is far from perfect, having Token holders share in the revenue gets much more value than Uniswap’s model. If Uniswap had introduced a Token that captured value at the time of the AMM launch, it would have been more difficult for Sushiswap to gain new users.

VeToken Economic Model

These are the basics, so what is Ve?

Ve is “voter escrowed” and since its introduction has quickly become a popular Token economics model, using the newer DeFi protocol. What’s interesting is that the ve model was invented by Curve Finance and it is “DeFi 1.0”.

It works by locking your CRV tokens and then converting them into veCRV with protocol governance. the lock-up period is not fixed, Token holders can decide how long they want to lock their CRV for, up to 4 years.

Over time, the number of veCRVs a holder has decays linearly over the duration of their lockup. This incentivizes holders to periodically re-lock their CRVs for veCRVs to maximize governance and rewards. The main innovation is how to create weighted votes and weighted rewards. In addition, once you convert a CRV to veCRV, you are locked in for a specified period of time. You cannot unlock early like other protocols.

Suppose Bill and Alice each have 100 CRV. Bill decides to lock his CRV for 2 years, and Alice locks hers for 4 years. Even though they start out with the same number of CRVs, Alice will get twice as many veCRVs as Bill, which means she will get twice as many governance votes and awards as he does.

Effectiveness of VeToken Economic Model

One of the main problems solved by the veToken economic model is the 1 token = 1 vote. Under the non-ve model, a large whale can buy a large number of tokens for short-term governance and reap the rewards without taking any risk in the game other than the short-term price. Thus a like-for-like protocol can buy millions of dollars of competitor protocol Tokens and vote for bad proposals and then dump the Tokens.

Under the ve model, this type of whale manipulation is much less effective because their votes will not be as valuable as those of long-term holders. If a protocol or whale wants to make Once their Token is locked, this creates an incentive to act in the best interest of the protocol. the CRV wars are the best example of this.

In addition, hardcore supporters of a protocol that chooses the longest lock-in period will have a greater say than they would under the 1 token = 1 vote model. These hardcore backers gain more revenue and passive income than short-term speculators. As long as the protocol continues to advance, pledgers will understand that they will receive passive income for the foreseeable future rather than jumping from one protocol to another under uncertainty.

Finally, the ve model has a direct impact on 3 of the 4 pillars, and distribution is the only pillar that has a weaker relationship with the Ve model.

The Ve model affects supply through long-term locking of Tokens. Holders are incentivized to lock their tokens for the long term to maximize impact and revenue. When these Tokens are locked, they exit the market for a long period of time, thus reducing selling pressure. Because there is less supply, this should organically lead to higher prices over time. This circulating supply performs very well compared to the 1 token = 1 vote model.

The holder of the VeToken is the one who decides the monetary policy of the agreement, just like under the 1 token = 1 vote model. The difference is that the veToken model is an upgrade because it aligns the long-term incentives of the protocol with the incentives of the pledgees. As mentioned earlier, this would incentivize the holders with the most vested interests to vote for favorable monetary policies of the protocol, rather than allowing potentially malicious third parties or third parties with only their own interests in mind to support policies that undermine the protocol.

The final pillar of the Ve model that makes a huge impact is how the protocol distributes the captured value to its holders. The model allocates captured value based on how long you are locked out. But there is still plenty of room to innovate to maximize the value captured in return to the user.

Innovation

A lot of protocols in the DeFi are working to implement the veToken economy model, and that’s great! This is an improvement over traditional token economy models, but veTokenomics will not be the pinnacle of token design. This section will present some of the innovative designs that projects are building using the veToken economy model as a foundation. (Note that I’m not talking about putting your entire net worth into the token I discuss below, I’m just discussing the innovations they are working on for the veToken economic model, which is still an unknown experiment.)

Cartel is currently creating a ve version of their BTRFLY token, but with a little difference. They plan to release blBTRFLY and dlBTRFLY instead of veBTRFLY, representing bribery-locked and DAO-locked BTRFLY, respectively. blBTRFLY is a retail-oriented Token that maximizes revenue for holders, while dlBTRFLY focuses on DAOs and protocols that want to maximize their DeFi governance. Simplified understanding:

blBTRFLY = higher yield
dlBTRFLY = higher DeFi governance

This is an interesting design based on the veToken economic model, and I will focus on how it works in practice.

The next innovative protocol is Trader Joe. they have released a new Token Economics model that introduces three Joe derivatives to replace xJOE: rJoe, sJoe, veJoe.
Pledging JOE for rJOE allows rJOE holders to participate in the launch of projects in the JOE ecosystem. (Rocket Joe is more subtle than this, but that is beyond the scope of this paper)

Pledging JOE for sJOE allows sJOE holders to get a share of the revenue paid by the platform. This revenue is paid out in the form of stablecoins, which allows users to receive passive income.

Pledging JOE for veJOE allows veJOE holders to receive higher rewards in Joe’s farm, as well as governance rights.

The veToken economic model is currently in development. We are seeing the protocol begin to create multiple derivatives of its primary Token, each with a specific use case. This allows users to maximize their investment strategy on the part of the protocol they most want to participate in.

Conclusion

In short, Token economics is hard and all the protocol needs to ensure that the four pillars are properly paired with the economic system. In addition, they need to innovate on top of these four pillars to remain competitive. veToken Economics model is a big step forward and a huge improvement on the previous Token Economics system. It reduces supply, rewards long-term investors, and combines protocols with investor incentives. in 2023, more protocols will continue to add the veToken economic model to their design architecture and innovate to create unique economic systems using the veToken economic model as a middleware foundation on top of the four pillars.