Designing Token Supply-Demand Dynamics

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Hi folks 🙋🏻‍♂️,

The existence of tokens is what makes crypto, well… crypto.

It’s by far the sole determining factor of what makes the asset class valuable and controversial at the same time. Without a token, we’re back to the saying of “blockchain, not Bitcoin” — remember that from the 2018 bear market? Yikes.

More recently, the status of a token is being questioned. Although not challenged directly, US regulators are making an active push to classify more tokens as securities. This is done via the ongoing Coinbase and Binance lawsuits.

Regardless, builders keep on building.

Founders need to understand how a token can be integrated into their products and services. This step is critical. A mistake that destroys the user base's trust in your token will take months, if not years, to fix.

Let’s dive in and take a look at how founders can best design their token supply-demand dynamics.

P.S. Big thanks for supporting this publication over the past six months. Stay tuned for more interesting content for the remaining half of 2023.

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Designing Token Supply-Demand Dynamics

First, decide if your project needs a token.

The answer depends on what types of products and services you’re building.

If the use case of a token for your project is akin to air miles for airlines, it might not be the best time to launch one.

• You don’t really need a tradeable reward/point system.

• The current regulatory environment is not supportive.

Assuming the answer is yes, let’s go to step 1.

Step 1: What Type of Tokens?

Depending on the projects you’re working on, the types of tokens being launched will be different. From a macro level, there are a few key questions that need to be addressed:

• Will there be governance-related activities related to the token?

• Will the token be associated with a blockchain layer? (L1, L2, Cosmos-based)

• Will there be any revenue-sharing (or alike) mechanism?

• Is there a maximum supply of the token?

• Identify the percentage of tokens that you can use to design and alter the supply-demand dynamics.

Regardless of the answer, the last bullet is critical.

Most of the time, the % of supply that you can use to most effectively design the supply-demand dynamics are foundations token and community/ecosystem allocations.

• Public sale → pure selling pressure (primary market)

• Insiders → mostly selling pressure (secondary market)

Step 2: What Is the Supply For?

Founders who are building alternative L1, L2, or other “blockchain-layer” projects tend to have tokens with perpetual inflation.

• The tokens are equivalent to gas. It contributes to the network’s stability and is necessary for users of the network (L2 can be a bit different, but that’s for another post).

• This means that the north star of your token should be that it has enough users and interest from buyers to offset the annual supply emission rate which is mostly just selling pressure (networking rewards, staking rewards, etc.).

• For example, Solana has an annual inflation of ~6%. This equates to 24,149,341 SOL, or approximately $507M in selling pressure per year.

Putting aside blockchain-layer projects, the most common reason for application-layer projects to launch a token is growth hacking.

Every single protocol’s business model can be boiled down to:

“How do we design incentives so that users use our products, contribute fees in the process, and get rewarded with our tokens”.

This is basically the Uber model.

• You subsidize the end users’ real cost to use your products. Uber gave cheap unprofitable rides, crypto projects give their protocols native tokens.

  

• If you go this route, the key is rapidly iterate and only reward users with stickiness.

• The open-source nature of crypto means that a competitor can easily fork your code, print their own tokens, cut your margin, give out more rewards, and hamper your growth significantly.

“What are the reasons, for users to stay on your platform and continuously use your product?”

Step 3: Who Is the Buyer?

Having no other utilities for the token other than for speculators to speculate, is the most common pitfall in token design.

There are only 3 reasons why tokens have demands:

1. Number go up → I buy because L1/L2 [insert name] is good.

2. Perks → CEX discounts, launchpad access, reward points-like system

3. Ownership → governance interest/value capture

The products and services that you’re building need to benefit from the token, and vice-versa. Ironically, this is an “easier” problem to solve for a blockchain-layer project, as the token itself is generally treated as a gas token.

The reason people buy a blockchain-layer token is [1].

For application-layer projects, it’s more challenging. Take Uniswap (UNI). It’s a pure governance token whose entire value is predicated or speculators pontificating whether Uniswap as a DEX will capture enough value. Hint: it does.

However, there’s no guarantee that this value will go toward UNI tokenholders.

Hence, the reason people buy application-layer tokens is [2] and [3].

• The mature DeFi protocols (COMP, SNX, MKR, AAVE) are good examples. There are perks that you can get by owning the tokens while ensuring that decentralized governance is functioning with a proper DAO and a relatively lighter control of power from the original founders.

• Newer DeFi protocols tend to be in relatively more centralized structures. The original founders still have significant control and there might not be a guarantee that your rights as governance tokenholders will be honored.

There are usually two ways for mature application layers to accrue value toward their tokens.

• Tokenholders control the DAO treasury, which receives revenues from the fees being charged by the protocols.

• Implement a mechanism that buyback-and-burn the tokens to reduce the circulating and maximum supply — circumventing a real revenue sharing mechanism (dividend-like) to hedge their regulatory risks.

Step 4: Iterate

In simple words:

• Identify the % of supply you can allocate to influence the supply-demand dynamics.

• Identify your growth lever and allocate as much supply as possible while ensuring the users are sticky.

• Identify use cases and incentives that will create demand and make speculators/users purchase the token.

• Implement a mechanism to accrue value toward the token.

• Iterate.

Once you have a broad idea of how your token supply-demand lever, create a methodology to be more granular with your thinking, so the team know exactly when to push the gas pedal or to slam the brakes.

This is important because there’s a dollar value associated with your token.

Uber doesn’t need to worry about external influence towards its ride-share subsidy. It knows exactly the amount of money it burns to get users.

However, having a dollar value attached to a token means things can go exponential without proper controls. If you aren’t cautious, you can easily go off the balance by creating too much supply without any demands — which brings us to the final step.

Step 5: Find Equilibrium

Let’s recap everything thus far:

• Understand the type of tokens you’re creating.

• Identify what levers you have to influence the supply-demand dynamics.

• You have the most control over your supply, so make sure these are used effectively to grow your revenue.

• Create demand by providing superior products, accruing real value, or giving true ownership of the protocol.

• Iterate your approach every few weeks and find an equilibrium between growing your userbase/revenue, and creating more value for tokenholders.

Last but not least, communicate consistently to your audience. Always. It’s the easiest thing a crypto project should do to establish trust in the community.

ELI5 — A token is a double-edged sword. Times and times again we’ve seen projects, investors, and retail buyers getting fleeced because of bad supply-demand flow designs. Take your time and plan ahead.

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Disclaimer: All the information presented in this publication and its affiliates is strictly for educational purposes only. It should not be construed or taken as financial, legal, investment, or any other form of advice.