Part 1: The Problem with Existing Tokenomics
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Introduction
As we gear up for our upcoming IDO, we wanted to write a primer on tokenomics.
What is tokenomics? Why do projects issue tokens? Why do token prices tend to tank? And what can we do to avoid it?
This is Part One of a series.
In this part, we talk about the biggest mistakes projects make in their tokenomics: namely, launching without clear token utility, launching with too low of a supply, and emitting too much supply (usually via liquidity mining).
In the next part, we’ll reveal Socean’s governance token and tokenomics strategy and explain how it avoids these mistakes.
Finally, we’ll announce the plan for our upcoming IDO.
What is tokenomics?
There are two main phases in tokenomics.
First is the phase leading up to the IDO. What should the token allocation be? How many tokens to mint? How many tokens should you sell? How do you sell them? At what price?
The second is the “treasury management” phase after the IDO. What do you do with your tokens? Give them out? To whom? How much should you give out? This part is important because people need to be incentivised to contribute, and giving out protocol tokens is by far the most common way for protocols to incentivise contributors.
We can thus think of tokenomics as a lever the protocol can pull to maintain long-term interest in the protocol.
The problem with existing tokenomics
Tokenomics is a powerful lever, but also a dangerous one. Many things can make or break a project’s tokenomics, and I observed several common missteps as I researched the best way to build Socean’s tokenomics.
First and foremost, tokens often launch with no clear utility, which causes price anxiety.
The vast majority of governance tokens on Solana are governance-only, with no clear way for users to cash out the value locked in the protocol. Buybacks are promised at some time in the future, but these promises may or may not ever materialise.
This understandably engenders anxiety in would-be governance token holders, and results in price volatility.
Second, projects often launch with too low of an initial supply, which inevitably results in a long-term fall in token price.
Many projects launch with an artificially low supply (<5% of total supply). It’s tempting for many projects to do this as it generates hype and makes the protocol look attractive (Look Ma! We have a 1B market cap!).
This tends to play out predictably, however: the price starts off incredibly high due to hype/FOMO and artificially low supply, then quickly begins to fall as a high emissions-to-initial-supply ratio results in >100% yearly inflation.
Andrew Kang of Mechanism Capital writes:
Note that it’s not low supply in and of itself that is problematic. It’s low supply coupled with aggressive emissions that results in token price freefall. And the largest source of aggressive emissions is liquidity mining — the second largest mistake projects make.
Why liquidity mining is harmful
Many protocols give out a large amount of their governance tokens as “liquidity mining” (LM) rewards. This is when a protocol gives out its governance tokens for users providing liquidity in its liquidity pools.
As an example, Marinade Finance gives out MNDE for people who provide liquidity on their mSOL-X (e.g. mSOL-USDC) pools. Because the only way to provide liquidity on an mSOL-X pool is to buy mSOL, this causes people to deposit into the Marinade stake pool, which increases the protocol’s TVL.
It’s tempting to do this to grow aggressively and establish a dominant market position. Indeed, many protocols have seen a large TVL gain after launching their liquidity mining programs, which can be enough to establish a strong network effect.
In practice, however, liquidity mining causes a collapse in token price. LM attracts mercenaries: people who don’t believe in the long-term health of the protocol and are only interested in short term yield. These people jump from one pool to the next, chasing fleeting 1000% APYs. After farming tokens, they immediately sell them. This exerts massive sell-side pressure, causing token price to collapse.
We see this happening with many protocols on Solana. Low initial supply and high inflation from liquidity mining often causes token prices to fall:
We are not the first to make this point. Here’s Haseeb Qureshi of Dragonfly Capital saying that liquidity mining is “malinvestment” :
“[protocols] are wasting tons of money [mining liquidity]… we’ll look back in two years and see how much money we’re wasting… Supply is not sticky, it’s mercenary.”
And here’s 0xTomoyo
Worse yet, liquidity mining can cause reflexive downward pressure in token price and LM effectiveness.
Since rewards are denominated in the token, the lower the token price, the lower the APYs become, which makes liquidity mining less and less attractive. This causes liquidity to leave the protocol, which can in turn result in a downward price spiral as consumer confidence falls.
Even if the token maintains its value, liquidity mining becomes less and less effective as TVL increases.
Protocols usually assign a fixed amount of token emissions every period to each liquidity pool. When liquidity in the pool is low, these rewards are very attractive (since the ratio of tokens to TVL is large). But as the pool gets larger and larger, the ratio of tokens to pool size gets smaller and smaller, causing the APY to decrease.
Eventually a plateau is reached: liquidity rewards for that pool can no longer incentivise further deposits, even as emissions continue to be pumped into the pool in perpetuity.
Liquidity mining is not entirely bad. It has its place in a tokenomics toolbox when used judiciously.
But far too often, protocols do aggressive, mindless liquidity mining that impoverishes the protocol and tanks the token price. Done this way, liquidity mining should really be called liquidity “strip-mining”, as it impoverishes the protocol for short-term gain.
Protocols give wealth away to mercenaries and get nothing (except temporary liquidity) in return.
Conclusion
We identified the three largest mistakes protocols make: launching without clear token utility, launching with too little supply, and inflating the supply too quickly. The result is inevitably a depressed token price and an impoverished protocol.
Is there a better way? A solution should have the following desirable properties:
- Provides clear utility (and a redemption mechanism) for governance tokens.
- Stabilises (and eventually grows) the price of the governance token.
- Incentivises deposits in LPs effectively even as TVL grows to >100M.
- Grows protocol wealth continuously and in perpetuity, instead of strip-mining it to gain temporary TVL.
- Filters out short-term mercenary liquidity; rewards long-term holders of the governance token.
We think we have come up with something that does exactly that — and you’ve already gotten a glimpse of how it works in our latest announcement Socean Streams.
In the next part, I’ll introduce Socean’s tokenomics, explain some of its core innovations, and demonstrate how it possesses the above desirable properties.
Contact Us
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