By Nelson Ryan
Token design can play a critical role in value capture for crypto networks. Network’s without a well designed token risk becoming unsustainable and may even be vulnerable to competitors taking a more thoughtful and direct approach to value capture. Token design can vary considerably which is one of the benefits to crypto is the open design space for teams to financial engineer and experiment with new means of value capture. This piece will take a look at some of the more prominent token models looking at the benefits and drawbacks of each approach.
As the one of the original and most battle tested crypto networks, Bitcoin has the original token model which most people understand. BTC’s token model centers around a fixed supply of 21 million BTC with gradual issuance over time with issuance going to the miners for the security of the network halving every four years. Today Bitcoin’s monthly inflation rate sits at 1.75% with 1.3m BTC left to be issued and the next halving in 2024.
Source: Glassnode Bitcoin Supply Curve
The benefit of the BTC token model is it’s predictability and provable scarcity with it’s fixed supply curve. Independent of activity on the Bitcoin network, BTC benefits from this scarcity. The disadvantage of this model is that as the miner subsidy issuance comes down over time, the network relies on organic demand to fill the gap in place of these subsidies. Today only 5.81% of miner revenue comes from transaction fees with the remainder coming from block subsidies. The other disadvantage with this model is that all value in the form of block subsidies and transaction fees goes to miners for security and none of this value flows back to BTC holders.
Unlike Bitcoin’s predictable issuance model, Ethereum took a more dynamic approach to issuance gradually reducing emissions over time as transaction fees rose over time. With Ethereum’s introduction of EIP-1559 and the move to Proof of Stake (PoS) Ethereum moved towards a new deflationary model. While in the past ETH gas fees went to miners like in Bitcoin, with the introduction of EIP-1559 a burn mechanism was added to the network with a portion of ETH gas fees burned allowing issuance to even become deflationary over time with growing demand for block space.
Source: Ultra Sound Money Dashboard
One of the benefit’s of the EIP-1559 ETH model is it’s dynamic approach to issuance allowing the network to adjust to changing demand for block space with issuance shifting from net inflationary to deflationary depending on demand. One of the disadvantages of this model is that token holders pay the cost of low demand through dilution in the form of additional issuance. To protect themselves from this dilution, token holders can stake their ETH to earn staking rewards to offset growing issuance and earn MEV rewards (this will be burned in the future), although this does involve taking on additional slashing risk.
One of the earliest DeFi projects on Ethereum, Maker is a collateralized stablecoin which introduced an interesting buyback and burn model. Inspired by share buybacks commonly utilized by publicly listed companies, Maker dedicates excess profits above the system surplus to MKR buybacks burning MKR supply. This mechanism makes MKR supply deflationary over time with Maker today estimating $115m in annual profits and around 9.84% of the supply which has been burned through buybacks. Make recently unveiled their new end game roadmap in which a new stablecoin token and governance token will be launched and this model will be subject to change.
Source: Maker Burn
The benefits to Maker’s current model is that profits for the protocol very directly result in the reduction in total supply of the token aiming to increase price per token over time. While Maker could instead pay out distributions, in most jurisdictions buybacks are more tax beneficial for token holders over income given the preferential tax treatment of capital gains. In addition to the tax benefits, token buybacks also benefit all token holders equally, not just those who stake or participate in governance. It’s important to note that MKR holders do take dilution risk in the event of significant losses to the system like those realized in the sharp downturn of 2020 in which DAI broke it’s peg.