The Impossible Promises of Tokenomics

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The last few years have seen an explosion of utility in crypto markets. This has created huge opportunities for investors to make large returns but has also produced many scams and deceptive projects too. Some are outright ponzi schemes while others have some semblance of real use but are not sustainable. Many projects use disreputable tactics to inflate the desirability of whatever they are selling (“utility” tokens, NFT’s, metaverse land and so on). There are many different flavours of these tactics and I illustrate some of them below:

  • Projects like Axie Infinity rewards users for being active within their game. At project launch, the rewards started off great, with users in poorer countries being able to farm a wage from the game. However the value of rewards get less and less over time as the coin inflates and more players join, meaning everyone gets less of the pie. Being early is profitable. As long as you aren’t taking on more risk than the reward is worth this is a good way to make gains. Of course in the AXS case a certain nine figure hack didn’t help matters. But the project was well past its peak when this occurred anyway. As rewards fall there is less incentive for new players to start and word spreads that the juice isn’t worth the squeeze anymore.
  • Popularity is vital to sustain these projects; if the flow of new users (and therefore fresh capital) slows or stops altogether it can be hard for the project to ever recover to previous heights. Crypto investors are fickle. If there is a shiny new project, perhaps on a new L1, it is more likely to pump than a similar, older project that already had a large run-up in a previous market cycle. Have a look at the performance of everyone's favourite 2017 erc20’s and see how they have performed in the most recent bull run. Rotation is key to get the most benefit out of a crypto bull run.
  • High APY projects like OHM, TIME, TITANO etc. produce yield by inflating supply of their own token to dish out rewards. Quick trades in these can be profitable but the only thing keeping these valuations up is new investors jumping in and keeping the inflationary price pressure at bay. Once this falters, faith in the project is quickly lost and a 99%+ loss becomes the most likely scenario.
  • Even legitimate projects have things you should be aware of. Something like DOT has an approximate inflation rate of 10% annually. So that 12% yield your seeing on Binance Staking isn’t quite what it appears to be.

Fundamentally money has to enter these systems from somewhere if you are to make a profit from them. That could be the team behind the project creating incentives from their own pocket (like Anchor Protocol) or from other investors buying the projects token, NFT’s, land etc.

This happens at a more complicated level with other financial products. If you are selling options you are collecting premium in exchange for taking the short side of an options position. If you lend your crypto, you are being paid a yield from the borrower of those coins (this rate is sometimes increased by the protocol giving some of their token on top of the base reward). There is no free lunch in crypto (apart from airdrops perhaps) and any promised yield from a farm, a game, an IDO launchpad or anything else should be met with the following question: where is this money coming from and is that safe/sustainable?

It seems some crypto systems have been designed to deliberately obfuscate where risk is and where returns are generated. This makes it harder for investors to know what risks they are taking and to assess what yield they are actually receiving. As more complex protocols are developed to generate yield (we already have on-chain options vaults, synthetic products, P2E games with multiple native currencies etc.) this will become even more difficult. And even if a system is producing legitimate value that generates a return for holders, that can all be snuffed out from a hack or smart contract bug or flaw in the initial tokenomics design. Terra is the most recent example of the latter and several large hacks, like Wormhole, have happened over the last year. I expect these hacks to continue for as long as their is an incentive to do so and people out there with the expertise to pull these off.

I would estimate that only a minority of crypto market participants will actually do significant research before jumping into a project with their own capital. Even sophisticated institutional investors like Three Arrows Capital, Jump Crypto and Delphi Ventures were badly burned by Terra’s collapse. No one is immune to making errors of judgment but there are best practices that should always be employed to minimise risk. The most underappreciated of these remains deep analysis of protocol tokenomics. Where is the yield coming from? Is this rate sustainable? What happens if yields drop substantially, which is to be expected as TVL goes up, and new users stop appearing? If there is a stablecoin involved, how is it holding its peg? Is there smart contract risk due to potential oracle issues, governance problems or any susceptibility to flash loan attacks? What about broader market conditions (what happens during periods of high volatility, especially to the downside) and any correlations to other assets that you may want to hedge against?

I would guess that many retail investors answer none of the above questions when investing in a new project. I would hope institutions have good answers for all of these. This of course still doesn’t mean you can’t be wrong. To use the example of LUNA/UST, it seems many smart people greatly underestimated the risk of a UST depegging event. And yet here we are. Even the cautious can be wrong but the diversified are most likely to live to see another day. The crypto market has shown many times that if you can survive downturns the gains on the other side can be incredible. It is always just a matter of time.

CM