Research, Education, Design

Evolution of Economics

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Economics and physics can explain the foundation of life. Economics with why we do what we do, our behaviors, our actions, our incentives, our outcomes. Physics explains the metaphysical world that we live in. Both economics and physics, although sciences, are different in their application but equally important in how we shape the world.

Evolution of Economics

With economics, technology has changed the way we apply economics. The good news though, is that principles in economics do not change. They remain and same, and now are just used differently. Just like in physics, gravity is a fact. It doesn’t change be it on Earth or the Moon, just different intensity and use-cases.

So how is this related to token economics?

We used to be in traditional physical economics: producing, consuming and distributing mostly physical products.

Then we moved to digital centralized worlds with new variables like digital assets. The production, consumption and distribution of this new class of asset has changed drastically. We need to account for that in our little ecosystems like how Amazon, Airbnb, Uber runs. These companies are not always producing physical products, and that changes the dynamic of business and business plans.

And next, we are going towards digital decentralised worlds, with the same sets of economic foundation as the worlds before, but now we have to consider more about governance and other variables.

So why foundational economic blocks need to exist?

Because they are the structure for us to build this new digital decentralized worlds on. We apply the learnings of “ordinary” economics to make ecosystems, digital assets (information, computer engineering, systems design) to amplify our objectives, do useful things and coordinate in all directions.

Not A Recipe Cookbook

It is not a cookbook. I would even argue that many things might not even apply. But it is the basic economic concept that is the most important. A cookbook says to add flour, butter, egg and baking soda into the cookie and bake it at 180C. The concept is to mix ingredients and cook it. For a person that can’t take gluten, you have to change the flour. For a vegetarian, you have to change the egg and butter. But the concept remains, to mix ingredients and cook it.

Similarly, the foundational economic blocks are the main ingredients to bake this cookie. You change it according to your constraints (permission vs permission-less, stable coin vs cryptocurrency, etc).

Impossible Task of Possibility

I will be honest here. It is impossible to build a completely holistic model, but hey, Rome isn’t built in a day. We take baby steps in building a nation and building a new field in economics. In my model and research so far, it is to combine market, mechanism and aspects of monetary + other macro economics fields and concepts into token economics. It is absolutely more than just the design of the token, aka how to value the token. It includes the decentralised governance, the coordination of people, allocation of resources, etc.

Game Theory and Token Economics

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What does that mean? Say the example of Airbus and Boeing. Airbus wants to produce and Boeing has little incentive to. But as a airlines company (e.g. British Airways), I know I need a bigger plan to fulfil the demands. That is my outcome: for the superjumbo jet to be produced.
Through game theory analysis, I can see that the probability of superjumbo jets happening is quite slim.

What can I do?

Some mechanisms to change the behaviours and outcomes:
  • Maybe I can pre-order 100 superjumbo jets from Airbus and Boeing, so they know they have a confirmed demand for it
  • Lobby the UK government to increase subsidies for the R&D part, so both parties have less losses/risks. Maybe that might entice them to develop
  • Look for a new competitor that produces plans and ask them to work with Airbus
Those are just basic simple (& maybe crazy, not-practical) ideas. But you get what I mean. I can introduce mechanisms to change the behaviours and outcomes, so it suits an objective.

What’s the link with token ecosystems?

Similarly, we want to analyse the outcomes and build in some mechanisms and rules to ensure that the outcomes are in line with the objectives.
Remember I mentioned that every ecosystem has 1 main objective? The truth is, that can be challenging to achieve sometimes, when you have a decentralised ecosystem and everyone behaves differently.
However, you can change that through rules.
I want my ecosystem to have honest miners. So I can make the hardware expensive and difficult to get, to reduce cheats from entering the game.
We can do that through incentives (rewards) or disincentives (punishments). These act as the mechanisms and rules to ensure that the outcomes are in line with the objective of the ecosystem.

What rules and mechanisms?

There are many, but to make it easy, let’s call it governance. Governance, in my opinion, is the most important aspect in the token ecosystem.
There are many types of governance:
  • How can we get the true value of the participants so we can allocate the goods efficiently? (e.g. there are 2 transactions waiting to be validated. What mechanism or governance can I have in place, to prioritise which transaction to approve first?)
  • How can I ensure that my rules induce a game among strategic agents in order to realise a system-wide objective or social choice function, in an equilibrium of the game? (e.g. how can I reduce instances of pump-and-dump, since this is not an objective of my ecosystem?)
We are just scratching the surface of game theory and its application to token economics. At the end of the day, it forms part of the design model for the ecosystem to exist.

Macro vs Micro Token Economics

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Economics is divided into 2 branches: macroeconomics vs microeconomics. Similarly in token economics, we can divide the various categories into these branches.

Macro Token Economics

Traditionally, macroeconomics looks at business cycles and economic growth. It means understanding how the economy, as a whole, behaves by looking at indicators. For example, inflation, price levels, income level, etc.

Business Cycles

This is where your governance comes in (see where I’m going?). For example, monetary policy and fiscal policy. These are movement or actions by the government to make sure that the economy is healthy. For example, we don’t want inflation to be too high or inflation to be too low.
Macroeconomics also includes analyzing how different sectors relate to each other, especially in times of international trade. For example, how does consumption, investment, savings and international trade affect each other? What policies (or rules) the government needs to have, to ensure that the economy is healthy and balanced?

Economic Growth

Economic growth is just growth of your economy or ecosystem. Here, we want to understand the factors that contributes to the long-run and income growth. For example, technology innovation helps economic growth as according to the Solow Growth Model.

So, what’s the link with my token ecosystem?

This link is in the design of your token.
Macro Token Economics
Macro Token Economics

Business Cycles

Although token ecosystems do not have a centralised government to respond to changes your ecosystem, there are rules that can be coded and embedded. For example, MakerDao uses various stability mechanisms like target rate feedback and risk parameters to govern the ecosystem.
We can also analyse the aggregate behaviour of the economy.
If the token function is a currency, there are plenty of literature to analyse the inflation model, interest rate, allocation of tokens, supply and creation or burn rates.

Economic Growth

Since token ecosystems are a form of business models, you have to consider the long-run growth and factors contributing to it. And it is also important to remember that these factors have to be endogenous, not just exogenous.
For example, if your business model is tokenising common data, what are the internal factors (endogenous) that will affect the long-run growth? Maybe proprietary IoT technology hardware, sale of data with confirmed partner, etc.
If the token function is a security, check out financial literature on asset valuation, profit distribution and other relevant factors.

Micro Token Economics

As the name suggests, microeconomics focuses on individuals actors. The 3 types of actors in the physical fiat economy are households (people), firms (companies that hire people), and government (sets rules for households and firms).
It means understanding how actors behave, as an individual, given the limited resources. For example, why you are happier drinking the first cup of tea than the 10th cup of tea in a row.
Microeconomics looks deeper into various allocation mechanisms of resources, methods to extract the right value from participants, and how people make decisions. We look at demand and supply, production theory (inputs to outputs), production costs, etc. The field is endless.

So, what’s the link with my token ecosystem?

This link is in the design of your market and mechanism.
Some fields in microeconomics that is applicable to token economy:
Micro Token Economics
Micro Token Economics
These are part of the factors to consider when designing a token ecosystem. There is not “right answer” or “perfect model” for the ecosystem. It depends greatly on the token function, use-case, business model, etc. The only way is to read, apply, test, improve.
In the next few videos and articles, I will share more about each field in details and its application to token economics.

Token Valuation Models

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Token valuation models are used to evaluate token prices. But what’s wrong with them?

Token valuation models

2 things about token valuation:

  1. Token valuation is not as important as you think it is. It is important from an investor’s point of view, but from the token economics and design perspective, it is the last thing to consider.
  2. Tokens should be valued with endogenous, not exogenous variables.

For the longest time, I am struggling with the last design aspect of token economics: “Token Design”. I struggle because I’m trying to balance what is necessary (variables needed to be considered in designing the token) and what people want (how much will my token be worth).

MV=PQ Token Valuation Model is wrong?

Let’s address the elephant in the room.
No, it is not wrong. This model is known as the “Quantity Theory of Money”, under the category of “Monetary Economics”. It is used to price money. Money itself has no price, but it has a value. We can extract this value from such models.
In the physical-fiat world, you have central banks governing our money. How do they price our money? The philosophy came from the general idea that price levels is directly proportional to the money in the market. Even in the physical world, this theory is challenged by Keynesian economics. Because prices are sticky and velocity is not stable in the short-run, this is a flawed model. This model is useful in the long-run.

The link with Token Economics?

Okay, so what the hell does it have to do with token economics?

2 things: (1) model for currency and (2) the idea of velocity.

1) This model is meant to get the price of money.

👉🏻 Your token is not always money. It’s like trying to use a fruit knife to cut a slab of beef. Please use the right tools instead.

2) Focuses on exogenous (external) variables.

👉🏻 Token ecosystems are amazing because you get to design many endogenous (internal) variables of the token. By that measure, the token’s value should be defined from the endogenous variables, not the exogenous variables. This is why token ecosystems are DIFFERENT from the fiat world ecosystem. We have comparatively more control of the output, given the input.
In token ecosystems, velocity is an exogenous factor because you can’t control how quickly your participants change hands. It can be indirectly linked to network effects, congestion, even your incentive mechanisms. But if we have direct links to the value the token ecosystem can provide, why not use it?

Why do people still use it?

Frankly, after speaking to many people in the industry, it boils down to 2 things.
(1) It is an easy model.
(2) This is the only model in the market.

To which I’d like to comment:

Easy doesn’t mean it’s good

(1) Yes, it is a pretty easy and straight-forward model. But is is not sound. If you are using velocity to figure the price of token, how are you defining velocity? Velocity of USD, a random number, or? If you modeled an ecosystem and allow the systems to trade to get a “V”, how does this account for the different behaviors of the participants (behavioral economics) and how sure are you that the incentivisation model will create such behaviors (mechanism design)? Also, how well designed is your market to allow for network effects to take place? There are so many questions.

It’s not the only model

(2) This is not the only model in the market. This model is just the popular model available. I believe that Chris Burniske was the first person to mention this model in his article: Cryptoasset Valuations. This model might work for SOME projects, but not all. Not every token model that we see or token function is a currency. Some are utilities, some securities. So, this model doesn’t always work.

So what token valuation models then?

Good question.

Firstly, value tokens with endogenous factors.

Token ecosystems are designed with multiple variables to allow value in its design. Hence, it is important to determine the value of tokens through the various design mechanisms in place.

Some variables that can allow tokens to have endogenous value:

  • Expected value of funds
  • Dynamic price equilibrium (Athey et al., 2016)
  • Exchange rate of tokens to dollars reflect buyer’s willingness to buy (ex-ante, market clearing condition)
  • Scarcity of tokens included by pricing choices causes buyer competition that reveals consumer values
  • Rational expectation of exchange rate in next period by agents
  • Value of price commitments
  • Demand growth from demand of buyers
  • Savings function/incentives to save
  • Function of expected growth through demand of platform or money supply
  • Value to consumer
  • Network effects
  • Heterogeneity of user base
  • Platform productivity
Disclaimer: this is not an exclusive list. This is not applicable to every token business model. It varies from the token function. There is NO one solution that fits every ecosystem.

Secondly, allow the market to dictate the price.

This can be done with either Dutch Auctions or Vickrey-Clarke-Groves auction. Or other new mechanisms.

Dutch auctions are more for homogenous good while VCG is for heterogenous goods.
Dutch auctions are a great pricing mechanism as the market will determine the price (value to buyer) instead of seller (usually monetary focused). It is a fairer way to allocate value to everyone in the network than being hostage to the dictation of a few people. Dutch auctions is also used by government when selling bonds.

The literature is researched till here, utilities and some extent of securities. I’m interested in valuation models for crypto securities. What is the current model for non-crypto securities (bonds, stock, options). What additional considerations needs to be in place for securities in the crypto economy? How different does securities need to be, when shifting from the physical to digital marketplace.

Sources and further reading:

Token Ecosystem Design Process

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Token ecosystem is all about design. The economics of tokenisation (aka tokenomics) is part of this entire process. This article shares the Token Ecosystem Design process stages, elements to consider during each stage and where economics of tokenisation (aka tokenomics) fits in.

Transparency is very important to me, hence I’d like to share the token ecosystem design process with you. (Unpopular opinion) There are too many bullshit “advisors” and people out there, who don’t know what they are doing. But if you are equally clueless, it’s difficult to tell who’s bullshitting you and who isn’t. (This is what we call, moral hazard in economics.)

So, this post can give you more ideas and information about the whole process, if you need help and what specific help you need.

Token Ecosystem Creation

Token ecosystem is the entire system where your tokens and users co-exist. If you think about it, it’s basically your business model.

Token Ecosystem Design process
Token Ecosystem Design process

The creation process comes in 3 segments: discovery, design and deploy. This is adapted from the 3 Ds of token ecosystem creation, created by Outlier Ventures. It’s easy to remember, and easier than a model I created previously.

  1. Discovery Phase: determine the particular characteristics of the business model or ecosystem and why a token is needed in the first place.
    1. Who: customer analysis, actors in the ecosystem, developers, users
    2. What: token business model
    3. Why: why it adds value to participants
    4. How: Smart contracts, boards/authority, other solutions
  1. Design Phase: making high-level design choices including, governance structures, the (mathematical) token model and its parameters. These need to be optimized for stakeholders’ incentives and the long-term sustainability of the associated ecosystem in order to avoid value leakage.
    1. Define Design space
    2. Define objectives and constraints
    3. Economics of Tokenisation Framework design
    4. Token network fit
  2. Deployment Phase: comprises of validating and stress-testing the parameters that were defined during the design phase, before fully integrating into the network
    1. Surveys/theories
    2. Experiments
    3. Simulations
    4. AB tests

How It Works

It’s as simple as it can get. It is the execution that is really difficult.

Token Ecosystem Design process
Token Ecosystem Design process

Step 1: Discovery stage. This stage is to understand the basics of your token ecosystem. A good way is to think of the various participants, the business model, what value you add and possible solutions.
(Spend 10% of the time here.)

Step 2: Design (1/2) stage. This stage is to fully understand and agree on the most important objective of the token ecosystem. Then, you can expand to 2nd most important objective, 3rd most important, … Also, define the design space and constraints. This is very important because it defines the environment in which the tokens and participants will co-exist in. It also defines the environment that we will be designing, in the next steps.
(Spend 10% of the time here.)

Step 3: Design (2/2) stage. This stage is where economics of tokenisation comes in (aka tokenomics). This is where the market design, mechanism design and token design comes in. The idea is to design each part individually, then combine them together and find a token network fit.
(Spend 60% of the time here, designing, editing and enhancing the previous model.)

Step 4: Deploy stage. This stage is to run various tests to test the token network fit in previous stage. Steps 3 & 4 are an ON-GOING CYCLE. That means, token network fit draft 1 —> deploy and run tests —> improve and create token network fit draft 2 —> deploy and run tests —> improve and create token network fit draft 3 … you get the idea.
(Spend a total of 20% of the time running tests and collating results.)

Where Does Economics of Tokenisation (Tokenomics) comes in?

The economics of tokenisation comes in at the last half of this process, steps 3 & 4. In step 2, we define the outcome that we want from the token ecosystem. In step 3, we will design the various environment and mechanisms to achieve the outcome in step 2. Then, we run tests in step 4 to see if the outcome is achieved!
If not achieved, return to step 3 to edit and test them again.

The economics of tokenisation is not a one-off service. It requires time to research, test and analyse the right model for the token. I wish it was as easy as a cooking recipe, where you can take an existing model out there, and edit it to suit your ecosystem. The beauty of token ecosystem is that it is highly customisable to the outcomes we want. We just have to spend a lot more time understanding what it takes to achieve the outcomes.

We all want answers, and we want them now. But the truth is that good things take time. I hope you allow sufficient time to design the right economics for your token ecosystem. It is not easy, but if we want to make real changes and define our future of tokenisation, we have to start creating sound economics right now.

Ps: token ecosystem design and creation is like baking the perfect macaron. You can have the steps and general ingredients needed, but it is the details that really determines the success of it. Over whip, undercook, not resting enough, and it’s destroyed.
Just like token ecosystem, the general steps is applicable to every project. To get the best success in the token ecosystem, you need knowledge and experience, that is less easy than reading an article.