10 min read
From the earliest days of Bitcoin mining to the eras of ICOs, yield farming, and airdrops, token issuance methods have continually evolved to address early incentive problems between stakeholder groups involved in a token launch. This article explores the next evolution in token design - the shift from fixed to dynamic supply tokens - and the benefits of a novel form of adaptive issuance, based on reserve-backed Primary Issuance Markets.
Most Web3 tokens today are essentially fiat. Among the first words found in the Bible are in the Book of Genesis: “fiat lux” was God’s initial decree, translating to “let there be light.” Fiat can be defined as “existence-by-decree”, such as how the dictates of central banks essentially print national currencies by setting interest rates (i.e. the cost of borrowing money), thus stimulating more (or less) debt-based money issuance through bank loans. Despite the oft-stated opposition to fiat money commonly heard in the Web3 space, ironically, most tokens launched today follow a similar (if not more centralized and arbitrary) issuance pattern.
Projects usually create their tokens by choosing their total supply and issuance in the initial minting of the token as a discrete event, such as an Initial Coin Offering (ICO) or pre-mine. As such, these tokens are brought into existence “by decree” of their developers. These tokens are often minted without anything backing their valuation, aside from the market rate of a small portion of these tokens that may be available on an exchange or liquidity pool. We consider these “fixed supply tokens” because their supply is predetermined at a single point in time. These tokens then require distribution policies (e.g., arbitrarily set 3-5 year cliff and vesting token unlock schedules) so that all tokens do not hit the market at once, which gives them the appearance of being issued over time.
Most of these tokens find their market price through a thin veil of liquidity, whether centralized or decentralized, or via venture capital (VC) enabled over-the-counter (OTC) liquidity (like many later-stage ICOs). These kinds of liquidity arrangements are not only highly extractive for projects, with most of the benefits accruing to early private capital, they are also comparatively ineffective at maintaining consistent pricing for tokens, especially in their bootstrapping stage. Projects with fixed supply tokens incur ongoing costs incentivizing liquidity providers and market makers to guarantee market liquidity for their token. This often leads to misaligned incentives over ecosystem growth, often prioritizing early investors or the project team at the expense of the community or other stakeholders. In a fixed supply token paradigm, projects cannot benefit from their token economy apart from selling their tokens into the market or selling them to VCs via OTC deals. This can exacerbate volatile pricing dynamics and “pump and dump” ponzinomics, which rewards manipulation by large holders and fosters continuous uncertainty and mistrust among token holders, regardless of how well a project's productive and technical development may progress.
Most token projects have several problematic metrics and key performance indicators (KPIs) like market cap and fully diluted value (FDV). These metrics tend to exaggerate assumptions about the underlying value of a token, which can be misleading for users and investors alike. The diagram below demonstrates the “market cap illusion,” pointing out the glaring difference between the rectangle of the area product (i.e., token price multiplied by total supply) and the triangle of “real value,” which accounts for the price slippage of tokens as they are continuously sold.
Figure 1. A visual depiction of the “market cap illusion,” wherein an investor evaluates the total “value” in a token ecosystem by multiplying the current token price by the total number of tokens in supply. This creates a misleading understanding of value, as it does not consider the decrease in token price as successive tokens are sold. In other words, if you were to liquidate the entire supply of a fiat token, the full “market cap” of that token would never be realized.
Similarly, FDV makes the same mistake in the calculation and even extends it further to the full token supply, by including locked tokens that will someday enter circulation. FDV typically represents a large block of tokens that will be unlocked at some point in the future, with the potential to flood the market and depress token valuation. When a barely used Web3 storage network has a fully diluted value rivaling the valuation of some of the world’s largest cloud computing platforms, it becomes clear that FDV tells us nothing more than a pipedream of imagined value in some distant future.
Metrics like market cap and fully diluted value can create a misleading picture of a token's value, ignoring the realities of market liquidity and future supply increases. Thus, they inflate investor expectations and distort financial assessments, to the detriment of those who rely on them.
In contrast to fixed supply tokenomics, new technologies such as Primary Issuance Markets (PIMs) allow us to consider a new paradigm of token issuance: dynamic supply tokens. By using primary automated market makers for the continuous issuance and redemption of a native token based on the deposit or withdrawal of the reserve assets backing them, PIMs enable token ecosystems to adaptively expand or contract their available token supply based on the market demand for those tokens (or lack thereof). This approach benefits fundraising by providing perpetual revenue generation to a project treasury, dampening price volatility to retain more economic value during market downturns, and offering algorithmic liquidity as a market maker of last resort.
It is clear from an analysis of Web3 token economies that insufficient or excessive token supply (and hence liquidity for the exchange of those tokens) can be a self-limiting factor on the effectiveness of these economies. This underscores the need for issuance mechanisms that can adapt token supply to the demands of the marketplaces they serve rather than setting pre-determined issuance schedules that are not responsive to the emergent needs of their ecosystems.
Figure 2. A chart of circulating versus locked supply for a range of recently launched tokens. This article discusses some challenges that insufficient token supply can bring to its exchange liquidity and resulting price volatility. (Source: https://x.com/HadickM/status/1791441674310152479)
Another benefit of using dynamic issuance is that some guaranteed proportion of a reserve asset backs each token in supply. Primary Issuance Markets use these reserve assets to provision buy and sell orders for a project’s token, helping to manage a more sustainable token valuation and smooth out price volatility.
An added benefit of this process is the continuous generation of fees and arbitrage profit that can be directed to a project treasury or allocated as a native yield for staked token holders. Primary Issuance Markets impose a generative friction on the system, through the introduction of transaction fees during the process of minting or redeeming tokens. These fees reduce the financial gameability of these economic tools, while providing continuous funding for the project by harnessing a token’s price volatility to feed into the project treasury. In this way, PIMs offer multiple useful functions within a token ecosystem by converting market volatility into regenerative assets deployable by a project.
Figure 3. Past market data of the interaction effects of primary and secondary markets dampening token price volatility in the Truebit token ecosystem. In this image, the secondary automated market maker (SAMM) price for the TRU token is denoted by the blue line, the orange line denotes the primary automated market maker (PAMM) price for the same token, and the red line denotes the token supply. Data and graph created by @banteg, with commentary and notes by Jeff Emmett.
The Bonding Curve Research Group is modeling primary and secondary market interaction effects, and how they react to different simulated market situations and configurations of Primary Issuance Markets. These market signal inputs can be informed by historical data and run through a suite of tools to identify KPIs around healthy liquidity and volatility metrics that future projects or decentralized autonomous organizations (DAOs) will need to effectively manage their token economies and ensure long-term sustainability.
Figure 4. A simulation of the volatility damping and fee generation capabilities of a Primary Issuance Market (mint price in green and redeem price in red) exerting influence on a secondary exchange market (price in blue). The impacts on fee collection, reserves, and supply can be seen below the price chart as well. (Source: Bonding Curve Research Group Simulation App - try it out!)
To put the benefits of dynamic supply tokens in context, we do not propose that they are the superior paradigm for token issuance in all scenarios. A tool is only useful when applied in appropriate context. For example, if a token is being minted to represent some fixed quantity of a scarce physical asset, then a fixed supply token may be more suited to the task of tokenizing those real-world assets. However, dynamic supply tokens offer several advantages for fundraising and bootstrapping new token economies, such as their consistent liquidity provision, price volatility damping, and continuous revenue generation. The table below compares fixed and dynamic supply tokens across a range of token ecosystem aspects:
Table 1. Comparing aspects of fixed and dynamic token supply paradigms.
New technologies take time to develop and mature, and blockchains are no different. In the context of token issuance, traditional fixed supply tokens have thus far been the norm. New tools that facilitate a shift to dynamic supply tokens are here to stay, offering a range of benefits for projects seeking a more balanced and adaptive token economy, one that can expand and contract its supply to meet necessary demand for effective usage of the token. This dynamic approach aims to solve several issues associated with fixed supply tokens, such as fair launch issuance, bootstrapping funding, stabilizing volatile pricing, and ensuring continuous liquidity for native tokens.
The model designs explored in this article are being deployed into the Primary Issuance Market stack built by Inverter, and will be used for subnet token deployments on GogoPools in the Avalanche ecosystem. We are excited to see new token designs explored through modeling, with a focus on safe parameterization prior to being deployed into production.
If you’re inspired to dive deeper into some of our ongoing research on bonding curves and Primary Issuance Markets check out the new and informative BCRG Gitbook Library.
This article was authored by Jeff Emmett, Dr. Omer Demirel, and Ataberk Casur, with edits by Jessica Zartler. It presents information and research carried out by the Bonding Curve Research Group, with special thanks to GoGoPool for commissioning this article compilation, and Inverter Protocol for the ongoing research collaborations exploring primary issuance markets. This article is not intended as investment or tax advice. Header image by Cleo Tse on Unsplash.
The BCRG is dedicated to the research, development, education, and application of bonding curves in their various forms. As a collective of multidisciplinary researchers, we are on a mission to empower projects with reliable token ecosystem tooling, creating new collaboration opportunities through Web3 education and token engineering.
