Utility Mechanisms in Token Architectures

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Part II of X from previous Part I: What is the Method to Create Priceless Tokens?

We need to grasp the difference between productive and non-productive tokens (as defined by Placeholder VC here) before we delve deeply into specific utility mechanisms because their value is influenced by various circumstances.

Non-productive tokens in conventional finance are those that behave like commodities. The equation of exchange (MV = PQ), which equates price multiplied by quantity with the monetary level (M) multiplied by velocity (V), can be used to determine the worth of non-productive tokens (PQ). The MV side of the equation represents the monetary worth of the tokens multiplied by the velocity, while the PQ side of the equation indicates the value of the protocol service. The frequency with which a token exchanges hands over time is known as token velocity. Lowering V while maintaining PQ results in a higher M, which is equivalent to a higher token price. Effective utility methods are those that reduce token velocity (V), boost protocol service utility (PQ), or ideally both at once. Designing and implementing utility methods that raise the token's intrinsic worth while lowering token velocity is essential for non-productive tokens. This can be done using techniques like:

1. Staking Mechanisms: Reduce the amount of tokens in circulation as a percentage of the overall supply.
2. Mint & Burn Mechanisms: Cut back on the token's overall supply.

Productive tokens are those that, for example, by having built-in voting processes or providing yields under particular conditions, mimic debt or equity in conventional finance. Similar to how capital assets are valued in traditional banking, the value of productive tokens can be determined as the net present value (NPV) of annual value flows to token holders. The key to efficient utility mechanisms in productive tokens is to develop and put in place mechanisms that boost value flows to token holders. This can be done using techniques like:

1. Fee Distribution Mechanisms: Implement or raise token holders' fee distribution.
2. Discount Mechanisms: Create a discount mechanism that would enable consumers to pay less for the protocol's underlying utility than they otherwise would if they didn't own or utilize the token.

The majority of tokens are both productive and non-productive, and any of the aforementioned processes can have a good effect on their token structures.

Staking Mechanisms

Typically, introducing a staking mechanism will reduce the circulating supply relative to the total supply. Staking techniques lower the coins' average velocity and frequently add further security to the network. A decentralized network called Filecoin is used to share free storage space. If a stakeholder has an extra hard drive, they can connect it to the network, turn into storage providers, let other stakeholders use it, and get compensated for it. However, storage providers must stake a particular number of Filecoin tokens into the protocol in order to give storage to the protocol. This approach has a variety of advantageous effects on its token design, such as increasing buy pressure for the token since storage providers must first purchase some Filecoin tokens in order to offer their storage capacity to Filecoin. Additionally, it lowers the token's velocity because storage providers must stake their tokens in order to participate, and it deters them from acting maliciously because doing so will result in the loss of their staked tokens. The primary categories of staking methods now utilized by cryptographic protocols include:

Continuous Governance Mechanism: encourages token owners to regularly stake their governance tokens in order to maximize their voting power. To show their support for a proposal, token holders typically stake tokens in a smart contract. Each proposal must meet a predetermined threshold within a given time frame. Token holders must first unstake their tokens from the previous proposal before using them to vote on another one. MakerDAO is now using it.

Safety Module Mechanism: encourages token owners to stake their tokens into the Safety Module smart contract in order to receive yields on their staked tokens and to use the tokens as a safety buffer in the event that the protocol goes bankrupt. A specific number of tokens staked in the Safety Module are auctioned off and used to make up for protocol losses in the event of a financial shortfall. Aave has made safety modules a field of study.

Reputation Mechanism: provides a source of truth for the crypto protocol and encourages token holders to stake their tokens in order to earn returns on their staked tokens. The value of the staked tokens typically serves as a proxy for the authority and applicability of the "truth." Augur and Chainlink are now using this mechanism.

Stake-for-Access Mechanism: requires token owners to stake a particular number of tokens in order to access the network's functionality or to participate in it. Usually, its purpose is to guard against network spam. Cryptographic systems like Filecoin and Cudos are some of the most well-known examples.

Treasury Management Mechanism: permits the use of the crypto protocol's Treasury as a mechanism with the authority to withdraw from or purchase tokens from the market. Axies Infinity or KeyTango are expected to use this method.

Liquidity Provision Mechanism: allows token holders to lock their tokens in the protocol and act as a source of liquidity for DeFi lending and borrowing protocols like Uniswap and Balancer. This mechanism does not need the usage of the protocol's native token, therefore token holders can establish any token pair they like in order to supply liquidity to Uniswap or Balancer without using their native tokens, UNI and BAL. Because of this, it is not especially intriguing from the standpoint of token design and is just included for completeness.

Proof-of-Stake Mechanism: protects layer 0 and layer 1 protocols used by Near, Cosmos, Polkadot, Solana, and Ethereum 2.0. A node is chosen to be the validator of the next block using the Proof-of-Stake consensus method using a pseudo-random election process, which may take into account the node's wealth, the age at which it has been staking, and randomization. Only layer 0 and layer 1 protocols are applicable to this technique.

Where the yield comes from must be carefully considered if token holders are to receive financial compensation for locking up their tokens. It may come from the cryptocurrency protocol's revenue (sustainable), a premined pool of tokens (semi-sustainable), or an increase in the token supply (semi-sustainable).

Mint & Burn Mechanisms

Using mechanisms like mint and burn, which reduce the overall amount of tokens, is another technique to lower the velocity of crypto protocol tokens. These are methods that, in addition to minting, can burn a specific number of tokens in accordance with a predetermined logic, increasing the token's rarity. The protocol should theoretically result in fewer tokens seeking the same value. On the extent to which this is advantageous for the protocol as a whole, there are differing views. This excellent post from Placeholder VC warns against the use of Mint & Burn Mechanisms.

Although decreasing token velocity by lowering the total supply of tokens can be appealing for the aforementioned reasons, it occasionally clashes with stakeholders' incentives (reduced profitability, etc). Token architects must carefully consider the tradeoffs they are making and strike a balance between the objectives of various stakeholder groups. Later blog postings will go into greater detail about this issue.

Fee Distribution Mechanisms

We can increase the utility of the token in addition to decreasing its velocity. Implementing a fee distribution mechanism or, if the token already has one, raising the fees accumulated on the token are two ways to accomplish this. The use of financial incentives to influence stakeholders to act in the protocol's best interests should be prioritized because they are one of the strongest incentives available in token designs. For instance, only token holders that invest their tokens into the SushiSwap protocol receive a percentage of SushiSwap's DEX fees.

Discount Mechanisms

Finally, tokens can be applied as discount coupons for the protocol's services. With this method, centralized exchanges typically emit tokens. If holders choose to pay trading fees using the token, they receive a discount. The BNB cryptocurrency from Binance and the FTT token from FTX are two prominent examples. These tokens typically use the Burn Mechanism to boost their value even more.

Conclusion and Next Steps

Remember that when paired with other functional mechanisms, utility mechanisms that are completely functional in isolation might have negative consequences on our token structures. Understanding the interactions between the various mechanisms we use for our token designs is therefore an important part of the token architecture process. Despite the fact that this is often the purview of token developers, a number of software tools have recently been created to assist in choosing, optimizing, and validating the mechanisms you choose for your token architecture. The simplest approach is a program called cadCAD, which stands for Complex Adaptive Dynamic Computer Aided Design. Blockscience, a token engineering consulting company, created it, and a thriving community maintains it. It is possible to create, optimize, validate, and comprehend dynamical complex systems using the free and open-source Python package cadCAD. It is helpful because it enables engineers to employ simulation capabilities like A/B Tests, Parameter Sweeps, or Monte Carlo Analysis to pose strong what-if queries. The developers of cadCAD have taken great care to make their software accessible to everyone, and they recently launched the first in-depth online course on a platform called cadCADedu.

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