The Crypto Supply Problem and Token Monetary Policy
Time to manage supply
When Bitcoin was born in 2008, the maximum supply of the cryptocurrency was set at 21 million coins.
From the beginning though, the non-believers were skeptical about the 21 million limit. Bitcoin's software was open-source and could simply be copied an infinite amount of times. So while Bitcoin might be limited at 21 million, we could just replicate many Bitcoin look-a-likes and have billions, if not trillions, of similar coins in circulation.
For a long time, many tried and most failed at creating successful Bitcoin replicas. People realized that it's not just about the software. First, network effects play a role in success. It was difficult to bootstrap a sufficiently compelling project that gained enough traction. Bitcoin had a few other things going its way too. It had a sizable group of developers supporting the project and a deeply committed community around it (i.e. HODL). It was a movement wrapped in software.
The history of cryptocurrencies is long so we’ll stick with the simplified version here. Eventually, after many failed attempts, we know that another project was able to break through the barrier of adoption. Ethereum, a cryptographic smart contract platform, came into the picture with much fanfare in 2015.
For the next five years until the beginning of 2020, Bitcoin and Ethereum gained more adoption and increased in price, even after accounting for the 2017/2018 boom and bust cycle. During that time period, the number of successful, large cap coins were relatively limited.
The landscape started to change with “DeFi Summer” in 2020. A number of Ethereum financial applications went viral and marked the start of the “web3” application boom. With all these new great new applications though, we were also introduced to many new tokens. The supply spigot had been officially cranked up a few notches.
As we rolled into 2021, the space started to grow across two additional dimensions:
1) Non-fungible tokens (NFTs); and
2) Layer 1 blockchains beyond Ethereum
The amount of NFTs sold in 2021 totaled $25+ billion dollars and the number continues to grow. As for the newer Layer 1 blockchains such as Avalanche, Solana and Fantom, each one started to blossom with its own ecosystem of applications. The security of all these new layer 1 blockchains are done through a proof-of-stake mechanism. In essence, you put up your tokens in the validation process and earn more tokens. The rates range from ~5-12% per annum. The supply spigot becomes even stronger with token issuance funding these “staking” rates.
In crypto, the kid cries wolf “best new token ever” quite often. So often that people stop believing that new, successful things can emerge. It’s kind of how we get Bitcoin Maximalists and Ethereum Maximalists. Failed experiments become “proof” that the maxi’s belief is true. It’s ironic to see that thought outcome because crypto’s fertile ground for experimentation is one of the things that make it unique. We want to see trial-and-error everywhere. As a result, we expect to see many failed projects. It’s the path to innovation.
At this point, the BTC and ETH maximalists are quite angry. Rightly so (from their perspective), I guess. Instead of bidding up the price of Bitcoin and Ethereum, there are all these “degenerates” buying other things instead of their bags. Besides all the new layer 1 blockchain tokens, each platform has a growing set of application tokens on top of it. Mo’ applications, mo’ tokens. Sure enough, the supply spigot starts to turn into a potential supply shock.
As mentioned in the previous post (Satoshi’s Ark), venture capitalists contributed $21+ billion dollars to crypto projects in 2021. If you think we have too many tokens and NFTs now, just wait until all these dollars are deployed.
This gets me to the crypto supply problem. I believe it to be composed of two parts:
The continuous flow of new tokens into the ecosystem. 21 million coins have become billions in coins
The way in which some tokens are introduced into the market. Specifically, programmatic minting of tokens
We can’t control the incoming supply. However, we can all make smart decisions around it if supply > demand of tokens. When there’s ample supply of projects and associated tokens, there’s also tremendous competition. One approach is to buy platforms instead of single projects (see Getting ETF-like market returns in crypto). As long as the platforms survive, we win. In this strategy, we’re indifferent to any one project failing.
Another approach is to only invest in projects that have a strong, defensible position. Given the open source nature of crypto technology, this may be projects that have parts that can’t be replicated by software (e.g. places where established relationships matter), winner-takes-all marketplaces or other distinct features. This approach - token picking - is hard and most people are bad it.
The second part of the supply problem is the manner of token issuance and applies to protocol operators. Satoshi designed Bitcoin such that its issuance would be programmatic, with the 21 million coins issued in a mathematical and fixed way. This allowed for transparency and eliminated potential “money printing” decisions to take place. As we all know, Satoshi’s plan was also to disappear and let the project evolve in its own way. It’s helpful to have programmatic issuance if you’re not going to be around.
In honor of the Bitcoin Prophet, many projects follow the same attitude in regard to token issuance. They favor transparency over any flexibility. Many token issuance schedules take a set-it-and-forget-it methodology, just like Bitcoin. Token issuance via incentive programs are also not calibrated for market conditions. The act of pursuing monetary policy (in this case, for a protocol’s token) appears off limits. Bitcoin’s birth is related to what many perceived to be poor monetary policy, so it makes sense that the crypto community might shy away from it.
Protocols need to consider alternatives to programmatic issuance though. To avoid price collapse or a continuous price downtrend, protocol treasuries need to think about monetary policy for their token. Beyond tokenomics design, it’s important to consider what actions are conducted throughout time. Even if a project has great intrinsic value (i.e. its valuation is well-founded), mismanagement of a token can lead to negative price outcomes.
If the crypto market is aggressively selling off day in and day out, it doesn’t make sense for a project to continuously dump its token. This is what programmatic selling does. We know how the U.S dollar or other assets are backed by the “faith” in something. No one has faith in a token that gets continuously trashed.
Recently, the game Axie Infinity reduced the instances in which players receive its SLP token. It seems like the uncontrolled distribution of the token helped lead to its 93% price collapse. They could have let the token go to zero or take action.
While preserving transparency, there are a number of actions that protocols could consider:
For projects with buyback programs, save the dry powder for the most opportune time. Use buybacks to support price when it’s needed the most
For those offering incentive programs via token issuance, create two tiers. One tier is baseline rewards, which creates some consistency for reward receivers, and the second tier is activated during favorable conditions
Include supply/demand conditions in the equation controlling token issuance. Like in the Axie example, if supply is outstripping demand, adjust accordingly
Recycle supply from current holders
This last one is the most interesting. While the protocol can continue to mint tokens programmatically, instead of distributing the new supply, they should keep it in a ‘for-later’ segregated account. To actually fund any incentive program at hand, the protocol should borrow tokens already in circulation from current holders and re-distribute those tokens. If the lender wants their tokens back, the protocol just gives them tokens from the for-later segregated account. Lenders get paid some type of staking rewards, which is calibrated to attract enough funds equal to the incentive supply. The recycling of tokens and smaller net supply in circulation could remove some sell pressure on the token.
All in all, crypto/web3 is growing and with it comes more and more tokens. If supply outstrips the token demand for a sustained period of time, that’s an ingredient for a crypto winter.
At the macro level, more supply likely means more failures of individual protocols due to increased competition. Choosing winners become harder.
As for each protocol, they need to be smart about managing their token dynamics. Token monetary policy can be a critical compliment to a great project, tightnit community and tokenomics design.
All opinions are my own. This is not investment advice.