Minterest Tokenomics

Josh’s Mini Deep Dives

Getting under the hood of Minterest’s design

Tokenomics

I consistently find tokenomics confuse people, and worryingly sometimes the people designing them. They are far from simply a set of numbers. Tokenomics are the architecture of a token’s economy and detail the often complex relationships occurring within, including a token’s utility, various emissions structures and accrual mechanisms and how it enters supply.

Well-designed tokenomics are remarkable. They act like a map to the seemingly impossible. Getting a group of human beings to do anything together is challenging, yet well-designed tokenomics have them interact online with each other in ways that optimise project outcomes. It’s why getting tokenomics right is important and makes it the natural place to start any exploration of Minterest.

Getting tokens

It’s worth first outlining some aspects of tokens, especially protocol tokens, which may not be obvious but which understanding is essential to grasping protocol architecture.

Tokens are unique capital instruments. They differ markedly from the most common form of capital instruments, company shares, although both share limited characteristics.

Shares have two functions in a company – value exchange and control. They enable exchanges of value between the company and existing and potential shareholders, and their voting rights impart ownership and control. This limit in their utility is core to what defines them as a security.

In DeFi protocols, the focus of our exploration, tokens also allow exchanges of value, but between the protocol, its users, and holders. Tokens can allow voting rights to holders, enabling them to determine protocol development but they do not convey ownership. Protocols are publicly accessible code on the Internet, which is contributed not owned.

Tokens have utility beyond a capital instrument, which is key in most cases to why they are not a security.

Spectators and players

The reason a company exists is to maximise value for its shareholders. Shareholders are distinct from the customers who consume the company’s outputs, which as we see all too often, can lead to conflicting interests. In contrast, a protocol’s key purpose is to provide value to its users through its utility or use. 

What there is to notice about shares is they act as scorecards of spectators. They reflect the judgement of how well spectators believe the company is playing its game, which they rate with market capitalisation. But it is the company who is the player in the game.

A company’s value is measured by market capitalisation.

Market Cap = Share Supply x Price

Market cap may reflect the company’s operational effectiveness, but it is separate from that effectiveness. Market cap does not participate in how operations day-to-day in the company play out.

Tokens are something very different. They can be spectator scorecards determining market cap, 

Market Cap = Token Supply x Price

and they can also allow for governance decision making. More than spectators though, tokens are players in the game of the protocol. That difference, and the reasons why, is profound.

Facilitating creators

The purpose of a protocol is to facilitate the creation and exchange of value between users. 

A lending protocol enables borrowing of assets in exchange for interest. Supplying creates value for borrowers, and borrowers create value for suppliers when they pay interest. The protocol simply facilitates the process.

Protocol performance is therefore most effective when it maximises its value to users. Tokens are instrumental in that happening. Lending protocols can certainly operate without native tokens, examples exist, but without them they are unable to maximise their value to users. 

Why? Because a token’s primary role is not to be a capital instrument.

Unrecognised manipulators

The role of a token is to act as a user incentive, one with a single purpose – to moderate user behaviour. 

Designing protocols is also about designing tokenomics which moderate user behaviour. Tokens are unrecognised manipulators, influencing people to act unconsciously in ways the protocol needs. They have people interact on the platform in ways which increase its overall value, known as traction. 

A common example is using emission rewards to incentivise the supplying and borrowing of liquidity. Emission rewards attract users to join and undertake the foundational activities that create the protocol’s value.

It is why token emissions are called rewards. They are provided in return for the interactions of the user which create value. 

No token is free

Yet tokens are not free. Like any capital instrument, issuing them dilutes value at a cost to the protocol’s capital structure. For a protocol’s market cap to increase over time the value the token creates for the ecosystem must exceed its cost. 

A token whose role, apart from governance, is limited to attracting users to supply and borrow, a form of customer acquisition cost (CAC), will struggle to achieve this. 

Why? It’s related to how network effects are generated, which reduce acquisition costs over time and which we’ll explore in a later mini deep dive. But the upshot is if a protocol wants to develop underlying value over time, its token must generate value beyond just attracting users and voting rights.

Lost opportunities

Beyond incentives, protocol tokens offer the possibility of something more. Protocols capture value from users as fees. In all current lending protocols however fees are extracted for the direct benefit of select participants. 

External liquidators earn liquidation fees, and interest rate fees for supplying token markets commonly benefit project developers. There are variations but the premise is the same. It would also be naïve to believe protocol developers do not have their hands in liquidations given the fees in that cookie jar.

The point is, in current lending protocols the value the protocol captures is not making a difference to its token economy, and that is fundamentally a lost opportunity. Those token economies cannot develop underlying value. As a consequence, their market cap cannot be determined by underlying value and instead are based solely on sentiment. Worse still, it means such protocols are unable to grow market cap over time, which is a huge limitation. 

Now let’s get into why.

Transforming performance

As stated, tokens allow exchanges of value. When a token transfers fee value from the protocol to users, it transforms beyond being a simple incentive and acquires something rare – performance value. 

Performance value occurs when the activity of the protocol develops underlying value in the token. The better the protocol performs, the more underlying value it drives into the token. This shift is profound. Performance value positively impacts the protocol’s entire token economy, which is necessary if the protocol is to maximise its value for  users.

Value over cost

Performance value escalates ecosystem value generating traction, which is important. The underlying value the token develops allows it to generate powerful network effects, creating more value for the ecosystem than the token costs. Surplus value creation means the protocol can develop underlying value over time. The token, acting in its role as a spectator scorecard, will then reflect this in market cap. 

Effect more

Increasing performance value, having a token accumulate underlying value from protocol functions, generates a powerful new network effect. This network effect, in the form of a self-reinforcing flywheel effect where TVL drives market cap and market cap drives TVL, is exclusive to DeFi protocols. And as any student of platform architecture will tell you, what determines success above all things is network effects.

Oh, and all of this; it’s what Minterest does.

We’ll unpack more on how Minterest maximises protocol value in this series of mini deep dives. Later we’ll cover performance value and network effects and why they matter so much. For now it’s about tokenomics.

Next up is why circulating supply and market cap determine protocol success, and again the answers may not be obvious

07, November 2022