Tokenomics 2/2: Game Theory, Examples and Token Types

Tokenomics and Game Theory

Game theory was one of the most exciting topics for me in my economics studies because it is ubiquitous and applied in almost every aspect of life.

Sure, game theory is mostly used consciously in economics, but it plays a central role in tokenomics and cryto projects in particular. By definition, game theory is a branch of mathematics that studies strategies in competitive situations where the outcomes for the players involved depend critically on the actions of the other players. 

The basic assumption is that each involved party is independent and makes its decisions after weighing the expected costs and gains of its actions. The big question here is who has what information. The more clarity (transparent rules) and equal amount of information all players have, the better future actions of the parties can be predicted. 

So the reason why game theory is ideally suited for the blockchain world is because here, thanks to smart contracts and transparently communicated tokenomics models, the rules in the "game" have been clearly defined and all actors (should) have the same info. This is usually not the case in the real world, which is why those with more and better information can benefit more than everyone else. Research has shown that the better informed party in a deal usually gains up to 18% more economic advantage than the less informed party.

Arguably the most famous figure in the genesis of game theory is the American mathematician John Forbes Nash Jr. According to Wikipedia, Nash was also interested in physics and even recited one of his theories to Albert Einstein when he began studying at Princeton in 1948, but apparently at the end of the conversation Albert Einstein advised him "to study more physics" 🙂

Now, in relation to our topic of tokenomics, the theory of "Nash equilibrium" is probably the most important to understand. The so-called "Nash equilibrium" arises in a situation where no player can benefit from changing their own strategy, provided that all other players also remain true to their strategies. 

The famous example of the prisoner's dilemma helps to understand the concept of the Nash equilibrium. Two suspects are interrogated separately for a crime. If both confess, they get four years in prison. If neither confesses, each is sentenced to two years in prison. If only one confesses, he is released and the other is sentenced to six years.

What will happen now? What would you do? Why? 

The most important question here is: does everyone have the same information? And therefore: which option will they choose? 

The best outcome is that neither confesses. However, the game theory model predicts that both will confess because they have no information about what the other prisoner will do and therefore hedge their bets and both converge on the middle outcome.

Satoshi Nakamoto also indirectly refers to game theory in his bitcoin whitepaper in 2008: "If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back their payments, or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favor him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth."

Game theory is a branch of mathematics that studies strategic decision making. Tokenomics is the study of the design and use of tokens within distributed systems. Game theory is often used in the analysis of tokenomics as it helps to understand the strategic behavior of different players within a network and the potential outcomes of different token design choices. For example, game theory can be used to analyze the effects of token issuance, distribution, and incentives on the adoption and growth of a decentralized network. Additionally, tokenomics can also be considered as a form of game theory in practice, as it involves the design of rules and incentives to encourage certain behavior within a network. The goal of tokenomics is to create a balanced and sustainable ecosystem that aligns the interests of different stakeholders within the network and incentivizes them to act in the best interests of the network as a whole. 

Different types and use cases of tokens

When talking about tokenomics, it is important to understand that there are different types of tokens, which have different use cases, opportunities, rights, obligations and also risks. Tokens used in cryptocurrencies have value and can be traded, much like regular currencies. Tokens can be classified into one of two groups. They are "layer 1 tokens" and "layer 2 tokens."

Another categorization popular among crypto enthusiasts are "fungible tokens" and "non-fungible tokens." Depending on how they are used, the last categorization is also possible. They are DeFi tokens, security tokens or utility tokens.

Herewith a short and non-exhaustive description of different token types. 

DeFi tokens / fungible tokens / Cryptocurrency

After the crash of FTX, this type of token is probably known by many stakeholders. In the past few years, this new world of cryptocurrency-based protocols has emerged and has been growing quasi-steadily since then. A completely new market has developed as a result. DeFi stands for Decentralized Finance and is a blockchain-based financial system with the stated goal to replicate the functions of traditional financial systems, but in doing so to take a key stakeholder in traditional banking out of play - the intermediaries. From lending, saving, insurance to trading, DeFi coins enable virtually everything that the traditional banking world offers. DeFi Coins / Tokens or Cryptos are digital assets that can be bought, sold and traded with the so-called DApps. 

Cryptocurrencies can be used to pay for things or send things to someone. Probably the best known cryptocurrency is Bitcoin (BTC), which runs on the Bitcoin network, a decentralised network of independent nodes that confirm every transaction. Besides Bitcoin, Ethereum (ETH) is also a well-known example. 

Governance token

In the decentralized world of blockchain, projects often need ways to give more power and responsibility to certain users or sometimes even to all stakeholders. In order for the influence and governance of a blockchain project to really work, it is absolutely important to use a method that is most likely to ensure that only users who are seriously committed to the success of the crypto project participate with voting / governance power.

Governance tokens represent just such an opportunity. Governance tokens enable the creation of a special and possibly very promising (this is my own opinion and may of course be completely wrong) type of collectively managed organization known as a decentralized autonomous organization (DAO). Probably the most important aspect of this type of organization is that stakeholders/employees invest their own money in exchange for voting rights (sometimes in addition to traditional share certificates) to ensure that they all act in the best interest of the DAO and of course have maximum motivation to ensure that this DAO develops in a healthy, sustainable and successful way. In many cases, those who invest more money in a DAO then also have more voting rights than those who do not.

Governance tokens, per se, are a type of utility token that are issued to users to represent each person's stake in a DAO. Thus, governance tokens are basically tokens that give users the right to propose ideas on platform development and vote for or against other proposals. The suggestions can be about platform improvements, transaction fees, token release and burn schedules, or even highly impactful things like migrating to another blockchain platform.

The use of Governance Tokens in relation to the governance/management of a DAO can be roughly compared to the voting rights of corresponding shares in a company. However, probably the biggest difference compared to most voting shares is that a Governance Token can be used not only for voting at annual shareholder meetings, but also for all important decisions in the operations of a DAO. 

Sure, there are already very different models of DAOs today and also in how decisions are made (I'll write another blog post about that sometime). 

Utility token

Utility tokens are used in blockchain projects to exchange for various benefits within a project or platform.

Already, it's probably becoming clear that there are a lot of different potential use cases for this type of token. First of all, native tokens can be introduced so that the target audience can buy them to get access to certain services or goods. See the example of the Indu token, which we implemented for Indu4.0. 

Utility tokens are also used for staking and liquidity mining. In token staking, users buy or use existing utility tokens, which are then frozen (staked) for a certain period of time. Quasi as their use for staking. For the crypto project or the platform itself, this is a form of support and investment by the community. For the user, it is a way to earn interest through their stake (purchased tokens), which is usually paid out in the form of additional tokens. In contrast to staking, in liquidity mining utility tokens are lent to liquidity pools (not frozen as in staking) and receive project tokens as rewards or interest after a certain period of time.

Utility tokens are often used as part a platform's implementation of loyalty programs. Just as it works with many other loyalty programs in the retail sector, customers receive points for online purchases or for participating in special campaigns in the form of tokens, which they can collect and later exchange for discounts or even directly for the purchase of new goods.

Another use case, that can of course be combined with other added values already mentioned, is that utility tokens can be accepted for the payment of goods or services on the platform. This is also the case with the Indu token mentioned above. 

A description of the utility token that we helped to create for Indu4.0 AG is included in the following blogpost: Smart Contracts for the Manufacturing Industry

Non-fungible Tokens (NFTs) 

NFTs represent the holder rights in relation to a unique digital asset or an asset in the real world. It is precisely the "uniqueness" that is probably the biggest difference to DeFi tokens, which must be quite easily interchangeable. NFTs can be used, among other things, to manifest the ownership and originality of digital artworks and accordingly also to enable the trade of digital art. Here we often speak of an NFT marketplace, of which we have already been allowed to implement two cases: elementum.art and assembly.art. However, the possible fields of application of NFTs are versatile and are by no means limited to digital art. For example, other unique virtual assets such as sneakers, stamps, audio, etc. or even all purchasable digital goods in a metaverse or videogame can be implemented as NFTs. NFTs enable a clean process for buying and selling digital goods. 

Security Tokens 

Security tokens are a new category of assets that aim to be the crypto equivalent of traditional securities such as stocks and bonds. They are mainly used to sell shares of a company (similar to the shares or stock units sold in traditional markets) or other businesses (such as real estate) without having to use a broker. Meanwhile, there are reports that big companies and startups are looking at security tokens as a potential alternative to other ways of raising capital.

What factors determine the tokenomics of a cryptocurrency? 

The Tokenomics of a cryptocurrency describe the fundamental factors that influence the use and value of a token, and in this case define per se the economics of a token. Other important factors of tokenomics are the creation and distribution of tokens, supply (quantity) and demand, as well as incentive mechanisms as we explained in Tokenomics 1/2: The Basics of Token Economics Another important factor that has an impact on the token economics is the defined mechanism for token burning.

Basic tokenomics models

Such models assume a fixed supply of tokens, with less and less money being spent over time. Many popular cryptocurrencies are subject to this model, including Bitcoin, Litecoin, Solana, Tron and others. On the other hand, an inflationary tokenomics model can also be adopted when building a new token economy approach.

Examine token usage and value variables

Basically, it's important to recognize what a token ends up being. What role does the token play for this blockchain project, what purpose does it have and what functionalities does it offer. The following two graphics illustrate these three important aspects. 

Evaluating the token benefit - important questions

Below are a series of questions to ask yourself when evaluating an organization's token utility and its token economics model:

• Does the token grant the user exclusive access to the product or does it only grant them interaction rights?

• Does the token enable a governance activity, such as voting on a consensus issue or some other aspect of decision making?

• Does the token allow the user to participate in an action that adds value to the network or emerging market?

• Does the token confer any kind of ownership, real or proxy value?

• Does the token create a monetizeable benefit based on the user's activity (active work)?

• Does the token provide value to the user in exchange for providing or disclosing data of their personal Information (passive work)?

• Is the purchase of anything part of the business plan?

• Does the business plan include any aspect of selling something?

• Can customers develop new goods or services?

• Is the token required to run an oracle or execute a smart contract?

• Does the blockchain business require the token as collateral?

• Does the token have a purpose (or a derivative thereof, such as a stable currency or gas unit)?

• Is the token required to join a network or other connected entity?

• Does the token allow access and connectivity to real users (networking)?

• Is the token distributed for free or at a reduced price to encourage product use or trial?

• Is the token the primary medium of exchange and thus acts as its own currency?

• Are all internal transactions using the token (or a derivative thereof) recorded as the primary unit of account?

• Does this blockchain project automatically pay out a profit to token holders?

• Do token holders on this blockchain automatically receive other benefits?

• Is there a benefit associated with built-in currency inflation for users?

Example: Ethereum Tokenomics after the London Hard Fork and The Merge

Herewith a short summary of the London Hard Fork, The Merge and the resulting tokenomics of Ethereum. If you are interested in reading more details on these three points, follow this link: Ethereum: London Hard Fork, The Merge and PoS Tokenomics

The London Hard Fork

The London hard fork was a significant upgrade to the Ethereum blockchain in August 2021, which included the implementation of five Ethereum Improvement Proposals (EIPs). The most notable EIP was EIP-1559, which changed the way transaction fees are calculated and managed, reducing congestion and making fees more predictable.

Ethereum PoS - The Merge

The Merge and all upcoming upgrades is a development phase consisting of major upgrades to the Ethereum blockchain network that aims to improve scalability, security, and sustainability. The shift from proof-of-work to proof-of-stake mechanism will increase transaction processing capacity and introduce staking, allowing users to validate transactions in exchange for rewards.

Tokenomics of Ethereum PoS

The tokenomics of Ethereum PoS include, amongst others, proof-of-stake, Beacon Chain, staking rewards, and shard chains which aim to increase scalability, security, and efficiency while maintaining a fair and decentralized distribution of rewards.

Example 2: Solana Tokenomics Model

Solana (SOL) is a decentralized computing platform for running smart contracts, similar to Ethereum.

Solana launched its test network in February 2020. SOL is the name of the native coin of the Solana blockchain. Solana rewards validators with SOL tokens, of which there is a fixed supply of 272 million tokens. Through innovative ideas such as the combination of Proof of Stake and Proof of History, the system can perform up to 50,000 transactions per second at low fees. Solana seeks to balance inflationary and deflationary forces. However, the Solana model projects that these forces will normalize over time, reducing inflation to 1.5% over a ten-year period. To offset this projected inflation, deflationary forces are simultaneously at work, which include the burning of a percentage of collected tokens for network fees. This transaction-driven deflationary model offsets the ongoing inflation driven by the validator block reward structure.

Here you can find the Solana whitepaper that includes more information about its tokenomics.

The following video explains how the „Proof of History“ algorithm works.

Details on the Solana Inflation Design Overview can be found in their forum.

Recap of this part of Tokenomics blog series

Designing crypto tokenomics is a challenging and success-related task, as it requires extensive knowledge of blockchain technology, the different types of tokens, their minting processes and any rules, as well as advantages and risks of individual models and distribution models. Per se, there is great value in understanding how tokenomics works in general. However, to optimally define the tokenomics of a new project as a layperson is a very big challenge. Fortunately, however, there are some good service providers on the market who can provide you with advice or very active support in this task. If you would like to receive this help from us, you can contact us at any time. Next blogpost about this topic will provide your with a seven step guide on how to define the tokenomics for your next blockchain project.