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Blockchain-Based Token Supply Control Mechanisms

by Brian Tinsman

The most famous chart in economics tells us that market price is a function of supply and demand. Good token economics design involves driving demand with fundamental value, but also carefully managing the supply side of the equation.

Why Control Supply of DLT Tokens?

A company with a utility token might want to use supply controls to mitigate the burden of market volatility on users. Or a company issuing a fund-raising token might want to give investors confidence that there are some protections against price crashes. Or, an ecosystem that pays service providers with tokens may need to ensure those providers are fairly compensated.

Companies that launch tokens into an ecosystem have a lot of supply control mechanisms to choose from with different effects on the resulting token economy. Here are some of the most important mechanisms taken from the plentiful examples we can see today.

Hard Cap

Example: NEM

You probably know this one, but it’s here for completeness. A hard cap means there is a fixed amount of tokens that can ever be issued, and it’s baked into the protocol. A fixed supply provides a simple answer to investors who are concerned about inflation diluting value - there isn’t any inflation. A hard cap is a given for almost every project that sells tokens to raise funds, but it does involve trade-offs. Inflationary systems can compensate for deflation, such as happens with lost private keys. Controlled inflationary mechanisms can also reward miners or investors, and otherwise drive good economic policy. There is a reasonable middle ground between no inflation and uncontrolled inflation.

Reserves

Example: Ethereum

Companies that issue tokens often keep some for themselves. The reserves may be held to sell for future funding, but sometimes they are held for the option to increase the circulating token supply as needed. (Or reduce the rate of circulating supply increase.) They might do this if there’s not enough economic activity, or if there is too much price volatility, or (rarely) to suppress price spikes. This is the main way many national federal reserve banks control their fiat money supply, although in most cases, governments simply create new money instead of spending reserves.

Inflation

Example: Bitcoin

Any token that has ‘mining’ has some form of inflation. This is a predictable increase in the token supply over time. This isn’t a mechanism for actively controlling price, but it is something economic analysts look at to make sure it’s not set too high. Some tokens like Bitcoin use totally algorithmic inflation. Algorithmic inflation may reduce or vanish with time, or may be controlled by demand for the token as with many stablecoin systems. Or, inflation may be set by governance and economic policy, central-bank style.

Lockups

Example: Ripple

Lockups are a way to take tokens out of circulation, reducing supply until some specified time. Ripple’s parent company held a huge amount of their token in reserve, making users nervous that they had the power to crash the market at will with a big sell-off. In response, Ripple put a large portion of their reserves into storage, making it inaccessible over a series of years. Smaller fundraising tokens also usually have investor lockup requirements, ensuring that investors are committed to the project’s success for a number of months or years and again making a big market dump more difficult.

Node Staking

Examples: Dash, Zcoin

A variant of lockups is staking. Staking provides an incentive to voluntarily remove coins from circulation. With node staking, users who maintain a balance of 1000 or more DASH in their account are eligible to process transactions and receive mining rewards. In fact, 58% of all DASH tokens are currently locked up in masternodes. ZCoin is another masternode system with 65% of its supply locked up in stakes to earn rewards. It’s easy to imagine that without these reward systems the prices of these tokens would be a lot lower.

User Staking

Examples: EOS, Decred

Another variant of lockups is staking as a form of payment. Most smart contract platforms require the contract issuer to pay tokens to the network in exchange for executing the contract. EOS’s system requires issuers to lock up tokens as a form of payment for contract execution. The issuer gets the tokens back when they remove the contract, but if usage grows the issuer will have to lock up more tokens. This is an interesting approach, since more network usage will make the supply go down, possibly amplifying the impact of adoption on price.

Decred has a different user staking system that lets users buy tickets that give the holder voting power and other rewards. Their coins are returned to them after they expire.

Vesting and Transaction Penalties

Examples: NEM and Skycoin

Some token systems give users ongoing rewards for keeping tokens in wallets for a long time or impose penalties for taking coins out. NEM’s system allows token holders to collect rewards, but only after their tokens are vested, which entails keeping a minimum balance of tokens untouched for a few weeks. Skycoin has a mechanism in which Skycoin holders slowly earn CoinHour tokens, which they can sell to network users. However, any time that wallet sends a Skycoin transaction, it loses half its CoinHours. This means if you aren’t a network user it’s best to refrain from frequent trading (effectively keeping tokens out of circulation.)

Buybacks and Burning

Examples: Binance, Iconomi

A policy of buying back and/or burning a certain amount of tokens on a specified basis acts like the opposite of inflation. Token holders like the idea that supply will slowly go down over time, increasing their share of the total. Each quarter, Binance uses 20% of its profits to buy back and burn BNB tokens. Notice that whenever a company does this, they try to get as much publicity as possible.

And All the Rest..

There are many more supply control mechanisms in the marketplace and research is underway to understand and design the best ones, including multiple-token systems and cap systems that sit on top of existing tokens.

In the meantime, we still haven’t seen full optimization of the common mechanisms above. All of these supply controls are tune-able, and many are tune-able well after launch, allowing the company to respond to the changing needs of the economy. In many cases it can be a good idea to build in mechanisms as an economic failsafe, even if you don’t intend to use them aggressively.

Here at He3Labs, we often create models or simulations of economic systems that use supply mechanisms like these, selecting those that suit the business, investor, and legal requirements at hand. This type of modeling can help reveal which supply controls may be most effective for your ecosystem’s needs. It’s great to tweak parameters like lockup periods or interest rates and instantly see how the economy changes within the model. This represents a practical method for getting closer to the right optimization or tuning of a token economy.