Blockchain protocols and cryptocurrencies can be valued in multiple ways, but a project’s “tokenomics” and value capture are front and center of the discussion. Crypto tokenomics refers to the economic principles and design of a cryptocurrency or token. It includes the total supply, distribution, and use of the tokens within a blockchain network or ecosystem. Tokenomics can also include the way in which tokens are created, distributed, and used to incentivize network participation, such as through mining or staking rewards. It plays an important role in the overall design and functioning of a blockchain or cryptocurrency project.

A well-designed token economy can help a project grow by creating a positive feedback loop where the value of the tokens increases as the project becomes more successful. However, the success of a project ultimately depends on the strength of the product or service being offered. Tokenomics can be affected by changes in the distribution of tokens, such as the shift from initial coin offerings (ICOs) to more professional investors having a larger share of tokens.

In addition, tokens can also be used for governance, allowing holders to vote on important decisions for the project. However, the lack of clear regulations and best practices for tokenomics can create challenges for established companies. They have to navigate the uncertain regulatory environment and exploit risk from new tokenomic models, and greater visibility of these firms keeps them trapped in the status quo.

Inflationary Rewards

Blockchain token prices are dependent on their supply and demand, both of which are affected by many factors, such as the token issuance rate, owner/VC vesting schedules, and revenues earned by token holders or stakers.

On the supply side, token issuance in protocols can cause inflationary pressure on the token price. Inflation for cryptocurrencies is an increase in the number of tokens in circulation, either through mining or issuance with a fixed schedule.For example, Bitcoin has a current supply of ~19.2 million and a supply cap of 21 million. The hard-coded and immutable supply schedule with its infamous “halvings” create supply inflation of 1.8% annually. These factors play a major role in making Bitcoin disinflationary as it approaches its 21 million ceiling.

Another example of a higher inflationary network is Solana. Solana’s initial inflation rate is 8% and decreases by 15% each subsequent year until reaching a final, fixed 1.5% inflation rate. Solana’s long-term inflationary goal is aimed both at supporting sustainable growth for its ecosystem and at rewarding stakeholders in proportion to the SOL they staked.

While protocol inflation and staking rewards are commonplace and a key part of any crypto asset’s most fundamental design, crypto users often only see it through a particular lens: a yield for holding the token.

Yield

Yield is the percentage return generated by deploying capital into specific strategies. Yield can be generated at the protocol level by participating in staking but is also a primary driver of DeFi adoption. Most often, yield is displayed as simply one number on a screen. However, as this piece will illustrate, there are many variables that go into that one number, as well as, many different types of yield.

DeFi Total Value Locked (TVL) is closely connected to the yield rates offered by DeFi protocols. Investors can provide capital to DeFi protocols and earn returns for doing so. There are various sources of yield in DeFi, such as lending protocols that charge interest and give those interest payments to liquidity providers.

When yields are high, investors tend to deposit more capital in DeFi protocols to earn higher returns. Conversely, when yields are low, investors tend to move their money to other opportunities where they can get better returns. This can be seen in the chart mentioned, where a decrease in median DeFi yield at the start of 2022 was closely followed by a steep drop in DeFi TVL. This indicates that investors are closely monitoring yield rates and adjusting their investment strategies accordingly.

In DeFi, there are two primary types of yields that can be generated from the deployment of principal tokens: token-agnostic yields and token-specific yields.

token-specific vs token-agnostic table — Source

Token-specific Yields

In the realm of cryptocurrency, there exist three primary types of token-specific yields:

Network Staking Emissions: Yields (at the protocol level) that are distributed to validators or delegators who contribute to the proper functioning of blockchain middleware
Token Holder Rewards: Yields (at the protocol level) that are provided to individuals who stake or hold a specific token
Participatory Rewards: Yields that are awarded to users who actively engage with and utilize a particular project (ex: DeFi or airdrops)

It is important to note that the yield properties of these token-specific yields are project-dependent and as such, realized returns can vary greatly. The yield that is accrued over time is hypothetical and denominated in the project's token price. It is only realized through the act of selling from one party to another. Therefore, there are underlying assumptions that must be met in order to realize the yield, such as the ability to sell on the open market, zero price movement, and the proper functioning of underlying mechanisms.

As an example, staking ATOM, as of January 2023, offers a nominal 22% staking reward. This sounds incredibly attractive, especially if you are bullish long-term on the ATOM token. However, that 22% ROI is not net ROI. We must account for the token inflation that is subsidizing those rewards, staking fees, lock-ups, and token price action.

Once taking into account dilution via token issuance, the net ROI on staking ATOM is closer to ~6%. So, staking rewards are closer to 6% minus the fees if a user chooses to delegate. This is competitive with other top PoS protocols like Ethereum and Solana and forces the user to take into account opportunity cost. If the ROI is similar, which crypto asset would you rather hold/will maintain its value?

This is also where a user has to determine if staking/locking up the coin for whatever period (variable across protocols) is worth dealing with the price action. Most crypto assets are down ~70-80% from their ATHs. It is probably not a stretch to assume that many of those holders would have preferred to just sell rather than get 3-7% net staking rewards. However, because staked tokens are locked up, this not only adds another point of friction in selling, it impedes a user’s ability to sell at the opportune moment.

Token Holder Rewards and Staking Emissions: A Closer Look with Ethereum

In the case of Ethereum, ETH holders can stake their ETH to help provide crypto-economic security to the network. For this act, stakers receive their proportion of the network’s inflation plus transaction fees. In Ethereum, one must stake 32 ETH to become a validator.

A validator is a person or entity who locks up (stakes) 32 ETH in order to run a validating node and secure the Ethereum blockchain. Validators are “are “entities responsible for ordering and packaging transactions into discrete data structures called blocks which are then proposed to the network to validate.” This means rather than relying on energy/electricity for security, as is the case in PoW, Ethereum security will rely upon staked capital. With PoS and staking rewards, ETH becomes a productive capital asset with yield as well as money underpinning network transactions and executing smart contracts.

The launch of Ethereum’s Beacon Chain in December 2020 marked an enormous milestone that has been on the roadmap from the early stages of the project in 2015 and has already become the largest, most decentralized PoS blockchain with ~500,000 validators.

There are several different ways a user can stake ETH. The most autonomous and preferred method is to personally run a staking node. However, this requires at least 32 ETH plus some intermediate technical knowledge of the protocol, nodes, and computer hardware.

However, there are other types of staking:

Centralized exchanges: High trust assumptions. Not your keys, not your coins.
Staking as a service and LSDs: Non-custodial. Entrusted node operation.
Pooled staking: Stake any amount, Earn rewards.

Over $26B worth of ETH has now been staked! Some stats on network progress:

ETH deposited to deposit contract: ~16,300,000+ (~13.5% of all ETH)
Current staking yield: ~5.5%
Active validators: ~500,000
Pending validators: ~50,000
Network participation rate: 99.0%

Too Much of a Good Thing?

In some instances, token-specific yields may contribute to the downfall of a project through heavy emissions that dilute token value or act as an inflationary mechanism for a failed project structure. Conversely, in other instances, project-specific yields may help to establish real demand, leading to the growth and success of the network.

It is crucial to evaluate not only the potential returns of a cryptocurrency token but also the source and sustainability of those returns over the long term. Inflating the token's supply excessively in the long term will ultimately lead to a decline in value, assuming a fixed market cap limit. In order to ensure long-term sustainability, L1 blockchain networks must generate enough fee revenue to cover the cost of maintaining network security through validator issuance. This is also in the best interest of the users, who are often the owners of the network.

A blockchain that is unable to generate enough revenue to cover validation costs will ultimately become financially unstable and unsustainable over time. This is due in part to the fact that validation costs are proportionate to the market cap, rather than a fixed expense, making it difficult for networks to grow without also increasing revenue in proportion to the market cap.

DeFi really exploded starting in Q2 2020, sometimes called “DeFi Summer,” in which DeFi projects saw massive adoption and usage growth. The increased adoption was sparked by a new bootstrapping mechanism called liquidity mining/yield farming in which users supply liquidity to the protocol (i.e., lend their funds) and are, in turn, rewarded by the protocol in a native token. One of the first DeFi experiments in liquidity mining was by Synthetix in 2019, which later inspired a wave of yield farming projects in 2020, most notably after Compound Finance enabled liquidity mining of COMP tokens in their borrowing and lending markets. However, this mechanism only works if new users are compensated with high returns stemming from high protocol inflation.

The protocol is essentially “buying” users in the early stages with the hopes they remain sticky, and the protocol matures with a solid user base as the rewards eventually decline. As the image below illustrates, it is not uncommon for even household name dApps to inflate at 10%+ in order to entice liquidity to their project. Unfortunately, threading this needle for dApps has proven difficult as users have proven time and again not to remain loyal to the protocol. Instead, moving their funds to whatever new protocol is offering higher rewards at that moment.

On the other hand, token-agnostic yields are generally more predictable but will typically have lower return potential. It is akin to selling shovels in a gold rush as opposed to identifying a metal that appreciates in value by 1,000x.

Lock-up and Vesting Schedules

Finally, one more aspect of a token’s tokenomics is the available/circulating supply. When evaluating the performance of decentralized finance (DeFi) tokens and forecasting future performance, it is crucial to consider the distribution of tokens held by treasuries, developers, and early investors. Many tokens have a lock-up period where certain individuals are granted early or discounted access to purchase the token, with the condition that these tokens must be held for a specific minimum period. The number of tokens held in lock-up can have a significant impact on the markets, particularly if token holders seek to liquidate their holdings.

Solana unlock headline — Example headline in the past over concerns from a Solana unlock. Source

dydx unlock headlines — A recent example of simply *delaying* an eventual unlock resulted in a ~20% increase in token price. Source

Cryptocurrency projects often employ smart contract technology to facilitate token vesting. This process utilizes smart contracts to automate the transfer of assets once specific predefined conditions have been met, similar to how a vending machine releases a product once the appropriate amount of payment has been received.

Token vesting serves to establish a clear timeline for token issuance and accessibility. Tokens that are vested are locked within a smart contract, thereby eliminating the ability to sell the token during a designated lock-up period. The use of smart contracts in token vesting provides a high degree of rigidity and, as long as the code has no bugs/backdoors, investors can rest easy knowing those assets cannot be accessed. Once the contract is deployed, the lock-up conditions cannot be changed by the deployer or any other external party, and must be fulfilled before the tokens can be released from the contract.

There are different approaches to token vesting, all with their own pros and cons depending on the project and which side you're on (the team vs. retail investor). One of the most straightforward options is immediate vesting, where employees/investors receive 100% of their shares right away. This is typically used for long-term employees who are not expected to leave the company in the near future.

Another popular vesting schedule is linear vesting, where employees gradually earn ownership of a percentage of their shares over a set period of time. For example, in a five-year linear vesting schedule, a team member would earn 20% of their shares after the first year, 40% after the second year, 60% after the third year, 80% after the fourth, and 100% after the fifth year. If the employee leaves the company before the vesting period is over, they will only retain the percentage of shares they have earned up until that point.

A reverse vesting plan also exists, where an employee is given all shares upfront but the company has the right to buy back any unvested shares if the employee leaves early. This plan is less common but can be useful for companies that want to retain key employees.

Finally, there is cliff vesting, where shares cannot be awarded before a certain date. For example, a common vesting schedule might include a one-year cliff followed by four years of linear vesting. This plan is popular among startups as it helps retain employees as the company grows.

One metric that can be used to estimate the percentage of supply that is not actively traded is the 1-year active supply percentage. Below are examples of certain DeFi tokens and their one-year active supply changes. As the chart illustrates, the “float” (discussed below) can vary wildly in just as little as one year. Balancer’s supply (dark blue) went from ~63% at the start of 2022 to ~87% by year's end!

Another measure borrowed from traditional financial markets, which can help to estimate the potential future risk of a large asset holder liquidating their tokens and causing significant volatility and price swings, is the float ratio. This ratio refers to the share of assets that are available for trade on the market. In the context of DeFi tokens, the float ratio can be used to protect investments from volatility by identifying tokens with a low float ratio.

Token-agnostic Yields

Token-agnostic yields are independent of the presence of a project token and are derived from direct exchanges of value between parties. This is similar to cash flows in traditional web 2.0 systems. On the other hand, token-specific yields must be issued directly from a project treasury and are subject to the structure determined by holders or founders. These yields contribute to an ongoing circulating supply that dilutes holders and cannot be controlled or distributed without a token. This is analogous to marketing and customer acquisition costs in web 2.0.

token-agnostic yield diagram ELI5 — Source

There are four main types of token-agnostic yields: network staking fees, lending, liquidity provisioning, and counterparty liquidity. Network staking fees are generated by delegating tokens to or running validators that secure and moderate blockchain middleware. Lending yields are generated by providing a token and allowing others to borrow it. Liquidity provisioning yields are generated by providing token(s) and allowing others to trade or utilize them. Counterparty liquidity yields are generated by taking one side of a trade, such as shorting volatility, and earning yield or losing principal depending on the outcome.

It is important to note that liquidity provisioning carries a high degree of principal price risk, as impermanent loss amplifies the potential for principal value loss. Additionally, the total return potential for liquidity provisioning is capped as liquidity providers (LPs) tend to purchase the cheaper asset as the other one grows in price. The yield return ceiling is typically lowest with lending. However, they are easier to predict, and lenders are less susceptible to borrower default. Additionally, LPs and those acting as counterparty liquidity are at risk of having a portion of deposited principal acquired by arbitrageurs or profitable counterparties.

The rate of yield for token-agnostic yields is determined by demand and supply, with higher rates for capital deployers when there is greater demand for access to a use case. The yield-earning mechanism is not unique and is similar across various platforms. Additionally, yield rates are also broadly similar across platforms. Token-agnostic yields are realized over events or epochs and can be accessed by either directly being a capital deployer or holding a project token that has claim to protocol cash flows.

Components of Net Yield: the Principal and the Yield

To further understand yield in crypto and DeFi, it is essential to consider two critical components: the principal asset and the yield earned. In general, there are two types of principal assets and two types of yield. The principal assets can either be in the form of crypto assets or cash, and the yield can either be in the form of interest or appreciation in the value of the principal asset.

Liquidity mining, for example, can be considered a use case that generates yield through interest on cash deposited into protocols and pools as a liquidity provider or lender. On the other hand, yield farming can be considered a use case that generates yield through appreciation in the value of crypto assets deployed passively or productively.

Overall, the use cases within the DeFi ecosystem provide a range of opportunities to generate yield through various strategies and deployment of capital. Understanding the underlying mechanics and potential risks associated with each use case is crucial for effectively generating real yield in the DeFi space.

In the decentralized finance (DeFi) ecosystem, there are two main types of principal assets that can be deployed to generate yield: price-stable and price-fluctuating.

Real Yield

(Most) DeFi protocols that have sustained usage are designed to generate revenue. These revenues suggest that blockchains can generate cash flows similar to traditional businesses. These revenues represent one form of “real yield” that blockchains produce. Using protocol revenues lets us find price/earnings per share (P/E) and price/sales (P/S) ratios, which can be used to compare blockchains.

Real yield is an emerging trend in DeFi, taking inspiration from the concept in Traditional Finance (TradFi) but with some strong distinctions. During DeFi summer, many individuals had the opportunity to take advantage of yield farming - often lucrative APYs earned from protocols encouraging individuals to stake their native token by issuing their own token as interest. While incentivizing users to purchase and stake the token, it also had the opportunity to lead to rapid devaluation of the token itself through the increased supply exposing stakers to inflation.

In TradFi, real yield is calculated by subtracting the cost of inflation from the nominal returns, for instance, a bondholder may receive. In DeFi, real yield is the process of rewarding users of a token in another denomination, such as ETH or USDC. Real yield can be derived from a variety of use cases that currently exist within the DeFi ecosystem. These use cases include liquidity provision, token swapping, directional trading, borrowing and leverage trading, yield farming, staking, depositing capital, and securely storing crypto assets.

With interest rewarded to stakers obtained potentially through trading and transaction fees from the platform, it has the opportunity to incentivize staking while minimizing investor exposure to token inflation. As with any other innovation in a quick-moving environment, it doesn’t come without its own risks though.

Risks with Real Yield

Primarily, the borrowed term from TradFi could be misleading to new investors unfamiliar with the DeFi distinction as a project may have the opportunity to tout its real yield APY as a good protected investment while real yield itself doesn’t natively protect against token inflation. For example, while real yield directly accounts for inflation in TradFi, in DeFi, a project could reward stakers using dividends in the form of other tokens while simultaneously increasing the supply of their own and maintaining a high DeFi real yield. Unless the project simultaneously guarantees to reduce token supply increases, the staked tokens of the investor may still be exposed to inflationary loss.

Further, it could diminish the project’s long-term viability. Traditionally, young companies defer paying dividends to stakeholders and instead reinvest profits to grow themself and ensure a sustainable, successful corporation. As the majority of the projects in crypto are new, and still establishing their product, paying out dividends at such an early stage of a project’s life cycle has the opportunity to deplete its treasury. One analysis done in Q3 2022, found that only ~six DeFi protocols offered real yield, and just two were doing so in a sustainable manner.So while real yield may show promise in the short term as a way to attract and protect investors, it also has the opportunity to diminish the long-term viability of a project.

Finally, borrowing a concept from TradFi may also make it clearer to regulators how to label different tokens. This could potentially lead to these tokens being labeled as securities, but would no doubt have an impact on the decision making. Regardless, real yield is an interesting recent development in DeFi that will be a player to watch in the projects that have already implemented it.

P/S

Now that we have established the types of yield a project can produce, we are now able to measure this return and begin to form valuation metrics. One such method is applying the concept of the price-to-earnings (P/S ratio) used in TradFi to blockchains. Investors can use this ratio to determine whether a blockchain is fairly priced by comparing its P/S ratio with blockchains of a similar function. For example, L1 blockchains can be compared with one another, as well as among dApps and between DeFi protocols. The P/S ratio is most suited for blockchains that are profit-seeking, such as DeFi protocols, which can earn high-interest income from user borrowing in the protocol.

Unlike traditional companies, blockchain protocols do not have shares, so we can manipulate some variables to create a more useable equation:

The fully diluted market cap, which we use for the P/S ratio, is conventionally calculated as the max supply of coins multiplied by the price. Total earnings represent the annual total revenue that goes exclusively to the protocol itself, which can also be defined as profit. A higher P/S ratio suggests that the project is more overvalued, while a lower P/S ratio suggests that the project is more undervalued.

This chart shows the P/S ratios of many major, leading L1 and L2 blockchains. These ratios are far higher compared to stocks in traditional markets. The average P/S ratio among these blockchains is far greater than the average P/E ratio of 29.1 for the S&P 500. All of these blockchains have a P/S ratio of over 100x, and more than half have a ratio of over 1000x. Cosmos sticks out with its extremely unusual P/S ratio of over 200,000. This is due to all the factors that affect the ratio. Cosmos has a very low annual profit, in the thousands, while its total token supply and price are very high, which means its market cap is high. Cosmos’s low profit and high market cap give it such a high P/S ratio.

The diluted market cap we use equals the max supply of coins and not the circulating supply. This means that, theoretically, protocols without a set max supply could have comparatively lower ratios and seem less overvalued because of their artificially lower market caps. For example, Ethereum has a P/S value of just 140.6, much lower than the other L1 blockchains. However, this correlation does not always hold, since Algorand also does not have a max supply but is relatively overvalued with a P/S of over 16,000.

Though the P/S ratio bridges the relatively new blockchain space with a more familiar stock market, it does not work perfectly for blockchains. Not all blockchains produce profits, such as Bitcoin, so these ratios cannot be used for all blockchains. In addition, revenues in blockchains are typically denominated in cryptocurrencies, which have historically been very volatile. The P/S ratio can be used to casually compare similar blockchains but should not be used as part of an investment thesis. The use case, roadmap, and management are more important qualitative measures to consider to better evaluate a blockchain.

defi valuation P/E — An attempt to view crypto protocols as revenue-generating businesses. Source

P/E

The P/E ratio is defined as the market cap/protocol’s annual revenue (revenue = protocol fees earned). The only difference is that the denominator for P/E (annual revenue) includes revenues that go to token holders, rather than just LPs that are yield farming. If all revenue goes to the protocol, then the P/S ratio will be the same as the P/E ratio. Investors can compare these ratios between different blockchains to determine how appropriate the price of the protocol and its tokens are, relative to its total revenue.

PARPU

One final metric used to determine the value/profitability of a DeFi protocol is the Protocol Average Revenue Per User (PARPA). As the name suggests, it is “An indicator of the profitability of a protocol based on the amount of money that is generated from each of its users.” As the table below shows, there is a wide distribution among DeFi protocols, with yield aggregators such as Yearn and Convex boasting ~10x the revenue per user compared to DeFi stalwarts Maker and Curve.

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