DeFi Tokenomics: Economics of Decentralized Finance

​I. Importance of tokenomics in DeFi

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“Tokenomics” is the term derived from the words “token” and “economics”. Tokenomics in most projects define its ecosystem together with the success and sustainability of the projects. While being the backbone of most projects, tokenomics is also an important concept from investors to consider when making an investment decision. Tokenomics of the projects that grant well-deserved incentives to holders are potentially more attractive to investors and, therefore, will be able to boost its credibility with use cases on the platform. As the demand sours, so the prices of the tokens.

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Overall, tokenomics grants price stability which can be achieved through mechanisms such as token distribution, token burning and token buybacks. At the same time, it also promotes token economy by rewarding users for contributing to the network resulting in a strong community. And by having a solid tokenomics, the platform can ensure sustainability through governance tokens which can be used to allow token holders to vote on proposals and steer the project to the right direction.

II. Understanding DeFi Tokenomics

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Tokenomics refers to the economic principles governing the supply and demand characteristics of a cryptocurrency project. Tokenomics sets up the economy of a crypto project by creating incentives for token holders and defining the utility of the tokens, which is a major factor behind their demand.

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To influence various facets of tokenomics, developers play with various variables such as the following to control the price of the tokens:

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Supply: Supply directly affects the price of the tokens and is a major criterion in tokenomics. Minting of new tokens adds new tokens into the circulating supply and, therefore, decrease the value of the tokens overall

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Token allocations: Showing detailed token allocations to the public is a norm in crypto projects. These allocations help investors to understand the budget in which the tokens to be spent on and also boost the projects’ credibility

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Earnings: Tokens can be rewarded to participants via many ways. Mining and staking incentivize miners and validators with tokens, respectively. Yield farming enables anyone holding crypto to earn additional tokens by lending their funds via smart contracts.

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Token burns: Token burns are used to permanently remove tokens from circulation to prevent inflation, which can increase the price of the remaining tokens.

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III. Factors Affecting DeFi Tokenomics

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Crypto tokens can have a wide variety of properties and functions. In DeFi, tokenomics refers to the way tokens are designed and used within decentralized finance protocols. Here are some key concepts in DeFi tokenomics:

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Store of Value: tokens can be bought and sold like any other currencies and have their own value based on damand

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Token distribution: Token distribution refers to the initially created and distributed tokens among users. There are several methods to distributing tokens such as initial coin offering, airdrops, or liquidity mining

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Token supply: The total supply of tokens has significant impact on the tokens’ prices. Tokens with a vast total supply unmatched with low demand can lead to a decrease in value over time.

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Utility Tokens: Some crypto tokens are designed to have specific functions within a platform and can be used to reward participants to promote a stable community

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Governance Tokens: Some crypto tokens are used to govern decentralized systems or organizations. Holders of these tokens may be able to vote and have a part in steering the direction of the project

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Staking and rewards: Most DeFi platforms allow users to stake tokens in exchange for rewards, rewarded in platform’s native tokens, such as a share of transaction fees or newly minted tokens. This incentivizes users to hold and use the tokens, which can help to increase their value.

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Liquidity: In DeFi, liquidity is crucial for the functioning of markets. Higher liquidity of the tokens can refer to more attraction and value

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Generally, the properties and functions of crypto tokens can vary widely depending on the project and its intended use case. Please be noted that some may not cover any properties and functions mentioned at all and are mainly created for a speculating purpurse.

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IV. Case Studies on DeFi Tokenomics

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In this part, as examples, we give analysis on Uniswap and Pancakeswap’s tokenomics and make a comprehensive comparison between the two as case studies:

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A .Uniswap

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Uniswap's token, UNI, was launched in September 2020, and it serves as the governance token of the Uniswap protocol. UNI has a total supply of 1 billion with the allocation listed as below:

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Community members: 60%

Team members and future employees: 21.5%

Investors: 18.5%

Advisors: 0.01%

UNI holders have the power to propose and vote on governance proposals, such as changes to the protocol's fee structure or updates to the user interface. Holders can also earn a share of the 0.05% fee charged on each trade on the Uniswap platform by staking their UNI tokens in the liquidity pools.

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Uniswap's tokenomics model is unique in that it has no pre-mine or ICO, and it is entirely community-owned and operated. Additionally, the team has committed to a four-year vesting schedule for the team and investor allocations, ensuring long-term alignment and commitment to the project's success.

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One potential concern with Uniswap's tokenomics is the large allocation to team members and investors. While this allocation is subject to vesting schedules, it could still lead to a concentration of power and potential conflicts of interest. However, the team has shown a commitment to transparency and community governance, which may mitigate these concerns.

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Overall, Uniswap's tokenomics model is well-designed to incentivize community participation and align incentives between stakeholders. Its unique approach of being entirely community-owned and operated sets it apart from many other DeFi projects, and its commitment to transparency and governance suggests a strong focus on long-term success.

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B .Pancakeswap

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PancakeSwap (CAKE) is another popular decentralized exchange built on the Binance Smart Chain (BSC) and has a market cap of around $4 billion.

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CAKE is the governance token of the PancakeSwap platform and is used for various purposes like staking, voting, liquidity provision, and yield farming.

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The total supply of CAKE is capped at 210 million with the allocation listed as below:

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Community members: 40%

Team members and advisors: 25%

Ecosystem development: 15%

Foundation and private investors: 10%

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Similar to Uniswap, PancakeSwap uses a 0.2% trading fee on each trade that goes directly to the liquidity providers. Moreover, PancakeSwap also distributes CAKE tokens as rewards to liquidity providers and stakers.

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One unique feature of PancakeSwap is that it uses a Burning mechanism, which means that a portion of the trading fees collected by PancakeSwap is burned, reducing the supply of CAKE over time. This creates a deflationary effect on the token, increasing its scarcity and potential value.

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Another interesting feature of PancakeSwap is its prediction market, called PancakePrediction. This allows users to earn CAKE tokens by correctly predicting the outcome of future events.

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Overall, PancakeSwap's tokenomics is focused on incentivizing liquidity provision and staking, creating a deflationary effect through its burning mechanism, and providing additional use cases for the CAKE token through governance and prediction markets.

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C .Comparative analysis

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The two popular decentralized exchanges (DEXs) built on different blockchains. While Uniswap is built on Ethereum, PancakeSwap is built on Binance Smart Chain (BSC). It’s noted that Uniswap has a larger market share, higher trading volume, and more diverse liquidity pool due to its longer history and larger user base. However, PancakeSwap has lower fees, faster transaction times, and more accessible user interface, making it more attractive to new users.

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In terms of tokenomics, Uniswap's UNI token has a deflationary model, with a portion of the fees collected from trades used to buy back and burn UNI tokens. On the other hand, PancakeSwap's CAKE token has an inflationary model, with new CAKE tokens minted as a reward for liquidity providers and stakers.

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In terms of cash flow, both Uniswap and PancakeSwap generate revenue from trading fees. However, Uniswap has a more established market and higher fees, resulting in higher cash flow.

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Regarding moats, Uniswap has a first-mover advantage and network effect due to its larger user base and diverse liquidity pool. PancakeSwap, on the other hand, has lower fees and faster transaction times, which could attract more users in the long run.

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Overall, Uniswap and PancakeSwap are both solid investment choices in the DeFi space, each with their own strengths and weaknesses. It ultimately comes down to the user's preference in terms of blockchain platform, user interface, and tokenomics.

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V. Conclusion

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In conclusion, tokenomics is a crucial concept in decentralized finance, and it helps to define the success and sustainability of projects. DeFi tokenomics is influenced by various factors, including token distribution, utility tokens, governance tokens, staking and rewards, and liquidity.

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While the prices of tokens fluctuate from demand and supply, Developers can also control the prices through various variables.

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Case studies on Uniswap and Pancakeswap show that a well designed tokenomics model can incentivize community participation and align incentives between stakeholders which creates more cashflow and bring sustainability to the project.