Why you should know the token's inflation before investing in it

If you buy tokens of a particular protocol, you would prefer that the tokens do not lose value over time due to an increase in the supply of the token.

Even though this sounds logical and straightforward, investors still invest in (high) inflationary protocols, where the circulating supply starts out low but a lot more tokens will become unlocked and released in the market. As a token holder, this means that your ownership percentage will get diluted over time. So, investing in an inflationary token only makes sense when demand pressures outweigh the supply pressures in the long-term.

To make an informed investment decision, it's crucial to investigate the dilution effect of inflation on your (potential) investments.

In this article, you will:

1. learn the relevant drivers behind token inflation;

2. learn whether the burning mechanism is effective to mitigate token inflation;

3. gain insights from comparing different tokens on their token inflation models;

4. receive a checklist that you can use to be best informed on the token inflation before investing in a token.

Token inflation at a glance

It's important to note that token inflation is different from the inflation of fiat currencies, which is primarily influenced by factors like monetary policy and economic conditions. The specific rules and mechanisms within the smart contract(s) of each cryptocurrency's protocol govern token inflation. Hence, tokens might be designed as inflationary to incentivize participation, reward holders, or fund network development and maintenance.

However, if the demand for the token does not increase at an equal rate at which there is supply, then the price will go down assuming all other factors remain constant.

Understanding the drivers behind token inflation

There are three main drivers of token inflation:

• Linear unlocks;

• Vesting schedule (Cliff) unlocks; and

• Additional issuance via governance changes.

Linear unlocks

This is often build in the protocol’s smart contract to incentivize participants (e.g., via staking rewards) and liquidity mining on decentralized exchanges. The amount of daily inflation really depends how much tokens the protocol has allocated for staking rewards and liquidity mining initiatives.

Vesting schedule (Cliff) unlocks

Vesting schedules are also used to keep developers' tokens locked for a certain period, thus saving investors from the perpetrators of pump and dump schemes. Vesting schedule (cliff) unlocks consists of the following elements that you need to be aware of:

• Stakeholders included in the vesting schedule (e.g., investors);

• Duration (number of years);

• Periodicity of unlocks (often monthly);

• Height of the first cliff unlock (% inflation spike);

• Height of the subsequent cliff unlocks (% inflation spike); and

• Signaling by insiders after a cliff unlock.

Regarding signaling, you need to exert caution when investing in a protocol where a periodic cliff unlock is due soon. There is a possibility that earlier investors or team - that were previously locked - dumps their tokens on the market. However, if the token price remains stable or rises - assuming ceterus paribus - it could signal confidence by these insiders in the token.

Vesting schedule example - dYdX 

One such example is dYdX. The dYdX token unlock on December 1st is a pivotal moment. It involves the release of 150 million tokens, which accounts for 15% of the total token supply. This may put a downward pressure on price. Furthermore, there will be a lot of subsequent cliff unlocks from employees and investors.

Hence, I would monitor the situation after the first cliff unlock and see whether insiders keep holding or dumping their tokens, which can be a strong signal that the intrinsic value of the token is higher than its current price.

Additional issuance via governance changes

There are two main flavors here:

1. Increase daily issuance to incentive stakers: Stakers are users who hold tokens and use them to validate transactions and create new blocks. By increasing the daily issuance, stakers are rewarded with more tokens, which can increase their participation in the network and improve its security.

2. Unlock tokens or proceeds to attract additional funding: Unlocking tokens that were previously locked or reserved to attract additional funding (possibly through a discount). When the cryptocurrency protocol has an unlimited supply, tokens can also be minted to achieve this goal.

When a project issues new tokens, you should assess ownership dilution and the use of proceeds. Token issuance is favorable when funds support protocol or ecosystem growth, but it's unfavorable if capital usage is questionable or viewed as a liquidity event and exit for founders and early investors. Furthermore, you must be aware of the actions of the protocol’s founding team, especially if it seems to be in conflict or misaligned with the project’s whitepaper or long-term roadmap.

Burning - a mechanism to mitigate inflationary effects

Regularly burning tokens helps maintain a balance between supply and demand. It is often used for deflationary purposes, aiming to reduce the token supply over time, which makes the existing tokens more valuable due to scarcity.

Token burning is similar to share buybacks by publicly owned corporations, which reduce the amount of stock available. However, one main difference between burning and share buybacks is that total supply will be reduced through burning while the total supply will stay the same with buybacks.

Burning in practice - Ethereum

In 2021, Ethereum (ETH) introduced the EIP-1159 upgrade, which restructured the fee model and began burning Ether with each transaction.

Ethereum's burn mechanism was implemented to regulate gas fees and exert deflationary pressure on the token. The mechanism involves sending tokens to an address from which they cannot be retrieved, reducing the asset's circulating supply and ultimately contracting the overall supply over time.

The burn mechanism has resulted in nearly $9 billion worth of tokens being burned cumulatively, with over 3.6 million ETH removed from the supply since the mechanism was instituted. The estimated ETH burn rate is about 0.69 ETH per minute as of October 19, 2023.

“Your size is not size” - Shiba Inu

Burning a small amount of tokens will not significantly affect the price of a token. For instance, burning a few thousand $SHIB would not have a significant impact on the overall supply, given that there are over 589 trillion Shiba Inu (SHIB) coins currently in circulation. However, the community has burned more than 263 billion $SHIB since October 2021, which is roughly 0.05% of the total circulating supply.

Do we need to avoid token inflation?

Remember, token inflation is not bad per se, as its issuance incentives people to build on their network by granting them the protocol’s native token.

When a protocol issues tokens, it is similar to issuing shares, and it can be costly. This is because it dilutes the number of tokens or shares outstanding. However, if done correctly, the cost can be an investment that generates a return. For example, a diligent employee who receives stock can create value for the company in excess of the stock granted. Similarly, a network participant can create value for the protocol in excess of the value of the tokens granted.

Hence, token inflation through issuance is a cost that can turn into a benefit if done correctly.

Comparative analysis of token inflation

The following table compares different protocols for inflation via linear unlocks and vesting schedules (cliff) unlocks.

Layer 2 solution comparison

Let's discuss the Layer 2 solutions mentioned in the table, namely Arbitrum and Optimism. These protocols have recently launched and have a low initial circulating supply, ranging from 5.0% to 11.6%. Despite the low initial supply, they have a relatively low annual token inflation rate, ranging from 1.7% to 2.5%. However, the inflation rate increases due to the Cliff unlocks, which start with an initial cliff unlock of 4.75% to 6.74% and subsequent cliff unlocks (c. 0.6-0.9% per month).

For Arbitrum, the total annual token inflation in 2024 will be c. 21.2% consisting of:

• 1.7% annual linear inflation

• 11.8% cliff unlocks for the founder / team (first cliff + subsequent monthly cliffs)

• 7.7% cliff unlocks for the investors (first cliff + subsequent monthly cliffs)

For Optimism, the total annual token inflation in 2024 will be c. 10.4% consisting of:

• 2.5% annual linear inflation

• 3.6% cliff unlocks for the founder / team (subsequent monthly cliffs)

• 4.4% cliff unlocks for the investors (subsequent monthly cliffs)

In 2024, Arbitrum is expected to have a higher annual token inflation rate compared to Optimism. This is because Arbitrum's first cliff unlock is scheduled for 2024, while Optimism already had their first cliff unlock on June 4, 2023. Overall, the token inflation of both protocols is high, which means that the holdings of tokenholders will be significantly diluted.

Other observations

As mentioned before, there is a significant amount of token inflation scheduled for dYdX between December 2023 and December 2024, with a rate of 53.7%. This means that the total supply of DYDX tokens will increase by more than half during that time period. However, it's important to note that the height of subsequent cliff unlocks decreases over time after a couple of cliff unlocks.

In the case of Liquity, the circulating supply of the LQTY token is already relatively high, which means that any future token issuance will have a lower impact on the value of existing tokens. This is because the percentage increase in the total supply of the token will be smaller compared to the other projected mentioned with a lower circulating supply.

JOE and Radiant Capital have unique unlock schedules compared to other protocols. They both had a one-time vesting (cliff) unlock in 2022. However, JOE's vesting schedule includes linear unlocks for the founder/team and investors. It's worth noting that despite nearly all tokens being unlocked, JOE's circulating supply is only around 67.2%..

Please note that the above only mentions linear and vesting schedule unlocks. The token inflation can also be influenced by governance changes. Thus, also check whether there are any rumors or proposals to change the token inflation rate.

Checklist to evaluate token inflation

Evaluating token inflation is an important aspect of cryptocurrency investing, as it can affect the value of the token in the long run. Here is a checklist for evaluating token inflation in cryptocurrency projects:

Step 1: Collect the relevant token inflation metrics

Start by uncovering the vesting schedule and linear inflation using one of the following sources:

• DeFiLama (Unlocks section)

• Token Unlocks

• CoinGecko

• The white paper of a cryptocurrency project usually contains information about the tokenomics of the project, including the inflation rate and the total supply of tokens.

• Bonus: examine the smart contract code to understand how token issuance and inflation are programmed.

Step 2: Study each metric

Next, understand each metric and ask the following questions:

• Does the linear token inflation truly incentivize users?

• Who are included in the vesting schedules?

• When does the first vesting schedule (cliff) unlock occur?

• What is the height of the first and subsequent vesting schedule (cliff) unlocks?

• Are insiders holding or selling their tokens after a vesting schedule (cliff) unlock?

• Are there any rumors or proposals which can change the token inflation rate?

Step 3: Calculate the annual token inflation

Calculate the sum of annual token inflation by adding all elements (linear inflation and the vesting schedule unlocks). When the token is inflationary, consider whether you expect that the demand pressures in this token will outweigh the supply pressures via token inflation of the protocol.

Step 4: Compare inflation metrics of similar protocols

Finally, compare inflation metrics of similar protocols and understand why they differ from each other. When evaluating similar investments, weigh in the inflation differences between similar tokens.

Closing thoughts

Token inflation can have a significant impact on a token's value and can affect investor sentiment.

If a token experiences high levels of inflation, investors may become concerned about the dilution effect on the token's value. This can lead to a negative feedback loop where demand for the token decreases, which can further decrease its value.

To address this issue, token designers need to take token inflation seriously when designing a token. They need to consider the potential impact of inflation on the token's value and take steps to mitigate this risk (e.g., via burning). In addition, token designers need to be transparent about the token's inflation rate and communicate this information to investors. This can help investors make informed decisions about whether to invest in the token and can help build trust in the project.

Hence, I assume that future projects will take this into account when developing its tokenomics. Otherwise these projects will probably fade in the abyss of abundant supply.

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