Cryptonomics: What are Deflationary Tokens

There are two fundamental categories that token models can fit into, deflationary or inflationary tokens. On this latest series, Cryptonomics, GoonTrades will dive into the realm of deflationary tokens.

Greg Gotsis
December 29, 2020

Deflationary Token Models

Crypto is transforming traditional finance as we know it; this is apparent with the rapid expansion of the De-Fi sector in the past 6-12 months. Many De-Fi projects’ main focus are their token models, and projects have begun to get very creative. There are two fundamental categories that token models can fit into, deflationary or inflationary tokens. We will dive into examples of both, but our focus will be on deflationary token models, which provide unique opportunities to long term holders.

What are Inflationary Assets/Tokens?

Many traditional Proof of Work (POW) and Proof of Stake (POS) tokes use an inflationary tokenomics structure to continue incentivizing miners and liquidity providers. This creates a critical system of incentivizing node operators or miners who validate the chain’s transactions. Simultaneously, inflationary tokens add supply to the market (as distributed in rewards) over time, diluting token holders shares. This scenario can be seen in BTC, where miners are rewarded 6.5 BTC every 10 minutes as compensation for verifying transactions onto the public ledger. While BTC is a scarce asset, as the total supply is 21 million, it is still an inflationary asset until the total supply is reached. Another prevalent example of an inflationary asset is the US dollar. The central bank has the freedom to continue “printing” (minting) excess dollars with no real supply cap. The key takeaway is that Inflationary tokens mint and distribute tokens for some time and have no systems to reduce the total supply.

Deflationary Tokens

This leaves us with deflationary tokens, which implement models where tokens are removed from the market over time. The term for the process that “eliminates” tokens from the market has been coined as token burns. Burns are executed through numerous different strategies, but the most common compose of the following:

--Buy-back and burn

--Burn on Transaction

Buy-Back and Burn

In this model, the company or entity in charge will participate in a buy-back of tokens from the public market and send them to a dead address, one that is inaccessible, therefore “burning” them. This system lowers the circulating supply through destroying tokens, driving value to the asset since demand remains the same and supply is reduced. This system is a bit comparable to a dividend, where a company distributes a portion of profits to shareholders. Both methods drive value to shareholders based on the governing body’s success, but they are executed differently. Many people struggle to wrap their head around how burning supply drives value to holders, but it is key to keep in mind that when supply is decreasing with a constant or increasing demand, price will increase. This tokenomics model is seen in most deflationary tokens, such as BNB, FTT, CRED (sort of), and PancakeSwap.

Source: Binance

Binance Coin (BNB) is the native Binance Chain token which serves numerous functions revolving around Biance’s platfourms. This token has a quarterly buy-back and burn mechanism implemented in its model, making it one of the largest deflationary tokens. The latest quarterly burn done in October burned an equivalent of $68 million USD. This burn totaled 2,253,888 BNB, which was the highest burn amount denominated in fiat. The following chart below displays the steady growth of BNB’s quarterly burns. These burns remove about 1% of the circulating supply quartely, making BNB holders asset more scarce then before, ultimately driving value to these holders.

This burn will continue until BNB reaches 50% of its total supply, 100,000,000 BNB.

Burn On Transaction

While buy-back and burn tokenomics structures are typically executed manually, burn on transaction models generally are integrated into the contract. These deflationary tokens collect a tax on every on-chain transaction, of which a percentage is burned. This system is entirely dependent on a token’s volume, the more trading volume, the more tokens are removed from total supply. In turn, this burn drives value to token holders as tokens are continually being removed from circulation while demand remains constant and possibly increases.

For example, the THUGs token triggers a burn when a user sends, sells, adds, or removes liquidity. The THUGS token is an extreme example of a burn on transaction token, charging a large tax, but in turn, burning an extraordinary amount of tokens based on their variable burn rate. The transaction tax is allocated with; 51% going to a burn address and the other 49% going to a Thugs.Fi vault, to be used for future developments. For those interested  in more info on the THUGS.Fi variable burn, check out my project review.

Another burn on transaction model present in the BSC can be seen in the JetFuel.Finance model. This is a 2% constant burn with half sent to a dead address and half allocated to JETS holders for rewards. 

Both of these structures derive their % of supply burned from the tokens volume, making the burn represent the “performance” of a token. As previously mentioned, these burns also drive value to holders as it decreases the circulating supply..

A Bit Tricky

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So this is where this concept can get a bit confusing and tricky to categorize tokens. With the rise in yield farms launching and governance tokens being used to bootstrap liquidity to projects, we see highly inflationary periods that slowly get tapered off in each respective model. I believe for this exact reason there was a bit of confusion regarding why JetFuel was classified as a deflationary token, yet they were to release 120,000 tokens over 6 months. 

The key concept I mentioned early on was that deflationary tokens implement a system to reduce the circulating supply. On the other hand, an inflationary asset such as bitcoin has no means of removing tokens from the circulating supply. While FUEL’s circulating supply will inflate for a period of a 6 months, it has constant deflationary pressure, burning 1% of all transactions making the token deflationary in relation to its maximum supply.

This also segues into what I refer to as “net deflationary tokens”. These are tokens where the amount of tokens minted daily are less than the amount of tokens burned daily. I would argue nearly all De-Fi protocols do not maintain this structure in the preliminary stage of their projects.

So on that note, yes, FUEL is currently not a “net deflationary token”, but it still is considered a deflationary token. It can also be valuable to consider that an inflationary token’s inflation rate is constantly decreasing, as the fixed amount of newly added circulating supply has less of an inflationary impact on existing circulating supply as time goes on.

Deflationary Assets as Whole

Overall there are two core token models, Inflationary and Deflationary. This topic gets a bit tricky, especially in the current liquidity mining and highly inflationary token distribution models. The keys points to remember are that Deflationary tokens contain a process that allows them to reduce the circulating supply of a token, such as a burn on transaction or a buy-back and burn event. On the contrary, inflationary assets have no such way of reducing their circulating supply. It is key to remember that even though Bitcoin is scarce, it is still subdued to inflation due to its block rewards. 

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I even went a step further and defined “net deflationary tokens” as token who reduce more supply then they mint on a net level. This is a rare occurrence for many new projects as they are still in the middle of their liquidity mining stages, which are necessary to bootstrap liquidity. Overall I hope this article helps explain the deflationary process used in crypto in order to drive value to token holders.

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Greg Gotsis

Greg is a co-founder of BSC News and Solana News. He is also the current editor in chief where he pursues crypto and decentralized finance research. In his free time he finds himself in nature, surfing, or learning piano. His bags are heavy with Solana NFTs, CAKE and multichain DeFi protocols.

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