Token supply caps

Tokens represent a stake in decentralised networks and serve as a tool to align and incentivise network participants. Different networks can have different token designs. One of the main components of token design is the total token supply.

A lot of networks today opt for setting a fixed token supply at genesis. A fixed token supply, or supply cap, is an amount of tokens the team has decided will constitute the total supply indefinitely for the network.

Supply caps are great in theory because they provide token holders with the assurance that there will be no further dilution. In crypto, many token holders, particularly retail investors not closely engaged in early decisions, have a strong aversion to any sign of being disadvantaged by project "insiders" such as founders and investors. With a fixed cap, there is not even a possibility of change and that simplicity instills trust.

However, there are a couple reasons for a why a fixed token supply doesn’t make sense in my view.

First, it’s difficult to know from the beginning what an optimal token supply is. The value proposition of most networks is a product or service they provision. Tokens are supposed to be in support of that product or service, they are not the product themselves. For a network such as Bitcoin, which is designing a new form of money, the fixed supply is its product. Bitcoin also played a major role in creating the meme of “fixed token supply = good.” However, not everything is Bitcoin.

The second reason, is that the supply cap is set either too high or too low. Either option comes with its own set of problems.

Too high of a supply cap can lead to profligate spending. Teams sit on what seems like a bottomless pool of tokens and hand out large percentages of their network with little thought.

Too low of a supply cap can lead to a lack of tokens to incentivise later contributors or raise additional funds from investors, thereby hindering the growth of the network.

The result is that teams often renege on their initial promise of a fixed token supply, which can lead to a lack of trust amongst network participants. The solution is to establish an initial token supply and regulate it (expand or contract) thoughtfully. There are two mechanisms through which to regulate the token supply.

The first is through human decision-making. This approach is analogous to the established practice in traditional capital raises, where companies gradually raise funds through generating new shares and offering them to external investors. It forces the team and investors to be thoughtful and transparent about how much to dilute to fund future growth initiatives. Early on this decision should be driven by the core team but as the network grows and decentralises over time these decisions should be made through community governance.

The second method operates via programmatic rules. Ethereum is an example of this. The main driver that regulates token supply is the network's demand; as Ethereum usage increases, its token supply contracts. This programmatic approach is particularly suitable for infrastructure projects like Ethereum, which support numerous applications. All parties that rely on Ethereum understand its underlying economic model, which is enforced and executed by machines.

My hope is that more teams move beyond setting a token supply cap and instead think more critically about their initial supply, and how to expand it thoughtfully in the future.