Polygon Armed With Tokenomics 2.0 for L2 War

Table of Contents

1. Notable Change in Polygon 2.0 Tokenomics

2. $POL to be converted into a Deflationary → Inflationary token

3. All’s to Secure Capital for Polygon’s Layer 2 Competition and Validator Rewards

4. Limited Selling Pressure Expected Despite Rising Inflation

 

 

1. Notable Change in Polygon 2.0 Tokenomics

Polygon Labs proposed Polygon 2.0 in June of this year to unify the liquidity of previously fragmented solutions and improve scalability. On June 19, starting with the announcement of the PoS restructuring, Polygon Labs announced changes to the stack, tokenomics, and governance. Polygon Labs has proposed this agenda to the Governance Forum, and given that Polygon's governance has been centered around Polygon Labs, it’s expected that this change to pass with flying colors.

In the meantime, here's a quick recap of the Polygon 2.0 announcements:

• Polygon PoS: The Polygon PoS chain will transition to Polygon zkEVM Validium in Q1 2024.
• Polygon Structure and Stack: The fragmented Polygon solutions will have a common layer—te Staking layer and Interop layer—on top of which zkEVM, zkEVM Validium, and Supernet will operate. Transactions across all solutions are processed in parallel for better scalability. It is expected to be similar to the vertical/horizontal scaling roadmap of Arbitrum and Optimism.
• Polygon Tokenomics: The existing $MATIC will swtitch to $POL and inflation will be set at 2% per year. And a staking reward system designed to create competition for validators will be introduced.
• Polygon Governance: Governance is dvided into protocol governance, system smart contract governance, and community treasury governance. Issues of protocol direction such as PIP will be handled by Protocol Governance, technology/smart contract related issues will be handled by System Smart Contract Governance, and community treasury usage will be handled by Community Treasury Governance.

Most notable among these Polygon 2.0 changes is the proposed change to tokenomics, which was announced on the 14th. Converting the previously deflationary token $MATIC into an inflationary token called $POL is a significant change that could potentially dilute the value for existing holders in certain cases. In this article, we'll take a closer look at the proposed changes to the tokenomics of Polygon 2.0, and also discuss what led Polygon to make this decision and token investors should interpret this news.

2. $POL, the Deflationary → Inflationary Token Conversion

First, let's take a closer look at the changes to Polygon’s tokenomics. The most noticeable change in the tokenomics is the inflationary shift of $POL. Previously, $MATIC was a deflationary token of reduced total supply from the introduction of EIP-1559 in 2022. However, with this update, the token will be rebranded as $POL and an annual inflation rate of 2% will be come with 1:1 swap with the existing $MATIC, and an annual inflation of 2%. Of the 2%, 1% will be paid out as staking rewards to validators for the next decade, and the remaining 1% will be kept in the community treasury and used for the Polygon 2.0 ecosystem.

 

< Validator Reward Structure on $POL Tokenomics, Source: Polygon Blog>

The second element of this update is the change in validator staking rewards. Previously, $MATIC had 12% of the total issuance tied to a vesting contract, paying validators on the Polygon PoS chain 4.5-20% per year in validator rewards and burning transaction fees. In this new proposal, 1% of annual inflation supply and transaction fee are paid as validator reward for the next 10 years, with additional rewards for each chain such as zkEVM, PoS, and Supernet. As for the additional rewards, each chain proposes additional rewards to validators in the form of $POL or stablecoins in the community governance by policy, and validators can choose their chain among the reward proposals. Based on the assumptions in the Polygon 2.0 whitepaper, it is designed to allow validators to earn at least 4% per year.

Other than that, the utility of the $POL token is nearly identical to the existing $MATIC. In addition to staking, staking rewards, and transaction fees, $POL has the same utility as $MATIC, with the addition of governance voting.

3. All’s to Secure Capital for Polygon’s Layer 2 Competition and Validator Rewards

So what brought on such change in Polygon’s tokenomics? The apparent reason stated by Polygon Labs is the value accrual of the Polygon token, emphasizing the $POL token’s role as a productive token that enables Polygon's many multi-chain staking and validator rewards.

However, I believe there is a better reason. It seems Polygon 2.0 tokenomics is more about securing capital and validator reward for Polygon's Layer 2 competition. So in this chapter, we'll discuss the reasons why Polygon made this choice.

Objective 1) Securing capital for Polygon's long-term Layer 2 competition

Polygon has been positioning itself as a leading Layer 2 solution through aggressive marketing and acquisitions in 2021 and 2022. It gained significant traction among global companies and has shown competitiveness in the field of zk technology and ranks 5th in TVL ranking. However, as much as Polygon has grown, Polygon Foundation has spent considerably. The amount allocated to the Polygon Foundation and the ecosystem totaled $4.52B $MATIC, or about $3.34B at July 20th prices, but Polygon spent $1.1B on fund formation in 2021-2022, including $1B for the ZK Strategic Fund and $100M for the Supernet Fund. There was also significant spending on corporate partnerships. With $5M spent to onboard the NFT project Y00ts alone, it's likely that the company has spent a staggering amount on grants to onboard global Web2 companies such as Starbucks, Adidas, and Nexon. Currently, Polygon’s available supply on Etherscan is $692M ($242M for the foundation and $450M forthe ecosystem) of which 80% is already used.

However, the Layer 2 race is in full swing. Layer 2 competitors such as Arbitrum and Optimism have been gaining traction since late 2021, with Arbitrum surpassing Polygon’s TVL in in late 2022 and Optimism has similar TVL has Polygon. Arbitrum and Optimism also issued their tokens later than Polygon, having secured $4.6B and $3.7B in treasury respectively. Arbitrum's DAO treasury can be voted on and used for business at any time. Optimism, on the other hand, has allocated 68% of its treasury funds to ecosystem funds for governance, partners, and early-stage funding, and has laid the foundation to encourage dApps and users to utilize Optimism through its "contribute first, reward later" RPGF.

Therefore, Polygon needs to raise additional capital to compete in Layer 2. With this change in tokenomics, Polygon will be able to secure a total token supply of approximately $760M (as of July 20, 2023) over the next 10 years in the form of a community treasury. It is possible that the inflation rate will go down after a decade through community governance, but for now, Polygon has the capital to compete in Layer 2 for the next 10 years.

Purpose 2) Securing validator reward supply

Unlike the governance tokens $ARBI and $OP, Polygon's $MATIC is used for chain security. Therefore, the issue of validator rewards is vital for Polygon. The reward allocation for Polygon PoS is 12%, and there is only a plan for the first five years. According to Polygon's first five-year reward plan, about 99% of the allocated rewards would be depleted by 2024. This raised concerns about how to sustain validator rewards for Polygon PoS beyond 2024 and how to incentivize validators (or sequencers) of other solutions. Therefore, Polygon needed to secure the validator rewards by changing its tokenomics. 

<Polygon's initial 5-year reward distribution plan, Source: Polygon Blog>

And it seems that Polygon is doing exactly that—addressing the validator reward issue through this change. The announced $POL tokenomics will allocate 1% of the annual inflation supply of $POL as rewards for validators over the next 10 years. In the fifth year of issuance, validators were initially expected to receive 148M $MATIC as rewards. However, the 1% per year allocation will decrease the reward to 100M $MATIC, reducing validator rewards from the current 5.4% to 3.3%. In order to ensure minimum 4% annual return for validators, Polygon has introduced transaction fees and additional validator rewards per chain. However, transaction fees are expected to generate around 24M $MATIC per year at current levels of activity, so we expect to need to generate at least 25M $MATIC in additional validator rewards in order to pay validators at least 4%.

4. Limited Selling Pressure Expected Despite Rising Inflation

Is Polygon’s revamped tokenomics a good thing from an investor’s perspective? In general, token inflation has a negative impact because it dilutes investors’ holdings, meaning that if there is 2% inflation per year, the value of your tokens will decrease by 2% per year, assuming Polygon's market capitalization remains the same. Thus, token inflation is similar in nature to a stock market's capital increase, where an enterprise raises capital by issuing new shares, diluting the value of existing shares held by investors.

The impact of a capital increase on the stock price is generally determined by the purpose and scale of the capital-raising effort. If it is an effort to raise capital for investment, like in the case of Tesla and Samsung Biologics, it usually has a positive impact. On the other hand, if it is to improve the company's financial position, like in the case of Lucid and Daewoo Shipbuilding & Marine Engineering (now Hanwha Ocean), it will have a negative impact. Also, the larger the scale, the more diluted the stock price gets, which is generally perceived as a bad thing.

So what kind of implication does this have on $POL? If you consider the purpose, $POL’s inflation (the token version of “capital increase”) is both to raise capital for investment (community treasury) and to improve financial standing (validator rewards). However, given Polygon's current balance sheet ($692M in treasury), it's more likely that the bigger goal is to prevent validator churn. Thus, it's reasonable to assume that $POL's inflation is primarily to raise funds to prepare for the upcoming Layer 2 war and fuel growth. In other words, it’s likely that the $POL will have a positive impact on investors.

Considering the scale of the capital increase by issuing, the impact of 2% inflation on prices is likely to be rather low. In 2017, 221 listed Korean companies carried out capital increases, with an average dilution of 14.5%. In 2021, due to the increase in scale, the dilution is likely to exceed this average. This means that it would take about six years for Polygon to catch up to the average Korean listed companies with an annual inflation of 2%, so the price impact is expected to be somewhat low.

Even in comparison with its peers, $POL's inflation is appropriately moderate. Its direct competitors, Arbitrum and Optimism, also experience 2% annual inflation. Not only that, Polygon's $POL will be less affected because it has the utility of security through staking, unlike $ARBI and $OP, which only serve as governance tokens.