Note: The original text comes from XION Blog and is compiled by XION World.

The introduction of cryptocurrencies has created a wide range of innovations in the digital space, which can be used to create novel decentralized networks and on-chain governance systems, incentivize network participants, overcome product cold start problems, and more. Amid all the innovations, one aspect remains clear: the right token economics design plays a critical role in whether a network can effectively incentivize participants to contribute to its stability and security.

In this article, we will discuss the intricacies of the Cosmos minting module and examine XION's unique approach to token inflation for staked tokens, exploring XION's approach to combating hyperinflation. A sustainable token economy is key to building a lasting ecosystem, and XION's token economics design places great emphasis on this aspect to better realize the vision of making Web3 easily accessible to everyone.

What is XION?

XION is a Proof of Stake (PoS) blockchain secured by a group of validators (network participants responsible for proposing and validating new blocks). Since they stake tokens, they are allowed to participate in the production and validation of blocks. If they behave maliciously or fail to perform their duties correctly, part of their staked tokens will be confiscated. To incentivize these validators to participate in the network consensus and contribute to its security, they receive staking rewards.

As a PoS blockchain, XION's security depends on the number of validators and the value of their staked tokens. The higher the value of the staked assets, the more money an attacker needs to destroy the network. But this also means that a poorly designed network with rapidly declining asset value will face a greater risk of attack.

Overcoming the evil of token inflation

Over the past few years, new public chains and their ecosystems have tried to attract more validators and stakers by offering abnormally high staking rewards. However, this practice has had unintended consequences as it has triggered hyperinflation. As the industry has grown, it has become increasingly clear that hyperinflation is not a sustainable model. It hurts active users and token holders as assets quickly depreciate. This will ultimately lead to a loss of stability and security in the network.

To address the risk of hyperinflation, XION’s token economics is built on an extended version of the Cosmos minting module. XION makes two small but significant modifications to the minting module:

- Accumulated fees will be used to offset inflation, if possible.

- Token inflation will be calculated only for staked tokens and not for all tokens.

Before diving into the impact of these changes, it’s important to first understand how the minting module works.

Cosmos Minting Module

The goal of the Cosmos minting module is to maintain a predetermined ratio of staked tokens to liquid tokens in the ecosystem. This is an important balance between market liquidity and staked supply as it affects the long-term security and growth of the network. This is achieved by setting three values: inflation cap, inflation floor, and target staking ratio.

To better illustrate, let's take the Cosmos Hub as an example. It sets the upper limit of the inflation value to 20%, the lower limit to 7%, and the target stake ratio to 2/3 of the tokens. If more than 2/3 of the tokens are staked, the inflation rate will slowly decrease to 7% over multiple blocks. If the staked ratio is less than 2/3, it will slowly climb to 20%. If exactly 2/3 is staked, the inflation rate will remain unchanged. The minting module will calculate how many tokens need to be generated in the block to meet the inflation percentage, and then distribute these tokens to validators and stakers.

Change #1: Using fees to offset inflation

The default Cosmos minting module and the Cosmos Hub currently collect fees accumulated in blocks and distribute them to validators on top of the new tokens minted in each block. For example, if the Cosmos Hub collects 10 tokens in fees in a block and 1000 tokens are newly minted, then 1010 tokens will be distributed to validators.

The first modification that XION implemented to the minting module was to use the fees collected in a block to offset the number of new tokens that needed to be minted in that block.

For example, if 1000 tokens are minted and distributed to validators, and 600 tokens are collected in fees in the same block, the minting module will only mint 400. These 400 minted tokens are then combined with the 600 tokens in fees so that the full 1000 tokens can be distributed as expected.

As the popularity of the XION network grows, the accumulation of fees will continue to offset the minting of new tokens, which will mitigate inflation. It will also lead to the token value remaining stable while still maintaining the necessary incentives for validators and stakeholders to contribute to a healthy ecosystem.

There is an interesting secondary effect worth noting: when block fees exceed the number of new tokens per block required to be distributed to stakers, the excess tokens are burned, reducing the token supply. This means that during these blocks, the token supply becomes deflationary.

Change #2: Token Inflation for Staked Tokens

Current Model: Inflation of All Tokens

The default Cosmos minting module calculates inflation for all existing tokens. This means that the staking annual yield (APY) is often much higher than the inflation rate, because the percentage of existing staked tokens never reaches a maximum. This is easiest to understand with an example:

If there are 1000 tokens today, only 500 tokens are staked, and inflation is 10%, then stakers will realize a 20% APY. Why? Because 10% inflation (i.e. 100 newly minted tokens) of the existing 1000 tokens is only distributed to half of the token holders.

This creates “unnecessary” incentives that attract short-term network participants seeking quick returns. Validators and stakers are incentivized to get on these chains early to earn extreme hyperinflationary rewards. These rewards then disappear quickly, and once they disappear, the tokens face tremendous selling pressure as early participants try to realize quick gains. Another consequence of inflation based on all tokens is that APY becomes more volatile because it depends heavily on the number of tokens staked.

XION Token Model: Inflation of Staked Tokens Only

The XION network changes an important variable on the existing mechanism of the Cosmos minting module. Inflation is not calculated for all tokens, but for staked tokens. To illustrate what this means, we will use the same example as above:

If there are 1000 tokens today, only 500 are staked, and inflation is 10%, then stakers will realize a 10% APY. Why? Because the 10% inflation is for 500 tokens, so only 50 new tokens are minted, not 100. As a result, stakers will always see their APY equal to the inflation rate. This change creates a more stable APY and helps attract long-term participants to the network.

Summarize

XION token economics is based on the principles of stability and security, with a long-term perspective. Through two major changes - offsetting inflation through accumulated fees, and calculating token inflation only based on staked tokens - XION strategically reduces the possibility of hyperinflation. It takes a first-principles approach to align ecosystem incentives, aiming to attract long-term validators and users rather than short-term speculators, strengthening the network's ability to resist volatility, and ensuring that the entire ecosystem is more stable, secure, and sustainable.