Token Lockup

Why Trust Techopedia

What Is Token Lockup?

Token lockup (or vesting period) is a specific time frame when cryptocurrency tokens cannot be traded or transferred.

Advertisements

During this lockup period, holders of such tokens are restricted from selling tokens received either from airdrops, presales, or after an initial coin offering (ICO) in the open market.

Token lockups are often enforced using escrows or smart contracts, which are pieces of code capable of executing commands autonomously.

These lockups serve as a preventive strategy intended to stop token sales shortly after their launch into the market. This step is taken because most investors tend to offload their tokens as soon as they acquire them.

In the event of such a mass sell-off, the token price can experience a steep decline due to increased sales with minimal demand. Hence, token lockup prevents this from happening and instills a level of confidence in the minds of token holders.

Furthermore, it incentivizes both the project founders and participants to focus on building the project for the long term.

With a token lockup, a blockchain protocol can craft an appropriate support base for the token before it goes live in the market. This way, they can reduce the potential volatility of the digital asset in the long run.

Meanwhile, locked-up tokens are often not considered part of an asset’s circulating supply, thereby often disregarded in technical analyses conducted by asset traders.

Token Lockup Structures

Given the rising prevalence of rug pulls and scams, investors usually require crypto projects to initiate vesting periods for their digital coins. This offers a level of confidence that project founders won’t make off with the funds.

Below, we consider some of the popular strategies employed by blockchain protocols for token vesting:

  • Time-Based Vesting Period: This is the most popular structure embraced by blockchain projects. It restricts the trading or transfer of assets for a period of time, which can range from six months to a year, two years, or even longer. This approach serves the dual purpose of confirming the genuine commitment of participants and ensuring accountability on the part of the project’s founder. Hence, it encourages long-term investment in the protocol instead of profiting from token sales.
  • Milestone-Based Lockups: Tokens are often secured until certain milestones in the project’s roadmap are achieved. For instance, a project can lock up its tokens until its mainnet launches, when its user base hits a certain figure, or when it launches a feature. This often draws support for the project to meet its preset aims.
  • Tiered Vesting Period: With this vesting structure, tokens are released according to preset stages over a set period. For instance, a project may release 10% of its tokens into the market after it completes its presale and spread the remaining 90% across five years. This often ensures that the market is not flooded with the tokens, but investors have enough liquidity to execute trades. Inadvertently, it reduces the possibility of a price dip.
  • Performance-Based Lockup: Performance-based vesting structures are similar to their milestone counterpart. Tokens will only be released if the company hits its preset performance metrics. This could be either a certain level of profitability or major partnerships with other blockchain protocols in the same area of interest.

When choosing the most suitable vesting period, there’s no one-size-fits-all solution in this context. Project founders will need to consider their unique offering alongside the goals and objectives of their protocol. This will guide their decision in selecting the token lockup structure that ensures long-term investment security and mitigates the risk of significant price drops in the market.

Techopedia Explains Token Lockup Process

Crafting a token lockup mechanism is quite a complex process that requires a strong background in blockchain development. However, what is universal across all structures is the role played by smart contracts.

A smart contract contains different proposals and agreements only executed once the premises align. Once this is in place, it deploys the terms of the agreements autonomously.

To execute a token lockup, the smart contract is often crafted to ensure that transferability and trading are non-existent until a preset period or certain conditions (milestones or performances) are met.

This is possible due to a locking mechanism that is hard coded into the smart contract. Hard coding is a process wherein written codes cannot be modified or rewritten once deployed.

Once this locking mechanism goes live, making adjustments to its components becomes a formidable challenge.

For instance, during some of the best crypto ICOs or crypto presales, when an investor claims tokens, they are often sent to their designated wallet addresses. However, if a token lockup mechanism is in effect, it prevents these tokens from leaving that wallet until the specified lockup conditions or duration is met.

Benefits of Token Lockups

Besides serving as a deterrent for massive sell-offs of an asset, token lockups provide other advantages:

  • Increases Confidence and Trust: Token lockups often signal to investors that a project’s team is fully focused on long-term success and not looking for immediate gains. This can significantly increase the level of trust between both the investor and the development team.
  • More Control: Token lockups are like raindrops and provide control for the project’s asset release. Instead of releasing all the assets at once and watching the price plummet due to an increase in the circulating supply, founders can provide just enough liquidity for traders and still shore up the asset’s price.
  • Dissuades Arbitrage Trading: In arbitrage trading, an asset is bought and sold within a very short period. It often leads to myopic trading and denotes a lack of trust in the project’s long-term performance. Token lockups can help dissuade arbitrage traders from dumping the assets they acquire during price or ICO. Instead, it attracts more long-term investors who will likely get returns over time.
  • Reduces Asset Volatility: By releasing tokens at preset periods, it ensures that the asset’s price is stable, thereby decreasing the chance of it being volatile due to massive sell-offs.

Risks of No Token Lockups

In the absence of a lockup mechanism before a project’s launch, investors may encounter a few associated risks:

  • Increased Chances of Fraud: Without a lock mechanism, the project team can easily dump the project tokens in the market and cart away early investors’ funds through a rug pull. The downside is that holders will be left with worthless coins devoid of any intrinsic value.
  • Short-Term Thinking: With zero restrictions on token sales, investors will be tempted to sell off their assets in pursuit of short-term gains. This depicts a lack of trust and support for the novel protocol.
  • Increased Volatility: This is the holy grail of a zero-token lockup system. If a token becomes immediately tradable after an ICO, there will be more supply than demand, causing the asset price to plummet. It often heralds the death of such a project as they cannot build a proper support system for the tokens.

Blockchain and Token Lockup

Blockchain, or distributed ledger technology (DLT), is the bedrock on which this token restriction is built. This is because it is secure and immutable. Immutability is an expression, meaning that data stored on blockchain protocols cannot be altered after it has been added to a block. This makes them a viable option for ensuring token lockups are implemented.

Moreover, blockchain technology is transparent, as anyone can view the transactions executed on it. With this system, projects can easily vet all transactions and store their tokens with zero worries in escrow. Once the conditions pre-coded are met, the underlying smart contract begins to execute them autonomously.

Bottom Line

Token lockup is experiencing widespread adoption in the cryptocurrency space. It’s now a standard practice among the majority of new blockchain protocols.

At the crux, it mitigates against the risk of price volatility while positioning the project for stronger long-term success. This often has the consequence of fostering trust between investors and the development team.

However, project teams must select the most fitting token lockup structure tailored to their goals and objectives.

Advertisements

Related Terms

Jimmy Aki
Crypto & Blockchain Writer
Jimmy Aki
Crypto & Blockchain Writer

A graduate of the University of Virginia, Jimmy previously worked for BeInCrypto, Bitcoin Magazine, Decrypt, Cryptonews and other major publications. Alongside writing for Techopedia, Jimmy is also a trained economist, accountant and blockchain instructor with hands-on work experience in the financial sector.