What are reflection tokens, and how do they work?

Arguably the most dynamic segment within the crypto ecosystem, decentralized finance (DeFi) projects have been revolutionizing how cryptocurrency investors can employ their tokens to access capital and even earn additional income on their crypto holdings. However, using DeFi products such as yield farming, liquidity mining and staking pools can often be a cumbersome experience for most crypto investors. 

To solve this problem, a new class of crypto tokens was introduced in 2021 that integrated self-generating passive income mechanisms to reward investors with supplementary crypto tokens. Known as reflection or reward tokens, these digital assets are increasingly gaining traction among crypto investors who are looking to harness the long-term potential of holding on to their cryptocurrency portfolio.

Understanding reflection tokens

Apart from the long-term price appreciation potential of cryptocurrencies, crypto investors are often found wanting an option to earn additional income from their tokens during the holding period. Considering that cryptocurrency markets can witness volatile price actions, short-term trading where traders try to record gains by selling high and buying low can be an extremely risky proposition. 

Similarly, DeFi products that require investors to deposit their crypto holdings in lieu of daily, weekly or monthly returns are a plausible option but are fraught with concerns, such as suffering from impermanent loss, rebalancing losses and even smart contract hacks that allow scammers to steal investor funds. 

In stark contrast, crypto reflection tokens or reward tokens encourage investors to hold on to their tokens, thereby promoting market stability while still offering investors the chance to earn incremental income on all transactions being made on the protocol. 

They utilize a built-in fixed reward mechanism that allocates a percentage of gas or transaction fees to be redistributed among tokenholders. This allows reflection tokenholders to earn additional crypto tokens in proportion to the number of tokens they own as compared to the total token supply. Some reflection tokens also apportion a part of the proceeds toward one or many liquidity pools, which are further used by decentralized exchanges (DEXs) to provide ample token liquidity.

The reward mechanism is driven by smart contracts that automatically tax every transaction and subsequently transfer the equivalent tokens as per set rules. The smart contract may be programmed to update the value of the reflection token on a regular basis, or it may be triggered by specific events or conditions. 

For example, the smart contract could be programmed to distribute a fixed percentage of the value of the underlying asset to holders on a daily or weekly basis. Alternatively, it could be triggered by certain conditions, such as the price of the underlying asset reaching a certain threshold or the completion of a specific task.

The smart contract is responsible for enforcing the terms of the agreement between the reflection token holders and the issuer of the token. It executes the terms of the agreement automatically without the need for intermediaries or manual intervention. This can help to ensure that the terms of the agreement are carried out transparently and fairly. 

However, smart contracts are only as reliable as the code that powers them, making it important that the code is tested and vetted before being deployed to power the reflection tokens’ reward mechanism.

Benefits of reflection tokens

By virtue of their smart contract-backed tokenomics, reflection or reward tokens not only create value for all tokenholders but also serve to stabilize the token’s market value by encouraging investors to hold for the long term. As long as the underlying project remains successful and token transaction volumes keep increasing, investors can earn passive income with reflection tokens without any additional hassles.

Unlike staking or yield farming, in which rewards are dispensed as per an extended schedule, reflection tokens provide real-time returns to all tokenholders in the form of additional tokens. These rewards can be exchanged for other cryptocurrencies or even fiat currencies through DEXs, such as PancakeSwap, Uniswap and dYdX, among many others. 

Related: What is dYdX? A beginner’s guide to trading on a decentralized exchange

Drawbacks of reflection tokens

Despite the apparent advantages of reflection tokens, there are a few aspects that investors ought to keep in mind before investing in them. Firstly, the transaction fee or tax applicable on these reward tokens can be as high as 10% and is to be borne on both purchases and sales. This necessitates that tokenholders remain invested for a longer period of time in order to recoup the transaction tax outgo, through token rewards and/or the overall price appreciation.

Additionally, the redistributed token amount depends on the overall transaction volumes of the native token, which could suffer during bear cycles in the crypto market. Lower trading volumes generate lower transaction tax that results in lower gains for investors. The combination of high transaction taxes and an increasing probability of thin rewards in bear markets make reflection tokens unsuitable for short-term trading.

Reflection tokens vs. hyper-deflationary tokens

Although the two share similarities, reflection tokens have subtle differences that set them apart from hyper-deflationary tokens. Reflection tokens aim to control the tokens in circulation by allocating tokens as rewards to long-term investors, thereby motivating more tokenholders to remain invested for the long term. On the other hand, hyper-deflationary tokens are those that have a built-in token-burning smart contract mechanism to create a deflationary effect on token supply. 

As a result, hyper-deflationary tokens aim to increase the token value by burning tokens, while reflection tokens directly reward tokenholders with a portion of gas redistributed among them. That being said, reflection tokens, like SafeMoon (SFM), incorporate a token burn rate in their smart contract code ostensibly to positively influence the token’s price and regulate the token supply.

The most important difference between both types of crypto tokens is how they envisage creating value for their investors. Hyper-deflationary tokens such as BNB (BNB), XRP (XRP) and Polygon (MATIC), among many others, use a variety of token-burning mechanisms that occur periodically to gradually reduce the tokens in supply. As a result, the token’s price is expected to appreciate as the demand outstrips supply, generating positive capital gains for tokenholders in the process.

Reflection tokens rely on their redistribution reward mechanism to award investors regularly while also ensuring a depreciating supply through a smart contract-administered token burn rate. By accounting for the reflection or reward rate and the total market volume for the reflection token, the smart contract code constantly adjusts the number of tokens allocated to the burn address, making the entire process much more transparent than that employed in hyper-deflationary tokens.

Both tokens encourage tokenholders to hold on to their token holdings for the long term, even if reflection tokens offer a better value proposition through their reward mechanism. In fact, reflection tokens combine the benefits of token scarcity offered by hyper-deflationary tokens and the prospect of earning continual rewards, as long as token transactions grow at a healthy pace.

Is it worth investing in reflection tokens?

For investors looking to park funds in cryptocurrency but also earn interest on their holdings similar to fiat currencies, reflection tokens can be perfectly suited for such balanced requirements. However, they are subject to similar price volatility as other cryptocurrencies, which needs to be accounted for when making a buying or selling decision.

Related: How to earn interest from crypto saving accounts

The time taken for the accrued rewards to compensate for the transaction tax levied on every buy or sell transaction can vary depending on the project’s popularity and overall market sentiment. Investors would do well to research the use cases being promoted or developed by the underlying blockchain project that is issuing a reflection token, investing in only those projects that do not display any signs of a rug pull.

Thus, investing in reflection tokens requires a little more involvement in terms of understanding each project’s vision, the founding team’s past successes, and whether the tokenomics can sustain a growing ecosystem. However, it can be an extremely rewarding experience for long-term investors who can tide over short-term market volatility without selling out their positions.

How to buy reflection tokens

Buying crypto reflection tokens is as simple as purchasing any other cryptocurrency. Usually bought using major cryptocurrencies like Bitcoin (BTC) and Ether (ETH), investors will need an active crypto wallet to hold the reflection tokens in. They can then either go onto dedicated swap platforms that enable users to trade BTC, ETH and other supported cryptocurrencies for a particular reflection token or trade via DEXs that provide access to a number of such reward tokens.

After deducting the transaction tax and any applicable swap fee, the purchased reflection tokens will reflect in the user’s wallet in lieu of the swapped tokens. Investors can then start earning rewards on these reflection tokens and do not need to take any further action to qualify for the same.

The future of reflection tokens

Despite being in existence for a little under two years, reflection tokens are still a relatively new concept in the cryptocurrency world and are increasingly gaining preference among crypto investors. While tokenholders are enticed by the instant and transparent reward mechanism, developers looking to build community-centric projects are attracted by the potential to create sustainable ecosystems that could power Web3 platforms of the future in a truly democratized fashion.

However, as was seen with other types of cryptocurrencies such as stablecoins, memecoins and other altcoins, reflection tokens, too, will witness a natural consolidation, with some projects performing better than others. Investors will have to carefully select projects with strong fundamentals, while developers will have to strike a balance between affordable transaction fees and a healthy redistribution reward mechanism for tokenholders.

With some proponents believing that reflection tokens could see massive retail adoption compared with other asset classes in the crypto world, critics point out that the increasing complexity of smart contract code could limit the number of possible use cases. The future evolution and success of crypto reflection tokens will, therefore, depend on the pace of smart contract innovations and rising investor adoption of this self-rewarding type of cryptocurrency.