Tokenomics is becoming a pivotal part of cryptocurrency these days. The term is used to describe the economic properties of crypto projects including the psychological or behavioural factors affecting their value. The tokenomics design of a project can often make or break it.
Tokenomics is, therefore, important not just in the field of cryptocurrencies but also for other blockchain-based digital assets such as NFTs. Understanding it can help you in deciding whether you should buy a cryptocurrency or not.
This article will, hence, shed light on cryptocurrency tokenomics, the concepts of tokenomics, and the role of tokenomics, and explain its importance in simple words.
What is Tokenomics in Crypto?
Tokenomics is a portmanteau of the terms “Token” and “Economics.” In simple words, it is a field of study concerned with the economic aspects of cryptocurrency tokens. It studies the supply and demand characteristics of crypto tokens and other factors affecting their value such as their attributes, distribution mechanism, and psychological factors that may have an impact on their value.
Tokenomics is central to evaluating the future prospects of a crypto project. It is what often determines the sustainability of a crypto project. The development team of a crypto project designs its tokenomics rules which are then implemented through the project’s code.
In a project with good tokenomics, these rules would be transparent, predictable, and difficult to change. You can then study the project to decide whether it is something worth investing in or not.
What are the Concepts of Tokenomics?
There are certain core concepts that you need to know about to better understand the idea of Tokenomics. These concepts or features are:
Most cryptocurrencies have a hard cap on the number of coins that will ever exist. Bitcoin, for example, has its supply capped at 21 million coins. The maximum supply of a coin depends on several factors including objectives and uses.
What happens is that when a token is launched, a portion of its maximum supply is put into circulation which is called ‘circulating supply.’ Subsequently, projects may circulate additional coins according to their schedule. But sometimes projects can delay the release of more coins with little to no justification which is more often than a red flag.
A crypto token’s utility refers to its practical usage. The market value of a token is often determined by its use cases or utility within a particular crypto ecosystem. Some common use cases for crypto tokens are:
Offering Exclusive Benefits
Tokens can be used to offer users of a platform some exclusive perks and benefits. Such perks generally are discounts on trading fees, early access to new projects or sales, etc.
On Proof-of-Work(PoW)-based protocols, tokens are used to reward miners for their role in validating transactions on the blockchain.
Enabling Participation in Governance
Crypto tokens are also a way for users of a project to participate in its governance. Token holders are given the right to vote on proposals which are then implemented only with their consent.
Token Mining and Distribution
In order for people to use a network, the crypto project must distribute coins to existing and prospective users. This is usually done via mining or initial coin offerings(ICOs).
In token mining, users participate in the network by validating transactions on the blockchain. These validators or miners are, in turn, rewarded with newly minted crypto coins. On the other hand, a part of the token supply can be directly sold to users via ICOs as a token distribution measure.
Cryptocurrency projects adopt deflationary measures to ensure long-term value for investors. The rationale here is that reducing the token’s supply would increase the value of the coins in circulation. Hence, most crypto projects practice coin burning.
Token burning is the process by which coins are permanently removed from maximum supply. Binance, for example, uses its quarterly profits for buying back and burning BNB coins to maintain its value. Some projects also go for periodic token buybacks to reduce the circulating supply of their tokens.
Tokenomics includes measures that are used to make a token accessible to users across various networks. It is the tokenomics design that gives clarification about the token’s base layer and its bridge infrastructure.
Most tokens are created on Ethereum and hence, follow the ERC-20 standard. This means that all these tokens can be easily transferred across Ethereum’s network infrastructure. However, project developers may subsequently provide for bridging across different chains such as Solana, Polygon, or BNB Chain to boost interoperability.
How Does Cryptocurrency Tokenomics Work?
It is essential to talk about the ‘Economics’ part of tokenomics to understand how the process works. In economics, the two most important aspects of determining price are demand and supply. The same applies to cryptocurrencies.
Keeping aside other factors like utility or investor sentiment, the supply theory states that the value of a token will increase if its supply is reduced. This is known as deflation. Inversely, it is believed that increasing the supply of a token will dilute its market value. This phenomenon is called inflation.
Crypto projects aiming to maintain their tokens’ value in the long term wish to avoid inflationary pressures as far as possible. Hence, they employ measures such as buybacks and token burning to control the supply of their tokens.
Let us consider Bitcoin as an example to understand this better. As stated earlier, Bitcoin has a maximum supply of 21 million coins. A Bitcoin halving event takes place every four years which reduces the mining reward. Hence, the amount of new tokens released into circulation keeps on decreasing with every subsequent halving event.
This helps in ruling out the possibility of severe inflationary pressures in the future.
Only supply does not guarantee value. Anything needs to have value in the eyes of the buyer to create demand. The same is true for crypto tokens. It is useless unless it has significant demand. For cryptocurrencies, the factors that determine demand can be boiled down to return on investment(ROI), game theory, and memes.
The cash flow an investor expects from his token holdings is called ROI. SushiSwap, for instance, entices SUSHI holders by giving them the earnings of the protocol. Other crypto projects may encourage staking to secure the network. These stakers are then rewarded with crypto tokens for their efforts.
Users stake their assets as they expect good ROI on their holdings. If a token does not give any sort of ROI, people would not be interested in investing in it or holding it.
In simple words, Game theory studies how and why people make decisions. Mathematical models of conflict and cooperation are applied in game theory to understand the psychology of decision-makers. In the crypto world, it is used to predict and analyze decision-making by investors in a virtual interactive ecosystem.
Generally, some aspects of the tokenomics design can be a good gauge of a token’s demand. Protocols incentivizing token lock-ups and subsequent rewards generally tend to have decent demand.
Memes or Community Sentiment
Remember Dogecoin, the first meme token that gained legitimacy and popularity due to its fan base and memeability. This just shows how larger community sentiment and enthusiasm can play a significant role in determining a token’s demand. The energy levels of the community around a particular token can be gauged on social media channels such as Discord and X(formerly Twitter).
Cryptocurrency Tokenomics Examples
Bitcoin is the most famous and sought-after cryptocurrency. It was created by an anonymous developer Satoshi Nakamoto who capped its supply at 21 million coins. It uses the PoW protocol and rewards miners with new coins for validating transactions. Users also have to pay a small network fee to complete their transfers.
Bitcoin’s distribution schedule is pretty predictable. New coins are given to miners every ten minutes as new blocks are mined. The reward received by miners is reduced every four years after an event called Bitcoin halving. Accordingly, the mining reward which was initially 50 BTC has now come down to 6.25 BTC after subsequent halving events.
Interestingly, Bitcoin never had an ICO or ICO-like event where presale tokens were allocated to select investors. Hence, every Bitcoin today in existence is a mined token.
As per Satoshi Nakamoto, Bitcoin was created as a peer-to-peer digital currency that was to be an alternative to government-controlled fiat currency. However, this use case has not been fully realized till now. Bitcoin’s popularity is driven largely due to its speculative nature and most people see it as a lucrative store of value rather than an alternative payment option.
After Bitcoin, the Ethereum network’s Ether(ETH) token is the largest cryptocurrency by market capitalization. But unlike Bitcoin, ETH does not have a predetermined maximum supply. The token is designed such that its supply keeps increasing at a controlled pace. Therefore, new tokens will keep coming into existence as the network expands.
ETH was pre-mined and then issued to early insiders soon after the Ethereum blockchain was launched. After that, it was sold via an ICO in 2014 to investors across the globe. It is reported that 7 million ETH worth $2.2 million at the time was sold just in the first 12 hours.
While Ether is very much a cryptocurrency like Bitcoin, it is primarily used for transactions on the Ethereum network. Its main use case is in facilitating the transfer of assets on Ethereum as users pay the fees for their transactions in ETH.
BNB is the native coin of the world’s largest cryptocurrency exchange Binance. Like ETH, it does not have a hard cap on its supply and the platform uses a portion of its profits to buy back and then burn BNB tokens to maintain its value.
The BNB ICO was launched in 2017 to raise funds for the Binance platform. Out of the total tokens available for sale, 40% were allocated to the founding team. 10% went to angel investors and the remaining 50% was sold to the general public in an auction.
BNB can be used by traders to get discounts on trading fees on Binance. BNB holders may also be given early access to new token sales on the platform. The token is also used for paying fees on the BNB Chain.
What is Good Tokenomics?
Studying the tokenomics of a crypto project can give you a good idea about the project’s viability. So what are some positive signs that you should look out for when studying a project’s tokenomics? Let us have a look at some such features:
Existing User Base
A project that already has a decent user base even before the release of its tokenomics has more chances of surviving in the long term. This is because something designed to serve an existing user base indicates that the toeknomics design has an established business model that would last into the foreseeable future.
A great example of this phenomenon is UniSwap’s UNI token. The platform was up and running towards the end of 2017 years before the token launch. This helped the team build a user base before the token was eventually launched in 2020.
Legitimate projects would usually enlist third-party firms to conduct security audits of their token code or smart contracts. Such audits minimize the possibility of rug-pull schemes(particularly in DeFi projects) and assure potential investors that the core smart contracts and token addresses match with the publicly available information.
Good tokenomics is when the project team readily discloses information about the token. This includes information about the influencers and third parties it has hired to market the token as well as data about the number of tokens sold to early investors. Most crypto projects, however, do not publicly share such information.
Why is Tokenomics Important?
A good tokenomics design is important for crypto projects to become self-sustaining. It is an area of study that helps developers create a new model or modify an existing one as per the needs of their project. This helps in building a stable platform which in turn helps to attract users towards the platform.
For investors, tokenomics is important to analyze the viability of a crypto project and make informed decisions about their participation and investment. Further, a coin’s tokenomics design also impacts its liquidity and value which determines whether investors view the token as worth it or not.
Tokenomics is a field of study concerned with the economics of crypto tokens. It has been gaining importance as a proper understanding of tokenomics can help users better evaluate a crypto project. Studying a cryptocurrency’s white paper can give prospective investors an insight into the token’s aims and objectives. In this way, they can analyze the project’s future prospects and accordingly make decisions.