The role of tokenomics in the cryptosphere
Tokenomics is at the heart of cryptocurrency functionality as it defines the internal dynamics or the monetary policies hard-baked into crypto projects’ code, explaining how the asset functions and the forces likely to affect its value.
Like the concepts of inflation and deflation in economics, tokenomics relies on the principles of supply and demand. In short, tokenomics considers the economic dynamics of a cryptocurrency, such as distribution, issuance, attributes and supply.
The tokenomics of supply and demand in crypto determine token circulation and provide pointers on when and how more tokens will enter circulation. Likewise, it can determine how holders accrue the cryptocurrency and, in response to demand, decide the timing for withdrawing tokens from circulation.
Tokenomics determines the value and usage of a token. For instance, Bitcoin (BTC) has a total supply cap of 21 million coins, while Solana’s SOL (SOL) caps out at 508 million. On the other hand, nonfungible tokens (NFTs) are unique, exclusive tokens, which makes them suitable for digital art.
Crypto project creators typically predict the number and distribution of coins in circulation and create algorithmically and pre-determined schedules for issuing or withdrawing tokens. Token supply dynamics play a key role in deflationary and inflationary token market liquidity and economic models in crypto.What are inflationary tokens?
Inflationary tokens are meant for day-to-day activities, so they are usually in ample supply and hardly ever suffer from low levels of market liquidity.
Cryptocurrency inflation refers to the declining purchasing power of a cryptocurrency over time. Inflationary tokens apply the same principles, employing a crypto framework aimed at devaluing the coin by increasing its supply.
An inflationary token allows for an increasing number of tokens in circulation through a mechanism facilitating a steady increase in coin supply entering the market. The tokenomics of each crypto usually provide a predetermined rate of inflation, determining the percentage increase of the token supply over time.
As more coins enter the market, the coin’s value drops, at least in theory. This decreases its purchasing power, as users spend more tokens to buy assets. Some of the approaches employed by inflationary coins include mining and staking. This can encourage participation in the network, as users who mine or stake tokens typically receive rewards.
An example of inflationary crypto is Dogecoin (DOGE). In 2014, its creator removed its 100-billion supply hard cap, ensuring a limitless supply of the token. As a result, DOGE has decreased in value as supply outstripped demand.
What are deflationary tokens?
Cryptocurrency deflation refers to the increase in the intrinsic value of a cryptocurrency over time when the supply decreases or remains constant.
Deflationary cryptocurrencies take a different approach, as they are engineered to reduce the token supply. Despite consistent demand, reducing the number of new coins should lead to at least maintaining their value.
The design of a deflationary cryptocurrency aims to achieve token scarcity by reducing supply and driving up the token’s value over time. The process hopes to gradually reduce the number of tokens and maintain practical utility without upsetting the balance or triggering market volatility.
Deflationary tokens, unlike their inflationary counterparts, don’t have a fixed deflation rate in their protocol. Instead, the protocol dictates the conditions under which tokens are removed from circulation, usually through a burning process. This mechanism reduces the supply over time, but the rate of decrease isn’t set for a specific period and varies based on network activity. For instance, a token with a 2% deflation rate will reduce its total token supply by 2% annually. A deflationary token may have a fixed or variable supply cap limiting the number of tokens.
Creators of deflationary tokens may utilize direct or indirect mechanisms to destroy coins in circulation. A common way to facilitate a reduction in supply is by utilizing token burn mechanisms, a process that eliminates a portion of the tokens from circulation permanently. Alternatively, they could burn some tokens as gas fees for transactions on the blockchain.
An example of a deflationary cryptocurrency is Binance’s BNB (BNB). Every quarter, Binance holds a burning event to get rid of excess BNB. Additionally, it burns a portion of the BNB as transaction fees. Binance has pledged to burn 50% of the BNB supply.
How inflationary and deflationary tokens affect trading volumes
Deflationary and inflationary tokens affect market liquidity in various ways as they experience diverse drivers of fluctuation.
High trading volumes are desirable, as they facilitate better order execution and, therefore, more liquidity than lower trading volumes. The goal of inflationary and deflationary tokens is high market liquidity while maintaining token price stability, which is achieved in several ways.
Supply regulation
Fundamentally, deflationary and inflationary tokens hope to regulate the supply of tokens in the market, directly impacting market liquidity. It involves adjusting the circulating supply, total supply and maximum supply. For instance, Bitcoin has a 21-million hard-cap supply.
Staking and mining
Blockchains like Bitcoin and Ethereum provide rewards that incentivize miners (liquidity providers) to keep releasing tokens, ensuring a steady supply of tokens. Miners utilize proof-of-work (PoW), while stakers rely on proof-of-stake (PoS) mechanisms to generate new tokens.
Token burns
Deflationary cryptocurrencies occasionally take a chunk of coins permanently off the blockchain by burning them to prevent inflation and stabilize market liquidity. For instance, the founder of Uniswap burned nearly $650 billion worth of HayCoin (HAY) in October 2023, or about 99.9% of all HAY tokens, over concerns about speculation.
Yield farming
Users who don’t intend to utilize their tokens can turn to yield farming. A yield farm allows one to employ smart contracts to lend funds to people needing loans and earn interest and more principal tokens in return. Yield farms utilize liquidity pools to improve market liquidity and make transactions smoother.
How inflationary and deflationary tokens affect market liquidity
The reduction or increase in the supply of tokens caused by inflationary or deflationary tokens can either improve or hinder liquidity.
Inflationary tokens increase the supply of tokens, facilitating liquidity, while deflationary cryptocurrencies reduce the supply of tokens in circulation, which might cause liquidity constraints. Inflationary tokens typically have a lower purchasing power as adding tokens increases supply, which reduces demand and lowers their value.
Deflationary tokens are susceptible to market or price manipulation. Large tokenholders (whales) might hoard tokens in anticipation of a deflationary event and then dump them when the scarcity drives prices higher, setting off price volatility.
However, some inflationary cryptocurrencies like Ether (ETH) have embraced burning mechanisms during high activity, reducing the number of tokens in circulation and stabilizing token prices. Consistent demand and the reduction of tokens for deflationary tokens ensure they generally appreciate in value because of the lowered liquidity.
Inflationary cryptocurrencies are intended for daily usage and spending; therefore, they are in ample supply and usually have no hard cap limit. Because of this, they have high liquidity, unlike deflationary cryptocurrencies, which are meant for value preservation as a store of value and a hedge against inflation. On the contrary, inflationary tokens are generally not highly liquid.
Moreover, inflationary tokens have a flexible monetary policy, ensuring a steady supply and addition to circulation whenever there is a shortage, improving market liquidity. Deflationary tokens are geared toward increased adoption and scarcity with time, leading to suboptimal liquidity.