A popular word for describing the internal dynamics of crypto projects, tokenomics, sheds light on how the asset functions, along with the psychological or behavioral forces likely to affect its value. Incentivizing buying and holding of the token and well-designed tokenomics plays a pivotal role in the success of a project.
On the other hand, projects with poor tokenomics bite the dust sooner or later. Improper token mechanics is the first sign of upcoming trouble. Understanding tokenomics is a critical step when making the decision whether or not to buy a crypto asset.
This article digs into the functioning of tokenomics, main features, cryptocurrency supply and demand, token burning, allocations and more. You’ll learn why tokenomics is important and how to use tokenomics to determine cryptocurrency value.
What is tokenomics?
Tokenomics is an amalgamation of two words “token” and “economics,” referring to the supply and demand characteristics of a crypto project. It takes into account the economics of a crypto token: issuance, attributes, distribution, supply, demand and other characteristics.
Let us examine what a crypto token is. It is a unit of digital currency built by crypto projects on top of an existing blockchain. Like any usual currency, crypto tokens hold a certain value and are exchangeable.
Regarding economics, it will help to find out how token economics differs from traditional economics. Regardless of the era in history, governments have been creating additional money out of thin air. Fighting a war or dealing with drought can be very expensive. To deal with it, raising revenue isn’t always an option and authorities find minting currency a simpler alternative. Creating additional currency eventually reduces the value of the existing money.
Crypto projects, however, have pre-determined and algorithmically created issuance schedules for the tokens. We can accurately predict the number of coins in circulation at a specific time. The distribution of coins among various stakeholders is thought out in advance as well. Though it is technically possible to alter the issuance schedule and distribution plan, the process is hard to implement.
How does tokenomics work?
Tokenomics set up the economy of a crypto project by creating incentives for the hodlers of the token and defining the utility of the tokens, a major factor behind their demand. Various variables that developers play with to influence various facets of tokenomics include:
A major criterion in tokenomics of various projects is the supply of coins. You need to take into account the total as well as the circulating supply. Bitcoin (BTC), for instance, caps the total supply at 21 million coins and the last coin is expected to be minted around the year 2140. Solana (SOL), on the other hand, has a total supply of 508 million SOL.
Nonfungible token (NFT) projects, too, restrict the number of tokens to be minted. CryptoPunks, for instance, has a mark of 10,000 Punks in the v1 and v2 contracts, while Bored Ape Yacht Club has a total of 9,999 NFTs. Rarity and exclusivity lead to a higher price of the NFTs.
Token allocations and vesting periods
Detailed token allocations to stakeholders are a norm in crypto projects now. To establish credibility of the product, the practice now is to keep a vesting period on the tokens allocated to venture capitalists or developers. The vesting period keeps developers’ tokens locked for a certain period, thus saving investors from the perpetrators of pump and dump schemes.
Mining and staking
Initial blockchains like Bitcoin and Ethereum — at the moment — release tokens to incentivize miners for validating transactions. This process is called proof-of-work (PoW). Miners have to use their computing power to mine new blocks and add them to the blockchain. In proof-of-stake (PoS) blockchains that have implemented a staking model for validators, rewards go to those who have locked away a certain number of coins in a smart contract. With the consensus layer upgrade, Ethereum is moving toward this model.
Yield farming enables anyone holding crypto to earn additional tokens. You may lend your funds to anyone wanting a loan via smart contracts, earn interest and principal in the form of tokens. Yield farming powers huge pools of yields in decentralized exchanges (DEXs).
To prevent inflation, crypto protocols need to burn tokens to permanently remove them from circulation. As the number of tokens in circulation becomes scarce, the price is likely to go up. Binance quarterly burns its native token BNB to reduce its total supply. In November 2019, Stellar destroyed 55 billion XLM tokens, about 50% of its total supply, resulting in a short-term price increase of over 30%.
The supply and demand of cryptocurrencies are major determinants of their prices. Let us examine how developers work up tokenomics:
At its core, economics is all about understanding the supply and demand of a currency. These two factors give an insight into how desirable a given currency is. The same theory also works in tokenomics, giving you a clear idea about the supply of a given token and its demand.
Let us examine the supply side first. We need to determine whether the value of a token will increase in real terms or will it be inflated away, factoring in just the supply. Economic theory holds that the value of a token will increase if there are fewer tokens in circulation. This phenomenon is called deflation. On the other hand, if the total number of tokens increases, the value will decrease. This is what inflation is.
When examining the supply side, you don’t have to consider factors like the utility, the capacity to generate income for its holders or others. The only criterion is the change of supply over time. You consider the number of tokens in existence currently, the number algorithmically set to be mined or released in the future during the process of release.
Examining the supply side of Bitcoin will help in understanding it all better. As mentioned, its supply is capped at 21,000,000 Bitcoin, which is released at a rate that is halved every four years or so till 2140. More than 19,000,000 Bitcoin have been mined by June 2022, so the pending 2,000,000 more to be released over the next 120 years. This means only around 10% of Bitcoin will be mined for more than 100 years from 2022, ruling out any serious inflationary pressure.
The demand side
Only the supply side doesn’t create any value. Rather, it is the demand side that makes a token valuable. Let us understand this phenomenon.
Suppose you have 10 beautiful baskets at home. Buoyed by the intricate design, you begin believing they are in great demand. You announce you will bring home no more of them, creating a fixed supply. Job done well? Baskets should be worth diamonds now. A genius move? No.
A fixed supply doesn’t automatically get translated into value. People need to believe the stuff has value now and will carry it in the future. To determine whether a token will be in demand, you need to examine the return on investment (ROI), game theory and memes.
ROI refers to the cash flow a token is expected to generate for someone just holding it. A hodler of Avalanche (AVAX), for instance, can stake their tokens to secure the network and earn more AVAX in the process. Some protocols allow stakers to take home a share of the protocol revenues. Anyone holding SushiSwap (SUSHI), for example, is entitled to the earnings of the protocol itself.
If the token has no inherent ROI, people won’t have the intent to hold it. If you conclude others trust the token to hold value, you will be willing to put your money in it.
Energy levels of the community
Community enthusiasm provides an insight into the belief of the people who have staked their funds or emotions in the token. Gauge their energy levels on Discord, Twitter and other social media. Determine how long the people have been active in the community. Are they willing to make the token part of their identity?
Moreover, community energy levels are a key driver of the future demand for the token. A prime example of how plain belief can drive a token ahead is Dogecoin (DOGE). A meme token made its way into the top crypto tokens thanks to its cult-like following.
A fundamental mechanism beneath any technology is called game theory. In simple words, it is the systematic study of how and why people make decisions. It uses mathematical models of conflict and cooperation to understand the behavior of decision-makers. Applied in the crypto domain, it enables developers to gauge the process of decision-making by the stakeholders in an interactive environment.
Elements in the tokenomics design help augment the demand for a token. Lockups have proven to be a good game theory in tokenomics. It has the protocol incentivizing token holders for locking tokens in a contract and, in return, getting more rewards.
On Curve protocol, you have to lock your Curve Protocol (CRV) tokens to get a share of the revenue. Lock the tokens for a longer period and your earnings will go up as well. With strong incentives to stake CRV for a longer time, stakers have few reasons to unlock their tokens.
Tokenomics examples: Near Protocol
Near Protocol (NEAR), powering Near Protocol, has a string of use cases such as securing the protocol, acting as a unit of account and medium of exchange for internal resources and external applications and more.
Token utilities include:
Fees for executing transactions
Staking and participating in network security
The total and maximum token supply of NEAR is 1,000,000,000. The protocol incorporates fixed issuance of tokens that is around 5% of the total supply each year. 90% of tokens go to validators as a reward, securing transactions, storage and computing. Transaction fees collected by the network are burned to keep inflation in check.
The way ahead
A proper understanding of tokenomics under your belt provides you with fundamental skills to evaluate a crypto project. With their docs or white paper, you can get an insight into the supply and demand of tokens. You will be able to figure out how their team is driving demand for the token and rationally analyze its future prospects.
Tokenomics is a key factor in determining how a token will perform against the United States dollar, Bitcoin or altcoins. Analyses helps you conclude if the developers have come up with innovative ideas regarding the token allocation or just have implemented the prevailing ideas. It also helps to pick up projects with good tokenomics, enhancing the value of your investment.