What is “Tokenomics”?
written by: Danielle Davis (NFTignition)
Tokenomics is a combination of two words, “token” and “economics”. It refers to rules and elements that define the prospect of different aspects of a crypto project. Looking at the tokenomics of crypto projects is vital to fundamental analysis as it considers the issuance, distribution, supply, demand, attributes, and other crucial economic information of a token. Therefore, it allows traders to evaluate the prospect of a token effectively.
A token is a digital asset or currency built on an existing blockchain network. The need for tokenomics arises because tokens have value and can be exchanged like any other financial instrument. Therefore, like traditional banks map out rules to print money and other monetary policies, tokenomics indicates how a token’s economics works within its ecosystem.
Unlike traditional economics, where the centralized body can create money out of thin air, every single economic action taken on a token and cryptocurrency, including its issuance schedule, is spelled out in the tokenomics. Therefore, traders and investors can accurately know and analyze the supply at any given time. Apart from this, the token distribution within the token’s ecosystem and among various team members is thought out in the tokenomics.
Elements of Tokenomics
As mentioned earlier, tokenomics defines an important economic component of a token. It defines the utility and maps out distribution, especially incentives for hodlers (HODL — Hold On For Dear Life). Here are some of the elements of tokenomics:
1 | Utility
The utility of a token is its importance or use case. It describes the functionality and use cases, indicating that the token is beyond a store of value — a factor important in making informed decisions about investing in a token. Many tokens serve as the native token of their network. This way, they can serve as legal tender while influencing economic activities.
For instance, Ether is the native and utility token of the Ethereum Blockchain. It powers the network and is useful for paying transaction fees and interacting with smart contracts on the chain. Tokens can also serve as governance tokens, especially in a DAO (Decentralized Autonomous Organization). This gives voting and decision-making power to its members.
2 | SUPPLY
Another element of tokenomics is the token’s supply. You can agree that there’s no economy without supply and corresponding demand. In fact, supply paves the way for demand. Meanwhile, supply and corresponding demand influence the value and price of a token. Therefore, all tokens, both fungible and non-fungible, have their supply. Different types of supply that exist in tokenomics include:
● Maximum Supply: The maximum number of tokens coded to a contract. It is also the number of tokens that will ever come into existence.
● Total Supply: This is the number of tokens that are in existence at a specific time. In other words, if some tokens have been removed from circulation or the maximum supply due to burning, the remaining tokens are the total supply.
● Circulating supply: This is the total number of tokens that is in circulation at a specific time. It is the total number of tokens held in public wallets.
For instance, BNB has a maximum supply of 200 million coins, a total supply of 159,978,810 BNB, and a circulating supply of 159,979,964 BNB. Bitcoin has a maximum supply of 21 million BTCs and a circulating supply of about 19.19 million coins. Some stablecoins like USD Coin and Tether (USDT) have no maximum supply. Their supply solely depends on the value of the reserve currency.
Looking at supply can help understand the future of a token’s value in the long term. For instance, Bitcoin’s 21 million maximum supply influenced its coin value of more than $20,000 per coin. On the other hand, Solana is trading at $34 with a max supply of more than 510 million.
Supply also influences rarity and exclusivity in non-fungible tokens. Bored Ape Yacht Club, the most popular NFT collection, has a total supply of 9,999 NFTs with a floor price of more than $110,000. Meanwhile, NFTs for gaming packs and merchs have high supply and low floor prices on secondary marketplaces.
3 | TOKEN DISTRIBUTION
Aside from the supply and demand, the allocation and distribution of tokens within its ecosystem. Knowing who and what holds tokens and allocation for different aspects of token development can greatly impact the token’s value.
A token’s developer determines token distribution before its launch. Generally, distribution according to launching can be via fair launching or presale access. A fair launch gives everyone a fair and equal opportunity to buy the token at launch. Presale gives early access or private allocation to some selected investors.
Token distribution is integral to a token’s issuance and sale process. The goal is to accrue enough funds to sustain the development of a project. Therefore, you should pay attention to how a token is evenly distributed among various investors and team members.
Also, pay attention to the token vesting period and the lock-up duration for tokens allocated to developers and investors. Usually, when a token is launched, some amount of circulating supply is allocated to developers and future investors. The vesting period of a token is the duration that the token allocated to the developer is locked. This way, investors can be sure that the project is not a pump-and-dump scheme.
4 | INCENTIVE MECHANISMS
Setting aside incentive mechanisms for participants and members of a token’s ecosystem is crucial for its long-term success. Some of the most common incentive mechanisms include:
● Mining and Staking Reward: Block reward for mining Bitcoin motivates more validators into maintaining and improving the network. Here, miners must invest and expend huge computational power to earn incentives.
However, Proof of Stake is gaining more popularity because its validation method does not require participants and users to have any computational power. Instead, they can earn incentives by locking up their tokens in staking pools. In other words, if you dedicate your tokens to the PoS network, you will earn a share of transaction fees.
● Yield Farming: Yield farming is similar to staking. It enables token holders to enjoy myriads of DeFi opportunities by holding tokens. A common example is lending and borrowing, where you can lend them out to anyone willing to take up a loan via smart contract. Examples of lending and borrowing protocols include Compound, Aave, Sushiswap, and Centralized Exchanges.
5 | BURNS SCHEDULE
The tokenomics also give details about the hyper deflationary mechanism in place to keep the token price from inflation. Tokens are permanently removed from the supply by burning — therefore, burning schedules gives insight into how and when the burning will happen.
Hyperdeflationary mechanisms ensure that the supply is kept at bay in relation to the token’s price. Therefore, some tokens are permanently removed to increase demand if the supply is high.
Importance of Tokenomics in Trading and Investment
In tokenomics, token utility is important in determining an asset’s practical use cases and applications. Understanding how a token works and how it will be used allows traders and investors to speculate about its growth and long-term viability. This potentially influences supply and demand — thereby affecting token value.
Supply and demand are important economic elements that every economist, trader, and investor considers. With excellent tokenomics that dictates innovative utility, there is a greater tendency for a balanced or greater demand for the token. Meanwhile, the greater the demand, the higher the price.
Tokenomics also give insight into the maximum supply, circulating supply, and total supply of token — remember, the higher the supply, the lower the price. However, it is important to note the difference between the value of a token in terms of total market capitalization and its price.
For instance, the Shiba Inu token has a one quadrillion supply and a staggering market capitalization of $6 billion. However, its price is just $0.00001046. On the other hand, Yearn.Finance has a low supply of 36,666 tokens and a market cap of $291 million. Its price is $7,900. Therefore, while demand always directly influences the long-term success of a token, supply may not.
Additionally, you can easily speculate the amount of ROI you can earn from incentivizing mechanisms set aside for tokens. ROI (Return on Investment) means the amount of token an investor can earn by holding a token.
Tokenomics helps in effective decision-making when investing in a token. It helps understand various price control mechanisms like burning/hyper deflationary and hyperinflationary mechanisms. This way, investors can have an overview of fail-proof for token value.
Lastly, elements of tokenomics help developers study the general game theory within the crypto space. This gives systematic knowledge about how people make decisions and what influences them to do things. This way, they can create a compelling and alluring story to build demand around their project.
written by: Danielle Davis (NFTignition)
The concept of Tokenomics was introduced in our most recent episode of From The Blockchain (a podcast brought to you by Fame Lady Squad). From time to time, listeners can expect educational content to be introduced on the podcast and further explored here — make sure to subscribe!
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