Understanding Tokenomics (I) — Introduction to Incentivization/ Role of Supply & Demand
All of us deep into the crypto space have come into contact with the term tokenomics in one form or the other. Whether it be research on new upcoming De-Fi projects, or assessing P2E economies, tokenomics seems to be a core aspect of any serious whitepaper out there. So, what makes tokenomics so important other than its effects on the price of a coin or token?
What’s the Difference?
To assess tokenomics we must first begin by looking towards the purpose it serves and its differences from classical economics. In essence, economics looks more towards explaining the way our current economy functions by creating theoretical concepts based on prevailing economic statistics. Tokenomics on the other hand looks to utilize these preexisting and well-reviewed economic theories to artificially create a functioning economy for exchangeable assets/tokens.
Incentivization: Role in Tokenomic Mechanism Design
Incentivization is one of the core considerations when developing the economic infrastructure of a particular token. How a user of a platform is rewarded and the methods in place to maintain the value of said reward are key aspects of tokenomics and play a pivotal role in the success of any one project. Incentivization is not limited to only the users of a particular token but also other stakeholders such as miners, early investors, and the founding members of the team. How much of a particular token is “burned” when a transaction is executed compared to how much is mined, can help determine whether a coin is deflationary (Coins in circulation decrease with time) vs inflationary (Coins in circulation increase with time). Some coins like Axie Infinity’s SLP token have no cap on circulating supply. SLP is earned by players when completing in arena type battles using their Axie NFTs. While there are current methods employed to limit SLP creation such as limiting the amount of SLP a player may earn on a particular day, the amount of SLP created daily far outweighs the amount burned by breeders. The above example Segue us beautifully to the study of supply and demand.
Supply and Demand: An Assessment on Price Impact
Price of any coin or asset is based off a combination of supply and demand factors. Limiting supply and inelastic demand (a measure of changes in demand to changes in price, indicating low demand change relative to price change) can result in major pumps pushing price higher all while creating strong support levels to limit the size of any potential corrections. For example, staking mechanisms limit coins/tokens available for sale, thus reducing supply. If the project has any form of value, staking rewards that prevent significant inflation, and strong demand from retail investors, the limited supply will increase prices as investors becoming more willing to pay to obtain a position. While many investors may be more interested in short term gains and will most often take profit after a certain holding period, causing a correction in price levels, other long term-oriented investors would rationally stake their coin/token to earn the associated APY. If the percentage of coins/tokens staked grows after the correction, then supply is effectively further limited, which in turn reduces selling pressure and providing the optimal environment for strong support levels.
Conclusion
The same thought process may be applied to any form of De-Fi tokens. In the end of the day incentivization will form the foundation on how the overall economic model will be built. How the economic policies set in place play out to expected / unexpected factors will determine how well it maintains its long-term price level. Fluctuations around a mean treading in a specific direction, or more preferred horizontally, are expected and are indicative of the stability of the implemented tokenomic policy.
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