“In the short run, supply and demand alone determine market prices. Over the long run, the crowd is always wrong.”
~ Legendary value investor, Seth Klarman
Tokens, a digital cryptocurrency unit, do not have a mutually agreed-upon worth. The fair value must be created for them at launch and over time. In the long run, though, we must slice and dice how economics and tokens interplay to accurately predict and understand tokenomics in the web3 world, whether we are a user, a regular user or an investor. Every crypto project has a tokenomics model, a web3 term coined to mean the following set of defined or undefined rules about tokens and how psychological or behavioural factors can affect and fluctuate them and the digital coin’s fair value in the future. The parameters are for understanding purposes and are in no particular order.
Project-market fit
Basic business principles still apply to the product-market fit lens, and the same traditional questions are to be answered about whether a good product correlates with a utility-driven virtual token: (a) is there a demand for this intangible product, service and project? (b) are other web3 players trying to solve the same problem? (c) are investors showing interest and willing to place bet on this and similar blockchain projects?
Economics models
In crypto projects, this can be explained via four models: (a) Deflationary, when there is a hard cap on the number of tokens generated. (b) Inflationary, when there is no hard cap or limit on the number of generated tokens. (c) Dual-token, when there are two tokens, one for utility and the other for security. The security token is a credential obtained for regulatory compliance, offering scope to offer upgrades and to vote, trade and stake. In contrast, the utility token allows the freedom to access the project or protocol’s products, services, and payment means. (d) Asset-backed, when the token value is tied to a tangible, real-world asset, making it possible to sell gold, real estate, etc.
Supply and demand
Supply has a bearing on inflation and deflation tendencies. As more tokens come into circulation from foundation, treasury, marketing, or liquidity, or when there is a big release on a particular day, each token decreases in value, or the supply may even crash the token value. It could have inflationary repercussions and endanger its longevity as a whole. The token value increases when you remove tokens from the circulating supply. It is burnt, i.e., permanently removing tokens from the maximum pool or performing periodic token buybacks, thereby temporarily reducing the circulating supply. It prevents inflation, maintains demand, and preserves token value.
Staking
The longer you stake (lock) some of your holdings, the more you earn rewards over time, giving other stakers a reason to refrain from withdrawing their unlocked or locked tokens. By using the consensus mechanism called proof of stake, every transaction is verified and secured without a TradFi bank or payment processor in the middle.
Distribution
After minting and generating comes distribution and how and to whom it is done with vesting or lockup periods. It can be (a) crowdfunded through Initial Coin Offerings and Initial Decentralised Exchange Offerings (b) pre-allocated to advisors, developers and team members (c) fair launch or public distribution (d) airdrops to receive free tokens in exchange for promotional work or task completion, or simply for token project awareness (e) stakeholders as in large institutions, retail investors, and, of course, the founding team (f) to early-bird investors (g) through mining rewards as in proof-of-work blockchain networks and staking rewards as in proof-of-stake networks.
Vesting periods
The tokens will be locked for a designated period before distribution or getting released to the circulating supply to incentivise the project’s long-term development. Projects with little to no vesting period are red flags inviting players who seek to get in and get out, using the project as a quick way to make money. Projects with extended vesting periods attract and lock investor interest, ensuring that they believe in the idea, the goal and the project’s long-term future and allowing the necessary time for a product to be developed and launched without any added pressure.
Rewards model
User incentive models are implemented to encourage developers’ participation and keep participants actively engaging with it honestly. Incentive mechanisms motivate users to take action, providing the project with trust and long-term stability. The most apparent examples of user incentives are rewards for mining a new block and transaction fees on the Bitcoin network. Thus, it can mean and market many things, viz. (a) to incentivise to buy tokens (b) to buy the tokens to submit their projects to a chain (c) to vote and stake tokens (d) to participate in funding crowd loans of the developer projects (e) to allow voting on topics like fees, chain connections, and upgrades thereby cultivate a sense of participation and pride (f) to make users feel that they are contributing in the meaningful evolution of an exciting project thereby creating a sense of goal alignment and purpose.
Security audit
It is customary for projects with legitimate tokenomics to enlist a third-party security firm to periodically audit its token code or core smart contracts, especially for DeFi projects, and check areas such as regulatory mechanisms. Such audits guarantee that the core project team does not reserve the right to issue new tokens outside the publicly disclosed amount or suddenly assume control of user tokens. It ensures that functionalities such as vesting contracts and token distribution addresses match publicly available information.
Existing users
A tokenomics designed to serve an existing user base would have greater longevity than one targeting new customers. For instance, a project with hundreds of thousands of existing users before releasing its tokenomics would have an existing business model that would last into the foreseeable future. Early adopters can, then, receive a sizable portion of the token allocation as a reward for supporting the project in its early years.
Token disclosures
It is a green flag if the project team discloses the influencers and third parties it has engaged to promote the project and the number of tokens given to each influencer. This information also includes the number of tokens sold and the value of the tokens when sold to early-stage and subsequent investors.
Skewed allocation
Suppose a tokenomics distribution is skewed towards the core project team, with, say, ~50% of the total allocation with a short vesting period. In that case, it could signal a red flag for potential investors, as it can enable price manipulation. The same principle applies to a distribution heavily concentrated on early-stage investors, who usually buy in at a discount and can sell at massive profits even if the asset’s price drops.
Bogus use cases
Without a clear use case, tokens will struggle to find demand aside from pure speculation. Investors should consider how stated use cases are core to the primary product offered by the crypto project. Wary investors might be concerned if the core product can exist without the token or has no precise method of driving demand for the asset.
Opaque schedule
Suppose a project’s tokenomics does not disclose the release schedule for non-circulating tokens. In that case, it may be considered evidence that the project intends to dump tokens on unsuspecting investors. Such token release schedules must be publicly disclosed and updated frequently to ensure all stakeholders keep track of key dates.
Utility chain
With the token in the blockchain ecosystem, users should envisage and, viz. (a) be able to quantify the return on investment (b) access exclusive benefits on the platform (lower trading fees, discounts on purchases, participating in new token sales, etc.) (c) to incentivise miners or validators for maintaining security and verifying transactions on the underlying blockchain. Users also pay fees to transfer assets between addresses (d) to establish a system to reward active users and new depositors with tokens through a liquidity mining program or gamified tool used in web3 games.
Governance model
On-chain governance tokens give voting rights on critical decisions with consensus mechanisms. For instance, it allows holders to vote on changes to a lending protocol, support proposed changes, vote on proposals, elect representatives, or make changes to the decentralised exchange.
Yield farming
You may lend or stake your cryptocurrency to anyone wanting a loan via smart contracts to earn interest and other rewards in the form of additional tokens. Yield farming powers huge pools of yields in decentralised exchanges.
