Understanding Supply Tokenomics: What Is It and Why Does It Matter?

Tokenomics is a relatively new term, in short, it is the economic model of a token. It encompasses everything from the initial creation of a coin or token to its eventual use and retirement including supply and demand, distribution, utility and token burn schedules. This article is a 5-minute read and guide to tokenomics, with particular attention to supply tokenomics.

Defining tokenomics

Tokenomics — simply put — is the topic of understanding the economics and characteristics of a cryptocurrency such as, supply and demand, distribution and incentive mechanisms that provide the coin or token with value and/or utility.

Tokenomics is vital to the success of crypto initiatives, it outlines the key components of the project such as, the white paper, founding team, plan and community development. It should be noted, in spite of its misleading name, ‘tokenomics’ refers to both tokens and coins.

Rules are designed around the tokenomics to encourage or discourage various user actions within the cryptocurrency’s ecosystem. These include things such as buying, holding, selling and the general movement of the currency. This is comparable to fiat currencies, where banks develop policies to assist forecast or manage currency movement in the market.

These rules are outlined in a whitepaper, an extensive document that explains what the proposed coin or token will do and how it will work. They are also written into the computer code of the coin or token, usually by the founding developers and are transparent, predictable and because it goes on the blockchain, extremely difficult to alter.

Supply: supply cap, circulation and burning

There are three types of supply components to look for with any cryptocurrency: circulating supply, total supply and maximum supply.

A token’s circulating supply is the number of tokens that have been issued and are presently in circulation. The total token supply is the number of tokens that are currently in existence, even if not circulating, excluding those that may have been burnt. Finally, a token’s max supply is the maximum number of tokens that can ever be produced. Not all tokens have a maximum supply.

When you are deciding on purchasing a pair of trainers, one of the factors that you might consider is how in demand those trainers are. When trainers are created as limited-edition, suppliers are able to charge more in the primary market, where you the consumer might purchase them i.e. the store. It also boosts the price in a secondary market such as Amazon, where you might choose to sell them on at a potentially higher price to someone who has lost the opportunity to buy them in the primary market due to scarcity. In much the same way, supply and demand hugely influence the price of a particular cryptocurrency.

Understanding how these are embedded into tokenomics gives us a solid idea of how attractive a particular token or cryptocurrency should be. When examining the supply side, you are essentially considering supply and how it will vary over time.

Some key questions you want to answer are:

• How many of these tokens exist right now?
• How many will ever exist?
• How quickly are new ones being released?
• How many are being burned and how quickly?

When evaluating tokenomics, an important question to ask is whether a limited or unlimited supply makes the asset more valuable; is there incentive to buy and is there incentive to hold?

Examples

Take Bitcoin for example, Bitcoin has a supply cap of 21,000,000 BTC, with a release rate that is halved approximately every four years. In twenty years, Bitcoin has released a total of 19,000,000 The remaining 2.1 million Bitcoins are expected to enter circulation after a century, and even then, not all tokens will reach the market. Going back to the trainers, if you are aware that the item is limited in supply, you are more likely to purchase them when opportunity arises as you know the value will increase and you wouldn’t expect the price to drop — if you haven’t chosen to wear them that is! It also acts as an incentive to hold rather than buy and simply sell, as you would expect a return on your investment (ROI) if you hold on to the asset(s) and sell it at a later time when the asset is worth more.

Some cryptocurrencies have no supply cap. Ethereum (ETH) for example, can in theory mint a limitless amount of Ether forever. However, Ethereum have around 118,000,000 Ether circulating and have implemented a burning mechanism to stabalize their supply. Crypto burning is a process that effectively takes coins or tokens out of circulation by reducing the total supply of the coin or token, in many cases increasing demand.

Stablecoins, created to be free of the shortcomings of cryptocurrencies — namely price volatility — have no maximum supply and the coins are issued based on the reserves backing the coin. The Himalaya Dollar (HDO), for example, combines the cutting-edge blockchain technology with the robust features of a stable coin to create ‘inherent ‘immunity’ to market volatility. HDO offers deep liquidity and reliability to its holders because it has reserves that are backed by 100% cash reserves, “so in a difficult market we’re not looking for outside governance or third parties to get our liquidity” — Jesse Brown, CEO of Himalaya Exchange.

Supply: allocation

A final note of consideration when it comes to supply is allocation. Thinking about how a currency is distributed will give you a better idea of how risky an investment might be. A fair launch, for example, aims to ensure that most coins or tokens go to the public and usually involve less pre-sale rounds where a select group of investors has early access to a percentage of the supply. This information will usually be outlined in a cryptocurrency’s tokenomics and can help you predict how the price or demand of a token or coin may be influenced.

Some questions you may consider:

• Do a few investors own a large number of the tokens or coins?
• Did the protocol distribute the majority of its tokens to the community?
• How fair does the distribution appear to be?
• Has there been early access to the token or coin, or pre-mining?

There is of course a reason understanding allocation is important. If a group of investors are allocated a large quantity of the tokens or coins, there is a risk of a few players in the market, who control a large percentage of the total supply, being able to move the price and influence the market. Not every crypto project will have a large percentage of total supply being allocated to its investors, some crypto projects may not have a pre-sale before launch at all.

Contrarily, if the project is distributing assets fairly, to as many participants within the community as possible, it allows users to buy tokens or coins under the same set of rules and same market price as other participants. The effect this will have on the market price of the currency is based on there being not too many or too few participants acquiring the tokens or coins. Too many users can lead to distribution being too scattered, inviting extreme market volatility. Too few, on the other hand, could lead to investors purchasing huge quantities of the coins or tokens which defeats the purpose of a fair launch!

Note: ‘communities’ in this context refers to crypto miners and groups of individuals with a shared interest in a particular cryptocurrency.

Closing thoughts

Supply alone is not enough to properly understand the benefits or risks to holding or selling a particular cryptocurrency. Demand is in part determined by the supply mechanisms in place however other factors such as Return on Investment (ROI) and social perception play a huge role. Having volume alone doesn’t make something automatically attractive, so people also need to believe it is attractive for a cryptocurrency to have value in the future. Elements such the utility of a particular currency, the incentive mechanisms in place and their burn schedules are also vital to assessing the attractiveness of the tokenomics surrounding a coin or token.

If you want to enter the crypto scene, you should have a firm grasp of tokenomics. Tokenomics is invaluable for businesses, investors and stakeholders in the assessment of a project’s prospects. It is a fundamental part of conducting research that will ultimately define the cryptocurrency’s path of success or failure. So before opting to engage in any crypto project, it is crucial to conduct a rigorous assessment of any project’s tokenomics.

What coin or token do you think has strong tokenomics? Let us know in the comments below.

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