Breaking Down Tokenomics

Tokenomics 101 for cryptocurrency beginners.

ShapeShift
Nov 17 · 7 min read

Token economics are what happens when tokens act as a vehicle for the creation of entirely new economic models. It can be difficult to understand these models because of the nascent nature of the concept. The boom of initial coin offerings to hit the cryptocurrency market in 2017, spawned many of these new ideas and tokens. Amidst all of that uproar, these tokens were released to the public living on a variety of blockchain platforms, and each token is programmed in a unique way.

Understanding the dynamics of token economics provides many insights that cryptocurrency enthusiasts and investors alike can appreciate. Let’s take a closer and see what we can learn from the basics of tokenomics.

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Receive 100 FOX tokens when you create a ShapeShift account. Trade crypto for free in the ShapeShift Platform. ShapeShift.com

Token Economics

Token economics focuses on the study, design and implementation of economics systems based on blockchain technology. Every blockchain in the industry has its own token economics model. There are literally thousands of different variations of these models.

These tokens encompass more than those that solely exist for fundraising. The crypto community left that idea behind in 2017 with the ICO boom. Now the crypto industry is focused on a much broader definition. The bottom line is, for any token economics model to be present, the token needs to play a pivotal role in driving that model.

The Incentive Theory in Tokenomics

Incentive theory is a human behavioral theory that assumes that a human’s behavior is driven by the desire for reinforcement or the ability to receive incentives. In the world of token economics, incentives motivate users to participate in the exchanges of value that blockchain networks facilitate. Incentives also motivate users to secure the blockchain and validate transactions. This helps to execute every unique feature of that blockchain network.

Every participant who follows the rules of the given network gets rewarded with cryptocurrencies. The model must be set up for people to earn more tokens, simply by doing what’s best for the network. The token incentives are deemed financial because they have a financial value and contribute to a project’s overall market capitalization.

Designing Tokenonomics

A token economics model has to be bulletproof. If the infrastructure is weak, participants are going to find ways to exploit the network to enrich themselves and steal funds. This is the part of designing a token that's not easy — coming up with a good model. A strong token model usually requires a team of highly-intelligent programmers, mathematicians, and economists to scope out and build the model. While it is certainly a challenging task, developing a new model does start with just a few basic steps.

Choosing a Consensus Algorithm

A consensus algorithm motivates users on the network to reach a consensus in validating transactions. Bitcoin and Ethereum both use a proof-of-work model. In the PoW model, miners work to secure the network, verifying transactions by solving cryptographic puzzles organized in blocks. Solving the equations gets more and more challenging as the network grows, and the number of coins awarded to miners drops over time. This is as a way of creating scarcity and avoiding inflation.

There is another type of algorithm called proof-of-stake. While the Ethereum project is currently in the process of switching to a proof-of-stake model, other crypto projects like DASH and Tezos are already using it. The proof-of-stake model allows holders of the currency to stake their value in a wallet and thus allowing those wallets to act as security deposits in a validator, which then validates blocks. The more tokens a particular user holds, the more likely they are to get the reward for solving the next block. In this way, PoS is a more efficient way of reaching consensus, because not everybody is racing to win the next block award. It doesn’t, however, stop anyone from accumulating enough token value to become a major influencer on the network and thus centralize a greater amount of control.

Overall, both of these consensus models use incentives for engaging network members to participate and secure the network, confirm transactions and maintain the integrity of the network. All of this action on the blockchain causes the value of these currencies to become inflated. This is because the number of coins on the market increases while the demand stays the same. A good consensus model like Bitcoin halves the number of Bitcoins that can be mined approximately every 4–5 years and there will only ever be 21 million Bitcoins ever produced until the end of time.

Use Cases for Token Economics

There are many use cases in the world of tokens that have taken off in the past few years. Some of which are very familiar like Bitcoin’s exchange of value, with some concepts like profit-sharing having yet to be deeply explored.

Exchange of Value

Using tokens to exchange value is by far the most common way to utilize the benefits of token economics. Bitcoin was the first to showcase this use case. Ethereum was the first to prove that a project not only has to use token economics to exchange value but can also create value by allowing fundraising and launching of decentralized applications.

Staking

In staking the network keeps value in a wallet. Validators with more value in their wallets are more likely to reap larger rewards for validating transactions. A Delegated Proof of Stake model is similar to this. The difference is that delegates are selected randomly, making it harder for participants with the most value to get the validation reward consistently. Basically it attempts to make things fair in terms of sharing the wealth.

Payment of Transaction Fees

Completing a transaction on the blockchain means paying a fee. On the Ripple network, sending XRP to another wallet burns some of the tokens. This decreases the supply of remaining tokens and thus increases their value.

Governance

Governance is a way of dictating the rules of the game when it comes to ‘social’ interaction. That includes managing things like power distribution, new models of democracy, and network cooperation. Token holders get a vote or say in what should happen next, as a particular blockchain evolves.

Contributing to a Project

STEEMIT is a social media platform where users get rewarded for being content creators, commenters and moderators. Everyone gets rewarded in tokens to make the project better. Users can even get paid to drive traffic to the content they feel is most interesting. The rewards handed out are the incentive to keep building a bigger and better version of the STEEM platform, and those rewards are paid out in SteemIt dollars.

Blockchain-Based Services

These services require users to hold tokens to access a specific service. SiaCoin is a perfect example. The project gives users access to cloud storage, but only if they use SiaCoin to pay for it. Similar projects on the Ethereum network and other blockchains also impose this style of economics. Civic, Golem, and Augur represent a few.

Profit-Sharing

Where a cryptocurrency exchange like Binance allows users to save on trading fees for holding Binance’s token, a competitor like KUCoin does the opposite. KUCoin allows users to split 50% of the coin’s daily transaction profits.

Where do we go from here?

The token economic models face two ongoing and obvious struggles. One is that creators are still making them fund initial coin offerings for projects that have no fundamental value. Two, those creators and the investors who help fund the initial startup costs of a new project lock up a majority of the coins, not allowing them into circulation. This takes away from where the community thinks the value should be going — development. While various token economics models promote the democratic transfer of value, the future of those models will likely be focused on how to filter out the bad actors and move the value towards the future of development.


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