Your Guide To Researching Tokenomics
Learn What Determines The Value Of A Cryptocurrency Or Token And Prepare Yourself For The Next Altcoin Season!
As of 2022, there are about 6.000 Crypto tokens. That’s a lot of opportunities for investors. However, just in 2021, investors lost $12 Billion to fraudulent Crypto projects. So it’s paramount to pick the right ones.
In this guide, I’ll teach you everything you need to know about tokenomics — the economics of tokens and coins.
You can see it as an extension of my big how-to on Crypto research which you can find here:
With that, let us get to the point and see what things we should pay attention to before investing in a token or coin!
What Is The Difference Between A Token And A Coin In Cryptocurrency?
While both terms are often used synonymously, the term coin usually refers to a cryptocurrency running on the layer 1 blockchain. The term “token” can have different meanings, it can refer to a crypto asset that is created by a layer 2 protocol and must adhere to the rules of the base blockchain it is using. For example ERC20 tokens, ERC721 NFT tokens. More generally, any crypto asset can also be referred to as a token. Tokens have functionality such as allowing votes or acting as digital representations for real-world assets. A token can also be used as payment within the protocol. While a token is generally not recognized as money, its value depends on how the overarching project is performing.
What Are Tokenomics in Crypto?
The word tokenomics refers to the study of the economics of cryptocurrencies and tokens. This enables investors to determine the quality and value of potential investments. Tokenomics have a strong influence on sell and buy decisions.
How To Research Tokenomics — A Step by Step Guide
Here is the process I use for researching tokenomics. The following points do not require any special knowledge or skills.
1. Crypto Layers Explained
Let’s start with taking a closer look at a blockchain's layers because it’s important that you understand this stuff.
The first thing you need to know is whether a coin or a token runs on layer 1 or layer 2.
A layer 1 blockchain runs independently from other blockchains, layer 1 token examples are Ether on Ethereum, Avax on Avalanche, etc.
A layer 2 solution is a third-party protocol that is built on a layer 1 blockchain system. For example, the Maker protocol is built on Ethereum. It is a layer 2 protocol, thus MKR and DAI are layer 2 tokens.
Layer 1 blockchains and layer 2 protocols affect each other. If layer 1 blockchain provides an easy-to-use, fast and secure infrastructure, it will attract more layer 2 projects. If layer 2 projects are doing well, it has positive effects on layer 1, thus increasing the value of the layer 1 cryptocurrency.
2. How To Research A Blockchain’s Ecosystem
From what I wrote above, it becomes clear that there are a lot of inter-dependencies between different cryptocurrencies and tokens. It is important to get as comprehensive an overview of these relationships as possible.
What you want is a blockchain ecosystem that shows potential for future growth. That means that there is a solid layer 1 blockchain that is home to multiple layer 2 applications that offer good use cases.
To get an understanding of the ecosystem of a layer 1 blockchain, go to coingecko.com.
On the homepage, find the “All Categories” button and enter the name of a layer 1 blockchain. Coingecko will provide you with a list of all Crypto projects that in some way are tied to the layer 1 blockchain. From the list, you can pick individual projects and access more information such as market data, charts, news, links to other sources, etc.
3. Original Chain vs Forked Chain
What you should also consider in this context is whether a blockchain is an original chain or a forked chain.
For example, Ethereum Classic is a fork of Ethereum. Litecoin, Bitcoin Cash are forks of the Bitcoin blockchain. It is important to know what modifications the forked chain made to understand in which way it is better or worse than the original chain. For example, Bitcoin Cash will never have as many users as Bitcoin. However, Binance Smart Chain (BSC) is a successful fork of the Go Ethereum protocol but with a different consensus mechanism.
4. Researching Tokens
After you have covered all the basic information about a blockchain, a comprehensive analysis of individual tokens follows.
4.1 Utility vs Security Token
The purpose of a token is essential. For example, holders can use tokens as payments, to cover transaction fees, enable access to services, staking (PoS), or for governance (voting).
A utility token usually has specific use cases. For example, some tokens enable the user to have access to a product or a service on the blockchain. Others give the user the right to vote.
Security tokens are similar to stocks. There are two categories of security tokens:
- Asset tokenization: a traditional financial asset is represented by tokens on the blockchain. For example, the shares representing the percentage of the ownership in a company can be tokenized. Also, the ownership of a unit of gold can be tokenized and represented on the blockchain.
- Asset origination: the token represents a digital financial asset that is already on the blockchain. Tokens are created through asset origination, for example, by staking or mining.
In the US, companies that want to issue security tokens need to be regulated by the SEC. Blockchain projects that are not complying with these regulations face the risk of being fined or shut down. As a result, it is important to know if the token you want to invest in is a utility token or security token.
In general, if a token cannot be qualified as a security token according to the Howey Test, then it is a utility token.
To determine how likely a token is a security or utility token, you can use the scores given by the Crypto Rating Council website. The higher the score, the more likely the token is a security token.
4.2 Fungible vs Non-Fungible Tokens
Fungible tokens are not unique. For example, one Ether you have is the same as one Ether in my wallet.
Non-fungible tokens (NFTs) are unique. They are not replicable and are used to store data such as academic records of individuals, artworks, music, etc. For example, each CryptoKitty is unique and is represented by an NFT or each piece of land in Decentraland can also be represented by an NFT.
On the Ethereum blockchain, ERC721 tokens are non-fungible, and ERC20 tokens are fungible.
4.3 Token supply
When analyzing the supply of a token you need to take into account the following points:
Total supply: the number of tokens created minus the tokens which have been “burned”.
Maximum supply: refers to the total amount of a token that will ever exist. For example, the maximum supply of Bitcoin is 21 million, whereas Ether has no maximum supply.
Circulating supply: is important, because it influences the market capitalization of a token. Here is how marketcap is calculated:
Marketcap = number of coins/circulating supply of the token * current price per coin/token
Compare the marketcap with the diluted marketcap which can be found on coinmarketcap.com and coingecko.com. The diluted marketcap indicates the theoretical marketcap if the maximum supply of a token is in circulation.
To make sure, you should always double-check data on block explorers because some of the information on websites such as coinmarketcap or coingecko is not up-to-date.
Market capitalization of the token: a better indication of the token’s economic value than an individual token’s price. Some projects issue a large number of tokens at a very cheap price, e.g. $0.0001 per token. They do this to make investors think that the price can easily go 1000x. But the reality is if the marketcap of the token is already very large, it is probably unlikely for the token price to go very high. E.g. Shiba Inu coin.
The higher the marketcap, the more difficult it is to manipulate the price, though all cryptocurrency prices are often being manipulated by whales.
4.4 Is the token pre-mined?
Pre-mined means that the token has already been created before it was launched. This happens a lot in ICOs (initial coin offerings). Many layer 2 tokens such as ERC20 tokens are pre-mined so that contributors, early investors, and contributors can be awarded.
Why is it important to know if a token a pre-mined?
Because pre-mined tokens often get distributed internally before they can be bought by the general public. If a significant amount of tokens is held by insiders at launch, then the token price can be easily manipulated by them.
Token allocation and distribution: you should always find out how the token is allocated and distributed. You can check this information from the project’s Whitepaper and websites such as messari.io or icodrops.com. But remember to cross-check holders on a block explorer, because sometimes the information in the Whitepaper or on other websites could be outdated.
Other questions that need to be answered when researching the allocation and distribution of a token include:
- Who receives the token as a reward?
- For ICOs, how much does the token cost in a private sale? This information can be found in a project’s Whitepaper and on websites such as icodrops. If the token is already listed on an exchange, then you can compare the pre-sale price to the current price. If the presale price is very cheap, then the investors who got the token in pre-sale could dump their tokens to take profit.
- What is the token Vesting Schedule? Token vesting refers to that a certain amount of the token being locked up for some period of time to prevent the sudden sale of a large amount to crash the price. If a large amount of the token is locked you should verify the release schedule. When more tokens are released, it will affect the token price and marketcap. If the project unlocks a large number of tokens at one time, it will have a high probability that the price could drop sharply.
4.5 Is the token model inflationary or deflationary?
This affects the token’s supply. If a cryptocurrency or token has no maximum supply then it is inflationary. Some projects use a mechanism of coin or token burning to control price inflation.
You should keep in mind that just because some token will be burned in order to reduce the supply, it does not mean that the price will increase for sure. The value of the token comes from what value it provides to the users rather than how much supply there is.
