You’ve probably heard that a huge part of a crypto project's potential success can be attributed to its tokenomics. But what does this mean, actually?
Tokenomics is a fundamental concept for anyone interested in investing in cryptocurrencies. It refers to understanding the economic and financial principles that underlie the design and functionality of various cryptocurrencies.
Tokenomics is a combination of 'token' and 'economics' hence the name tokenomics. The concept is relatively new but has quickly become an important aspect of the cryptocurrency and blockchain industry. Before making any crypto investment, it is important to understand the tokenomics of a project to assess its real value and potential.
In the crypto realm, tokenomics can be likened to the way central banks regulate currency by printing money and setting monetary policies to influence behaviors like spending, lending, saving, and money circulation. However, unlike traditional fiat systems, tokenomics operate under rules coded transparently, ensuring predictability and resistance to arbitrary changes.
The overarching aim of tokenomics is to forge a token that not only holds intrinsic value to its users and its integrated ecosystem but is also sustainable and resilient to threats. This intricate design considers numerous elements, from the token's core utility, market-driven supply and demand, and its distribution mechanics, to governance structures. Furthermore, tokenomics is deeply rooted in the broader context, reflecting the underpinning technology, the engaged community, and the prevailing market dynamics.
Why is Tokenomics Essential?
Tokenomics matters for a few key reasons:
Value and Utility
Tokenomics ensures that a token holds genuine value for its users and the surrounding ecosystem. A well-designed token serves a distinct purpose, drawing users and fostering a robust community. This can naturally boost the token's demand and, subsequently, its worth.
Stability and Security
Proper tokenomics safeguards the token’s longevity and security. By smartly overseeing its supply and allocation, creators can avoid pitfalls like inflation, deflation, or external manipulation, aligning the token’s usage with the ecosystem's objectives.
Governance in Decentralized Systems
Tokenomics is pivotal in directing decentralized networks. Many such networks deploy governance tokens, enabling holders to have a say in the network's direction. Tokenomics ensures these tokens are equitably distributed and used in ways that amplify the network's collective benefit.
Supply and Demand: the two core components of crypto tokenomics
What is it?: Just like how there's a limited amount of gold or oil in the world, in the realm of cryptocurrencies, 'supply' refers to the total number or quantity of a particular token or coin that exists or will ever exist.
Why does it matter?: If a token has a vast, unlimited supply, it could decrease its value because it might be too common or easy to acquire. On the other hand, a limited or decreasing supply can make a token more rare, potentially increasing its value. The lower the supply, the higher the value of the token. It's similar to the reason why platinum, being rare, is valued higher than common steel.
Its circulating supply is 33,041 tokens. This means there are currently over 33k YFI circulating in the market and tradeable by the public. It is an extremely low number of tokens for a project in crypto.
Supply has various factors to it like:
- Emissions - Emission is the speed at which new tokens get created (minted) and released as directed by the protocol.
In the case of a blockchain, minted tokens usually get distributed to miners, when Proof of Work (PoW) consensus mechanism is used as with Bitcoin, or to validators, when Proof of Stake (PoS) is used as in the case with Ethereum. So mining and staking are an important part of the equation.
- Inflation - If a token's value or price decreases with an increase in its supply then it is called Inflationary.
Inflationary tokens don't have a fixed supply with a constant increase in their supply. They don't have any mechanisms to reduce the supply.
The popular meme coin Dogecoin (DOGE) is an inflationary one. It does not have a supply cap. And it inflates at a 5% rate per year.
- Deflation and Token Burns
If a token's value or price increases with a reduction in its supply then is called Deflation.
Interestingly Ethereum used to be an inflationary token, but now it is a deflationary one.
August 23, 2022: 120,224,061
August 23, 2023: 120,213,931
(September 2023 is the first month of the year which has been inflationary for ETH).
There are now fewer Ethers than what we had one year ago. Deflationary tokens have mechanisms such as burning to reduce their supply.
What does burning tokens mean? Some blockchains and protocols “burn” tokens or coins, thus reducing the supply that is in circulation. This leads to a scarcer token which benefits its price. For example, Binance Coin (BNB) uses a burn mechanism to reduce its supply over time and increase its value.
Lock mechanics involve restricting access to a token for a certain period of time. This can create scarcity and increase the value of the remaining tokens during the lock-up period.
Optimism has one of the craziest token unlock mechanisms we’ve seen. 25 m OP tokens are being unlocked every month.
Many cryptocurrency projects have specific plans for how they distribute their tokens. It's common for a portion of these tokens to be set aside for investors or developers. However, there's often a stipulation that these recipients can't sell their tokens immediately but must wait for a predetermined period. This waiting time influences the number of tokens available in the market, which can affect the token's price. The goal for most projects is to design this distribution method to minimize disruption to the token's availability and price stability.
Pro tip. You can follow token unlocks with: https://token.unlocks.app/
Let’s go back to our example with Yearn Finance. As you already know, its circulating supply is 33,041 YFI. Yearn’s total token supply is 36,666 YFI. This means there would never be more than 36.6k YFI on the blockchain. So around 90% of YFI that would ever come into existence is already there.
Limited vs unlimited supplies
Tokenomics sets the supply rules for tokens.
Bitcoin’s fixed maximum supply of 21 million coins creates scarcity and drives demand. As of October 2023, there are about 19.5 million Bitcoins in circulation, with new ones being released at a decreasing rate through a process known as Bitcoin mining. Of these 19.5 million coins, nearly 4 million are irretrievably lost because no one has access to them.
Shiba Inu, on the other hand, is a meme coin with no real application and is used for gambling. It has a much larger maximum supply than Bitcoin, with 1 quadrillion (15 zeros) tokens in circulation, creating an abundant supply. The demand for Shiba Inu is driven by the growing interest in meme coins and the buzz generated by social media and various celebrity endorsements, which in turn bring in new investors. However, the large supply and lack of significant or meaningful utility for the token make it vulnerable to rapid price swings based on changes in demand.
What is it?: Demand refers to how much or how strongly people want to own, buy, or use a particular cryptocurrency.
Why does it matter?: No matter how limited the supply of a token, if nobody wants it, its value is likely to be low. Conversely, if a coin or token is highly sought after – for its functionality, as an investment, or for any other reason – its value can rise.
In essence, supply is about how much of a token exists, and demand is about how much people want it. The delicate balance between these two determines the value or price of a cryptocurrency.
- Market cap
MarketCap is calculated by multiplying the circulating supply with the token price. Lets say, if circulating supply = 10,000,000 and price = 10$:
Then the Market Cap of the token is $100,000,000 Million.
Market capitalization is a measure of the total value of a given cryptocurrency. It is calculated by multiplying the circulating supply of the cryptocurrency by its current price.
When it comes to selling cryptocurrency, the price you get depends on the available liquidity and percentage of ownership of the total supply. If you own a large percentage of the tokens in circulation, say 20%, you are unlikely to be able to sell them all at fair market value because the market may not have enough liquidity to absorb that amount of tokens at that price.
- FDV (Fully diluted value)
FDV is the total supply of the token multiplied by the token price. For example, Bitcoin's market cap is $420 billion, while the fully diluted market cap when all 21 million bitcoins are mined will be $456 billion, according to data from Coingecko. So next time you hear someone tell you that a useless meme coin like SHIB could reach a price of let's say $0.01 per token, you can tell him that this would mean the price should rise around x1400 times, and if this happens, then the FDV would become nearly $6 trillion (something like x6 of the whole current crypto market and 7% of the world GDP). So this is simply impossible.
Types of tokenomic models
Tokenomics refers to the economic principles and models underlying digital currencies. There are several types of tokens - utility tokens, security tokens, altcoins, and stablecoins. Bitcoin is the first cryptocurrency and is often called "the first coin". Bitcoin operates on a decentralized network, meaning it is not controlled by a central authority or institution. Transactions are verified by a network of users and recorded on the blockchain.
The difference between a coin and a token is that a coin has its own blockchain - like Bitcoin, Ethereum, Cardano, and many others, while a token does not have its own network and its issuers use a foreign blockchain to create it. Coins are issued by the foundations or developers behind the blockchain they develop, while tokens can be issued by organizations, exchanges, venture capital firms, and others.
Altcoins, or alternative coins, are all cryptocurrencies that are not Bitcoin (sometimes people count Ethereum, too). They were created after Bitcoin and have sometimes similar characteristics, but may have completely different goals or functions, sometimes aiming to upgrade the functionality of the first coin. Altcoins can be created by anyone, and there are thousands of them on the market. The popular meme coins, also known as shitcoins can be created within minutes.
These tokens provide access to products or services within a particular network.
Utility tokens are often used in decentralized applications, or dApps, that are built on top of blockchain technology. Utility tokens can also be used to reward users for contributing to a network or performing specific tasks, including staking and/or airdrops, where the condition is to hold the token for a certain time or at a certain point in time.
Security tokens are digital assets that represent ownership of an underlying asset or company and often correlate with how that company is marketed. Security tokens are often used in fundraising, with companies offering them as a way to raise capital. Most companies use the same process when developing their security tokens. They create a whitelist that contains the crypto wallet addresses of investors who are approved to buy these tokens.
To be eligible for inclusion in this whitelist, prospective investors must demonstrate that they can successfully adhere to all restrictions and regulations associated with the asset in question. This requires at least compliance with the rules relating to "Know Your Customer" (KYC) and "Anti-Money Laundering" (AML). For those interested in investing in security tokens, this happens through STO (Security token offerings) platforms such as Polymath, Securitize, or Swarm, and examples of such tokens are Sia Funds, Bcap (Blockchain Capital), and Science Blockchain. In the SEC's lawsuit against Ripple (XRP), the commission argued that the sixth-largest cryptocurrency by market capitalization at that time was also a security token. The SEC also recently announced Solana (SOL), Cardano (ADA), Polygon (MATIC), Coti (COTI), Algorand (ALGO), Filecoin (FIL), Cosmos (ATOM), Sandbox (AXS), and Decentraland (MANA) as securities.
In the US, the Securities and Exchange Commission (SEC) is responsible for regulating any financial instrument that can be classified as a "security". Security tokens are also included. There are still many tokens that combine characteristics of securities with those of utility tokens, making their long-term viability unclear and potentially confusing to investors.
To decide whether a token is a security, one of the important factors is that the SEC applies a test known as the Howey Test. It includes:
- Are you putting money into something with the intention of getting something of value out of it, such as a profit?
- In a "shared business" the funds of the investors are shared or there is a direct relationship between the marketing of the investment and its success or failure.
- Does "reasonable profit prospect" include fixed income and capital appreciation, which are the two main sources of expected profits?
- Ultimately, it becomes clear that any investment can be considered a "security" if the investor expects a return based on the efforts of someone else.
These tokens aim to maintain a fixed value against a specific asset, the most commonly used being the US dollar. Examples of stablecoins are Tether (USDT): A stablecoin that aims to maintain a 1:1 ratio against the US dollar and USD Coin (USDC). In order to maintain this link, the issuer of the stablecoin must constantly maintain reserves in dollars, equivalents, or securities to maintain the link to the dollar. If there are $1 billion worth of stablecoins issued, then there must be assets of the same value in the reserves.
There are also stablecoins that use crypto collateral only such as the decentralized stablecoin provider Liquity Protocol. It has created LUSD stablecoin, which is overcollaterized by Ethereum.
This is a type of fraudulent token economy model similar to a Ponzi scheme that offers high returns to early investors by using the capital of later investors to fund payouts. The most famous such fraudulent schemes are Bitconnect, OneCoin, PlusToken and any other coin that at some stage of its development lies and robs its investors.
Initial token distribution
Initial token distribution refers to the process of distributing tokens of a new cryptocurrency to its initial investors or users. This is a critical stage in cryptocurrency development because it sets the stage for the token's market value, distribution, and adoption.
Initial Coin Offerings (ICO)
ICOs are fundraising events where new tokens are sold to investors in exchange for other cryptocurrencies or fiat currency. This method was particularly popular 6-7 years ago, especially in 2017, but has since been largely replaced by other distribution methods, mostly due to regulatory challenges.
Airdrops involve distributing free tokens to a large number of users as a way to jump-start adoption and generate interest in the token. Airdrops can be used to reward early backers or build a broad base of holders.
Uniswap (UNI): UNI was initially distributed via airdrop to users who interacted with the Uniswap protocol before September 2020. Each eligible user receives 400 UNI tokens, which were worth around $1,200 at the time. UNI is now the most popular decentralized exchange with a market cap of over $3 billion as of October 2023.
Some cryptocurrencies use a proof-of-work mechanism that allows users to mine or earn tokens by contributing computing power.
Ethereum (ETH) was originally distributed through a pre-sale in 2014, where investors received ETH in exchange for Bitcoin. The distribution collected 31,529 bitcoins, which at the time equaled $18.3 million. Since then, Ethereum has become one of the most widely used cryptocurrencies and has a market capitalization of over $186 billion as of October 2023.
Utility of the token
A token that has a specific use case and is in high demand on the network will have a higher value than a token with limited utility.
Curve (CRV): CRV has utility on the Curve decentralized exchange, allowing users to manage the protocol and receive a portion of trading fees. CRV holders can vote on proposals for the platform and receive a share of the revenue generated by the exchange.
Issuers of exchange tokens and some stablecoins can manipulate investors by controlling supply and demand. Both crypto exchange tokens and stablecoins can also offer discounts on their services to users who hold their tokens. While this can be a legitimate way to incentivize token ownership, it can also be a misleading tactic to artificially increase demand and increase the value of the token because no real value is created.
Additionally, some exchange tokens and stablecoins can create value out of thin air by mining their own tokens and buying them back themselves. This also reduces the total supply of the token and may increase its price. Risky practices like this can lead to a bubble and subsequent crash if demand for the token is not sustained. Investors should be aware of the potential risks associated with exchange tokens and stablecoins, including the possibility of artificially manipulating supply and demand. It is important to carefully evaluate the utility of the token and the underlying technology before investing in it. Always DYOR.
Verification of token holder addresses
Another crucial factor to consider is the number of tokens held by the largest addresses. This information can indicate the level of centralization in the network. If a small number of addresses contain a significant amount of tokens, they can have a disproportionate amount of power and influence on the network. Blockchain Explorer (for the relevant blockchain) is a tool that allows you to view transactions and addresses on a blockchain. Using the blockchain explorer, you can see the number of tokens held by each address and track changes in token ownership over time. Another way you can do various research yourself, such as the number of addresses that own a token, is through sites like Coinmarketcap and Coingecko.
Token standards define the guidelines for creating, managing, and trading tokens within specific blockchain ecosystems. Here are some of the most well-known standards:
- ERC-20: This is by far the most common token standard used on the Ethereum network and is designed for creating interchangeable (fungible) tokens.
- ERC-721: Used on Ethereum for crafting unique non-fungible tokens that are known as NFTs.
- BEP-20: A standard on the Binance Smart Chain, mirroring the properties of ERC-20.
- TRC-20: Adopted by the TRON network, it resembles the ERC-20 standard.
Tokenomics plays a crucial role in guaranteeing the value, longevity, and security of tokens. By crafting tokens with defined roles and uses, token creators can foster vibrant communities and boost demand for their offerings.
The term "tokenomics" blends "token" with "economics" and is vital when researching the foundation of a cryptocurrency project. To fully assess a project's potential, one should examine its white paper, founders, development plans, community engagement, and, importantly, its tokenomics. Thoughtfully designed tokenomics is key to ensuring the steady growth of a crypto initiative.