Crypto for Beginners 101: What Is Tokenomics? Why is Tokenomics important?

The crypto industry is always bustling with a number of digital assets, tokens being one of them. The study of the economics of crypto tokens or cryptocurrencies is called tokenomics. It fundamentally involves studying the factors that impact the demand and supply of tokens. The factors include quality, distribution, and production of crypto tokens. But what are crypto tokens, and why are they so popular? We unravel the various layers of tokenomics to help you gain a better understanding.

What is Tokenomics for a Crypto Token?

A crypto token in case anyone needs to recall the definition- is essentially a crypto coin based on a blockchain platform that can be exchanged with another blockchain, and that provides many incentives to the holders of said token. 

Now, tokenomics. The term is formed by pairing up the two words token and economics. So the word tokenomics basically points to the economics of a crypto token; tokenomics refers to all the qualities of a crypto token that makes it appealing to investors. The tokenomics for a particular crypto token is usually thoroughly discussed in the project whitepaper, and it should help you grasp the functionality, objective, allocation policy, and more of the crypto token.    

As an investor, why do you need to know about tokenomics?

It is essential for investors to know the demand and supply factors of the crypto market for these reasons :

• It gives an understanding of the short-term performance of the crypto market, according to Seth Klarman’s book, Margin of Safety.
• ‍Tokenomics helps to ascertain the future worth of an asset.
• It gives an insight into the profitability of one crypto asset over the other in future.

Nevertheless, investors should remember the following factors help to get hold of tokenomics:

• You should learn the usage of digital currency and direct connection between the services being built and the digital asset.
• Find out the total number of existing tokens, their future stock limit and when they will be created.
• Do know about the owner of the digital coins and whether coins are reserved to be released later to the coin developers.

Why Is Tokenomics Important When Investing in Cryptocurrency?

In his famous investment book, Margin of Safety, value investing legend Seth Klarman explains that “In the short run supply and demand alone determine market prices.” If we believe that to be true and that it applies to crypto assets using blockchain technology as well as the stock market, then understanding the factors that will impact either supply or demand is of vital importance to both speculators and investors. 

In which case, there are a number of factors to consider when looking at crypto tokenomics. Perhaps the most important is to understand how the digital currency will be used. Is there a clear link between usage of the platform or service being built and the asset? If there is, there is a strong chance that a growing service will require purchases and usage that ultimately helps to increase the price. If there is not, what can the token be used for?

Other important questions to answer include the following: 

• How many coins or tokens currently exist? 
• How many will exist in the future and when will they be created? 
• Who owns the coins? Are there some set aside to be released in the future to developers? 
• Is there any information to suggest that a large number of coins has been lost, burned, deleted or are somehow unusable?

Factors affecting crypto tokens

For every beginner just getting into the realms of cryptocurrency, it is important to know the factors that might even remotely affect the value of a crypto token.

1.Distribution and allocation of tokens

One of the primary factors that decide a crypto token’s worth is how the token is being distributed. There are two ways of generating crypto tokens – either by pre-mining or by a fair launch. By the phrase “fair launch”, we mean that a cryptocurrency is mined, earned, owned, and governed by the community from the outset. It is a decentralized network and no concept of private allocation exists here. However, with pre-mining, a portion of the coins is created (mined) and distributed before it is launched publicly. A portion of the coins is sold to prospective buyers in an initial coin offering (ICO). This is a way to reward founders, miners and early investors with newly minted coins.

So, if you want to make sure that the project you’re investing in is legitimate and ambitious, make sure that it distributes its tokens out to prospective users.

2. Supply of token

A very important parameter required to study a crypto’s tokenomics is the supply of a token. There are three kinds of supply for crypto tokens — circulating supply, total supply, and max supply. Circulating supply refers to the number of cryptocurrency tokens that are issued publicly and are in circulation. Total supply, meanwhile, is the number of tokens that exist currently, minus all the tokens that were burned. It is calculated as the sum total of tokens currently in circulation and the tokens that are locked somehow. Lastly, total supply cannot be confused with max supply, which quantifies the maximum number of tokens that will ever be generated.

Noticing the supply of a token can be a good indicator of its future. The circulating supply of a token is increased by developers by active mining. If the circulating supply keeps increasing, then investors can expect the value of the token to go up. On the contrary, if too many tokens are released, the value might drop as well.

3. Market Capitalization of a token

In the context of cryptocurrencies, the market capitalization or market cap is a metric used to determine the popularity of the token. It is calculated by multiplying the current market price of a token with the circulating supply. The market cap is a good indicator of the value of the token, even in the long run. Small-cap cryptocurrencies are therefore riskier. While large-cap cryptocurrencies often potentially guarantee better returns and safety.

4. Token model

Every crypto token has a model which ultimately determines its value. Some tokens are inflationary, which is why they don’t have a max supply and can keep mining as time goes on. Quite the opposite are deflationary tokens where the token supply is capped at max supply. Deflationary tokens are useful to avoid circulating unsold coins and are usually not affected by market volatility. Inflationary tokens, on the other hand, does a good job at incentivizing miners, delegators and validators in the network.

5.Price Stability

Tokenomics also points out how important it is to study the implications of price stability. Cryptocurrencies are known for their volatility, which might not always work out in favor of the investor. Fluctuations can often lead to dwindling interest among investors. Furthermore, fluctuations can even lead to networks being restricted.

Investors should make sure that the project is doing everything to combat such fluctuations. The challenge could be dealt with by ensuring there are adequate tokens to match the supply levels. This would stabilize the price and thereby, investors can use the tokens for their intended purpose. Tokenomics can also help developers to stabilize the prices by creating equilibrium.

Token Models

Inflationary

Just like the US dollar, an inflationary token will be continually printed/produced over time with no max supply.

Inflation is still a misunderstood concept. Inflation is not the increase in asset prices but the falling of purchasing power. A currency can be the same price and still fall in real value if another 10% of that asset is released into the market.

Most proof of stake tokens such as Ethereum and Polkadot are inflationary to reward network validators and delegators who are responsible for validating transactions within the blockchain network. For example, Cosmos(ATOM) has an inflation rate of 7.5–20% depending on the total amount of coins staked.

While it is not a crypto asset, the USD is an inflationary currency that has

There are however cryptocurrencies like Dogecoin and Grin that have an unlimited supply. This makes their token supply unlimited too. In September 2021, the circulating supply of Dogecoin was 131.13 billion. The indefinite supply of doge makes it inflationary and it is this tokenomics that makes Doge very popular.

Another facet of tokenomics is the burning of certain coins to reduce their supply and inflate the coin and token value. The more a digital coin is used, the more tokens are burnt.

Dual token model

In this model, 2 separate tokens are used in the same blockchain where one is used as the funding option and the other is used for utility. This new type of model is a result of regulations imposed on unregulated ICO’s. Apart from the added safety of dual tokens, they also allow projects to be more flexible as both tokens can each have their own properties.

Examples: Vechain and VechainThor(VET/VTHO), MakerDAO(MKR/DAI)

For Vechain, VET is the primary token of the blockchain where its main function is to transfer value across the blockchain and trigger smart contracts. VTHO, the ‘energy’ token functions as gas to power the smart contract transactions. Each VET generates VTHO at a rate of 0.000432 per day. users can stake VET to generate VTHO.

Deflationary model

Bitcoin has set the industry standard for a deflationary token model. In this model, there is a set number of tokens to be created, with that limit never being adjusted upward. This creates a deflationary currency where even as demand increases, supply does not.

• Pros: A limited supply of tokens generates natural demand as the supply dwindles. It also completely eliminates the worry of inflation which plague fiat currencies.
• Cons: Some wonder if the incentive structure in a deflationary model will ultimately lead to its downfall. Because there is a limit to the number of tokens produced, users are incentivized to hoard tokens, not spend them. Without enough spending, most tokens will fall out of circulation and the token itself will become less valuable.

Examples: Bitcoin (BTC), Cardano (ADA)

Asset-backed model

Some cryptocurrencies have chosen to back their tokens to another asset. In this asset-backed model, users can derive the value from the token based on the value of the token’s underlying assets. The most well-known (and highly controversial) asset-backed token is Tether, which purports to be backed by the US Dollar.

• Pros: With the right transparency, asset-backed tokens can create stable digital assets which remove unwanted volatility in cryptocurrencies.
• Cons: Is this model really transparent? Just ask Tether, which claims to hold US Dollar reserves equivalent to the outstanding supply of tokens. This has been repeatedly called into question many times by skeptics (not to mention the US Department of Justice).

Example: Tether (USDT), Dai (DAI)

Token Economics Use Cases

The study of token economics is quite an expansive domain, with new trends and principles gaining recognition every day. However, it is also important to notice that use cases also define the direction of tokenomics price evaluation. The study of different use cases of token economics could offer a detailed impression of how it can define the future of crypto and blockchain technologies. Here are some of the notable use cases of token economics.

1. Staking 

Staking is one of the notable topics that you can come across in a tokenomics guide. The network stores value in a wallet in staking, and validators having more value in their wallets can have better chances of reaping massive rewards for verifying transactions. The Delegated Proof of Stake model is a perfect example of the use case of token economics in staking. The primary difference of this model from a PoS model is the random delegation and selection. As a result, participants with the highest stakes could find it difficult to get validation rewards constantly. So, it offers a credible approach for sharing wealth.

2. Exchange of Value

The most common example of the use cases of tokenomics also refers to their use for exchanging value. Bitcoin is a formidable example of token economics use cases in exchange for value. Ethereum has been successful in proving that token projects can use token economics for exchanging value as well as creating value. It can leverage token economics for encouraging fundraising activities as well as for launching decentralized applications. 

3. Project Contributions

Among the many use cases of tokenomics in 2021 was evident in the contributions for project development. The example of STEEMIT clearly showcases the potential use case of tokenomics for encouraging contributions to a project. STEEMIT rewards users with tokens for their contributions as content creators, moderators, and commentators.

Furthermore, the platform also incentivizes users to drive traffic to the content that is interesting according to their perspective. The rewards for content creators, moderators, and commentators can play a crucial role in expanding the STEEM platform. Users could cash out their token rewards in STEEMIT dollars for their work in developing a bigger and better STEEMIT platform.

4. Value of Tokenomics

The final addition in a tokenomics guide would obviously refer to the value it brings to the table. Token economics could help in reflecting on the economics as well as social costs in accounting for token projects. This is a huge requirement in a time when we can expect tokens to represent almost any real-world asset such as precious metals, real estate, artwork, and collectibles. Most important of all, tokenomics is essentially capable of offering the value of community-based solutions aligning with consumers’ values.

Tokenomics in Determining Cryptocurrency Value

‍Tokenomics is also helpful as guidance to understand how much an asset might be worth in the future. For example, many people new to crypto will think something like, “If this coin becomes as valuable as Bitcoin, then one day…” while in reality, it might never be possible. As an example, let’s think of two coins mentioned above, Bitcoin Cash and Tron. Bitcoin Cash has the same total supply as Bitcoin, so thinking that one may become as valuable as the other in time has some legitimacy — it is possible. However, with more than 100 billion Tron existing, for one coin to be valued in the thousands of dollars, Tron would need to become the most valuable business in the history of the world — how likely is that to happen?

While these questions may seem to require complex answers, they will provide an extra way to view crypto assets and help to understand whether one asset is more likely to have a great future than another.

Conclusion

Tokenomics play a central role in the functioning of a blockchain or dapp. It uses a set of hard-coded rules and a token to align the behavior of all actors in a way that benefits the protocol. As we have seen, there is not one good tokenomics model. There are several recipes for good burgers with different ingredients leading to various flavors. For each recipe, the right mix of ingredients is key. Depending on the blockchain services offered, tokenomics are different.

Four ingredients are essential. The first one is the total supply and demand. The number of tokens in circulation must fit the token demand. The second element is the initial allocation of the token. It must incentivize all participants to the network without harming anyone. The third component is subsequent token distribution. It has to be made dynamically and reward participants correctly without diluting the value of the ecosystem. Finally, value accrual gives the token value and cements its place in the ecosystem.

Issac

Coincu Ventures