Crypto Dictionary

Tokenomics Deep-dive

What is tokenomics and why should you care? Read on to learn about how tokenomics work, what information to look for, and how to use it to make better investment decisions.

What is Tokenomics?

Token Economics - Tokenomics refers to the economic system and monetary policy of a cryptocurrency or token. It is the study of how a token is created, distributed, and managed. Tokenomics helps us understand the underlying mechanisms of a token and how it interacts with the rest of the ecosystem

We will explore the basics of tokenomics, including its components such as token distribution, incentives, and token use cases. We will also discuss the importance of tokenomics in shaping the success of a cryptocurrency and the impact it has on the growth and adoption of a project. Whether you're a seasoned crypto enthusiast or new to the space, this post will provide you with a comprehensive overview of the key concepts in tokenomics.

TL;DR

  • Tokenomics is the study of how tokens are created, distributed, and utilized
  • The study of tokenomics is essential for recognizing and creating sustainable value
  • Total supply is the number of tokens that will at some point enter the market
  • Supply can be increased (minting) and decreased (burning) to stabilize supply and demand
  • Tokens are initially distributed through ICOs, IDOs, IEOs, Airdrops, and private sales
  • According to their use case, we distinguish several token types - Payment, Security, Utility, Governance, and NFTs

Why care about Tokenomics?

Knowing and understanding at least the basics of tokenomics can help tremendously with distinguishing and creating crypto projects that bring genuine value. Whether you are a trader or developer starting your own project, it is essential to know the ins and outs of tokenomics. No project can function well long-term without a solid tokenomics foundation - that means correct token settings and functional model right from the beginning. 

Of course, there is not just one completely right way to set a tokenomics, but if you follow a set of certain rules and logical reasoning, it can put your project on the right trajectory. It is also important to make changes on the go as you start figuring out what's working and what's not.

From an investor point of view, studying tokenomics can help identify early investment opportunities and mitigate some of the risks. Poorly set tokenomics is one of the main indicators that help you reveal fraudulent or worthless projects very early in the research. On the other hand, interesting and sustainable tokenomics can be a great sign of a perspective project.

For project founders - sustainable tokenomics design as a strong foundation for crypto projects

For traders/investors - identifying new investment opportunities and sorting out fraudulent or worthless projects

Basic principles

Token supply

In general, token supply refers to the total number of tokens that are currently in or will at some point enter the market. It is different from the circulating supply, which contains only the tokens currently in the market. This tokenomics concept plays a crucial role in determining the value of each individual token, making it a powerful tool. The psychological impact of the supply size should not be overlooked, as it can influence investor sentiment.

The value of a token is also affected by whether its supply is fixed or not. Fixed tokenomics means that there is a predetermined maximum number of tokens that can ever be created, creating a sense of stability and predictability within the ecosystem. 

As demand increases over time and all available tokens are put into circulation, the price of the token will naturally rise. This fixed supply model is exemplified by Bitcoin, which relies heavily on steady or growing demand.

On the other hand, some projects have chosen not to impose any limit on the supply of their tokens, meaning that new tokens will continue to be created at a predetermined rate - emission rate. These new tokens are often introduced to the market through a process called staking. Ethereum is an example of a project that has taken this approach.

To know more about total supply, visit our dictionary post.

Token Supply Allocation

The allocation of tokens refers to how the tokens are divided among different stakeholders, such as the founding team, early investors, and users. This can be done through a combination of ICOs, airdrops, staking, mining, and other token distribution strategies. Well-thought-out token allocation can be a major building block for the whole tokenomics of the project.

An example of a possible token allocation:

Entity Part of the Total Supply
Early investors/VCs 5 % to 20 %
Founding team, employees, advisors, etc. 5 % to 20 %
Users and community 60 % to 90 %

Supply Control - Minting and Burning

The supply of tokens in the market (circulating supply) can be increased or decreased by various mechanisms. This is done usually in order to balance the supply and demand of the token.

Increasing supply - circulating supply can be increased by staking or mining, more described further below. Essentially any minting and distributing of new tokens increases the circulating supply. This procedure can be beneficial if the demand is too high for a low token supply. The price of the token decreases - can be compared to inflation in traditional finance.

Decreasing supply - to decrease the circulating supply of a token, it is necessary to remove it from circulation completely. The process of removing is referred to as token burn. Burning involves sending the coins to a crypto wallet that has no private keys and therefore cannot be manipulated, rendering the tokens inaccessible. Decreasing the circulating supply increases the price of the token.

Token Distribution Strategies

Token distribution refers to the process of introducing tokens to the market and determining how they are distributed to the general public, developer team, and stakeholders. Many different token distribution strategies can be used, including:

Presale mechanisms

ICO (Initial Coin Offering) - is a token distribution method where projects sell tokens to early investors in exchange for funds. It operates similarly to crowdfunding, with investors receiving tokens instead of a product or service. ICOs have been used to raise funds but face regulatory challenges due to high risks for investors. New regulations have been introduced in some countries to protect investors and ensure transparency.

IDO (Initial DEX Offering) - was developed to address some of the problems that ICO struggled with. A project may offer its token on a presale for a fixed rate. Investors then lock their capital on a DEX (decentralized exchange) and later receive tokens of the project as compensation. More detail in our IDO dictionary post.

IEO (Initial Exchange Offering) - An IEO is a token sale event held on a centralized cryptocurrency exchange platform. The exchange conducts due diligence on the project and offers tokens for sale, which can be purchased using the exchange's native cryptocurrency or other accepted forms of payment. This alternative to ICOs offers a higher level of security, but a more centralized approach than IDO.

Private sale - usually done in an early phase of crypto projects. The funding entity, for example, a Venture capitalist will buy newly minted tokens at a fixed rate before they are offered to the general public. The investors get participation in the project and the founding team is given capital to scale the project. In this type of distribution, a vesting schedule for the investors is frequently used.

Airdrops

An airdrop is a token distribution strategy where tokens are given away for free to a select group of individuals or to holders of a specific token. The aim of an airdrop is to increase awareness and adoption of the token by making it more widely available.

Airdrops can be used to incentivize specific behaviors, such as holding a certain token or participating in a network and can also be used as a marketing tool to generate buzz and interest in a project. Tokens distributed through an airdrop are typically claimed by individuals through a simple process, such as registering for the airdrop or holding a specific token in their wallet. 

Airdrops can be an effective way to distribute tokens and increase adoption, but it's important to carefully consider the potential risks and to choose a distribution model that aligns with the project's goals and objectives. 

If you wish to know more about airdrops, as well as how to find the best ones, visit our Airdrop dictionary article.

Staking/Mining

Apart from being a network security mechanism, staking and mining can also be thought of as a way of distributing new tokens to the general public. Staking usually involves locking a portion of the tokens in exchange for a certain interest rate (APR/APY). Mining on the other hand requires powerful hardware, which solves computational problems - miners are rewarded by newly minted coins.

The setting of the interest rate influences the whole dynamic of the ecosystem. A sustainable interest rate to reward stakers should not be too high, because the number of tokens would rise quickly and therefore reduce the price. However, a low interest rate may not provide enough incentive for users to participate in the staking altogether.

Token types

According to the intended use case, we can distinguish several types of tokens. The use case will be the main factor when establishing other aspects of such tokens, such as supply and emission rates.

Payment Tokens

Payment tokens, such as Bitcoin, are designed to be used as a medium of exchange. They are usually scarce and have a fixed supply, which contributes to their value. The incentive structure for payment tokens is based on their ability to be exchanged for goods and services, making it important for the network to maintain high levels of security and scalability.

Security Tokens

Security tokens represent ownership in an underlying asset, such as equity or debt. The value of security tokens is derived from the underlying asset, and they may offer dividends or other forms of financial rewards to their holders. The incentive structure for security tokens is based on their ability to provide investors with a return on their investment.

Utility Tokens

Utility tokens provide access to a product or service, such as an app or platform, and may have additional features, such as governance rights or access to premium features. The value of utility tokens is tied to the demand for the product or service and the scarcity of the tokens. The incentive structure for utility tokens is based on their ability to provide access to a valuable product or service, which can lead to increased demand for the tokens.

Governance Tokens

Governance tokens provide holders with the ability to vote on the direction and development of a project, such as changes to the protocol or the allocation of resources. The value of governance tokens is tied to the ability to influence the project's direction and success.

Non-Fungible Tokens (NFTs)

NFTs are unique, non-interchangeable tokens that represent ownership of a unique asset, such as digital art or collectibles. The value of NFTs is derived from their uniqueness and scarcity, as well as the value of the underlying asset. The incentive structure for NFTs is based on the ability to represent one-of-a-kind digital assets, which can be highly valuable to collectors and enthusiasts.

Closing

Tokenomics plays a crucial role in the success of crypto projects. Understanding the principles of tokenomics, including token supply, token distribution, and incentive structures, can provide valuable insights into the health and potential of a project. 

By carefully considering the tokenomics of a project, individuals can make informed decisions about their participation in the network and can increase their chances of success. As the crypto space continues to evolve and mature, the importance of tokenomics will only continue to grow, making it a critical area of study for anyone looking to participate in the crypto world.

FAQs

Why is tokenomics important in cryptocurrency?

Properly set tokenomics is necessary for a sustainable and profitable crypto project. Without tokenomics, the cryptocurrency would not have any set rules on how to behave and would collapse instantly.

What is tokenomics in NFT?

NFT tokenomics refers to economic rules applied to a Non-fungible token. Balancing supply and demand is a big part of creating a working NFT tokenomics. NFT collections usually play on the scarcity principle - a limited amount means a higher price.

What is a tokenomics example?

Example of a tokenomics on BTC. The total supply is 21 million BTC. New coins enter circulation through mining. Miners receive a reward in BTC for solving computational problems. Mining difficulty is set to increase over time and therefore slowing the emission of new coins. When a total of 21 million BTC enters the market, the emission stops.

What is good tokenomics?

Both BTC and ETH have functioning tokenomics, although in very different ways. BTC relies on its fixed supply of 21 million coins, whereas ETH has an unlimited supply with some amount of ETH being burned every transaction.

Which crypto has the best tokenomics?

It is difficult or even impossible to mark a single tokenomics as being the best one. A lot of interesting solutions have been introduced and many of them take a completely different approach. Only time will tell which tokenomic model will prove to be the best functioning.

Disclaimer: The content of this piece reflects the writer's opinion. This article is not intended to provide financial advice and is meant solely for entertainment and educational purposes. Investing in cryptocurrency involves significant risk. Capital is at risk, and returns are not guaranteed. Always conduct your own research.

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