TL: DR - Tokenomics is an umbrella term for all the factors that affect a coin or token's value, such as maximum and circulating supply, utility, distribution, incentive structure, and allocation.
Let's say you want to buy a new phone from an online store. You scroll through the list of available phones till you find one you like. Typically, there should be a list of specifications about the phone's features and capabilities, like battery life, camera pixels, network specs, storage capacity, etc.
This list would help you decide whether to buy the phone or look for other options. Tokenomics is like this list but for cryptocurrency tokens. It's all the important economic details investors need to know before buying a token.
In this article, we'll explore the different elements of tokenomics, from utility to supply up to distribution.
What is a Cryptocurrency Coin?
A cryptocurrency coin is a digital currency or unit of value that runs on its own blockchain. Think of a coin as a house built on land owned by its parents. For example, ETH is native to and operates on the Ethereum Blockchain, and BTC is native to and operates on the Bitcoin Blockchain.
Some commonly traded coins are BTC, ADA, ETH AND LTC.
What is a Cryptocurrency Token?
A cryptocurrency token is a digital unit of value or currency that doesn't run on its own blockchain but is developed and operated on existing blockchain networks like Ethereum. Using our house analogy- A coin is a house built on land its parents own while a token rents space on that land to build a house.
Some commonly traded tokens are USDT, DAI and BNT.
Please Note: For the purpose of this article, 'Token' refers to both coin and token. Although they are slightly different, tokenomics apply to both.
What is Tokenomics?
Tokenomics is a fusion of the words "token" and "economics". It is an umbrella term for all the elements and factors that affect a coin or token's utility and value. Tokenomics is a crucial part of any cryptocurrency project because it can either attract or discourage investors and potential traders. Before launching any crypto coin or token, the developers and founding team must structure every tokenomic element to increase their potential for success.
Elements of Tokenomics
There are five elements of tokenomics that must be considered when launching a cryptocurrency. These are:
- Token Supply
The token supply consists of maximum supply and circulating supply.
Maximum supply is the highest number of a particular token (written into the code of a cryptocurrency by its developers) that can be mined or produced.
Once that limit reaches, no tokens will be mined or produced anymore.
For example, Bitcoin has a maximum supply of 21 million coins, while BNB has 200 million. However, some tokens like USDC and USDT have no maximum supply because they are produced and issued based on their backing reserves. Basically, because they're pegged to the value of a fiat currency like the dollar, they won't run out as long as their fiat reserves are continually refilled.
ETH is another token without a maximum supply because the developers of Ethereum's network coded its supply to increase yearly. However, the number of ETH coins issued every year is limited.
Circulating supply is the number of tokens in circulation. Tokens can be burned, staked or minted.
Burning means the removal of tokens from circulation by a blockchain network to reduce supply.
Staking means locking your cryptocurrency in a wallet on an exchange platform to validate blockchain transactions or provide liquidity for transactions.
Minting means creating new tokens by creating new blocks or verifying transaction data on the blockchain.
These three actions can affect a token's price negatively or positively.
- Token Utility
What can a token be used to do? Is it used for online game payments? Is it used to pay for browser features? Is it used to pay for NFTs or digital art?
Token utility is everything and anything a token can be used for. For instance, ETH is used for trading NFTs and as currency, while USDT is a stablecoin that helps manage crypto volatility. Tokens can be used for governance, blockchain security and currency. A governance token allows its holder to vote for changes to how a token's mechanism and organisation work. A security token is a financial asset similar to company shares. It offers holders ownership dividends and rights to a token or blockchain network.
A token with practical utility will easily attract investors, traders and venture capitalists.
- Token Distribution
There are primarily two ways to distribute or launch a token - a premining launch and a fair launch.
Pre-mining means minting and issuing some tokens to selected people before the public launch.
Fair launch means minting and distributing tokens to the public without early access or private allocations to anyone.
It is crucial to know how a token is distributed. Knowing which individual investors, institutions or corporations are holding a particular token offers insight into its value. The general principle is that if several large corporations are holding huge amounts of a specific token, it's a risk red flag. This is because "big corps" don't often act in the best interest of the individual trader.
Conversely, if notable individual investors or venture capitalist groups, founding teams and developers hold large amounts of the token, it signals potential long-term success.
- Token Incentive Structure
The incentive structure significantly determines the sustainability of a token. It keeps miners, traders, investors and participants returning to trade. Proof of Stake and Proof of Work are two common incentive mechanisms.
The proof-of-work model involves making miners or users solve complex maths problems before creating a new block or validating a transaction. The miners are rewarded with the native coin of the blockchain, like Bitcoin, for each block they successfully create and transaction they validate.
The proof-of-stake model uses an algorithm to randomly select validators to verify new information before it's added to a block or to create a block. Validators are users who invest their cryptocurrency for use as blockchain verification. They are rewarded with cryptocurrency, like ETH, for each confirmed transaction or created block.
DeFi Staking is another mechanism where users are rewarded for locking their tokens on a blockchain. The rewards vary between platforms and cryptocurrencies. You can earn as low as 1-5% or as high as 70-150%.
How people are rewarded for supporting a token's operations can make the difference between it flopping in a year or lasting as long as ETH or BTC.
- Token Allocations and Vesting
Most times, a particular number of tokens are reserved for developers or venture capitalists, with a clause that they can sell them after a set time. This token reservation is known as token allocation, and the time before the token can be sold is called a vesting period.
Why Should You Pay Attention To Tokenomics?
Knowing how a product, service or currency works is always good practice before buying it.
Think of it this way; you wouldn't buy a phone or a laptop without checking the specifications first. How much more cryptocurrency?
There are currently over 20,000 cryptocurrency tokens in circulation, and more are launched every other day. Getting caught up in the hype is easy, but assessing the tokenomics of a cryptocurrency can help show the real deal.
Tokenomics is a vital part of cryptocurrency fundamental analysis. Fundamental analysis means finding out the critical details about a cryptocurrency. For example, you might dive into a token's market capitalisation, price trends since launch, developer background, etc. This analysis aims to estimate the general value of a digital asset. You could use the information to adjust your trading strategy or add a coin to your portfolio. Read more about it here.
Tokenomics is an economic roadmap that shows how sustainable a token can be in the market. It covers every critical aspect a trader or investor should know, from utility to supply. Always do your tokenomics research before buying any coin or token.
Disclaimer: This article was written by the writer to provide guidance and understanding of cryptocurrency trading. It is not an exhaustive article and should not be taken as financial advice. Obiex will not be held liable for your investment decisions.