What is Tokenomics and Why Does It Matter to Crypto Investors?

How valuable, profitable, and sustainable is that coin or token you have your eyes on? Before you put or leave your money where your heart is as a crypto investor, you must understand the tokenomics of a blockchain or crypto project.

Tokenomics, also known as token economics, is critical to the growth of any cryptocurrency project. In a world where the tokenization idea is becoming increasingly adopted by many individuals and companies alike, new crypto coins and tokens are being created and introduced into the crypto market almost daily.

This has taken the count of known and tracked cryptocurrency or cryptoassets to over 22,400 at the time of writing, as shown on Coinmarketcap. With these many crypto assets in the market and still counting, some investors could find it difficult to ascertain the ones to buy or invest in. While there are many parameters to consider before investing in any crypto project, tokenomics is among the key and top elements to pay attention to.

Tokenomics can greatly affect a cryptocurrency’s or cryptoasset’s value over time. Hence, crypto investors, on the one hand, must carefully study and understand a project’s tokenomics. On the other hand, project founders must carefully design a token economy that makes their blockchain or crypto projects not only attractive but also sustainable to investors. Notably, a blockchain or crypto project with robust utilities, reasonable supply, and well-thought-out issuance patterns stands a better chance of growing in value and achieving huge adoption in the long run. But any blockchain or crypto project whose tokenomics sucks is bound to receive low patronage from investors and become history eventually.

In this piece, we discuss what tokenomics is, features of tokenomics, types of token models, and how to research and analyze tokenomics before making investment decisions. You will find out how the different aspects of tokenomics and how it impacts crypto investment.

What is Tokenomics?

The word ‘tokenomics’ is a portmanteau of two words ‘token’ and ‘economics’. It is a common term in the crypto space used to describe the economics and design of cryptocurrencies or cryptoassets—coins or tokens. Tokenomics covers everything from the supply and distribution of the token to its use cases, economic incentives, and rewards. Also, it entails all the elements that make a particular cryptocurrency or cryptoasset valuable and attractive to investors.

The concept of tokenomics controls how and when a new coin or token should be generated or removed from a particular blockchain or crypto network because once the tokenomics is written into a smart contract, the token system becomes automated. Just like central banks intervene through monetary policy enactment to combat real-world economic problems, including inflation and deflation, tokenomics is a technique that helps to structure and implement policies for a particular token network via automated smart contracts.

Tokenomics is an important aspect of any blockchain or crypto project. It can influence the value of an asset, the level of decentralization, as well as adoption of the asset. A well-designed tokenomics system can promote decentralization and adoption of crypto by creating a fair and equitable distribution of tokens and providing practical use cases for the token.

Some common tokenomics models include the deflationary model, inflationary model, and dual-token model. Given that the blockchain is open to use by developers, different project teams can create their unique tokens with any of the aforementioned tokenomics models depending on their objectives.

Types of Token Models: Deflationary, inflationary, and dual-token model

Inflationary Coins or Tokens: This means the number of coins or tokens in circulation increases over time. While some inflationary coins or tokens have a fixed supply, others have an unlimited supply. On the one hand, bitcoin (BTC) is a good example of a coin with a fixed supply. Notably, although BTC has a hard cap of 21 million, the rate of inflation is reduced over time based on its protocol. For instance, through bitcoin halving which reduces the amount BTC miners receive approximately every four years, there is a disinflationary effect. This causes a decrease in supply and an increase in demand, potentially increasing the value of each individual BTC over time. On the other hand, Dogecoin (DOGE) is a good example of a coin with an unlimited supply. As supply increases, demand may reduce, thus potentially decreasing the value of each individual DOGE over time.

Deflationary Coins or Tokens: Opposite of what inflationary coins or tokens are, deflationary coins or tokens mean the number of coins or tokens in circulation decreases or deflates over time. Hypothetically, as long as demand increases, the price of each coin or token increases. A good example of a deflationary coin is Binance Coin (BNB). Each quarter, BNB is burnt or destroyed to reduce its supply until it gets to its minimum supply: 100 million BNBs.

Dual Coins or Tokens: This is a coin or token that mixes inflationary and deflationary mechanisms in order to control price. Ethereum (ETH) and Ripple (XRP) are two examples of a dual coin or token.

Features of Tokenomics

Understanding what makes up tokennomics is an important step in evaluating the potential of a cryptocurrency or cryptoasset. By understanding all aspects of the token economy, investors can make more informed decisions and potentially generate higher returns. Let’s talk about important features of the token economy that you should be familiar with.

Token Supply and Distribution

Token supply and distribution are important aspects of tokenomics. Token supply simply refers to the total number of tokens created and available for circulation. Distribution, on the other hand, is the method of making tokens available to the public. A fair distribution of tokens, where a significant portion of tokens are spread across a broad pool of holders, may indicate a more decentralized ecosystem. Always watch out for projects where more than 70% of the tokens are owned by a single wallet. There’s a high chance of getting rekt.

Circulation supply refers to the number of tokens available in the market for trading per time. This number can be affected by many factors, including token issuance patterns and burns. Meanwhile, total or maximum supply is the exact number of a particular coin that will ever exist. For example, no more than 21 million BTC will ever exist. It is important to note that not all tokens in the overall supply may be in circulation at any given time. Also, not all crypto projects such as ETH have a maximum supply. That is, ETH adopts the inflationary model of tokenomics whereas bitcoin could be said to be deflationary.

Token burns and buybacks are also related to token supply and distribution. Token burning refers to the process of permanently taking tokens out of circulation forever by any token holder. Token buyback, on the other hand, entails a project team using its revenue to buy its ecosystem tokens and then burn them. These mechanisms can be used to stabilize the value of the token and maintain a healthy balance between supply and demand.

An example is Binance which utilizes the burning mechanism to reduce the total supply of its native currency Binance Coin, represented by the ticker BNB. As of June 2022, the total supply of BNB was 165,116,760. But Binance has said it would burn more BNB until 50% of the total supply is phased out. This means that the total supply of BNB will be reduced to 100 million BNB in the future. Likewise, Ethereum is taking a similar approach and has burned over $4.6B worth of ETH since the EIP-1559 upgrade.

Not forgetting that supply affects the demand and price of an asset, project founders should endeavor to keep token supply moderate and distribution even. An investor should also be wary of a project with outrageous supply with no clear utility associated with them. This brings us to token utility.

Token Utility or Use Cases

Token utility is another crucial aspect of tokenomics that refers to the use or function of a token within a specific project ecosystem. Use cases are what make a particular blockchain or crypto project unique and sought after. But projects with no clear utility tend to lack significant adoption. Notably, tokens can be used for various purposes, including governance and payments.

A token used to facilitate real-world transactions could have a positive impact on the price of the token as it increases demand for the token. Likewise, crypto whose use case revolves around governance could do well in the long term. A governance token is a digital currency through which holders can participate in the decision-making process of a decentralized platform. This can include things like voting on proposals or electing leaders.

Likewise, a crypto token’s utility could be in the area of granting holders access to a certain product or service. That is, tokens can be used as a form of access to certain products or services, such as subscriptions to platforms or access to exclusive content. These categories of digital assets could see high demand from investors.

Incentives Mechanism

Incentives and rewards associated with holding a certain token is part of the core features of tokenomics. These incentives and rewards could be in the form of yields. They can influence the token’s present and future value. The incentive mechanism of the token is crucial as it also contributes to the distribution of certain tokens.

Staking, for example, is a token incentive method that is growing in popularity. This design allows participants to lock their tokens to be able to validate transactions. The more tokens locked, the higher the scarcity and chances of such tokens spiking in price.

Many decentralized finance (DeFi) projects have achieved rapid growth for native tokens through innovative incentive mechanisms. Notably, DeFi platforms offer high yields to incentivize people to buy and stake tokens. Tokens are staked in liquidity pools and yields are paid out in the form of new tokens.

How to Research and Analyze Tokenomics before Making Investment Decisions

The first step in researching and analyzing tokenomics is to review the project’s whitepaper. A white paper is a document that provides a detailed overview of a project, including its goals, technical specifications, and token economics.

While reading a project’s whitepaper, it is important to keep a close eye on token supply and distribution, including circulating supply, total supply, and any mechanics such as token burns or buybacks. Good token distribution could attract both individuals and institutions to a project, enhancing price growth.

It’s also important to pay attention to the token use cases and distribution of tokens among team members. Large allocation of tokens to team members could be a red flag. Such cases indicate a high degree of centralization and that could deter the growth of the token.

Conclusion

Tokenomics is an important part of a blockchain or crypto project that investors should understand before making investment decisions. It is also an aspect of fundamental analysis and is crucial to the success of a project. Just as a reckless CEO can run a company into the ground such as in the case of Sam Bankman-Fried’s defunct FTX crypto exchange, a poor token economy kills a project from the start.

Credit: Ndianabasi Tom A crypto journalist and content writer who has been talking about cryptocurrency and blockchain technology since 2018, Ndianabasi is a Writer at Crypto Asset Buyer (CAB).