What Is Tokenomics and Why Does It Matter?

Tokenomics is a word used to describe a token's economics. It provides an explanation of the elements that have an effect on the use and value of a token. These elements include, but are not limited to, the token's generation and distribution; supply and demand; incentive systems; and token burn schedules. Token economics need to be carefully constructed for cryptocurrency initiatives to succeed. Investors and other stakeholders must evaluate the tokenomics of a project before determining whether or not to participate.

Introduction

Tokenomics, which is a mashup of the words "token" and "economics," is an essential part of doing primary research on a cryptocurrency project. Tokenomics is one of the most important aspects to consider when assessing the long-term potential of a blockchain project. Other aspects to consider include the white paper, founding team, plan, and expansion of the community. To ensure that their long-term and sustainable growth, crypto ventures should take great care in designing their tokenomics.

Tokenomics at a glance

To incentivize or punish a wide variety of user behaviors, blockchain projects build tokenomics rules that are centered on their tokens. This is analogous to how a central bank creates money via printing and executes monetary policies to either stimulate or discourage spending, lending, saving, and other monetary activities. Take note that the term "token" may refer to either money or tokens in this context. You will get an understanding of the distinction between the two here. Tokenomics, in contrast to fiat currencies, has rules that are easy to understand, can be reliably predicted, and are difficult to alter. These characteristics are achieved via the use of code.

Take the digital currency bitcoin, as an example. The entire number of bitcoins that will ever be available has been pre-set at 21 million. Mining is the process that is used to generate new bitcoins and release them into circulation. When a block is successfully mined every ten minutes, miners are rewarded with a certain number of bitcoins.

The incentive, which is sometimes referred to as the block subsidy, is decreased by one-half every 210,000 blocks. According to this plan, every four years there will be a reduction of one half. Since the creation of the first block, also known as the genesis block, on the Bitcoin network on January 3, 2009, the block subsidy has been reduced by fifty percent three times: first to twenty-five bitcoins, then to twelve and a half bitcoins, and now to six and a quarter bitcoins.

According to these guidelines, it is simple to calculate that about 328,500 bitcoins will be mined in 2022. This can be done by dividing the total number of minutes in a year by 10 (because a block is mined every 10 minutes), then multiplying this result by 6.25. (because each block gives out 6.25 BTC as rewards). As a result, it is possible to forecast the total number of bitcoins that will be mined in a given year, and the last bitcoin is anticipated to be extracted some time around the year 2140.

Tokenomics in Bitcoin also includes the formulation of transaction fees, which miners are entitled to collect whenever a new block is successfully verified. The magnitude of each transaction and the congestion on the network will cause this cost to escalate. It keeps spam transactions from happening and gives miners a reason to keep verifying transactions, even though block subsidies are going down over time.

To summarize, the tokenomics behind Bitcoin are both straightforward and well conceived. Everything is completely open and may be anticipated. Participants in the Bitcoin network continue to get compensation thanks to the incentives around Bitcoin, which add to the value of Bitcoin as a cryptocurrency.

Key elements of Tokenomics

"Tokenomics" is a catch-all phrase that refers first and foremost to the structure of a cryptocurrency's economy as its inventors created it. This is because "tokenomics" may apply to a broad variety of elements that influence the value of a cryptocurrency. When analyzing the tokenomics of a cryptocurrency, these are some of the most significant considerations you should keep in mind.

Token supply

The price of any good or service is primarily determined by supply and demand in the market for that product or service. The same principle applies to crypto. When judging a token's supply, there are several important things to keep in mind.

The first model is referred to as the maximum supply model. It indicates that there is a predetermined limit on the total number of tokens that may ever be produced using this cryptocurrency. There can never be more than 21 million Bitcoins in circulation. The total number of Litecoins and Bitcoin Cash that can ever be mined is capped at 84 million and 200 million, respectively.

There is no hard limit on the number of certain tokens. The amount of ether available on the Ethereum network continues to rise each year. There is no upper limit on the quantity of stablecoins like USDT, USD Coin (USDC), and Binance USD (BUSD), since these coins are created in accordance with the reserves that back the currencies. In principle, there is no upper limit to their potential expansion. Dogecoin and Polkadot are two further cryptocurrencies that do not have a supply limit.

The second aspect is known as the circulating supply, and it describes the total number of tokens that are currently in use. Tokens are able to be locked away in a variety of ways, including being minted and burnt. The cost of the token is impacted as a direct result of this as well.

By examining the token supply, one may get a fair idea of the total number of tokens that will eventually be in circulation.

Token Utility

The phrase "token utility" refers to the many use cases that were developed specifically for a token. For instance, the BNB token may be used to power the BNB Chain, pay transaction fees and benefit from trading fee savings on the BNB Chain, and operate as a community utility token in the BNB Chain ecosystem. Users may also generate extra revenue by staking their BNB with a variety of other items that are part of the ecosystem.

Tokens have a wide variety of further applications as well. The holder of a governance token is given the ability to vote on proposed modifications to the token's underlying protocol. The purpose of stablecoins is to function as a kind of money. On the other hand, security tokens stand for many financial assets. During an Initial Coin Offering (ICO), for example, a company might decide to sell tokenized shares, which would give the holder ownership rights and dividends.

With these criteria, you can figure out how likely it is that a token will be used, which is important for figuring out how its economy will likely change over time.

Analyzing token distribution

It is vital to take a look at the distribution of tokens in addition to supply and demand considerations. There is a behavioral divide between large institutions and ordinary investors. If you are aware of the many entities that own a token, you will have a better idea of how those entities are likely to trade their tokens, which will affect the token's value.

In most cases, there are two methods for launching a cryptocurrency project and distributing tokens: a fair launch and a pre-mining launch. Before a token is coined and distributed to the general public, a launch is considered to be fair when there are no early access or private allocations of the token. This category includes things like Bitcoin and Dogecoin, for example.

On the other hand, pre-mining enables a part of the cryptocurrency to be mined and given out to a chosen set of individuals before it is made available to the general public. This form of token distribution may be seen in action with Ethereum and BNB, to name just two instances.

In most situations, it is important to pay attention to the degree to which a token is dispersed uniformly. It is common practice to consider it riskier for a small number of major businesses to have a disproportionately large amount of tokens. When most of a token's supply is held by patient investors and the team that created it, it shows that the interests of the different parties are more closely aligned.

You should also look at a token's lock-up and release schedule to determine whether or not a large number of tokens will be brought into circulation. This puts downward pressure on the value of the token.

Examining token burning

Many cryptocurrency projects "burn" tokens, which means they permanently take them out of circulation.

For instance, BNB uses a method called "coin-burning" to eliminate coins from circulation and cut down on the total quantity of its tokens. As of June 2022, the entire supply of BNB is 165,116,760, despite the fact that 200 million BNB have already been pre-mined. BNB will continue to destroy coins until half of the entire supply has been used, at which point the total amount of BNB that is in circulation will be decreased to 100 million. In a similar way, Ethereum started "burning" ETH in 2021 to reduce the amount in circulation.

It is said to be deflationary when the total amount of a token in circulation is decreased. The reverse of this, in which the supply of a token continually grows, is referred to as inflationary.

Incentive mechanisms

The incentive mechanism of a token is quite important. Tokenomics revolves around the question of how players might be incentivized to maintain the network's continued viability in the long run. The way Bitcoin's block subsidy and transaction fees are set up is a perfect example of a well-thought-out idea.

The Proof of Stake mechanism is another validation approach that is gaining acceptance. Participants may lock their tokens using this architecture, which allows validating transactions. In general, the more locked tokens, the better the possibility of being picked as validators and receiving incentives for verifying transactions. This is because the more locked tokens, the more competition there is. It also indicates that the value of the validators' own assets will be put in jeopardy in the event that they attempt to do damage to the network. These things give people a reason to be honest and help keep the process's validity.

Many different DeFi initiatives have successfully achieved fast development by using novel incentive systems. Compound is a platform for lending and borrowing cryptocurrencies that gives investors the opportunity to deposit cryptocurrencies into the Compound protocol, earn interest on those deposits, and obtain COMP tokens as an extra incentive. In addition, COMP coins perform the function of a governance token for the Compound system. Because of the decisions made in the design, the interests of all players are now aligned with the long-term prospects of the compound.

What’s next for tokenomics

A tremendous amount of progress has been made in the field of tokenomics since 2009, when the first block of the Bitcoin network was generated. A wide variety of tokenomic models have been investigated by the developers. There have been a number of victories as well as defeats. The tokenomics paradigm that Bitcoin employs is one that has withstood the passage of time and continues to be relevant today. Others have failed because their tokenomic concepts were flawed.

Non-fungible tokens, often known as NFTs, provide an alternative paradigm for tokenomics that is based on digital scarcity. The tokenization of conventional assets such as real estate and artwork may in the future give rise to new breakthroughs in the field of tokenomics.

Closing thoughts

If you are interested in entering the cryptocurrency market, you should familiarize yourself with the idea of tokenomics. It is a word that encompasses the primary elements that affect a token's value. It is essential to keep in mind that no one element may operate as a magic doorway. Your evaluation has to take into account as many aspects as is humanly feasible and be thought of as a whole. Tokenomics can be used in conjunction with other fundamental analysis methods to reach an educated conclusion about a project's potential outcomes and the value of its token.

In the end, the economics of a token will have a big impact on how it is used, how easy it is to build a network, and whether or not the use case of the token will attract a lot of attention.

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DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.