Beginner’s Guide To Tokenomics: A Crypto Investor’s Handbook

What is tokenomics?

Tokens can be generally issued by blockchain projects for various purposes and are usually done for utility, governance, incentives, or other objectives. The demand for these tokens generates their value in the crypto market. At the same time, a higher supply of these tokens without a spike in demand could result in its prices staying low. These fundamental principles of economics, specific to crypto tokens, are known as tokenomics.

However, unlike governments, who have the choice to print fiat money when the need arises, blockchain protocols usually depend on pre-decided or algorithmic schedules to decide the supply, allocation, or burn mechanisms of their tokens. This is not the case at all times, but blockchain protocols, being decentralised, rely on consensus mechanisms for such decisions.

For example, major blockchain protocols like Bitcoin rewards miners with tokens as an incentive, which in turn impacts their tokenomics. Currently, the maximum daily reward for Bitcoin is 450 Bitcoins/day that is distributed among all miners. Hence, the inflation rate would be (450*365)/19.8mn (current supply) ~ 0.82%.

How does tokenomics work?

Tokenomics primarily decodes the utility of a token and its corresponding intrinsic value. Therefore, it helps understand if any price changes of a token are justified. Conceptually, tokenomics works on the same economic theory of supply and demand. 

Let's take the example of Solana (SOL). Around 90% of the SOL tokens have been unlocked and are in circulation, which amounts to over 466 million tokens. About 9.99% are still locked. According to its token distribution, over 32% are inflationary tokens that ensure a steady increase in circulating supply through Solana's proof-of-stake mechanism. Further, the Solana community holds over 22% of the tokens, the Solana foundation 8%, and so on. 

Although SOL's supply is not finite, an inflation rate keeps it in check. Its current inflation rate is just over 5% and is scheduled to decrease every year. Meanwhile, 50% of every transaction fee is burned and then given to validators. Theoretically, the fall in staking rewards can be offset by a rise in fee volumes.

Key components of tokenomics design

Five fundamental aspects of tokenomics design are crucial while assessing a crypto token:

• Token utility

  The primary use case of a crypto token, defined as its utility, is vital in evaluating its value, adoption, and demand. A blockchain protocol may have a native token for a specific service or as a representation of ownership. This underlying utility fuels its demand in the blockchain ecosystem. For instance, POL tokens in the Polygon blockchain are used for both governance and paying transaction fees.

• Token supply

  One of the most important elements of tokenomics design, token supply, refers to the total number of a particular crypto token in circulation. It could either be fixed, in the case of Bitcoin, or infinite as well among other tokens like DOGE or ETH. As we explained earlier, token supply impacts the fundamental economic dynamics of  demand and supply in a crypto token.

• Token distribution

  The respective allocation of a crypto token among its stakeholders in a project is termed as token distribution. Let's suppose a blockchain protocol has a loyal community, users, developers, and investors. The scheme of distribution of tokens to each one of the stakeholders, through methods like airdrops, mining rewards, or initial coin offerings, influences its tokenomics. In some cases, a protocol may keep a vesting period for token allocations, which prevents cases of pump and dumps.

• Token incentives

  Protocols like Uniswap have staking and yield farming provisions for those who choose to take part in it. In exchange, they receive tokens as incentives, which in turn affect its tokenomics.

• Price stability mechanisms

  Some methods like burning or buybacks are also used by blockchain protocols as a measure to keep their prices stable. The former involves reducing the number of tokens in circulation as a deflationary measure, while the latter is used for building trust and creating a price jump for tokens by inducing demand. 

Why is tokenomics important?

Tokenomics helps ascertain and dictate the overall economic position of a crypto token, which in turn has an effect on the sustenance and potential of its underlying blockchain protocol. From an investment perspective, tokenomics is likely the most important metric to consider before investing or trading a crypto token.

Good tokenomics can ensure the economic sustainability of a blockchain project, and also help increase adoption with better participation from stakeholders. A well-designed token economy is also key to sufficient liquidity in a blockchain protocol, especially in decentralised exchanges like PancakeSwap. The tokenomics of a dominant crypto like BTC also impacts sentiments and behaviour in the broader crypto market.

Game theory and tokenomics

Game theory is the study of strategic decision making, or in other words, an analysis of how fellow stakeholders of an ecosystem make decisions. These decisions can be interdependent, which means that their outcomes can affect each other in the ecosystem. Hence, a game theory model involves all stakeholders strategising for optimising their rewards. An auction, for example, is a typical example of a game theory model, where every participant aims to maximise their returns according to the decisions of their fellow participants.

In tokenomics, game theory models can be applied to use cases like governance, staking, or yield farming that helps enhance favourable behaviours and disincentivise malicious players.

A roundup

Sound tokenomics is the foundation of successful crypto projects. The core elements of tokenomics design go a long way in helping craft innovative and sustainable crypto projects and aiding investors in making well-constructed decisions. The right balance between all tokenomics components is the key to the best outcomes for all stakeholders in a crypto project!

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FAQs

• What is tokenomics?

  Tokenomics, an amalgamation of ‘token’ and ‘economics’, are primarily economic principles that govern the current and potential values of a crypto token. The tokenomics of a crypto project comprises its underlying economic characteristics, which help in its analysis.

• How do you analyse tokenomics?

  A few core elements like token supply, distribution, incentives, utility, and price stability mechanisms help analyse the tokenomics of a particular crypto project.

• What is good and bad tokenomics?

  Good tokenomics constitute those cases where each element is in the best interest of the corresponding token. Case in point, a token with a stable supply, important utility in its underlying protocol, effective incentives for its stakeholders, an appropriate distribution scheme, and measures like burning which keeps its circulation in check. An imbalance in even one of these factors could lead to bad tokenomics.

• What is an example of tokenomics?

  Let us take the example of ETH. Its supply is infinite, while regular burning mechanisms keep its inflation in check. Its main utility is as a governance token in the Ethereum blockchain, which helps derive its inherent value. Ethereum works with a Proof of Stake consensus mechanism, which means validators in the blockchain network stake a portion of their holdings in return for a yield as an incentive. The locked tokens in Ethereum also prevent hackers from attacking them. Meanwhile, the distribution of ETH was historically based on early crowd sales and initial contributors. This distribution strategy has changed over time with new stakeholders and investors. All the above factors account for the tokenomics of ETH.