Tokenomics

Tokenomics definition: The study of how tokens function within an ecosystem, encompassing factors like supply, demand, utility, and distribution mechanisms.

What are tokenomics?

A portmanteau of token and economics - tokenomics is the word used to describe the economic models and principles of a given cryptocurrency or blockchain project. Some of the main factors considered in tokenomics include:

• Supply

• Utility

• Token allocation, distribution, and vesting periods

• Consensus mechanisms

• Security

• Yields

• Token burns

Why do tokenomics matter?

With more projects than ever in the crypto market, tokenomics can help investors better understand which projects have long-term viability and value. This can help investors avoid projects that are likely poor investments.

Key factors of tokenomics

Token supply

The token supply of a cryptocurrency is shaped by predefined rules in its protocol and various external factors. It's crucial to differentiate between maximum and circulating supply and whether the token amount in an ecosystem is fixed or inflationary:

• Maximum supply: This represents the total number of tokens that will ever exist. For new projects, a significant portion of the supply is often initially locked and gradually becomes accessible.

• Circulating supply: The portion of tokens that are currently liquid and can be bought or sold on the market.

• Fixed supply: Some projects pre-mine all tokens before launch, creating a set number of tokens available to the public. These tokens are used for fundraising, developer rewards, and marketing campaigns, with the rest distributed over time. Fixed supply simplifies economic modeling, focusing only on demand.

• Inflationary supply: In systems like proof-of-work (PoW) and proof-of-stake (PoS), miners or validators receive new tokens for validating transactions. Similar mechanisms can be programmed into a token’s smart contract, making future supply difficult to predict based on reward frequency and conditions.

When evaluating a project, considering the maximum supply is essential. Relying solely on circulating supply and market capitalization may not accurately reflect a project's valuation.

Token distribution

Using cryptographic tokens as a unit of account is revolutionizing fundraising for startups and DAOs. Issuing tokens can provide early liquidity and utility to investors while ensuring transparency for all stakeholders. Common terms include Initial Coin Offerings (ICOs), Security Token Offerings (STOs), and Initial Exchange Offerings (IEOs), which describe the nature and distribution channel of the asset.

A well-structured issuance process is vital for a project's sustainability, rewarding early supporters and incentivizing new participants. To ensure long-term success and avoid extreme volatility, consider the following instruments:

• Vesting: To prevent early sell-offs and stabilize token prices, vesting schedules with lockup periods are introduced, allowing gradual access to tokens over time.

• Staking: Staking removes tokens from circulation, increasing scarcity and potentially affecting price. Staked tokens can also grant voting rights, giving committed stakeholders more influence over the project's direction.

• Airdrops & rewards: Token incentives enhance a project's visibility and can prevent token concentration, reducing centralization risks. Some projects prefer airdrops over traditional sales to distribute tokens more naturally and avoid regulatory issues.

Token utility

Token utility refers to the specific use or purpose a token serves within its ecosystem. Good token utility aligns with the project's goals, adds genuine value, and encourages user participation. Examples include:

Good token utility examples

• Access rights: Tokens can grant access to certain services or features within a platform (e.g., Basic Attention Token (BAT) in the Brave browser).

• Governance: Some tokens provide voting rights, allowing holders to participate in decision-making (e.g., MakerDAO's MKR token).

• Staking & network security: In proof-of-stake systems, tokens can be staked to validate transactions, enhancing network security (e.g., Ethereum 2.0, Cardano’s ADA).

• Collateral & borrowing: In DeFi platforms, tokens can be locked as collateral to borrow other assets.

• Fee reduction: Some exchanges offer tokens to pay for trading fees at a reduced rate (e.g., Binance’s BNB).

Bad token utility examples

• Forced adoption: Requiring token usage for services that don’t need it can seem forced.

• Redundant utility: Tokens with overlapping utility within the same ecosystem without distinct purposes can confuse users.

• Overcomplicated utility: Complex use cases that deter adoption should be avoided.

Token demand

Increasing demand for a token involves strategic, technical, and marketing efforts. Key drivers include:

• Clear use case: The token's value should be evident to potential users.

• Technology & security: The project’s technology should be strong, scalable, and secure, with regular audits by reputable firms.

• Partnerships & collaborations: Partnering with established players can open new use cases and access new user bases.

• Community engagement: A dedicated community can be a significant advocate for the project.

• Liquidity: Easy tradability on multiple exchanges removes access barriers. Consider creating liquidity pools on decentralized exchanges or using liquidity incentives.

• Ecosystem development: Encouraging third-party developers to build on or integrate with the platform broadens the ecosystem and increases potential demand.

Long-term success is determined by the genuine value a token provides and the problems the project aims to solve.

Token security

Security audits are crucial for reinforcing the integrity of a cryptocurrency token and its platform. By rigorously examining a token's code and infrastructure, security audits identify vulnerabilities and potential attack vectors. In an industry where trust and security are paramount, regular and transparent security audits establish a token's credibility, enhance its reputation, and contribute to its long-term market success.

How to evaluate tokenomics

You can evaluate the tokenomics of a given project by following ten simple steps:

1. Review whitepaper & documentation: Understand the project’s purpose, technical details, and economic model

2. Check team token vesting: Assess allocation and vesting periods for the team and advisors

3. Investigate private sales: Compare private sale prices and conditions with public sales or market price

4. Analyze token utility: Verify the token’s real-world applications and partnerships.

5. Examine monetary policy: Look into token burns, buy-backs, staking rewards, and funding strategies.

6. Assess community & governance: Evaluate governance rights and community engagement.

7. Check transparency & Security: Ensure regular updates and security audits.

8. Evaluate economic barriers: Identify high entry costs that might deter adoption.

9. Market analysis: Review trading volume, liquidity, and exchange listings.

10. Competitive analysis: Compare the project’s value proposition and tokenomics with competitors.

What are the signs of bad tokenomics?

Common red flags in tokenomics include:

1. Excessive reserves for insiders: Large allocations for early investors, founders, or the team can indicate centralization and potential market manipulation, leading to price instability.

2. Unrealistic or uncapped hard cap: Projects seeking excessive funds without clear use cases or having no fundraising cap may signal greed or poor financial planning.

3. Promises of guaranteed profits: Guaranteed returns often indicate Ponzi schemes or fraudulent activities.

4. Absence of a clear roadmap: A vague or missing roadmap suggests a lack of planning or commitment to project development.

5. Inconsistent token metrics: Frequent changes in token metrics or allocations without justification can reflect instability or unclear vision.

6. Complex or opaque distribution mechanisms: Distribution should be transparent and simple. Overly complex processes may hide unfavorable terms.

7. No clear utility or purpose: Tokens lacking clear utility or value within the ecosystem may merely be a fundraising tool without offering genuine value.

It's worth noting that the principles of tokenomics are neither static nor universally applicable. As cryptocurrencies mature and develop, tokenomics evolves in response to new insights, technological advancements, and the ever-changing landscape of regulatory considerations.