Tokenomics 101: The Concept That Determines the Success of a Cryptocurrency

Tokenomics 101: The Concept That Determines the Success of a Cryptocurrency

Whether you read an article, chat with fellow community members, or check a project’s whitepaper, you may notice that the phrase “tokenomics” is frequently mentioned within the cryptocurrency space.

And for a valid reason.

Tokenomics is an important concept within the cryptocurrency space that analyzes multiple key factors that can influence the future of a project’s token.

Why Does Tokenomics Matter in Crypto?

Created from the combination of the terms “token” and “economics”, tokenomics is a crucial concept. Yet it lacks a universally agreed definition within the cryptocurrency space. However, the two words “token” and “economics” are excellent starting points to better understand our topic.

Economics is a social science that analyzes how individuals, organizations, governments, and states allocate their resources primarily through producing, distributing, and consuming products and services. On the other hand, a token refers to a non-native digital asset that is based on an existing blockchain (e.g., ETH is the native cryptocurrency of Ethereum, while projects can launch their own fungible tokens via the ERC-20 standard).

Combining these two definitions, we can conclude that tokenomics is the science that explores all the essential parts of a token’s economy, which includes crucial factors, such as its utility, supply, price stability, distribution, and governance.

Just like how central banks leverage monetary policy in connection with their respective fiat currencies, the proper design, management, and execution of tokenomics allow project teams to create an efficient economy around their solutions that facilitates the growth of the ecosystem and the token’s price.

From the investor’s point of view, tokenomics is a critical factor to consider, as it has a great influence over the future price of a digital asset as well as whether the project is capable of achieving the goals specified in its roadmap.

Simply put, no matter the team’s expertise and dedication, the potential of the concept, and the amount of funding collected from early investors and venture capitalists, bad tokenomics will likely lead to the ultimate failure of a crypto project.

Tokenomics: 4 Crucial Factors to Consider

Now that you know the basics let’s see when we can say a project has good tokenomics. Below, you will find the four crucial factors for answering this question.

1. Utility

Utility is probably the most important factor in a project’s tokenomics.

Even if a token is deflationary, has the best price stability mechanisms, distribution, as well as a decentralized and highly efficient on-chain governance process, it won’t be worth too much if it is not used for anything.

The same applies to a fiat currency, as it only has value if the nation’s citizens use it, for example, to conduct their everyday payments, investments, and other transactions. And this is the reason why some central banks cracked down on digital assets in the past (check out our article about China’s history with Bitcoin for an interesting story).

To avoid the scenario detailed earlier, project teams have to empower their digital assets with multiple functionalities that benefit the ecosystem and its participants. Examples of such can include:

• Earning opportunities via activities such as staking, mining, yield farming, and revenue-sharing
• Governance
• Medium of exchange on a platform or in the whole ecosystem
• Access to exclusive features or discounts (e.g., personal meetups with athletes in the case of fan tokens and cheaper trading fees for exchange coins like AAB)
• Collateral for other assets in the ecosystem (e.g., stablecoins)

For example, ETH’s primary utility is to cover transaction fees as well as the deployment of dApps and smart contracts. On the other hand, users utilize Bitcoin both as a store of value and a medium of exchange (especially on the Lightning Network).

In general, the utility of a token is responsible for creating demand, which drives up the digital asset’s value if the supply stays the same or decreases.

2. Supply and Price Stability Mechanisms

In addition to the demand, crypto projects also have to carefully manage the supply of their tokens, as it also has a direct influence on its price in the following ways:

1. If the token’s supply increases while demand stays the same, it will lead to a fall in its price.
2. On the other hand, the coin’s price will increase with the decrease of the supply (while the demand remains unchanged).

For that reason, if a project seeks to facilitate great returns for investors, it can design the token as a deflationary asset that moves a significant portion of the coins out of circulation over time.

One alternative solution is to create an inflationary asset and reduce its rate of inflation gradually. Bitcoin is an excellent example, which halves the new coins that can be mined with each block roughly every four years until it reaches its maximum supply of 21 million BTC in 2140.

However, in some cases, inflation or the lack of a maximum supply is necessary for a token to execute its core functionalities due to the nature of a project’s solution. For example, while ETH’s supply doesn’t have a hard cap, the project mints new coins to incentivize validators to maintain the ecosystem (however, this rate of inflation is expected to decrease due to upgrades implemented via the Ethereum London hard fork).

Basically, projects can control the supply of their tokens in two primary ways:

• By (not) limiting the number of coins that can be issued (maximum supply)
• By implementing a price stability mechanism that moves coins out of circulation (e.g., coin burnings and buybacks, as well as the halving in BTC’s case)

Overall, before investing in a coin, it’s essential to analyze the dynamics and mechanisms of an asset that directly impact its supply.

While some coins can maintain long-term growth with minimal increase in demand due to deflationary processes, there are others that experience inflation-induced price crashes even after attracting a record number of new capital and buyers.

3. Distribution

Distribution is a crucial element in not just tokenomics but also in the history of a token. If a project fails to distribute coins to its users in one way or another, no one will be able to use its network, as the community won’t have access to the asset that powers the platform.

There are many ways projects can introduce their tokens to the market. Some methods reward team members and early investors more, while others, mostly fair launch models, are designed to benefit the community.

For example, coin distribution occurred in the following ways at the below projects:

• Ethereum started its history with a crowdsale, in which participants contributed 31,000 BTC. For that reason, crowdsale contributors received 60 million (83%) of the initial 72 million ETH, with the remaining 12 million ETH (17%) being distributed among early contributors and the Ethereum Foundation. After that, the new ETH supply has been sent to miners as a reward for securing the ecosystem.
• While there is a in the community whether Bitcoin creator Satoshi Nakamoto pre-mined the first few coins or acquired them as a regular miner (as he was the first to mine BTC), we can conclude that the cryptocurrency features a fair launch model in terms of its initial distribution. No matter pre-mining was involved or not, Satoshi’s approximately 1.1 million BTC stash has been left untouched, without any of the coins circulating on the market. That said, the remaining coins have been distributed among Bitcoin miners (just like in the case of ETH).
• On the other hand, the Ethereum-based AMM Uniswap features a much different distribution model, which is somewhere between a fair launch and a 2017-style ICO model (in the latter, the project team, investors, and advisors benefit the most). After its release in September 2020, the 1 billion UNI genesis supply was allocated in the following way: 15% in a community airdrop, 2% for liquidity mining, 43% to the governance treasury, 21.51% to the team, 17.8% to investors, and 0.69% to advisors (everything comes with a 4-year vesting period except for the tokens allocated for the airdrop and liquidity mining).

While a token’s distribution model has a great influence on whether a project has the necessary funding to achieve its goal on its roadmap and whether its business model is sustainable, it also has an impact on how the public perceives its solution.

On the one hand, an entirely fair launch model facilitates trust. However, suppose the majority of the coins are distributed to team members and private investors. In that case, the community could become suspicious. Yet, such a strategy could ensure that developers and ecosystem participants have access to the necessary resources to make their vision a reality.

That said, as decentralization and transparency are two qualities that are highly valued in crypto, the community usually prefers a fair launch model.

Furthermore, it is generally safer to distribute coins fairly among (tens of) thousands of users instead of a dozen of whales or large early investors, as it significantly reduces risks, such as price manipulation, malicious activity, or the centralization of the governance process.

4. Governance

The last thing to consider in terms of tokenomics is governance.

While it has an indirect influence on the future success of a project and the price of its native token, it is just as important a factor as the others we have listed earlier, especially for coins that have governance among their primary functionalities.

Just like the impact a government has on a nation’s economy, the core development team of a project or the governance committees and bodies elected by community members via decentralized governance have a significant effect on a crypto solution’s future (and, thus, its native token’s price).

Furthermore, the process itself that allows the team or the community to govern the project also matters here. In terms of the governance model, here are some key highlights you should consider:

• The level of centralization (the core team has the ultimate authority vs. a fully decentralized community governance process)
• Whether governance occurs on the chain or off the chain (although, off-chain governance can still be decentralized)
• How accessible is the governance process for the average user (e.g., how easy it is to create a proposal and vote on it)
• The minimum share of votes required to approve a proposal
• The core team’s background, skills, and experience if they are highly involved in the project’s governance

Overall, while decentralization is highly valued in crypto, it doesn’t mean that all projects featuring decentralized governance are better than ones that are either fully or partly centralized. Transparency, integrity, cooperation via an efficient process, and a professional team (whether they are core developers or elected community members) matter more in this field.

Tokenomics: a Crucial Concept in Crypto

While it lacks a universal definition, tokenomics explores the most important parts of a token’s economy that significantly impact the future of the project and the price of its native digital asset.

For that reason, tokenomics is a crucial concept everyone within the cryptocurrency space should be aware of.

While project teams can leverage it to design their tokens in a way that allows them to reach their goals and achieve their visions faster, investors can use it to evaluate whether a digital asset is worth investing in as well as its risks and potential returns.

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