Tokenomics 101: Understanding the Basics of Cryptocurrency Economics

8 min read

What is Tokenomics?

Tokenomics is a combination of two words, “token” and “economics,” that refers to the features that give value to a cryptocurrency and make it appealing to investors. It encompasses aspects such as how the token is created, how many tokens are available, and what purpose they serve.

The term “tokenomics” gained popularity in 2017, and while there isn’t an official definition, it refers to the science of the token economy and how we evaluate the value of a cryptocurrency. Simply put, anything that affects the worth of a cryptocurrency is part of tokenomics.

Tokenomics is crucial to consider when deciding to invest in a cryptocurrency because a project with a thoughtful and clever token design is more likely to succeed and perform better in the long run. A solid platform with well-structured incentives to hold tokens for an extended period can lead to increased demand over time, attracting new investors and causing prices to rise. Conversely, a project with weak tokenomics is less likely to thrive and can struggle to gain popularity.

Tokenomics operates differently than traditional fiat currencies because it’s implemented through code, and the rules are transparent, predictable, and difficult to change.

For example, let’s take a look at bitcoin. The total supply of bitcoin is predetermined to be 21 million coins, and bitcoins are created through mining. Miners are rewarded with bitcoins every time they mine a block, which occurs approximately every 10 minutes.

The reward, also known as the block subsidy, is halved every 210,000 blocks, which means that it halves approximately every four years. Since the first block was mined on January 3, 2009, the block subsidy has been halved three times, from 50 BTC to 25 BTC, 12.5 BTC, and currently 6.25 BTC.

Bitcoin’s tokenomics also include transaction fees, designed to increase as transaction size and network congestion rise. This incentivizes miners to validate transactions, even as block subsidies decrease, and prevents spam transactions.

It’s important to note that in this context, the term “token” refers to both coins and tokens.

The Key Components of Tokenomics

Tokenomics is the backbone of any crypto project. It defines the incentives for the token holders and sets the utility of the tokens, making them valuable in the market. Developers use various parameters to influence different aspects of tokenomics, such as the supply, token allocations and vesting periods, mining and staking, yields, and token burns.

Supply

The supply of tokens is an essential factor in determining their value. A limited supply of tokens can create scarcity and drive up demand, increasing token prices. Conversely, an unlimited supply of tokens can lead to inflation and a decrease in their value. Developers can also adjust the supply of tokens to control inflation rates and ensure the project’s long-term sustainability.

Tokenomics experts emphasize the importance of token supply in analyzing a token. To fully understand the tokenomics of a particular cryptocurrency, it is crucial to examine the different forms of token supply, which include the following:

  • Maximum Token Supply: This refers to the exact amount of tokens that can be minted. If some tokens are burned, the maximum token supply will decrease accordingly. 
  • Circulating Supply: This refers to the number of tokens available in the market at a specific time. Circulating supply only includes available tokens, not those vested, reserved, or burned. 
  • Total Supply: This refers to the total amount of tokens created, whether or not they are in circulation. Burned tokens are no longer part of the total supply.
  • Initial Supply: This refers to the total amount of tokens circulating when the secondary listing is approved. The initial supply starts to count when secondary exchanges list the token.
  • Unlimited Supply: This refers to tokens with no limit to the number of mintable tokens. 
  • Market Capitalization: This refers to a project’s value, calculated as the product of the circulating supply and the current market price. 
  • Fully Diluted Valuation: This differs from the market cap and refers to the maximum token supply multiplied by the current market price. 

Token Allocations and Vesting Periods

Token allocations refer to the distribution of tokens to different stakeholders, including developers, investors, and community members. Vesting periods can be used to ensure that these tokens are locked up for a certain period before they can be traded, preventing early investors or insiders from dumping their tokens and causing a sudden drop in their value. 

Source: Uniswap

Token allocations and vesting periods are crucial in maintaining trust and transparency in the project.

Mining and Staking

Mining and staking are methods used by blockchain networks to secure and validate transactions. In proof-of-work (PoW) blockchains, miners use their computing power to solve complex mathematical problems and add new blocks to the chain, earning rewards in the form of tokens. In proof-of-stake (PoS) blockchains, validators stake their tokens to secure the network and earn rewards. These methods incentivize users to contribute to the network’s security and help maintain its decentralization.

Yields

Yield farming allows token holders to earn additional tokens by lending or staking their assets on decentralized finance (DeFi) platforms. These platforms use smart contracts to automate lending and borrowing activities, and users can earn rewards through interest and other tokens. Yield farming has become increasingly popular in recent years, creating new DeFi protocols and incentivized liquidity provision.

Token Burns

Token burns are a mechanism used by some blockchain projects to reduce the supply of tokens permanently. By destroying a portion of the tokens, the remaining tokens become more scarce, which can lead to an increase in their value. Token burns can also be used to reward long-term holders or align the incentives of the project’s stakeholders. Some projects use a portion of their revenue or profits to buy back and burn their tokens, creating a deflationary effect.

Who Decides?

Protocol developers make all the crucial decisions related to tokenomics that are deeply integrated into the code of a cryptocurrency. Typically, a whitepaper outlines the tokenomics of a cryptocurrency before its launch. A whitepaper is a detailed document explaining the cryptocurrency’s technology and its intended purpose. The most notable white paper is the one published for Bitcoin, which revolutionized the digital currency space with its innovative distributed ledger technology called blockchain. The paper also proposed a solution for the long-standing issue of double spending that had plagued previous attempts at digital payments. 

Factors Which Make Tokenomics Bad

Bad tokenomics can be a major factor in the failure of a project. There are several indicators of bad tokenomics that investors should be aware of. Here are three factors to watch out for:

  1. Massive Pump and Dumps. Token pre-sales can attract attention to a project, but if early investors are given a disproportionate amount of power, it can lead to market manipulation. This is especially true if they dump their tokens on new investors. Before investing, check if the token distribution is fair.
  2. Unlimited Supply. While unlimited supply may not always be a bad thing, it can be a red flag if there is no convincing reason for it. The founding team can choose this model for dubious reasons. They can mint more tokens and sell them for profit once the token’s value increases, leading to a loss for investors.
  3. No Actual Utility. Every project must have a utility token that serves a real purpose within the ecosystem. Without a tangible reason for people to buy the token, its value will inevitably plummet. This is particularly true for meme tokens.

Tokenomics Example

To make it easier to understand some aspects of tokenomics, below is some information about the Solana project:

SOL Utility Token

SOL serves as the fundamental token for the Solana blockchain, utilizing a delegated-Proof-of-Stake consensus algorithm that rewards token holders for verifying transactions. The token itself serves three primary purposes:

  • Staking;
  • Transaction fees;
  • Governance.

Source: The Tie Research

SOL Token Distribution

  • Community – 38.89%;
  • Seed Sale – 16.23%;
  • Founding Sale – 12.92%;
  • Team – 12.79%;
  • Foundation – 10.46%;
  • Validator Sale – 5.18%;
  • Strategic Sale – 1.88%;
  • CoinList Auction Sale – 1.64%.

What Does a Good Token Look Like?

To gauge the potential success of a cryptocurrency, tokenomics offers a framework to evaluate the token’s utility and functionality. The key attributes that define a well-crafted token include the following:

  • Utility within the ecosystem: A token that serves a vital purpose within its respective ecosystem and enables users to perform transactions or access specific features can be a promising investment opportunity.
  • Inflation-resistant: To maintain the token’s value and ensure its long-term viability, a good token should be designed with built-in mechanisms to prevent inflation and devaluation.
  • Scalability: As the demand for a cryptocurrency grows, its underlying infrastructure must be capable of scaling to handle the increased volume of transactions. A good token should have the potential and the ability to scale its network to accommodate future growth.
  • High value: A token’s value is a critical factor that determines its attractiveness to investors. A well-designed token should have a clear and compelling value proposition that justifies its price.
  • Availability on exchanges: A token’s liquidity and accessibility are essential for its success. It should be listed on major cryptocurrency exchanges to facilitate trading and enable investors to buy and sell the token with ease.
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