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Concepts & Definitions - Tokenomics

An easy to read guide on what Tokenomics is.

Tokenomics

Tokenomics refers to the economic model and mechanics of a cryptocurrency or blockchain-based project. Tokenomics is the study of how a cryptocurrency token works. It includes the token's supply, distribution, utility, and value. Good tokenomics is important for the success of a cryptocurrency project.

Here are some of the key things to consider when evaluating the tokenomics of a cryptocurrency project:

 

Token supply: The total number of tokens that will ever be created. A limited supply of tokens can create scarcity and drive up the price. When there are a limited number of tokens, it becomes more difficult to acquire them, which can drive up the price, while an unlimited supply can lead to inflation and devaluation. This is because the value of each token will decrease as more and more tokens are created.

 

Supply Metrics You Should Know:

  •  Circulating Supply: How many tokens are in circulation now. This doesn’t include future emissions or vested tokens yet to be unlocked.

  •  Max supply: The total amount of tokens that would ever enter circulation.

  •  Market Cap: Current Price * circulating supply

  •  Fully Diluted MC: Current Price * max supply

Why the Metrics Above Hold Significance?

These metrics play a crucial role in predicting future availability and scarcity. To illustrate, a situation where only 40% of the supply is currently in circulation. The creation of more coins will almost always exert downward pressure on the price. It is important to note that the supply of a cryptocurrency is not the only factor that affects its price. Other factors, such as demand and utility also play a role. However, a limited supply can be a significant factor in driving up the price of a cryptocurrency.

Token Distribution: This is the process of allocating tokens to investors and users. It can include pre-mined tokens, token sales (Initial Coin Offerings or ICOs), airdrops, bounties, and allocations for development teams and advisors. A fair distribution can help to build trust and support for the project, while a concentrated distribution can give too much power to a small group of individuals.

Here is a more detailed explanation of token distribution:

 

  • Pre-mined tokens: These are tokens that are created before the project is launched. They are often allocated to the development team, advisors, and investors who participated in the pre-sale.

 

  • Token sales: These are events where tokens are sold to investors in exchange for fiat currency or other cryptocurrencies. They are a common way for cryptocurrency projects to raise money.

 

  • Airdrops: These are free distributions of tokens to users. They are often used to promote a project and attract new users.

 

  • Bounties: These are rewards that are given to users for completing tasks that benefit a cryptocurrency project. These tasks can include testing the project, writing code, translating documentation, or performing any other task that is helpful to the project. Bounty programs are a way for cryptocurrency projects to get help from the community and to incentivize users to participate in the project.

  • Liquidity mining incentives: These are the rewards that users receive for providing liquidity to decentralized exchanges (DEXs). These incentives are typically in the form of native tokens, governance tokens, or other digital assets.



Supply Limit: The maximum supply of tokens that will ever be created is an important aspect of tokenomics. Many projects opt for a fixed supply to ensure scarcity and potentially drive up value over time. Here are some examples of cryptocurrencies with limited supply:

 

  • Bitcoin: The total supply of Bitcoin is capped at 21 million coins.

 

  • Ethereum: The total supply of Ethereum is not capped, but the issuance of new ETH tokens is programmed to slow down over time.

 

  • Litecoin: The total supply of Litecoin is capped at 84 million coins.



Utility and Use Cases: Tokens frequently serve distinct purposes and fulfill specific roles within their designated ecosystems. They might represent ownership in a project, provide access to certain features, enable participation in governance decisions, or facilitate transactions within a platform.

 

Staking and Rewards: Staking is the process of locking up your tokens to support the security and operation of a blockchain network. Stakers are rewarded with tokens or other assets.

 

Proof of Stake (PoS): PoS is a consensus mechanism used by some blockchain networks to validate and confirm transactions. Unlike Proof of Work (PoW), where miners solve complex mathematical problems to validate transactions, PoS relies on validators who lock up a certain amount of cryptocurrency as collateral to propose and validate new blocks of transactions.

 

Incentive Mechanisms: Tokenomics can be structured to encourage specific behaviors or activities. For instance, a project could provide incentives to users who contribute to the expansion of the ecosystem, such as by supplying liquidity to decentralized exchanges (DEXs). The specific incentive mechanisms that are used will vary depending on the project. However, incentive mechanisms can be a powerful way to encourage users to participate in a project and help to achieve its goals and also distribute tokens to holders in the early stage.

 

Burn Mechanisms: Burning tokens involves permanently removing them from circulation. This can be done to reduce the total supply of tokens, potentially increasing their scarcity and value or to reward users or to fund the development of the project. For example, let's say there is a total supply of 100 tokens and 50 tokens are burned. This means that there are now only 50 tokens in circulation. This makes the tokens more scarce and may be perceived as more valuable.

Burning tokens can be a way to keep a cryptocurrency exclusive. By reducing the supply of tokens, it becomes more difficult to acquire them. This can make the cryptocurrency more desirable and can help to drive up prices and a project might also burn tokens to reward users who participate in staking or who provide liquidity to a decentralized exchange

A real-life example of the Burning Mechanism:

Supreme is a popular streetwear brand that has been known to destroy unsold products. In 2017, the company destroyed $50 million worth of clothing and accessories. Supreme claims that this is done to maintain the brand's exclusivity and to prevent counterfeiting.

 

Governance: Some projects use tokens to enable decentralized governance, allowing holders to propose and vote on protocol upgrades, changes, and decisions about project direction.

 

Economic Model: The economic model of a token determines its use, value, and how it incentivizes different participants in the ecosystem. This can include factors such as inflation, deflation, and the rate at which tokens are released over time. The economic model of a token is a complex and ever-evolving topic. There is no one-size-fits-all approach, and the best model for a particular project will depend on its specific goals and objectives.



Market Demand: The value of a token is determined by the interplay of supply and demand. The more people who want a token, the more valuable it becomes.

 

For example, Bitcoin is a token that is used as a payment method. It has a limited supply, which makes it scarce and valuable. It also has a lot of utility, as it can be used to buy goods and services from a growing number of merchants and many DeFi protocols accept bitcoin as collateral. On top of being one of the most decentralized coins ever known, Bitcoin's combination of scarcity and utility has made it one of the most valuable tokens in the world.

 

The demand for tokens is driven by various factors, including but not limited to:

  • Utility

  • Speculation

  • Liquidity

 

Utility: Tokens that have practical uses within a specific ecosystem or platform tend to be in demand. For example, in a decentralized finance (DeFi) platform, tokens might be used for lending, borrowing, or governance. In the case of GameFi, these tokens can be used for various purposes, including in-game purchases, participation in tournaments, governance and voting, as well as staking and yield farming. These are just a few examples, and the actual uses can vary widely depending on the specific GameFi project and its goals.

Speculation: Some people invest in tokens simply because they believe that the price will go up in the future. This is known as speculation. For example, the demand for Dogecoin has been driven by speculation, as many people believe that the price of the meme token will continue to rise as its culture grows and rumors emerge about Elon Musk’s plans to integrate it into the X platform. 

Liquidity: liquidity is the ease with which a token can be bought or sold. A liquid token is one that can be easily traded without affecting its price significantly. 

 

Here's why liquidity is important in crypto tokenomics:

  1. Price Stability: Liquidity plays a significant role in stabilizing the price of a cryptocurrency. In illiquid markets, even a small buy or sell order can lead to significant price fluctuations. High liquidity helps prevent extreme price volatility, making the cryptocurrency more attractive to investors and users.

 

  1. Reduced Manipulation: Liquid markets are less susceptible to market manipulation because it is harder for a single entity or a small group of traders to influence prices significantly.

 

Liquidity in the crypto space is vital for risk management, market efficiency, and ease of trading. It allows participants to access funds, promotes market efficiency, and enables smooth, timely trading without price discrepancies.

 

Risk: There is always risk associated with investing in cryptocurrencies, and investors need to carefully assess the risks before investing. It’s advised you DYOR (Do Your Own Research).

 

Bad Tokenomics

Bad tokenomics refers to design flaws in a cryptocurrency or digital token that can lead to problems or even failure. These flaws can include:

 

  • Inflationary supply (inflation): When there is too much of a token in circulation, it can lead to a decrease in its value. This is because there is less demand for the token as more and more of it becomes available.

 

  • Poor distribution: If the majority of tokens are held by a small number of people, it can give them too much control over the project. This can lead to centralization and make it difficult for the token to succeed.

 

  • Lack of utility: If a token does not have any real-world use cases, it is unlikely to be successful in the long term. Investors will not be willing to hold a token that has no value.

 

It is important to do your research (DYOR) before investing in any cryptocurrency token. If you see any of the red flags mentioned above, it is best to avoid the token.

 

Here are some tips for evaluating the tokenomics of a cryptocurrency:

  • Understand the token's purpose: What is the token supposed to do? What problem is it trying to solve?

  • Examine the token's supply and demand: How many tokens are there? How are they distributed?

  • Consider the token's inflation rate: How quickly are new tokens being minted?

  • Look at the token's security: How is the token protected from hacking and theft?

  • Evaluate the token's team and community: Who is behind the project? Are they experienced and trustworthy? Is the community active and engaged?

 

By following these tips, you can help to avoid investing in tokens with bad tokenomics.

 

Tokenomics Evaluation Framework:

 

Maintaining a comprehensive checklist is essential for objectively assessing all facets of a protocol. This structured approach aids in making well-informed decisions.

 

Conclusion:

 

In the world of cryptocurrencies and blockchain projects, tokenomics is a critical factor in determining success or failure. It involves assessing the balance between incentives for ecosystem participants, fair token distribution, and utility for holders. Well-designed tokenomics is essential, as poorly structured ones can lead to problems like inflation, token dumping, and lack of investor interest, negatively affecting a project's future. Overall, tokenomics encompasses factors like token supply, distribution, and market demand, shaping a token's value and success.