What is Tokenomics? – How Does It Work?
The value of tokens is one of the main parameters to consider when evaluating a cryptocurrency. The parameter is quite challenging to determine, especially if the digital coin has not been released yet, and the developers are only planning to launch the project. To understand how the price will behave in the future, investors take into account a range of factors. They necessarily take into account personal characteristics, prospects, and functions, as well as the potential position among other coins. All of this forms the tokenomics of cryptocurrency. The concept began to be widely used in 2017. However, not all investors know what it means. So what is tokenomics, and how does it help to evaluate a crypto project?
In this article, we will cover the concept of tokenomics and how it works. We will also touch on why tokenomics is important when investing in crypto projects and give an example of what the tokenomics of a specific crypto token looks like.
What is Tokenomics?
Making an investment decision requires a clear vision of tokenomics because, ultimately, a project with reasonable and well-designed incentives to buy and store tokens over time is more likely to survive and succeed than one that has not built an ecosystem and an active community around its token. A well-built platform often leads to higher demand as new investors flock to the project, increasing token prices and the desire to buy and accumulate.
Tokenomics is the key to the fundamental analysis of cryptocurrencies. There are so many crypto tokens in circulation right now (and they are still being created) that it is difficult to find a single method to estimate their value. The concept of tokenomics began to be used relatively recently. However, the idea of token economics was proposed back in 1972. It was suggested by Harvard psychologist B. F. Skinner. He was convinced that such a model was capable of controlling behavior. Giving a specific unit a value would cause it to stimulate the performance of certain actions.
Modern tokenomics is based on several methods of calculating the value of a token. One of the most popular is Chris Burniske’s model, which laid the basic principles of modern tokenomics. The specialist began developing his model in 2014, wanting to understand what factors would affect Bitcoin pricing. In his work, Burniske paid attention to the following indicators:
- Total market volume;
- The percentage of penetration of the coin;
- Turnover rate;
- The number of coins that are in circulation.
The model was first applied in practice in 2015. Since then, it has been put to use in crypto-economics.
How Does Tokemonics Work?
Cryptocurrency economic structure determines the incentives that motivate investors to acquire and hold a particular coin or token. The coinage policy of each cryptocurrency is unique, as it is with all fiat currencies.
Cryptoeconomics is concerned with determining two things: the incentives that influence the distribution of tokens and the utility of tokens that determines their demand. Utility that provides the right incentives can help projects to grow in price as demand and supply are significantly impacted.
The following are the key variables that crypto project developers have control over that have an impact on token economics:
- Mining and staking
For base-level blockchains such as Ethereum 1.0 and Bitcoin, mining is the main incentive in a decentralized network of computers to verify transactions. Staking rewards those who perform a similar role but instead freezes a certain amount of coins in a smart contract — this is how blockchains such as EOS work, and this is the model to which Ethereum is moving with the 2.0 update.
- Token burns
Some protocols or blockchains “burn” tokens to reduce the number of coins in circulation. According to the laws of supply and demand, reducing the supply of a token should help support its price as the remaining tokens in circulation become increasingly scarce (deflationary model).
Decentralized financial platforms offer high returns to encourage people to buy and place tokens. Such returns are paid in the form of new tokens. Tokens are placed in liquidity pools — huge pools of cryptocurrencies that support systems such as decentralized exchanges and credit platforms.
- Vesting periods and token allocation
Certain crypto projects allocate tokens in a detailed manner. It is often the case that a certain number of tokens are reserved for venture capitalists or developers, but they cannot sell these tokens until a certain amount of time has passed. Over time, this naturally has an impact on the number of coins in circulation. Ideally, we need a system where tokens are allocated to minimize the impact of issuance and the rate at which tokens are unlocked on the supply and price of tokens.
- Token supply
Supply is one of the main indicators which largely determines the evaluation of a cryptocurrency in the long term. It shows how much risk a coin will likely depreciate in the future and whether the tools are in place to control this process.
According to economic laws, if too many currency assets are released into circulation, they depreciate instantly. This also applies to crypto, which has an unlimited supply. As a rule, crypto-assets enter the market according to a predetermined algorithm.
Why is Tokenomics Important When Investing in Cryptocurrency?
Understanding the factors that will affect supply or demand is vital for all investors, without exception. Most important is understanding how digital currency will be used. Is there a clear link between the asset and the use of the platform or service being created? If so, there is a strong possibility that a growing service will push up the demand to buy and use the token, which will ultimately drive up its price.
Tokenomics helps to understand how much an asset might be worth in the future. For example, many people unfamiliar with cryptocurrency may think something like, “If this coin becomes as valuable as Bitcoin, one day…” when in fact, it may never happen. As an example, consider coins like Bitcoin Cash and Ripple (XRP). Bitcoin Cash has the same general supply as Bitcoin, so the idea that the former could eventually be worth as much as the latter has some validity. On the contrary, with XRP’s existing 50 billion coins, it would have to become the most valuable business in human history for a single coin to be worth thousands of dollars. These reflections give a different perspective on crypto-assets and help to understand if any crypto token has a chance for a great future compared to others.
Tokenomics can be called an experimental and new field at the intersection of mathematics, statistics, economics (especially macroeconomics and game theory), cryptography, IT, game design, and other related disciplines, which allows studying in detail the economic indicators of liquidity, supply, and other parameters of a single crypto project to make a balanced decision for further investment in it.
Tokenomics example: Solana
Solana is a third-generation blockchain that supports many DeFi solutions, including developing decentralized applications (DApps) and smart contracts. Unlike other blockchains, Solana uses a hybrid consensus algorithm that combines Proof of History (PoH) with Proof of Share (PoS), allowing the network to perform up to 50,000 transactions per second.
At the time of writing, the token has the following indicators:
- total supply: ~$511,617,000$SOL;
- circulating supply: ~$359,000,000$SOL.
Initial token inflation was 8% per year, with annual inflation decreasing 15% per year until reaching a fixed 1.5%; current inflation is ~7.2% per year. Historical price highs are $260, and the current price is ~$28.37.
The distribution structure of the SOL token is as follows.
- Community Reserve – 38%
- Seed Sale – 15.86%
- Founding Sale – 12.63%
- Team – 12.5%
- Foundation – 12.5%
- Validator Sale – 5.07%
- Strategic Sale – 1.84%
- Public Auction Sale – 1.6%
Tokenomics, while a new field of research, provides analysts and investors with some interesting insights into the success potential of each token project. Token metrics, while not absolute indicators of success per se, can provide key clues to understanding the long-term viability potential of a project that investors should take seriously. When the hype around a particular project reaches a breaking point, these metrics should act as a “true compass” for every investor and affect their future investment decisions. However, in addition to token metrics, investors should also analyze the qualitative aspects of any token project before making decisions. The project roadmap, partnership opportunities, and overall team quality are all key attributes of every project and should be communicated when developing an investment thesis.