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What is tokenomics? Why is it important?
2023-11-18 22:42 Update

Abstract

Token economics studies the economic operation model of tokens. Tokenomics describes the factors that influence a token’s use and value, including but not limited to token creation and distribution, supply and demand, incentives, and token destruction schedules. For cryptocurrency projects, a sound token economic model is the key to success. It is important for investors and stakeholders to carefully evaluate the token economics of a project before deciding to participate in it.

Introduction

Tokenomics is a combination of "token" and "economics". Understanding token economics is a very important aspect when conducting basic research on cryptocurrency projects. Not only do you need to pay attention to the white paper, founding team, roadmap, and community development, but you also need to understand token economics, as this is core to evaluating the future prospects of a blockchain project. The economic model of the token should be carefully designed when developing a cryptocurrency project to ensure long-term sustainable development.

A preliminary study on the economics of cryptocurrency

Blockchain projects will revolve around Tokens design their operating mechanisms to encourage or discourage various user behaviors. The principle is similar to that of a central bank printing money and implementing monetary policies to encourage or inhibit consumption, loans, savings and currency flows. Please note that the term "token" here covers both coins and tokens. Click here to learn the difference between the two. Unlike fiat currencies, the rules of token economics are implemented through code. These rules are transparent, predictable, and difficult to change.

Let’s take Bitcoin as an example. Bitcoin has a preset total supply of 21 million coins. The currency is generated through mining and enters the circulation market. Miners can mine a block every 10 minutes or so and are rewarded with some Bitcoins.

Reward, also called block subsidy. Every time 210,000 blocks are mined, the reward will be halved. According to this schedule, rewards will be halved every four years. Since January 3, 2009, when the first block on the Bitcoin network (the genesis block) came out, the block subsidy has been halved three times, from 50 Bitcoins to 25 Bitcoins, and then to 12.5 Bitcoins. Bitcoin, currently at 6.25 BTC.

Based on these rules it is easy to conclude that approximately 328,500 Bitcoins will be mined in 2022. It is calculated by dividing the total number of minutes in a year by 10 (one block is mined every 10 minutes) and then multiplying by 6.25 (6.25 Bitcoins are issued as a reward for each block). From this we can extrapolate the number of Bitcoins mined each year, with the last Bitcoin expected to be mined around 2140.

Bitcoin’s token economic model also includes transaction fees. Once a new block is verified, miners receive a transaction fee. As transaction sizes increase and the network becomes more congested, transaction fees will rise. This design helps eliminate spam transactions and incentivizes miners to continue validating transactions even as block subsidies continue to decrease.

In short, the operating mechanism of Bitcoin is designed to be both simple and clever. Everything is transparent and predictable. The incentive mechanism designed around Bitcoin gives participants the motivation to continue to inject value into the cryptocurrency and keep the network running stably.

Key elements of token economics

The term tokenomics encompasses the various factors that affect the value of cryptocurrencies. This term refers first and foremost to the economic structure of a cryptocurrency as designed by its founders. Here are some key elements to examine when studying the tokenomics of cryptocurrencies.

Token supply

For any goods and services, supply and demand are the main factors that affect price. The same goes for cryptocurrencies. Here are a few key metrics for measuring token supply.

The first is the maximum supply, which is the upper limit of the number of tokens specified by the default code. The maximum supply of Bitcoin is 21 million. Litecoin’s hard cap is 84 million and Binance Coin’s maximum supply is 200 million.

Some tokens have no supply cap. The supply of ether on the Ethereum network is increasing every year. Stablecoins such as USDT, USDC, and BUSD do not have a maximum supply because these coins are issued based on supporting reserves. In theory, the supply of these coins can continue to increase. Dogecoin and Polkadot are two other cryptocurrencies that do not have a supply cap.

The second metric is the circulating supply, which is the number of tokens in circulation. Tokens can be minted and burned, or otherwise locked. This will also have an impact on the price of the token.

Looking at the token supply will give you an idea of how many tokens will eventually be generated.

Token utility

Token utility refers to the intended use of the token. For example, the utility of Binance Coin includes powering the BNB chain, paying transaction fees and enjoying transaction fee discounts on the BNB chain, and serving as a community utility token on the BNB chain ecosystem. Users can also earn additional income by staking Binance Coin through various products within the ecosystem.

The token has many other use cases. Holders of governance tokens have the right to vote on changes to the token protocol. Stablecoins function as currencies, while security tokens represent financial assets. For example, a company could issue tokenized shares during an initial coin offering (ICO), granting holders ownership rights and dividends.

These can help you identify potential use cases for a token and are critical to understanding the future direction of the token.

Analyzing token allocation

In addition to supply and demand, you also need to understand how tokens are distributed. Large institutions and individual investors behave differently. Knowing the type of entity holding a token allows you to further infer how the holders are likely to trade, and how they trade will influence the value of the token.

Generally speaking, there are two ways to launch and distribute tokens: fair launch and post-premine launch. A fair launch means no one gets a first look at the tokens or a small distribution occurs before the tokens are minted and distributed to the public. Both Bitcoin and Dogecoin have taken this launch approach.

Pre-mining in the second method refers to minting and distributing a portion of the cryptocurrency before making it available to the public. to a specific group. Ethereum and Binance Coin have pre-mined.

Generally speaking, you need to pay attention to whether the tokens are distributed evenly. Typically, having a few large institutions holding the vast majority of tokens means greater risk. If patient investors and the founding team hold a majority of tokens, the interests of holders are more aligned and long-term success is more likely.

You also need to know the locking and release schedule of the tokens to see if a large number of tokens will enter circulation, so as to Put downward pressure on the value of the token.

Understand the destruction of tokens

Many crypto projects regularly burn tokens, meaning some tokens are permanently removed from circulation.

For example, Binance Coin uses token destruction to remove some tokens from circulation, thus reducing the total supply. The pre-mined supply of Binance Coin is 200 million. As of June 2022, the total supply of Binance Coin is 165,116,760 coins. A large number of Binance Coins will be destroyed in the future until the remaining amount reaches 50% of the original total supply. This means that the total supply of BNB will be reduced to 100 million. Likewise, Ethereum also started burning ether in 2021 to reduce its total supply.

Reducing the supply of tokens is deflation. On the contrary, the continuous expansion of token circulation is inflation.

Incentive mechanism

Token incentives Mechanisms are crucial. How to incentivize participants to ensure long-term sustainable development is the core issue of token economics. The design of block subsidies and transaction fees in Bitcoin is an example of a simple model.

Proof-of-stake mechanism is another increasingly common verification method. Under this design, participants need to lock their tokens to verify transactions. Generally speaking, the more tokens locked, the greater the chance of being selected as a validator and receiving rewards for validating transactions. This also means that if validators attempt to disrupt the network, their own assets will be at risk. These settings incentivize participants to act honestly and maintain the robustness of the protocol.

Many DeFi projects have taken advantage of innovative incentive mechanisms to achieve rapid growth. On the cryptocurrency lending platform Compound, investors can deposit cryptocurrencies in the Compound protocol, receive interest, and receive COMP tokens as additional rewards. In addition, the COMP token is also the governance token of the Compound protocol. These designs coordinate the interests of Compound and all participants and are beneficial to the long-term development of the project.

Where is the development direction of token economics?

Tokenomics have come a long way since the creation of the Bitcoin network’s genesis block in 2009. Developers have explored multiple token economic models. There are successes and there are failures. Bitcoin’s token economic model has withstood the test of time and is still in operation. Other coins with poorly designed models have fallen into trouble.

Non-fungible tokens (NFT) adopt another token model based on digital scarcity. The tokenization of traditional assets such as real estate and art may give rise to new token economics innovations in the future.

Summary

Tokenomics is a basic concept that you must understand if you want to get into cryptocurrency. Tokenomics covers the main factors that affect the value of a token. It should be noted that the assessment cannot be based on one-size-fits-all. As many factors as possible should be taken into consideration for a holistic analysis. Tokenomics can be combined with other fundamental analysis tools to help more comprehensively judge the future prospects of a project and the price of its tokens.

Ultimately, how a token operates will be influenced by its purpose, how easy it is to build a network, and how favorably users prefer the token. Tremendous influence.