What Is Tokenomics and Why Does It Matter?

Tokenomics (a combination of ‘token’ and ‘economics’) is a crucial part of researching any crypto-centric project. As well as studying the project’s creators, their plans for the future, and their documentation, tokenomics is vital to understanding the possible future that lies before a blockchain project. And any team involved in a crypto project MUST take the time to design its tokenomics with the utmost care to make sure that the project is sustainable and built to last.

Tokenomics in Brief

When launching blockchain projects, teams build tokenomics rules around their tokens to both encourage and discourage particular actions on the part of users. It’s not too dissimilar to a central bank printing paper money and implementing policies to encourage or discourage lending, spending, and the general movement of money.

In this sense, ‘token’ is used in reference to tokens and coins. Tokenomics are different to fiat currencies, though, as tokenomics rules are brought into effect via code, and they’re transparent and hard to adjust.

For example, let’s consider Bitcoin. This cryptocurrency has a pre-set limit of 21 million coins, which are produced and put into circulation through a process known as mining. As a reward for their hard work, miners receive a portion of bitcoins when a new block is mined (usually around every 10 minutes).

This reward (known by some as ‘block subsidy’) is halved with every 210,000 blocks mined, so it’s fair to say that a halving occurs once in four years. Since the first block on the Bitcoin network was mined in January 2009, the block subsidy has been halved a total of three times (at the time of writing). It started at 50 BTC, then dropped to 25 BTC, dropped again to 12.5 BTC, and stands at 6.25 BTC at present.

With this in mind, we can estimate that more than 328,000 BTC will have been mined by the end of 2022. How? Divide the number of minutes in a single year by 10 (based on the 10-minute mining rule) and multiply it by 6.25 (the current reward distributed to miners). That means we can predict the total number of bitcoins mined every year, and that the final bitcoin is likely to be mined in 2140.

Transaction fees are another key element of Bitcoin’s tokenomoics, as miners receive these following the validation of a fresh block. The fee will grow as the congestion of the network and the size of transactions increase. This helps ward off spam transactions and encourages miners to continue to validate transactions despite the ongoing reduction in block subsidies.

Essentially, Bitcoin’s tokenomics are both ingenious and straightforward at the same time. It’s all predictable and transparent, and the incentives put in place ensure that miners keep Bitcoin’s network strong while contributing to its value on the crypto market.

Essential Aspects of Tokenomics

Tokenomics is an umbrella term for numerous factors that affect a cryptocurrency’s value, but it primarily refers to the original design of a cryptocurrency’s economy. Let’s explore the top factors to bear in mind when assessing a crypto’s tokenomics.

Number of Tokens Available

The cost of any product or service is affected by two key factors: supply and demand. That applies to cryptocurrency, too, and a token’s supply can be measured with a few special metrics.

Maximum supply is the most important. A maximum supply of tokens has been coded to exist within the cryptocurrency’s lifetime (however long that may be). For Bitcoin, the maximum supply is 21 million, while Litecoin is capped at 84 million.

Still, not every token has a maximum supply — Ethereum’s ether supply grows each year, for instance. USDT and Binance USD lack a maximum supply, as their coins are distributed according to the reserves backing them. It’s possible that they would continue to grow and grow without restraint. Neither Polkadot and Dogecoin have a maximum supply.

The next metric for measuring a token’s supply is circulation supply. As you may have guessed, this applies to the amount of tokens in circulation. They may be minted or locked up in various ways, which has an impact on the token’s cost too.

Checking a crypto’s token supply offers a reliable insight into the number of tokens that will ultimately be out there.

A Token’s Utility

A token’s intended use cases are referred to as token utility. BNB’s utility, for example, includes functioning on the BNB Chain ecosystem as a community utility token and covering transaction fees. Users may also stake this token with a number of products in the ecosystem to generate extra income.

Tokens have numerous other use cases. With governance tokens, a holder can vote on proposed protocol changes affecting the token, while stablecoins are made for use as a currency. Financial assets are represented by security tokens: a brand may distribute tokenized shares as part of an Initial Coin Offering (ICO) to award holders with both dividends and ownership rights.

With these factors in mind, you may be able to determine a token’s possible use cases and understand how its economy could evolve in years to come.

Assessing the Distribution of Tokens

The distribution of a token is crucial to consider alongside supply and demand. Major oranizations and private investors act differently, and if you know which entities hold a particular token, you’ll be able to understand how they will trade their tokens. And that can affect the value of the token.

Tokens may be launched and distributed in two ways: a fair or pre-mining launch. A fair launch involves no private issuances or early access ahead of a token’s minting and public release. Dogecoin and Bitcoin fall into this category. During a pre-mining launch, though, a set amount of the cryptocurrency is minted and issued to a specific number of users before the public gets its hands on it. BNB and Ethereum both took this route.

In general, it’s important to look at the way in which a token is distributed. It’s generally regarded as riskier for a few big organizations to hold a significant amount of a token. When a token is primarily held by found teams and patient investors, stakeholders’ interests are better suited to the token’s success in the long run.

Pay attention to a token’s release and lock-up schedule to determine if a substantial amount of tokens will be put into circulation, which would place downward pressure on its value.

Analyzing Token Burns

When a crypto project removes tokens from circulation on a permanent basis, which many do, this is known as a token burn. BNB burns tokens to pull coins from circulation and decrease its overall supply. There are 200 million pre-mined BNB, so its full supply stood at more than 165,000 in June 2022.

More coins will be burned until half of BNB’s supply has been destroyed and the overall supply stands at 100 million. Ethereum has also begun burning ether to decrease its supply.

The reduction of a token’s supply is viewed as deflationary. But a continually expanding token supply is inflationary.

Incentives

Implementing an incentive mechanism is paramount: the way in which a token motivates participants to maintain its sustainability is at the core of tokenomics. The way in which Bitcoin handles its block subsidy and transaction fees demonstrates an effective, intelligently designed model well.

Another method of validation gaining popularity is the Proof of Stake mechanism, which allows participants to lock tokens for transaction validation. The more tokens that are locked up, the more likely they are to be picked as validators and to gain rewards for their efforts. Additionally, if a validator attempts to damage the network, their own assets’ value will be under threat. As a result, participants are incentivized to be honest and maintain the protocol’s robustness.

A number of decentralized finance (DeFi) projects have utilized groundbreaking incentive mechanisms to cultivate fast growth. A crypto borrowing and lending solution known as Compound enables investors to deposit coins in its protocol, generate interest, and claim COMP tokens as an extra reward. These tokens function as a governance token for the Compound protocol. This innovative approach aligns participants’ interests with the project’s future prospects.

What Does the Future Hold for Tokenomics?

Tokenomics have evolved dramatically since Bitcoin’s first block was made in 2009. Developers have created various models, with some failures and successes, but Bitcoin’s tokenomics model is still going strong. Other projects with weak tokenomics designs, though, have struggled to keep up.

Non-fungible tokens (NFTs) afford a different tokenomics model revolving around digital scarcity. In years to come, new tokenomics innovations could be sparked by the tokenization of conventional assets like art and real estate.

Conclusion

If you’re looking to step into the world of crypto, it’s vital that you understand the fundamentals of tokenomics. This term encompasses the central factors that determine a token’s value, though no one factor works as a magic key. You should make an assessment based on a wide range of factors (as many as you can think of). You can also combine tokenomics with various fundamental analysis tools to make an informed prediction on the future of a project and the cost of its token.

Essentially, though, a token’s economics will have a significant effect on how people use it, the simplicity of establishing a network, and the level of interest lying in the token’s use case.