Tokenomics 101: What Is It And All About It?

Introduction

Tokenomics has advanced tremendously since the Bitcoin network’s genesis block was created in 2009. It is important in the context of artificial economies that are being set up through blockchain. The idea of the token economy in blockchain opens up many different possibilities. Tokens unlock many possibilities, right from incentivization to automatic balancing of the economy. For token-based platforms, it enables platform owners to commit to predetermined rules of token supply.

In general, tokens among themselves are very different; it’s useful if we have a "frame" through which we better understand their functionality and utility. Through tokenomics, all qualities that make it attractive to investors are explained.

In this article, I intend to discuss the history and concept of tokenomics, highlighting its essential components and emphasizing the importance of understanding it. Additionally, the article aims to address the appropriate amount of emission and raise awareness regarding what does not fall under the realm of Tokenomics.

This article is to be read along with my previous blog on Terms you should know in Tokenomics 101.

What is a Token economy?

Tokenomics refers to how the economy around a crypto token is imagined. It refers to the use of tokens to incentivize certain behaviors within a decentralized network. These tokens can be used to represent various forms of value, such as access to a particular service or the right to vote on important decisions within the network. The use of tokens in this way has become increasingly popular with the rise of decentralized finance (DeFi) and other decentralized platforms. We have both a successful and failure model in tokenomics.

What is the history of the Token economy?

The concept of the token economy can be traced back to the 1960s when it was developed as a behavioral modification tool in the field of psychology. A token economy is a system in which individuals receive tokens or other reinforcement for engaging in desired behaviors. These tokens can then be exchanged for rewards or privileges. For instance, in the traditional world, you could have seen parents incentivizing their kids to do some chores and teachers rewarding the students for their good behavior.

The use of token economies has been applied in various settings, including schools, hospitals, and correctional facilities, to encourage positive behaviors and discourage negative behaviors.

Having understood the history of the token economy, let’s dive into understanding why knowing the basics of tokenomics is important.

Why is knowing the basics of tokenomics important?

Investors in the crypto space need to familiarize themselves with the term in question and grasp the concept of tokenomics and get a high level of understanding. A basic understanding of tokenomics and decentralized finance (DeFi) is beneficial to leveraging blockchain and becoming a savvy crypto investor. Be it seasoned or aspiring investors need to spend time studying the project’s tokenomics before deciding to invest in the project.

For example, if tokenomics is designed in a way to create scarcity or demand for the token, then it may increase the value. On the other hand, if tokenomics is not well thought out, it may lead to a lack of interest or adoption of the project.

William Mougyar, in his insightful article on Tokenomics, has a checklist of 20 questions for assessing the token utility. A must-read article for an ICO investor.

What are the must haves?

It can be compared to building a car from the ground up. In this context, tokenomics is one of the most important parts of the car. If you are planning to buy a car, you will look at many features, viz.,

• What is the engine capacity?
• What is the brand value?
• What are the features available?
• What is the market presence?

Similarly, tokenomics of a project talk about the quality of a token which will convince the users/investors to adopt it and help build the ecosystem around the underlying project. It includes but is not limited to functionality, objective, allocation policy, and emission schedule.

Going through the tokenomics of a project is an essential decision before making an investment. A project with smart and well-designed incentives to buy and hold tokens will do better than a project that hasn't built any ecosystem around the token.

Through tokenomics, we can predict how many tokens will be created by a certain time and date (Timestamp). It is difficult to alter the created schedule, which gives the owners comfort and security. This information is known through Tokenomics to what degree the asset will be created and supplied.

Now, let's understand some of the key elements of tokenomics.

1. Tokenomics allocation and distribution

This is a strategic decision found in the project whitepaper as a pie chart. It contains information about who will receive the tokens and how they will reach the market. There are two ways in which the majority of the project choose to distribute their tokens via fair launch or through pre-mine.

In the case of a fair launch – the crypto is mined, owned, and governed completely by the community, whereas, in the case of pre-mine, the number of tokens is created and distributed before public launch to raise capital. This quantity is sold to potential buyers as a part of several events known as Initial Coin Offering, Initial Distribution Offering, and Initial Exchange Offering.

Most of the crypto projects come with pre-mined tokens. It is not good to dismiss a project just because it is pre-mined; instead, check if any whale holds a considerable percentage of the circulating token supply. If that is the case, then there is a high probability that whales may dump their holding and cause the price of the token to drop in a moment

2. Token supply

It refers to the total number of tokens available in a certain project and how that number will change in the future. In particular cases, we can refer to several types of existing token supplies, such as circulating supply and total supply.

Circulating supply refers to the number of tokens that are currently in circulation.

Total supply refers to the total quantity of existing tokens either in circulation or stuck at different smart contracts and released later as part of events such as ICOs, or various airdrops. Some projects don't have an upper limit, so the total token supply will grow in time. Other projects have a fixed token supply, the best-known example being Bitcoin and its limit of 21 million.

Maximum supply refers to the total quantity of tokens in a project that will exist once the max supply has reached the possibility of creating or minting new tokens will cease to exist.

Market capitalization is the most used indicator to determine how much a cryptocurrency dominates the market and understand its growth potential. Classifying projects based on the project market cap can help in the decision-making process of investing or not. A project with a high market cap is considered a low-risk investment as it will have sustainable growth over time. On the contrary, projects with immediate or low market cap have higher investment risk but offer higher rewards for those who invest in them.

3. Token Model

In the traditional world, “inflation,” “deflation,” or “Money issuance” is created by the respective country’s monetary policy, the government. They play a vital role in current and future price movements. Central banks and governments of the respective countries have an undeniable role in controlling these factors.

However, in the crypto world, both “monetary policy” is related to the following.

1. Is the coin inflationary or deflationary?

2. What are the plans for the issuance of the coins in the future?

And it is controlled by code and defined by the underlying protocol. Crypto projects are creating their microeconomies with the goal of self-sustaining.

The manner in which a token is created can also affect its value. Some tokens are created with a fixed quantity in a one-time event, while others are created over time and are designed to become more or less scarce. A token’s scarcity is considered to be a key consideration of value. Among the most popular we can find, 

i. The Inflationary model

An inflationary model that doesn't have a limit for the maximum supply will continue to be a product forever.

Pros: The advantage is that it is well-known and studied because it resembles the economic model of a fiat currency. It can incentivize people to participate in the network and contribute to its growth and development. For example, miners may be motivated to contribute their computing power to the network in exchange for the opportunity to earn new tokens as a reward. This can help ensure the network's security and stability, as well as its continued expansion.

Cons: It favors inflation as well as devaluation. Increasing the supply of tokens can dilute the value of existing tokens as the total market capitalization of the network increases. This can result in a decrease in the value of individual tokens and potentially reduce their purchasing power. It may not be well-suited to situations with a fixed or limited demand for a cryptocurrency or token, as the increased supply may outpace demand and lead to downward pressure on the price.

Example: Dogecoin. It has no maximum supply limit and a block reward that decreases over time.

Initially, Dogecoin had a block reward of 10,000 DOGE per block, halved approximately yearly. However, in March 2021, the Dogecoin community decided to eliminate the block reward halving, which means that the block reward will remain constant at 10,000 DOGE per block. This decision was made to increase the Dogecoin network's long-term stability and encourage more people to participate in the network as miners. As a result, the total supply of Dogecoin will continue to increase over time.

ii. Deflationary model

Deflation is generally associated with a contraction in the money supply, leading to the currency's purchasing power increasing. It is essentially the same in crypto.

In this model, tokens will have a limited maximum supply without the possibility of modifying this limit. It can be achieved by implementing strategies like a fixed supply of tokens and a periodic burn mechanism.

Pros: It generates a natural demand for the tokens and eliminates the threat of inflation that affects the fiat currency. It protects investors by preventing the market from being flooded with excess tokens as more are minted and sold off by the project developers. This protects the value of the token. This model benefits the investors as it causes the value of tokens to increase.

Cons: Many worry that tokens will be taken out of circulation as investors are incentivized to hoard them. This creates a barrier to entry for newcomers, and it makes the token less valuable.

Example: Ripple XRP. One of the key features of its tokenomics is it has an XRP fixed supply of 100 billion tokens. This fixed supply means that there will never be more XRP in circulation, creating scarcity and potentially increasing the value of the tokens. It also includes a mechanism for destroying XRP. When users send XRP to another user, a small percentage of tokens are destroyed, reducing the overall supply of XRP in circulation.

4. Token Incentives

It goes without saying that users should have the motivation not only to join the project but to buy a few tokens early, stay there, and continue to invest their money and time in it. It could be through profit sharing or staking pools, as briefed below.

i. Profit-sharing

Allow token holders to benefit from holding their tokens by distributing rewards. These can be airdrops, fee reflections, or other discretional token distribution events.

Many incentives designing framework is emerging in recent days, viz., Play to Earn, Travel to Earn, Rent to Earn, Create Explore and earn

ii. Staking

Allow token holders to stake their tokens and earn rewards by being validators in the network. Different use cases of the staking mechanism are being tied with,

• Holding tokens
• Activity
• Features of platform
• Status of participants

5. Consensus mechanism

A Consensus mechanism or protocol allows distributed systems to work together and stay secure. These mechanisms conceal a great deal of the logic utilized behind a blockchain; they are key concepts to understanding how supply and demand work and set up an ecosystem's rules. Among the most popular consensus we can find:

i. Proof-of-Work (PoW): In this protocol, a miner in the blockchain competes with others to create new blocks of information by solving a complex mathematical puzzle. The one that solves it the fastest is rewarded with a freshly minted native token. Then the block is shared in the network to publish transactions or smart contracts. This protocol takes a lot of energy to function, and decision power is in the hands of miners.

ii. Proof-of-Stake (PoS): In PoS, the integrity of the network is maintained by allocating a share of this responsibility to a participant node holding tokens in it. This protocol is much more cost-effective than PoW, but it incentivizes holding tokens long-term to accrue more power within the system.

As of 2022, we can find many more consensus mechanisms available. Each tries to solve complex problems or improve consensus protocols already built. There is no answer on which consensus is best, but understanding where we participate is key to ensuring you are safe and sound while participating in a token economy.

6. Token flywheel

The flywheel is a cycle that can be started anywhere. It is the creation of a positive feedback loop by increasing the payoff of incremental efforts. It promotes the behavior of the ecosystem, which will drive the token price. A group of self-reinforcing activities is required for success, and fuelling any part propels the project forward.

The balance between supply and demand determines the price of the token. In simple terms, if an asset is scarce, but many people want it, then the price of that asset will rise. On the contrary, if the supply exceeds the demand, the prices will fall. In order to keep prices stable, demand and supply should go hand in hand. The flywheel aligns the network participants to work toward a common goal, growing the network that appreciates the price of the token. When the utility increases, the token value also increases.

For instance, bitcoin’s supply increases by a fixed rate. At the time of writing, bitcoin miners have been rewarded 6.25 bitcoin every 10 minutes for each successfully mined block. This way, the supply of bitcoin is slowly increasing while the demand also increases. However, the supply is limited to balancing the price of the demand and bitcoin.

In the case of Uber, passengers generate demand while drivers supply the demand. Uber as a facilitator, acts as a marketplace to achieve demand-supply equilibrium while getting a fee.

What is the right amount of emission based on the underlying north star metric?

There is no one-size-fits-all answer to the question of the "right" amount of emissions, as it will depend on the specific goals and objectives of the project and the needs of its users. Following are a few factors that can help guide the design of a tokenomics model with respect to emissions:

1. The underlying north star or growth metric

The amount of emissions in a tokenomics model should be aligned with the project's underlying north star or growth metric. For example, if the project's goal is to drive network adoption and usage, the amount of emissions might be tied to measures of network activity, such as the number of transactions or the number of users.

2. Token supply and demand

The amount of emissions should be balanced with the overall supply and demand for the tokens. If there is strong demand for the tokens, higher emissions might be appropriate. However, if demand is weak, lower emissions might be more appropriate.

3. Token value

The amount of emissions should be considered in the context of the value of the tokens. If the value of the tokens is high, a lower level of emissions might be appropriate to maintain the value of the tokens. On the other hand, if the value of the tokens is low, a higher level of emissions might be necessary to increase the value of the tokens.

Who makes decisions on Tokenomics?

Tokenomics is typically decided by the project’s founding team, and in some cases, this is developed in collaboration with advisors or other stakeholders, such as investors or community members. Before the launch of a token, the tokenomics of the project will be outlined in the whitepaper that discusses all the must-haves, as discussed above in this article. Finalizing a project’s tokenomics involves a number of steps and considerations. It may include researching and analyzing market conditions, and trends, developing and testing different economic models, and gathering feedback from potential users and other stakeholders.

What is not Tokenomics?

It is equally important to understand what is not tokenomics, and they are the following.

1. The technical details of how a blockchain works

Tokenomics typically focuses on the economic and financial aspects of a cryptocurrency or token rather than the technical details of how the underlying blockchain technology functions, viz., coding and programming.

2. The marketing and branding of a particular token or cryptocurrency

While the branding and marketing of a token may be important for its success, these aspects are typically not considered to be part of tokenomics.

3. The social and cultural context in which the token is used

Tokenomics generally focuses on a token's economic and financial aspects rather than the social and cultural context in which it is used.

4. Financial analysis or investment strategy

Tokenomics does not involve financial analysis or investment strategies for cryptocurrency markets.

Key Takeaway

Tokenomics is an important concept you need to understand while investing in a crypto project, as factors will significantly impact your investment. Additionally, you should seek information about the project’s team and members' background, verify the social media handles, and details of any other successful project built before in this space.