What Is Tokenomics?

What is tokenomics? In the crypto world, tokenomics is a summary of the most important economic aspects of a cryptocurrency.

In this guide, we’ll explore this field in more detail and offer simple explanations of its main features, importance, and the green and red flags of analyzing different projects. Without further ado, let’s start.

The word tokenomics is derived from “token” and “economics” and represents the study of cryptocurrencies’ demand, supply, distribution, and valuation. So, this is a simple way of referring to the overall economics of a particular crypto token.

Analyzing tokenomics means looking at how crypto is valued and whether that value will rise or fall. Over time, a cryptocurrency may lose value if the supply is too high or exceeds demand.

To persuade investors, projects usually include many details in the philosophy of their tokenomic model.

Main Features of Tokenomics

If you are unfamiliar with tokenomics features, you can’t fully understand what tokenomics is. So, let’s explore each one in detail.

Issuance

The process of generating a new cryptocurrency is called issuance. When analyzing tokenomics, it’s important to understand how the token is issued and which consensus mechanism the blockchain follows.

Taking two of the biggest cryptocurrencies as an example, we can see that while BTC uses the proof-of-work consensus, proof-of-stake is Ethereum’s consensus mechanism.

This means that new BTC coins emerge whenever a miner adds a new block to the blockchain, and these coins enter circulation through miners at a pre-determined rate.

To understand Ethereum tokenomics, keep in mind that validators lock up 32 ETH to validate transactions and generate new blocks. Based on their performance, active validators receive those new ETH coins at each epoch.

Total Supply, Circulating Supply, and Market Capitalization

The tokenomics meaning also encloses the maximum and circulating supply. A cryptocurrency can have an indefinite or limited supply. For instance, while Ethereum has an infinite supply, BTC is limited to 21 million coins.

The circulating supply is the number of coins currently in circulation. Regarding how many Bitcoins are left and how many circulate, there are 1.5 million BTCs left, while there are presently 19,7 million BTCs in circulation.

A cryptocurrency’s market capitalization represents the value of the total amount of circulating supply.

Token Burns

Burning is the process of sending cryptocurrencies to unretrievable wallet addresses to remove them from circulation.

Burning tokens can control inflation by reducing the circulating supply. Some projects burn a specific percentage of their circulating supply at random or pre-determined rates. Others code the burning on a portion of every transaction fee users pay.

Interestingly, Bitcoin doesn’t have burning mechanisms. Some cryptocurrencies are eventually upgraded to introduce one. That was the case of Ethereum, with its “London upgrade” in 2019.

Distribution

What is token supply distribution? Most cryptos are pre-mined tokens, meaning that the founding team generates the tokens and sells a portion to early investors to raise funds. Some examples of pre-mined tokens are Solana, Binance Coin, and Ether.

People investing in these tokens must be cautious about how the token is distributed to different holders. If early-stage institutional buyers hold a large portion of the tokens, with no carefully planned release schedule, the token’s value could decrease when the holders sell their tokens for a considerable profit.

The same goes for tokens allocated to the core project team. Investors prefer tokens in which the core team gets a share of the total supply and shows commitment by following a long-term vesting schedule for the allocated assets.

Utility

The market value of a crypto project’s token can significantly be influenced by how many use cases it has. The usual crypto token utilities are:

A way to incentivize validators or miners to verify transactions and keep security on the underlying blockchain
A means to access exclusive platform benefits
Rewarding new depositors and active users with tokens through gamified mechanisms or liquidity mining programs
A way for token holders to vote on critical decisions and govern the protocol

When speculation fades, use cases drive demand for assets. Investors are also reassured that the asset’s value will keep growing if the offered product or technology onboards new users.

Technical Aspects

To understand what tokenomics are, you should also know the unique technical features setting a cryptocurrency apart. For example, the Bitcoin protocol goes through a process called halving every four years. That’s when the number of new BTC created with every block is cut in half. Because of this halving mechanism, BTC’s inflation decreases over time.

On the other hand, ETH staking has led to a rise in dormant ETH tokens. As stakers lock more and more ETH, fewer tokens fall into the market. This decreased market supply may positively affect ETH prices.

Base Layer and Cross-Chain Accessibility

It is crucial that a token is accessible to users across many blockchains. Tokenomics design shows whether the token is initially created using the Ethereum network as the base layer and is accessible to other blockchains through a bridging process.

Since Ethereum-based tokens follow the ERC-20 standard, they are quickly transferable on all ETH network infrastructures, like decentralized applications and wallets. Yet, token creators may ultimately choose to make the token reachable on other networks by forming a pegged version of the assets on these networks.

DeFi Incentives

Decentralized finance platforms give users returns for locking their tokens in staking or liquidity pools.

While staking, users keep their tokens for a certain period, enhancing the network’s operations and security. In exchange, they get rewards, which are typically additional tokens. This promotes long-term engagement with a project.

Liquidity pools allow users to trade tokens seamlessly. When users provide liquidity, they earn transaction fees and occasionally more token rewards, encouraging more users to participate. All of this can impact the token’s circulating supply and even decrease selling pressure.

Why Is Tokenomics Important?

We know that tokenomics is integral to any cryptocurrency’s success. If no proper measures are taken to meet demand, the assets eventually crash. Therefore, people who acquire crypto should understand the coin’s tokenomics to make better investment decisions.

At the same time, tokenomics is extremely important to cryptocurrency protocols, too. Projects that use their native tokens effectively provide the necessary utility, resulting in extensive use cases. Not only does this attract users to protocols, but it also drives the cryptocurrency value.

Green and Red Flags When Considering Tokenomics

Crypto startups usually include tokenomics data in their whitepapers. This helps investors refrain from investing in projects with weak structures. So, let’s see the most common green and red flags.

Green Flags

Security Audits

Typically, projects with legitimate tokenomics enlist a third-party security firm. It audits the core smart contracts or token code, guaranteeing that the core project team isn’t authorized to suddenly take control of user tokens or issue new tokens beyond the publicly disclosed amount.

Let’s take the failure of the Save The Kids project as an example. A few influencers pointed out that the tokens are safe from manipulation. Still, the core team changed the token’s code soon before the public release and scammed negligent investors.

A security audit is a third-party assurance that such an event will not occur. It also ensures that functionalities like token distribution addresses and vesting contracts are the same as the publicly available data.

Existing User Base

A tokenomics designed to target new customers is less likely to have great longevity than one serving an existing user base.

For example, a project that has thousands of existing users before the tokenomics crypto release probably has an existing business model that would endure well into the future. As a reward for supporting the project’s early years, existing users can get a sizable portion of the token allocation.

A classic example is Uniswap’s UNI token. The founders developed a working platform at the end of 2017, almost three years before the token was issued.

Token Disclosures

The team behind the crypto with the best tokenomics discloses the influencers and third parties it has hired to promote the project and the number of tokens each influencer gets.

The disclosures also reveal how many tokens are sold to early-stage investors and the token prices to subsequent investors.

Yet, such information isn’t always publicly revealed, so investors have difficulty making more accurate decisions.

Red Flags

Skewed Token Allocation

All stakeholders benefit from a balanced token allocation, as they receive a fair portion of the token supply. The allocation corresponds to the stakeholders’ contributions to the project’s ongoing development.

If the tokenomics distribution heavily favors the core project team, with 40%–50% of the total allocation having a short vesting period, that could be a red flag for potential investors, as it may enable price manipulation.

The same goes for an allocation heavily concentrated on early-stage investors, who typically buy at a discount and may sell at substantial profits even if the asset price decreases.

Bogus Use Cases

With no clear use case, tokens will find it challenging to find demand aside from pure speculation. Investors should assess how declared use cases are integral to the crypto project’s primary product. Cautious investors may worry whether the core product can exist without a token or if there is no particular method to drive demand for the asset.

Opaque Release Schedule

Non-disclosure of the release schedule for non-circulating tokens typically means the project will dump tokens on unsuspecting investors. So, to ensure that all stakeholders can keep track of key dates, token release schedules should be publicly disclosed and regularly updated.

Conclusion

So, what is tokenomics? Tokenomics is a simple way of referring to the overall economics of a particular crypto token.

People who acquire crypto should understand the coin’s tokenomics to make better investment decisions. Tokenomics is also important to cryptocurrency protocols.

However, to better understand the concept, you should also comprehend the green and red flags when considering tokenomics.

What Is Tokenomics — All About This Important Crypto Aspect