Tokenomics, the shortened word for token economics, is an all-encompassing term to describe the science of how crypto assets derive their value. While tokenomics sounds like some term you would use to describe the coins you won at an arcade, It’s really the foundation for understanding the value of these seemingly fugazi assets that can fall anywhere from securities, to pseudo currencies, to Ponzi schemes. *FTX & Luna*
Overview of Crypto Assets
The beauty and the curse of crypto assets is their variable and dynamic essence, which is the result of their digital nature.
To fully understand tokenomics and the unique properties of each crypto asset, we need to clearly define the question: what even is the difference between a crypto asset on a blockchain and any other asset that you interact with digitally, whether it be a stock, bond, or even digital dollars in your bank account?
Let’s look at the simple answer to this question before we unpack it further.
Traditional financial assets are a contract bound by the legal system and often stored on a centralized server.
Crypto assets are like a contract, however, they are bound and executed by code, verified and secured by a decentralized network of computers. Additionally, these computers that make up the blockchain network are monetarily incentivized to act ethically.
Now let’s expand on these differences.
Everyone uses legal contracts every day, in this case, financial assets such as stocks, bonds, loans, and derivatives are all legal contracts. What a contract does, is specify the rights and obligations of an agreement between two or more parties. It then brings the legal system into the agreement to civilly hold all parties accountable for keeping their end of the agreement.
There are countless different articles and clauses that you can codify into a legal contract and as we know, there are hundreds if not thousands of different financial contracts used in the modern-day economy.
We can think of Crypto assets like writing a contract in code and storing it on an immutable decentralized database that is secured by a decentralized network of computers. This opens up many new possibilities, and in some ways, alleviates a need for the justice system.
Programmability: One beauty of putting things into code, is that you add a facet of programmability, allowing for more dynamic contracts. Additionally, contracts can now autonomously execute based on the specified parameters, which creates a more trustless system. Once both parties agree and the contract is signed, all of the parameters and actions encoded are then automatically carried out. It’s the perfect storm between a financial agreement and software.
Immutability: The other beauty of crypto assets is that they’re stored on an immutable public ledger, allowing them to be audited in real-time by the public, as well as making them unable to be tampered with or counterfeited.
Both of these features open up new abilities for the financial system to be more transparent, and predictable, with less human corruption and error.
Bitcoins Tokenomics
Let’s think about this in the context of Bitcoin. The system has a predictable and self-executing monetary policy, that you can audit in real time, and that isn’t controlled by a central entity.
Additionally, for the first time ever, you can self-custody your own assets digitally – as opposed to your bank holding your money, or your broker holding your financial assets such as stocks, bonds, and derivatives.
Bitcoin’s tokenomics – as clearly defined in its whitepaper released exactly 15 years ago, as of the time of writing – are clear and predictable.
6.25 new Bitcoins are created every 10 minutes.
The rate of issuance is cut in half every 4 years.
The maximum supply is 21 million.
The very last Bitcoin will be issued or “mined” in 2140.
This protocol is secured by one of the most powerful computing networks on the planet, making it virtually impossible to attack or change.
No worries about looking at economic indicators trying to figure out if the Federal Reserve is going to print more money, print less money, or raise interest rates, etc. Everything programmed into the Bitcoin protocol is predictable and immutable.
We can also audit all of the analytics in real-time, from the number of transactions to the number of users, to the size of each transaction.
Supply-Side Tokenomics
Getting into the more technical side of tokenomics, we can simply categorize the features and characteristics of different crypto assets into the two most fundamental aspects of economics, supply and demand.
The supply side of tokenomics simply refers to all supply-side dynamics, such as inflation or deflation rate, circulating supply, and maximum supply.
Circulating supply is the total number of tokens that are currently circulating in the market. It’s very important that circulating supply not be confused with total supply, which is all tokens, both locked and circulating.
Market cap: if you look up an asset on any platform such as coinmarketcap, coingecko, or your centralized exchange, you’ll see the asset’s market cap. This is very simply the token’s current price multiplied by its circulating supply. This is not to be confused with fully diluted valuation, which is the total supply multiplied by price.
Allocation refers to what percentage of the token supply is allocated to the project team, developers, and VC investors, and what percentage of the supply is either airdropped or sold to the public.
An Airdrop is a free distribution of tokens to a large number of people. Airdrops can be either announced beforehand or completely unexpected. They often require participants to fulfill certain conditions, such as performing certain tasks or sometimes owning a specific crypto asset.
Sometimes projects will also allocate a portion of the tokens towards incentivizing third-party developers to build new applications and features that utilize or integrate with the project.
Vesting: In line with token allocation is Vesting. Tokens provided to team members or venture capitalists, often come with vesting conditions. Vested tokens are generally locked for specified periods. This ensures that large token holders can’t immediately dump their assets, causing significant price declines.
The inflation rate describes the baseline amount of tokens being created every day or every year. Along with the inflation rate is the supply schedule, which refers to the change in the inflation rate over a specified period of time. For Example, maybe the inflation rate is 10% in year one but tapers off to 8% in year two, 6% in year 3, and so on.
Burn: Some projects also have a revenue burn model. This model can be based on different KPIs however, it generally means that the project uses a portion of its revenue to buy back its tokens and burn them i.e. destroy them forever, a similar procedure to stock buybacks.
Demand-Side Tokenomics
Supply-side tokenomics are relatively straightforward, however, demand-side tokenomics can become more complex. The Basics on demand side tokenomics can generally be hashed out into two key categories: utility and incentives.
Utility
The utilities for an asset can vary extensively. Among the various utilities, you’ll notice that the most common ones are fees, collateral, governance, and security.
Fees: Many tokens, usually layer1 tokens such as Ethereum, Cardano, and Solana, are used to pay fees for making transactions on the network.
Collateral: an asset being used as collateral is not generally a utility that is intended upon its original launch. However, as a project matures and a token becomes widely used, its monetary value can increase. This will generally turn it into a more commonly accepted form of collateral. The most widely used collateral in crypto is ETH.
Governance tokens are sometimes referred to as DAO tokens – Decentralized Autonomous Organization. These tokens give holders the ability to submit proposals and vote on various causes regarding the organization.
The majority of governance tokens are used for governing an application, protocol, or network, however, some DAOs can serve other ‘real world’ purposes. An additional point to note is that DAOs sometimes have treasuries as well, meaning they control assets. This can add weight to the value of a governance token as it technically can have a price-to-book (P/B) value.
Token utilities can add demand for tokens based on the number of users on a protocol or network. This allows us to analyze an asset’s fair value based on supply and demand, similar to a commodity.
Incentives
To keep it simple, Incentives basically refer to token features that incentivize people to either hold the token or stake the token. An example of this could be burning, which we discussed earlier, as it gives holders the ability to benefit from the cash flows of a project.
Access: One incentive that a token could provide is an enhanced experience in a protocol or application, this is usually in the form of lower fees or other additional features.
Staking incentives can often encompass features that we’ve already discussed. These incentives provide a reason for holders to lock up their tokens. Sometimes projects will even enhance the perks for longer staking periods. Simply put, the longer you lock your tokens the higher the yield you may accrue. One function of staking is to enhance the security of a network or protocol.
The most notable example for staking is Ethereum’s Proof of Stake (PoS) consensus mechanism. Parties lock their tokens and run a node to help verify transactions and secure the blockchain, as a result, they get paid in ETH for their efforts. If a staker attempts to attack the network or act unethically, they get slashed, meaning they lose a portion of their staked assets.
Yield: Staking incentives almost always include yield. This can add significant value to an asset because it effectively adds a “risk-free rate” for holding it.
Some projects will also pay out a portion of revenue and/or reserve governance rights for only stakers, to ensure that the voters have more skin in the game, which could be analogous to a startup offering advisory shares.
Tying It All Together
As we’ve discovered, tokenomics is a multifaceted field that combines many elements of economics, game theory, and behavioral psychology. Understanding the intricacies of supply and demand in the context of crypto assets can provide great insights into their potential value and long-term viability.
While the crypto space is still relatively young and evolving, a solid grasp of tokenomics can help investors, developers, and users navigate this dynamic landscape.
By understanding the unique factors that influence the value and demand for crypto assets, we can enhance our analysis and decision-making to better sift through the hype and the scams and Identify the real opportunities.