Tokenomics: The economy of the cryptocurrency

03/15/2022, 10:58 AM

Tokenomics: The economy of the cryptocurrency
Tokenomics: The economy of the cryptocurrency

Tokenomics is a concept that refers to the qualities and disadvantages of a cryptocurrency project. It often describes the features of crypto assets.

The term tokenomics is a derivative of the words "token" and "economics". A simple explanation of the term tokenomics would be: “It’s the economy of an individual crypto asset”.

What does that mean? Tokenomics includes everything, from the technology and mechanics of how the crypto-asset works, to psychological or behavioral forces that could affect its long-term value.

What elements does the term tokenomics include?

Tokenomics is basically a study of all factors that will help you understand how the token will be used.

It gives investors answers to questions like:

  • What is the market cap of a crypto asset?
  • Will it is be used as a means of payment?
  • How many tokens are in circulation?
  • Is there a hard cap or a soft cap?
  • How will tokens be allocated among the users?

The answers to these questions are important because they will affect the price of the crypto asset in the long run. Understanding tokenomics is like having an advantage because investors will have a clear image of crypto project direction while doing their own research.

Before we break down the elements required to understand tokenomics, we will talk about the differences between a coin and a token. Although many investors put them in the same category, there are slight differences between them.

What is the difference between coin and token?

Coin (also known as Layer 1 token) has the following characteristics:

The Coin uses its own blockchain network. That blockchain network contains all the data of transactions that were made with the network’s native crypto coin.

For example, when you pay someone with Ethereum, the “receipt” goes to the Ethereum blockchain. If the same person pays you back in Bitcoin, the “receipt” goes to the Bitcoin blockchain.

The infographic that shows the difference between a crypto coin and a crypto token.

Each transaction is encrypted and is accessible by any member of the network.

Unlike coins, tokens (also known as Layer 2 tokens) do not have their own blockchain. Instead, they use someone else’s existing blockchain. For example most tokens use Ethereum’s network as a foundation.

Tokens that use the Ethereum blockchain network are called ERC-20 tokens.

Although there are differences between a coin and a token, elements of tokenomics are applied equally on both of them.

Here are key elements that will help you understand the concept of tokenomics.

4 key elements for understanding tokenomics

1. Market cap and the circulating supply

Market capitalization is a parameter that gives a more accurate projection of the cryptocurrency value. How to find out a market cap of a cryptocurrency?

The infographic that shows how to calculate cryptocurrency market cap on Bitcoin's example.
Simple method for calculating the token market capitalization.

Calculate market cap by multiplying the total number of coins that have been mined by the price of a single coin at any given time.

When searching for crypt projects sometimes you will find cryptocurrencies with similar real-time prices (of a single coin). Having a similar price for one coin/token doesn’t mean that project has the same overall value. And this is why you have to check its market cap.

Alongside market cap it is necessary to track the following indicators:

  • Total number of coins(tokens that can ever exist.
  • Number of coins/tokens in circulation.
  • The number of minted coins/tokens that are not released in circulation.

The table shows the differences in cryptocurrency circulating supply.
The number of coins or tokens in the circulating supply can have an effect on the price.

Why you should analyze the number of coins or tokens in the first place? Let’s take Bitcoin for example. There can only be 21 million Bitcoin in total. At the moment of writing this text, there are around 18,979,300.00 BTC in circulation which is 90% of the total supply.

Given that demand for Bitcoin is high recently, and there are a limited number of coins, there will be a price increase.

On the other hand, some crypto projects have previously minted coins that are not yet released in circulation (they are locked for a certain amount of time). If the huge amount of locked coins/tokens enter the circulation it could also have an effect on the price.

2. Token distribution (allocation)

Token distribution is another important component you have to consider when doing crypto projects research.

Token distribution can tell investors more about the project’s transparency. A project with a good token allocation is focused on growing the network and onboarding more people to achieve a certain goal.

The distribution is usually presented in the form of a pie chart.

The illustration shows the character pointing to the pie chart and token allocation information.
Most crypto projects use pie charts to show the token distribution.

Most blockchain projects distribute tokens among four main groups:

  • Public (present and potential users)
  • Communities
  • Team
  • Foundations

The public refers to all people who want to invest in a project, while the community refers to beneficiaries who have supported and advocated for the project from the beginning and want to help it succeed.

The team consists of projects founders, investors, and advisors. The information about token distribution can be found in the project’s whitepaper. For in-depth research about token distribution, you can check Etherscan for ERC-20 tokens. If you are searching for a Bitcoin network, you need to visit btc.com and then click on “Addresses”.

After research, if you discover that a large number of tokens is allocated in a small number of wallets, there is a risk that whales will sell their tokens once the price goes up.

Token distribution tells every investor how decentralized and just a crypto project really is.

3. What model does the token use?

Recently we are hearing a lot about how the world economy suffers from inflation. The terms “inflation” and “deflation” are constructs coming from centralized bodies such as governments and central banks.

Like the traditional (fiat) currencies, cryptocurrencies can also have inflationary and deflationary characteristics.

Inflation and deflationary models play a vital role that will influence future cryptocurrency price movements.

A token with a net decrease in circulation is called deflationary & a token with a net increase in circulation is called inflationary.

Inflationary model

Cryptocurrencies with an inflationary model have no restrictions when it comes to the total number of tokens.

Since there is no definitive number of tokens that can exist, new tokens can constantly enter circulation. Unlike traditional currencies, cryptocurrencies don't have a central body that controls them, while the community (users) can have a vote in shaping the future steps regarding the token model.

That is why cryptocurrencies are more efficient than fiat currencies. Polkadot and Solana are currently the most known crypto projects without the total amount of tokens that can exist.

Deflationary model

Unlike tokens with the inflationary model, deflationary tokens have a max supply. Bitcoin is the best example. As mentioned before, Bitcoin has a maximum supply of 21 million tokens.

Cryptocurrencies with deflationary properties reduce their supply in the market over time. Many crypto projects achieve this with the “token burning” process. Others use the “buy-back and burn” method. This occurs when the project team buys a certain amount of tokens from the market and sends them to the inactive address.

The supply of that token will be slightly reduced, which can ultimately lead to a price increase.

Dual-token model

The dual token model means that the blockchain network has two tokens. Many projects decide to use two tokens in order to create a more efficient economic structure.

One token is often used as a means of preserving value, while the other is used to enourage various actions on the blockchain network.

Blockchain NFT game Axie Infinity is a good example of a project that incorporates a dual-token model - Smooth Love Potion (SLP) and AXS token.

Game players use Smooth Love Potion for in-game activities (like breeding new characters). SLP token doesn’t have the maximum number of tokens.

On the other hand, is the AXS token. Users can buy or sell this token directly on the crypto exchanges and for staking on the Axie Infinity platform, or to participate in defining decisions related to the development of the entire platform (depending on the number of tokens the user owns - more tokens, more voting power on the platform).

Asset-backed model

Asset-backed tokens are an evolution made possible by blockchain technology. They are a growing class of digital assets that open the door for compliant and regulated digital ledger investment.

Asset-backed tokens are digital claims on a physical asset and are backed by that asset. Gold, crude oil, real estate, equity, soybeans, or just about any other real, physical asset can be tokenized and become an asset-backed token.

The most common example of the asset-backed token is Tether, whose value is tied to the value of American dollar.

4. The token use cases

The cryptocurrency market is creating more opportunities for creating innovative solutions backed by blockchain technology.

Unfortunately, many individuals have used the ongoing crypto popularity to make quick money grab projects.

In the initial stage, these individuals present the project that promises a lot, but in reality, the project doesn't actually have a real utility.

If the project doesn't have a solution that can’t be applied in real life it means that it can’t be sustainable.

There are many projects that have amazing utility. For example, Ethereum is interesting to investors because it acts as an infrastructure where you can create decentralized apps or other solutions.

Also, projects like VeChain are trying to solve the problem of the supply chain with blockchain technology.

When doing your own research always look if the token has solutions that can solve real problems.

Why is Tokenomics important?

Every day more crypto projects will emerge. Some of them will have great ideas, but just like startups, many will fail.

Tokenomics is a concept that gives every investor insights into every project. it is basically a tool that can help detect the advantages or disadvantages of any crypto project.

Unlike more sophisticated cryptocurrency trading and metric tracking tools, tokenomics gives a clear picture to any investor about whether a project has a future and potential for value growth.

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