What is tokenomics in cryptocurrency?

Tokenomics is an important part of any cryptocurrency project. It is what decides how many coins or tokens the project will release, where they will go, what they will be used for, and more. As a result, it’s vital to understand what tokenomics is and how it’s used if you’re planning to invest in any cryptocurrency project — particularly those that are new to the market.

In this AAG Academy guide, we’ll explain tokenomics, how they work, and why they are important in detail. We’ll also answer some frequently asked questions.

What is a token?

Before we delve into tokenomics, it’s important to understand cryptocurrency coins and tokens. These are essentially digital assets that can be used for many different purposes, such as paying for goods and services, proving ownership of an asset, governing a cryptocurrency project, and more. You can think of them like traditional currencies, but in digital form.

There is a difference between coins and tokens: The word “coin” is used to describe a cryptocurrency that runs on its own native blockchain, like Bitcoin (BTC) or Ethereum (ETH). The word “token” is used to describe a cryptocurrency that is hosted on another blockchain, like Chainlink (LINK), which is hosted on the Ethereum network.

Despite the differences, many use the words “coin” and “token” interchangeably when talking about cryptocurrency assets.

What is tokenomics?

Tokenomics, which is a portmanteau of the words “token” and “economics,” is the word we use to refer to the economics of a cryptocurrency project. This includes everything that might be of interest to an investor, such as the token supply, how it’s distributed, and what purposes the token might have. As a result, it is an important thing to consider before investing in any project.

It is also critical that the creators of a new cryptocurrency project consider its tokenomics carefully. No matter how ambitious or promising a project may be, investors are unlikely to consider putting significant capital into it if its tokenomics is badly designed. It is also very difficult to make changes to the tokenomics later since it is written into a project’s code.

This does have its advantages, however. Unlike traditional fiat currencies, the tokenomics of a cryptocurrency, which are also outlined in its whitepaper from the very beginning, are predictable and transparent. Investors can be certain about how a project will operate in this regard, and there can be no nasty surprises further down the road.

Let’s look at Bitcoin’s tokenomics as an example, partly because it is currently the most valuable cryptocurrency in existence, and because its tokenomics are relatively straightforward. From day one, we’ve been aware that the total supply of BTC is 21 million coins, and new BTC is created and entered into circulation through the proof-of-work (PoW) mining process.

Bitcoin’s tokenomics also state that the reward for mining is halved every 210,000 blocks, which, at the current pace, is every four years. The reward started at 50 BTC, then dropped to 25, then to 12.5, and currently sits at 6.25. Given that these rules are set, we can calculate that roughly 328,500 BTC will be created during 2023, and the last BTC will be mined in 2140.

Why is tokenomics important?

There are some other key elements that are included in tokenomics, including things like token burns, and any incentive mechanisms used to encourage miners and other network participants to remain committed to a project. These typically consist of things like transaction and staking fees, all of which should be outlined in a project’s tokenomics.

The ability to predict these things is one of the key differences between cryptocurrencies and traditional currencies. It’s also key to investors and stakeholders who may be interested in funding a cryptocurrency project because it allows them to be sure how many tokens will enter circulation and how they will be distributed — both of which can affect a project’s overall value.

Supply and demand play a large role in determining the price of any asset. One of the reasons why BTC is so valuable is because its supply is finite, so there is a greater chance of demand outweighing supply — and continuing to push up the price of each coin — than there would be if its supply was unlimited and there were more than enough to go around.

Although tokenomics certainly isn’t the only tool a trader or investor might use to evaluate a new cryptocurrency project, it is one of the most important. Without taking it into consideration, you simply cannot be sure of how a project operates, and that’s not an ideal position to be in when you are thinking about parting with your capital.

From a cryptocurrency project’s point of view, tokenomics can play a large role in determining whether a project is a success or a failure in the long run. There is no fits-all template that works for every project, so it is hugely important that this element is well considered and designed.

How does tokenomics work?

To explain how tokenomics works, let’s look at its key elements in more detail:

Token supply
The amount of cryptocurrency tokens that a project plans to release, or its “maximum supply,” is critical. As we touched on above, supply and demand has the biggest impact on a token’s value, and if there are too many tokens in circulation, they’re not going to be worth very much — even if the project itself looks promising. That’s one of the reasons BTC is capped at 21 million coins.

Token utility
Supply and demand isn’t the only thing to consider, however. Another factor that can impact a token’s value is its utility, or what you can do with it. A token with no use case is never going to be in demand, and therefore never going to be worth much. A token that can be used to pay for goods and services or to distribute ownership of a project is much more desirable.

See our guide to the different types of cryptocurrency available today to find out more.

Token distribution

This tells us where a project’s cryptocurrency tokens are going, and this is another thing you’ll want to know before making an investment. There are two primary approaches to this: One is what’s called a “fair launch,” which is when there are no early access or private allocation tokens. Bitcoin has employed this approach since its inception.

The other is a “pre-mining launch,” which is when a certain number of tokens are distributed to a select group — which might include the project’s creators and early investors — before being made available to the public. This approach was used by Ethereum, and it’s not necessarily a bad one, but it is important to note how evenly tokens are distributed between different groups.

For instance, if you can see that 90% of tokens are going to regular investors, this is a good sign. It means that there is not a single entity, or a small group of entities, who can easily impact the token’s price. However, if a large percentage of tokens are going to project creators and early backers, it would be a very risky investment.

Vesting
Tokens that are distributed to team members and early backers are often vested, which means they are paid out over a certain period of time, or when certain milestones are met, rather than all at once. This is important because it means that those tokens cannot be sold off in one go as soon as a project’s value rises. If this was to happen, it would cause the token price to plummet

Token burns
Some projects, such as BNB, choose to use a “coin burning” system to remove tokens from circulation. These are known as deflationary tokens, whereas those with an ever-growing supply are known as inflationary tokens. Each project has its own approach to burning, but the end goal is always the same, and that’s to reduce the total token supply.

Total value locked
Total value locked (TVL) is a measure of all the assets locked into a DeFi project. This is a great indicator of a project’s health because it shows the level of value that investors are willing to put into it. Generally speaking, the higher a project’s TVL, the more confident investors are that it is a promising project worth supporting. A higher TVL also means greater potential for growth.

Incentive mechanisms
For a cryptocurrency project to be sustainable, it needs to not only attract supporters, but also ensure that they stick around for as long as possible. One way to do this is with incentive mechanisms that give investors and participants a reason to keep coming back. There are many approaches to this, but let’s focus on the two most common ones.

As we noted above, Bitcoin’s proof-of-work consensus mechanism has built-in halving, as well as a finite supply of tokens. That means that at some point, it won’t be possible to mint new BTC coins through the mining process. To counter this, Bitcoin pays miners a share of transaction fees, which means there should always be miners who are willing to contribute.

In a proof-of-stake (PoS) system like Ethereum uses, participants earn rewards for staking their tokens. The more they stake, the greater their chances of being chosen as a validator, and the more frequent those rewards become. In addition, Ethereum uses a system called slashing which allows it to penalize those who do not perform as expected by taking their tokens away.

References

• What is tokenomics and why does it matter
• Tokenomics
• https://www.investopedia.com/terms/v/vesting.asp
• What are tokenomics and why they matter
• What is a token
• What is tokenomics and why is it important