• Wed. Jun 19th, 2024

What Is Tokenomics? Understanding Crypto Fundamentals

html {scroll-behavior: smooth}
#table_of_contents {
border: 1px solid #c1c1c1;
padding: 25px 20px 15px 25px;
margin: 10px;
border-radius: 20px;
}

Table of Contents

What is Crypto Tokenomics?
Cryptocurrency Tokens Explained
Why is Tokenomics Important?
Factors of Tokenomics
Ethereum Tokenomics
Bottom Line

You’ve probably heard of the term “tokenomics” which has become quite popular in the crypto space in recent years. Tokenomics is generally a broad term describing the demand and supply characteristics of cryptocurrency. It encompasses everything about the mechanics of the crypto coin, including the token’s supply, the mechanics of how the cryptocurrency functions, as well as the behavioral and psychological forces that may affect its long-term value. 

Tokenomics plays an integral role in determining the success of a crypto project. Projects with well-designed tokenomics are more likely to succeed in the long term since investors can be incentivized by buying and holding the coins. 

When developing a crypto project, the founding members and developers must be keen to consider the tokenomics of the project’s native coin as it can make or break the project. Well-performing crypto projects have their ecosystem built around their tokens. 

When a token has strong tokenomics, its demand is naturally high. Hopefully over time, the token prices will appreciate due to increased enthusiasm from buyers in anticipation of future success or usage metrics fulfilling their potential promise as stated on paper by the design team. 

Any avid investor interested in a particular cryptocurrency project should first understand the tokenomics of the project in order to make a wise investment decision.

What is Crypto Tokenomics? 

The term “tokenomics” is derived from a combination of the words “token” and “economics”. A crypto token is a unit of digital currency (cryptocurrency) that can be used as an asset, a means of payment, or to represent a particular use case on a blockchain network. 

Economics is generally the study of scarcity and choice in relation to the use of resources, production, consumption, and transfer of wealth. 

Crypto tokenomics is therefore the overall economics of a specific crypto token with regard to the value of the crypto coin and whether its value is likely to rise or fall over time. Tokenomics describes two main things in regards to a crypto economy:

Token distribution 

Utility of the tokens in regards to supply and demand

Crypto tokenomics is a “blanket” term covering the different economic aspects of the token, including maximum supply, transaction fees, minting or burning process, and incentives for token holders. The tokenomics of a particular crypto token are usually comprehensively discussed in the project’s whitepaper and should give you an idea of the project’s objective, functionality, token supply, and allocation policy, among other aspects of the crypto project. 

Cryptocurrency Tokens Explained 

As mentioned earlier, a crypto token is a denomination of a cryptocurrency or a virtual currency representing a tradable asset or utility on a blockchain network that allows traders to hold it or use it for investment or economic purposes. Crypto tokens can be exchanged with other tokens on a different blockchain or held in wallets to gain value with time. 

There are different classifications of cryptocurrency tokens based on different aspects. Some common classifications of cryptocurrency tokens include:

Classes of Cryptocurrency Tokens 

Classification Based on the Blockchain Network

Layer 1 Tokens – Layer 1 crypto tokens are tokens with their own blockchain. Layer 1 tokens function to provide access to the blockchain’s resources including paying for network services such as transaction fees, minting tokens, and paying for smart contracts. 

 Layer 2 Tokens – Layer 2 tokens are crypto tokens without their own native blockchain networks. These tokens are integrated into Layer 1 blockchains via smart contract technology. Layer 2 tokens can be new tokens or more complex dApps project tokens. Layer 2 tokens generally function to scale decentralized applications in a network. 

Classification Based on Functionality 

Fungible Tokens – Fungible tokens can be interchanged with one another of the same kind. Fungible tokens essentially have the same value and can be interchanged with one another. Bitcoin and other altcoins are the best examples of fungible tokens. 

Non-Fungible Tokens (NFTs) – NFTs are a unique form of cryptocurrency tokens which have no similar value. NFTs facilitate the tokenization of art works, real estate, music, digital content, etc., allowing them to be held in digital forms. Think of NFTs as irrevocable digital certificates of ownership and authenticity of a particular asset whether physical or digital. 

Classification Based on Use Case 

Utility Tokens – These are cryptocurrencies representing a value on a blockchain network. They offer particular access to products or services run or operated by a token issuer. Utility tokens can be redeemed for a defined value of a particular service or product.

Security Tokens – Security tokens are securitized cryptocurrencies that can be traded under a financial regulation as security. They can function as securitized tokenization of bonds, stocks, properties, real-estates and more.

Payment Tokens – Payment tokens are used to facilitate transactions involving buying and selling goods and services on digital platforms without an intermediary. 

Exchange Tokens – Exchange tokens can be used to pay for exchange fees on cryptocurrency exchanges where buying, selling and swapping tokens occurs.  

Why is Tokenomics Important? 

Tokenomics is an integral aspect of any crypto ecosystem, allowing projects to prevent bad actors, establish trust, and build a strong, long-term ecosystem. Strong tokenomics supports the growth in value of a particular token in the long run, encourages hodling, and incentivizes early adopters while still controlling the token’s inflation rate and stimulating sustainable growth. 

The lack of regulation in the crypto space owing to decentralization makes tokenomics a vital aspect of any cryptocurrency project. It’s through tokenomics that a cryptocurrency project can be evaluated based on its real-life performance and not just the performance of crypto exchanges.

Tokenomics provides investors with an initial understanding of the value of the project, particularly the supply and demand of the token. The value of a token is determined by market demand and total supply, as well as its utility. Tokenomics can also be used as a guide for determining cryptocurrency value in the future. 

Tokenomics can help investors understand whether a crypto project will address future challenges and stay relevant. Besides, a crypto project may alter its tokenomics in the future based on the network’s growth and maturity as well as current industry trends.  

Factors of Tokenomics  

Factors of tokenomics are basically the different aspects of a crypto token that affect its value. Most of the factors that encompass a crypto’s tokenomics can be found on CoinGecko as well as in the project’s whitepaper. 

Below are vital tokenomics factors you should always consider when investing in cryptocurrency. 

Token supply

There are three types of market supply that encompass a crypto’s tokenomics. This includes total supply, circulating supply, and maximum supply. The circulating supply is the number of tokens currently in circulation, while the total supply is the total supply of tokens that have ever been created or burned. 

The max supply is the maximum number of tokens that can ever be generated. In healthy tokenomics, the token’s circulating supply should gradually increase with time, but the tokens should be released using a strategic mechanism to avoid hurting the token’s value in the long run.   

Market Cap and FDV

Market capitalization (or “market cap”) is the sum of total funds invested in the project. A token’s value can be indicated by the fully diluted market cap, which is essentially a product of the token’s maximum supply and the current market.

CoinGecko recently added a Fully Diluted Valuation (FDV) toggle and Coin Comparison Page allowing seamless comparison of MC and FDV between different cryptocurrencies. 

Token Allocation and Distribution

© Messari

Token allocation essentially refers to how tokens are shared after the project launch. 

As seen in the infographic above: There are four main categories of initial asset allocation:

 public sale

community allocations

insiders (core team, investors & company) 

Foundations, grant pools, and rewards

The public sale is open to anyone who wants to participate; the community allocations are ecosystem funding that goes back to the community; the insiders are the people who have a vested interest in the success of the company, in return they receive a lot of the company’s share. The foundations etc. are grant pools and other rewards given to people who participated in the community. 

Projects like Solana, BNB, Celo and Flow allocated more than 40% of their token supplies to insiders while projects like EOS, Cosmos, Ethereum, Cardano and Tezos allocated the majority (>70%) to their public sale.

Of course, many other factors can affect a project’s success, but token distribution is one factor that is definitely worth considering. For example, if a project’s tokens are primarily owned by its founders, they will have significant control over the project’s governance and could make decisions that are not in the best interests of the network as a whole. This could lead to stagnation, or even worse, a complete collapse of the project. 

Token distribution should ideally be diversified to ensure that no single group has too much power and that the project can remain decentralized and neutral over time.

Vesting/ Inflation

Vesting refers to the process of locking and releasing tokens after a particular period. Usually, vested tokens are offered to advisors, partners, team members, and others who contribute to the development and running of the project.

The vested tokens are then released gradually into circulation over the vesting period. Projects with token vesting rarely experience inflation, plus it ensures the long-term commitment to the project team members. 

Vesting ensures the team has a financial interest in continuing to grow the project, which in turn establishes faith in the project from investors. Without vesting, a single or few entities with control of large proportions of the project’s token can cause price instability and pose risks to the token’s ecosystem. 

Utility

A token’s utility refers to its specific use case or the problem it aims to solve. The utility is one of the most important aspects of any token. The main utility of a token is established by the use of the token in exchange for services or products. Tokens with no apparent utility should be a red flag for avid investors since they have no solid use case. 

Ethereum Tokenomics 

© CoinGecko

Ethereum was launched by an Initial Coin Offering (ICO) in 2014, raising 7 million Ether.

© CoinGecko

POS Issuance

According to Ethereum’s monetary policy, PoS issuance is the rewards that are paid out by the protocol at any given time. Ethereum’s PoS issuance currently stands at approximately 4.5% with 2 Ether per block. There’s also an additional 1.75 Ether per uncle block with fees being rewarded to miners.

Uncle Block and Rewards

Sometimes on the Ethereum blockchain, two blocks are mined and broadcasted simultaneously and with the same block number. Considering that only one block can enter the Ethereum chain, the block that gets validated across more nodes becomes the canonical block, while the other becomes the uncle block. To prevent centralization, Ethereum rewards miners with a small block reward for producing uncle blocks.   

Unlike Bitcoin, Ethereum is inflationary and doesn’t have a maximum supply cap, meaning that ETH supply continues to grow with growth in the network. Tokens are continually distributed by block rewards. However, Ethereum’s tokenomics model will likely change as the network transitions to a PoS consensus system. To maintain the token’s value and achieve a stable supply, the platform recently implemented a deflationary mechanism where 100-120 million ETH were burned. Checkout Ethereum tokenomics below: 

 Maximum Supply: N/A  

Current Market Cap: $170 Billion  

Circulating Supply: 120 Million     

Bottom Line

Crypto tokenomics is an incredibly important concept for both project developers and investors. For project creators, tokenomics can make or break a project and therefore must be well formulated. Investors can use the different aspects of tokenomics, such as market supply, allocation, and more, to determine whether a crypto project is a viable investment. 

Therefore, as a beginner in the crypto space, it’s crucial to study a project’s tokenomics, usually drafted in its documentation or white paper, to get a good sense of various tokenomics aspects and determine if it makes sense and is sustainable for the long term.