Tokenomics: The token economy and its impact on investment

Tokenomics: understanding the token economy and its impact on investment

Tokenomics is the term for the economics of tokens and encompasses a number of characteristics that affect their value and investment potential. Tokenomics is a key component of the fundamental analysis of a project, and its economic success or failure depends on how well it is scrutinized. Tokenomics is one of the most important basic documents for investors, along with technical documentation, roadmap and team presentation.

The role of Tokenomics in ICOs and IEOs is huge. Here, we can remember the ICO boom in 2017, which ended up as a bubble and investors went into deep negative territory for two years with a weighted average of -87%. Back then, startups that managed to attract millions of dollars in investment failed to realize the potential of their tokens due to flaws in tokenomics, and investors’ financial bottom line showed disastrously disappointing results.

The basics of tokenomics

Tokenomics primarily contains token circulation rules, similar to those of fiat money, designed to control issuance. We know that additional issuance of money leads to a decrease in the price of the asset (inflation). The decision to issue additional traditional currencies is made depending on the economic situation in the country, when it is necessary to support the banking systеm or balance the budget. Unlike the fiat currency systеm, the issuance of new cryptocurrencies and tokens is done according to predetermined, algorithmically designed schedules. In the case of blockchain, it is possible to predict the number of new coins on a given day with minimal error because the rules prescribed by tokenomics are fixed in the project code and are immutable and predictable.

Let’s take a closer look at what tokenomics is, what components make it up, and trace the relationship between tokenomics and investment.

Balancing supply and demand

Understanding the factors that affect supply and demand in cryptocurrencies is vital for traders and investors alike. The greater the demand — the greater the supply, and vice versa.

Supply

Supply is measured by two main metrics: maximum supply and the number of coins in circulation.

Maximum supply. Different models are used in the market depending on the presence or absence of issuance limits. At one pole of this model is the first cryptocurrency with the largest capitalization, Bitcoin, with a limited supply and with a strict limit on the issuance of new coins, at the other pole is Dogecoin with unlimited supply, the number of issues of which is not limited, but the number of tokens in a block is fixed (10,000 coins in a block).

Bitcoin caps the maximum number of coins in circulation at 21 million, which the network will reach around 2140. To create additional scarcity, bitcoin halves every four years, halving the reward to miners for mining new blocks. Because of the relatively small, finite number of coins, bitcoin has been called the “second gold” because its resource is finite. Bitcoin is also used to produce Bitcoin SV, Bitcoin Cash and ZCash (also with a maximum supply of 21 million) and Litecoin (with a supply of 84 million). However, most coins on the market have virtually unlimited freedom in terms of the number in circulation, which is in the billions. For example, in the Tron network, where the maximum supply is more than 100 billion, or in the case of stablecoins, where the issue size depends on the availability of reserves and the maximum supply can theoretically grow to infinity.

The number of coins in circulation shows the number of tokens available at the moment. According to tokenomics, tokens are created, burned or blocked, which adjusts this parameter and has a direct impact on the price.

Demand

Tokenomics should be primarily user-centric, and demand is driven by the “utility” of the asset. Investors need to understand what benefits and advantages they will derive from using a particular token.

The variability in the use of the asset is embedded in the project code. Typically, demand stimulation occurs in the following three main areas of potential token use that should be considered in tokenomics:

Identifying the value of the token to the user. The token should be functional and provide benefits to all target groups in the ecosystem. Thus, the target groups that the project relies on should be studied and derive important benefits for themselves from using the token.

For example, the BNB token, as a service token of the BNB chain community, is applicable for paying transaction fees and generating passive income from steaking when using the DeFi tools of the ecosystem. The tokenomics of CAKE, the native token of the decentralized exchange PancakeSwap, is organized according to a similar umbrella principle: stakers receive income from trading commissions and traders are entitled to discounts on futures trading.

Stablecoins, in turn, are endowed with functionality and “utility” identical to traditional fiat. Tokenized stocks or other assets can be useful for diversifying an investment portfolio. Each audience has its own benefits, and well-designed tokenization projects provide an optimal range of these benefits.

Incentives to buy and hold tokens. Investors should be incentivized to have as many coins in their wallet as possible. Reward models for token retention can vary from balance to balance. For example, more flexible interest rates on loans and deposits, a tiered cash back systеm, or prioritized access to new features. Tokenomics at DeFi projects are increasingly using innovative incentive mechanisms. In particular, the popular lending platform Compound operates a systеm where investors earn both interest and COMP management tokens as rewards.
Compound Rewards. Management tokens and their economics are very important. User engagement increases the efficiency of the platform, and projects should reward network members for voting and proposing innovations. For example, Optimism, an emerging Layer2 network on Ethereum, has allocated 19% of its total tokens to management rewards.

Token distribution

The distribution structure differs from project to project and should also be precisely defined by tokenomics. Usually, the distribution of token rights is determined by the team before the white paper is published.

Typically, tokens are distributed in different shares to the following categories:

the team involved in the creation and development of the project;

the envisioners, who advise the startup on strategic issues;

early investors;

public investors.

An uneven distribution of tokens prioritized by one company or individual can carry risks and critically affect the value of the asset. On the other hand, the more tokens allocated to product-creating categories, the greater the likelihood of rapid and efficient development and further appreciation of the token.

Token burning and its implications

Token burning is a method of token inventory management and an additional mechanism for controlling the number of tokens in circulation. It is used to curb excess supply and bring it in line with demand. Technically, the burning process most often looks like sending tokens to wallets without private keys, making them inaccessible and removing them from circulation.

Typically, projects burn a percentage of the total available tokens on a regular basis, depending on the tasks at hand. For example, by modernizing EIP-1159, Ethereum has implemented a model where a portion of the network’s tokens are automatically burned with each transaction. Thus, the more actively an asset is used, the faster its tokens are burned. The Gate (GT) coin has moved to a similar model, replacing the mechanism of manual redemption and further burning of a portion of the circulating supply with an automatic burning model.

Tokenomics Based Investment Strategy

A detailed tokenomics analysis of crypto projects is extremely important for an investor. A detailed tokenomics analysis provides a comprehensive view of the project, its risk tolerance and potential profitability.

It is a recognized fact that the best case of successful application of tokenomics is the simple yet ingenious bitcoin tokenomics. However, the approaches to viewing the economics of different cryptocurrencies are different and there is no clear formula to determine the success of a project. Nevertheless, there are markers in tokenomics that you should always pay attention to when planning investments.

Unlimited supply. Such a token characteristic increases the risks of uncertainty and inflation. In such cases, you may encounter a negative impact of tokenomics on the value of the asset. Such projects should at least use an efficient token burning algorithm as a method of inflation management.

Lack of a clear issuance schedule. It can be either calendar or phased (depending on the achievement of certain checkpoints). Irregular token issuance or lack of a transparent schedule speaks to the team’s unclear marketing goals.

Lack of clear scenarios for token usage. The impact of tokenomics on liquidity can be tracked through the presence of transparent and detailed usage scenarios. The asset should be closely tied to the core product, be useful, and allow the investor to maximize value.

Availability of independent verification. Conscientious development teams always use third-party companies to confirm the security of the code and smart contracts, as well as Tokenomics’ regulatory compliance. A successful audit will protect investors from the risks of fraud and encounters with law enforcement.

Developed user base. Having a user base in place prior to the start of tokenization demonstrates the strength of the team’s intentions and serves as a foundation for the potential effectiveness of investments. For example, UNISWAP’s decentralized tokenization base had been building its customer base for three years before the first issuance.

Conclusion

Tokenomics is being created to provide investors and traders with a clear understanding of what makes a token valuable and objective information to predict its prospects in the market. The future of Tokenomics and the prospects of token development depend on the initial foundation. Therefore, the more transparent the document describing the economics of the token, the more informed a decision an investor will make.

As the market evolves and competition increases, approaches to tokenomics become more fundamental and measured. Innovations in tokenomics are being implemented with the help of related specialists to provide more accurate data on various areas, allowing projects to start with more confidence and investors to invest with minimal risk.

Thank you for your attention. Invest safely and profitably!

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