Competent investors, before investing their money in digital assets, necessarily study the tokenomics of a cryptocurrency project. The term “tokenomics” refers to the economics of a token and includes the economic characteristics of the asset and a set of factors that may affect its value in the future. 

The role of tokenomics in the success of a crypto project is more than significant. Projects with a balanced and reasonable tokenomics structure have a much higher chance of success: the economic model of the asset contains rational factors that ensure the growth of its price. On the other hand, projects with unbalanced or superficial tokenomics multiply the risks and reduce the objective chances for sustainable income. Before investing in them, a thoughtful investor will weigh the pros and cons a hundred times.

Let’s understand what tokenomics is in cryptocurrencies, what principles underlie the token economy in blockchain projects, and how to plan investments in a particular project taking into account its tokenomics.

Understanding the Token Economy

The token economy, like any other economy, is based on the fundamental law of supply and demand equilibrium, where a product or service that satisfies a particular need of a buyer is sold at a price that suits the buyer. Thus, the price is at the point of equilibrium of supply and demand: when the price increases, demand decreases and supply increases, and when the price decreases, demand increases and supply decreases. 

The mechanisms of issuing and burning tokens provided by tokenomics exactly fulfill the function of balancing supply and demand. Issuing tokens increases supply and can lead to inflation, while burning tokens (removing a certain amount of tokens from circulation) triggers deflationary processes and provokes demand to outstrip supply. 

Transparency and predictability of issuance mechanisms and control over distribution and circulation are ensured by smart contracts, which act as regulators in each individual crypto project: they realize in their microeconomics the monetary policy set by Tokenomics.

Tokenomics: Principles and Basics

For a fuller understanding of how cryptocurrency tokenomics works, let’s look at the world’s first and most capitalized cryptocurrency, representing more than half the value of the entire global digital asset market — bitcoin. The white paper of “digital gold” initially included a limited edition: the maximum number of bitcoins in circulation will be 21 million coins, the last of which will be mined tentatively in 2140. Approximately every 4 years, according to the halving algorithm provided in the source code, the reward to miners for mining blocks is halved, which naturally reduces the number of new coins put into circulation and creates conditions for even greater scarcity of BTC. Halving is a deflationary mechanism inherent to the first cryptocurrency (the token burning mechanism was developed by the creators of later protocols and is used in the Ethereum network, Binance Smart Chain, and others). The circulating supply of BTC according to CoinMarketCap at the time of writing is 19.83 million, which means that in the next century with a tail, only a little over a million coins will enter the market (about 5.6% of the total issue). 

The history of bitcoin development is one of the most illustrative examples of the influence of tokenomics on the value of cryptocurrency: the simple and immutable economy of the first cryptocurrency, which almost completely eliminates the risks of inflation, demonstrates the results of its rationality and incredible profitability before our eyes — the value of one BTC today fluctuates at a level of about $95 thousand. 

Tokenomics Models

Two basic types are usually distinguished: inflationary and deflationary. Deflationary models are usually applied to cryptocurrencies designed to store value (such as bitcoin). Inflationary models are applied to tokens designed as a medium of exchange.

Both models are applicable in networks based on proof-of-work or proof-of-stake consensus algorithms: new tokens are created as a result of mining or staking processes. However, in the deflationary model, the issuance limit is limited, while in the inflationary model it is not. Inflationary tokens tend to offer greater liquidity and applicability as a means of payment, trading, daily and frequent transactions. 

Thus, deflationary coins may have risks of low liquidity due to limited supply, as well as risks of centralization or manipulation if a large number of coins accumulate in the hands of a few whales. 

When choosing a model, investors usually base their choice on their financial goals and intended use: for long-term investment or for daily payments and short-term income. 

The main components of tokenomics

Conscientious projects whose authors understand how tokenomics affects the adoption of cryptocurrencies describe their mechanisms in a white paper or on their websites and make it freely available. Additional information can also be found on specialized aggregators of cryptocurrency market information, such as CoinGecko or CoinMarketCap.

Let’s break down the main components of tokenomics that investors typically consider:

1. Token issuance (token creation, initial and maximum supply, total and circulating supply).

This describes the model of token creation (coin mining) before and after the public launch. Unlike fiat currencies, the supply of crypto tokens is usually transparent and predetermined. 

The initial supply deserves special attention because it sets the stage for coins to enter the market and sets the framework for early trading dynamics. 

Data on the exact limits of the maximum supply will give the investor an understanding of how exposed the token is to the risk of inflation. If issuance is unrestricted, it reduces the likelihood of reaching deflationary levels and a high price in the future.

Data on total supply shows how many coins exist today (including those locked in escrow), and data on circulating supply shows how many are available for trading. 

A large gap between the maximum supply and the total supply serves as a marker for investors and coin holders of a potential decline in value, as prices may fall as new tokens become available. 

As for NFTs, in their Tokenomics and DeFi applicability, a tight token issuance and supply strategy plays a vital role for the reason that uniqueness and “rarity” are key to ensuring their value. For them, the marginal scarcity of coins is often the only justification for a high price. For example, the well-known Bored Ape Yacht Club and CryptoPunks collections of non-replaceable tokens have limited issues (of 9,999 and 10,000 tokens, respectively).

1. Token distribution patterns.

One of the most important factors affecting a project’s tokenomics is the token distribution mechanism. They show in what proportion tokens are distributed among developers, investors, funds, and what proportion of tokens are allocated to maintaining liquidity, marketing, legal expenses, etc. The distribution of tokens is a key factor in tokenomics. 

For example, if a small number of investors hold a significant amount of tokens, this can have unpredictable consequences. And it is important to be aware of what might happen if, for example, developers entitled to 25% of the issuance unlock their coins at the same time. A large percentage allocated to marketing may indicate that the rational benefits of the product, such as manufacturability or utility, are lagging, so the team tries to stimulate demand through advertising.

The optimal model includes periods and percentages of token allocation to the team and early investors, and mechanisms to prevent excessive concentration of coins in single hands. 

Tokenomics also details the economic incentives for investors to attract and retain their maximum loyalty. Tokenomics, as a set of conditions to which the distribution policy of a particular coin is subject, includes, in addition to a competent supply, basic requirements for the creation and maintenance of demand. Tokenomics, aimed at incentivizing network participants, provides the best microclimate for the coin’s steady growth. 

1. Utility.

The utility model of tokens in Tokenomics outlines the variability of their use. For example, a token can give the right to vote on network management issues, generate income from stakes, serve to pay transaction fees, etc. 

1. Token inflation management in tokenomics. 

The most applicable deflationary tool so far is token burning. This mechanism allows tokens to be removed from circulation, potentially increasing the price of the overall supply. In particular, Binance implements this model in the following way: they buy back BNB tokens at the expense of 20% of their quarterly profits in order to burn them further. In this way, the network plans to reduce supply by 50%. 

1. Tokenomics and Network Security.

The potential increase in token value requires security rules for tokenomics formation: token design and development must be accompanied by a thorough audit of technical and economic security. The code, smart contracts and other token infrastructure should be subject to constant scrutiny by specialized experts. This will help identify vulnerabilities early and reduce the risk of both technical and economic attacks. 

Recommendations for Tokenomics Analysis

• Conduct your own analysis of the tokenomics of popular cryptocurrencies by studying information from open source developers and analysts.
• Determine the tokenomics model that fits your goals. If you’re a long-term investor, a deflationary token is more likely to suit you; if you’re a short-term investor, an inflationary token is more likely.
• Examine utility. High variability in the use of a token is a good thing.
• Evaluate the fairness of the coin distribution, whether there is a bias in favor of one stakeholder or another.
• See if the issuer conducts regular security audits. 
• Examine the factors by which the crypto project stimulates demand and subsequent investor commitment: loyalty programs, staking opportunities, participation in management, profit sharing, etc.
• Analyze what deflationary mechanisms are used (and if they are used).

Conclusion

Broadening your horizons to better understand the economics of cryptocurrencies is essential for both novice and experienced investors. Deepen your knowledge of the laws of tokenomics, but do not rely on it alone. Tokenomics is only one part of the fundamental analysis that every investor needs to objectively understand the situation and make the right investment decision. 

Thank you for your attention. Invest safely and profitably!

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