What Is Tokenomics? – Definition & Meaning 

“Tokenomics” is a catchall phrase that refers to the economics of crypto projects. Some cryptocurrencies have tokenomics sections in their white papers or on their websites, but for ones that do not, you can learn about them when you research what a cryptocurrency does.

What Is Tokenomics?

To understand the fundamental value of a cryptocurrency, you will need to understand tokenomics. While tokenomics should be considered a “general area of study,” there are some particular things you need to understand to calculate potential fundamental value.

What Is a Token?

To understand tokenomics, you need to understand what the term “token” means. A token is a unit of a cryptocurrency that represents a particular use on the blockchain. Tokens can have multiple use case scenarios, but the most common uses for tokens include security, utility, and governance. 

Cryptocurrency and tokens built on a blockchain have specific issuance schedules. Because of this, it’s possible to predict how many tokens will exist in a certain amount of time. Unlike a central bank that prints fiat currency at whim, the issuance of crypto is algorithmically built-in. Inflation should be relatively straightforward. 

Even though issuance can be altered, it almost always will take a consensus vote on the protocol to deviate from the predetermined schedule. This allows for more security for the owners of the tokens because they can have a predictable growth/inflation schedule.

What Are the Core Features of Tokenomics?

• Minting and staking: When referencing a base layer blockchain, like Ethereum or Bitcoin, mining incentivizes a decentralized network of computers to validate transactions. New tokens will be given to those who use their computer power to discover new blocks, fill them with data, and add them to the blockchain. However, regarding staking, rewards are given to those who lock away a certain amount of tokens to help facilitate transactions. “Ethereum 2.0” and many other proof-of-stake networks operate this way.
• Yields: DeFi or centralized finance platforms will offer a yield to incentivize those to stake their tokens. Tokens are staked in liquidity pools, which power decentralized exchanges and lending platforms. The rewards are given out in the form of new tokens.
• Token burns: Some ecosystems will “burn tokens.” This is to say that they permanently remove them from circulation. The idea is that reducing the number of tokens available increases the value due to scarcity. This is a way to create value for the tokens over the longer term.
• Limited/Unlimited supply: Tokenomics will determine the maximum supply of tokens available. For example, the Bitcoin protocol dictates that there will only be 21 million BTC. Ethereum has an unlimited supply, but it caps the amount produced each year. Whether there is a limited or unlimited supply of tokens can come into the supply/demand equation.
• Token allocations and vesting: Quite often, a certain amount of tokens will be allocated to venture capitalists that back a project. However, there is a certain amount of vesting time that they must hang onto the coins, but once it is reached, they can dump them into the ecosystem.

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Why Is Tokenomics Important?

Tokenomics is essential as it measures the supply and demand of a token, which in turn will significantly influence that token’s pricing. There are multiple ways to measure this, which goes beyond counting how many exist. By understanding how many tokens there will be, you can start to value a project.

What Are the Three Facets of Tokenomics?

Tokenomics addresses many of the critical elements of valuing a token. Before becoming a token holder, reviewing the blockchain project white paper is generally a good idea. This will give you an idea of how many tokens it will issue, much like how many shares a corporation will float. It should provide insight into the details of the three facets of tokenomics. 

What Fundraising is Being Done, or Has Been Done?

One of the most significant areas of tokenomics will be fundraising. This operates much like an initial public offering (IPO) for a stock, but in this case, called an initial coin offering (ICO). It is a way that early-stage cryptocurrency ventures will raise capital. A crowdfunding model will offer a certain amount of coins sold directly to the public. While not all blockchain ventures raise money via an ICO, it is relatively standard. 

The study of tokenomics looks into the fundraising model and how the coin will be offered to the public. This can impact value in many ways, not exclusive to but certainly including token distribution, the total supply of coins, and the current circulating supply. Each of these factors will influence scarcity, which will impact pricing.

What is Governance Like?

Token holders typically have voting rights on a blockchain, allowing influence on the operational standards of the network. Functionality issues such as mining rewards, hard forks, and total token allocations are voted on. 

Blockchain governance can be crucial in the performance metrics of a cryptocurrency or a project. For example, the Ethereum blockchain transitioned from proof-of-work to a proof-of-stake consensus mechanism through its governance standards. This will reduce barriers to entry, although it should be noted that 64 ETH are required. This should decrease the hardware costs, raise energy efficiency, and promote anonymity by adding more nodes to the network. The benefits created by POS could improve the token economy by providing more incentives to validators and streamlining the execution of smart contracts. 

Ownership

When you own a token, you own something of value in the digital world. In cryptocurrency and fintech, the value will be defined as tokens or coins. Holders of these assets benefit from a small degree of ownership in the project they are used in. 

A crypto project will disclose its token model in the official white paper, typically distributed on a website. Allocation metrics include the total projected token supply, distribution plan, and max supply. These factors can impact the token’s market capitalization, liquidity, and value, much like the total amount of shares of a corporation in the stock market. 

Bitcoin has a max supply of 21 million, with mining rewards being cut in half every four years. Bitcoin will not reach its maximum number of 21 million in circulation until 2140, making Bitcoin’s value dependent on perceived scarcity because of the limited supply. 

Unlike Bitcoin, tokens like Dogecoin are constantly minted. There is no max supply of Dogecoin, and 5 billion are minted yearly. Because of this, Dogecoin has an annual inflation rate of 3.78%.

What Are the Types of Tokens?

When studying tokenomics, you need to understand the different types of tokens you will be dealing with. They can be classified according to the structure they are built with and the basis on which they are used. 

What Are Layer 1 Tokens?

Layer 1 tokens are native to a blockchain and are used to power all services in the blockchain. Some well-known Layer 1 blockchain tokens include Either on the Ethereum network and BNB on the Binance Chain. 

What Are Layer 2 Tokens?

Layer 2 tokens are utilized in the case of decentralized applications of a specific network. Some examples include PERP, CELR, OMG, MATIC, and more. These tokens will sit “on top of” another Layer 1, such as Ethereum. 

What Are Security Tokens?

Security tokens are investment contracts that must meet several conditions. These tokens are subject to securities and regulations and get their value from tradable and external sources. They are subject to government oversight, making them a much safer choice. 

The way that Siafunds on the Sia network operates is one of the most prominent examples of security tokens. 

What Are Utility Tokens?

Utility tokens are vital tokens that are taken into account in tokenomics. They are issued through an ICO and are used for financing a network. The ICO is essential for funding project development. One of the most well-known utility tokens would be the Basic Attention Token (BAT), used for tipping content creators through the Brave browser.

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What Are the Classifications of Tokens?

 There are two main categories of tokens, classified as fungible and non-fungible. 

What Are Fungible Tokens?

Fungible tokens are recognized as having value because one token has the same use, value, and utility as another. In other words, when you think of Bitcoin, you understand that the value of one Bitcoin is the same as another. Another way to think of fungible tokens would be like a share of stock in a company like Coca-Cola. When you buy or sell a share in Coca-Cola, you do not care so much about the actual share itself, just that you get the value out of it. One share is the same as any other one.

What Are Non-Fungible Tokens?

Non-Fungible tokens are different in the sense that they are unique. Quite often referred to as an NFT, they do not share the same value as others. Examples would include digital art NFT tokens, NFT tokens that represent ownership of music, a token that represents a deed to real estate, and so on. 

While they have value, not all of the tokens have the same value, so you do not exchange them one for one. One way to think about this would be if you were a real estate investor because each property will have its own value, and therefore it’s very rare to have someone trade one property for another. 

Factors Affecting Crypto Tokens

If you’re trying to value a token, you must know some factors that will move the value of crypto over time. 

The Distribution and Allocation of Tokens

One of the most significant factors that will decide the value of a crypto token is how the token gets distributed. There are two ways of generating crypto tokens: pre-mining or a fair launch. The phrase “fair launch” means that a cryptocurrency is mined, earned, owned, and governed by the community from the outset. 

When pre-mined, a portion of the coins is created and distributed before the coin is publicly available. This typically goes to venture capitalists and those who are the founders. A portion of the coins is sold to prospective buyers in an initial coin offering, which rewards those holders from the beginning.

The Supply of Tokens

A crucial parameter that needs close attention to grasp a cryptocurrency’s tokenomics is the supply. There are three types of supply for crypto tokens: 

• Circulating supply, 
• Total supply, and 
• Max supply.

Circulating supply refers to the number of cryptocurrency tokens issued publicly and in circulation. The total supply is the current number of tokens, minus all the burned tokens. It’s a calculation that takes the total of tokens currently in circulation and the tokens that are locked away. Finally, total supply should not be confused with max supply, which tells us the maximum number of tokens that will ever be generated. 

Quantifying the supply of a token can be a good indicator of its future value. If the circulating supply of a token is increased by active mining, and the circulating supply keeps increasing, it shows demand. 

However, if there are too many tokens released, supply could overwhelm that same demand and drive the price lower. This often happens to coins like Dogecoin that have no max supply.

The Market Capitalization of the Token

Market capitalization is a metric used to determine the popularity of a token. It’s calculated by multiplying the price of a token by the circulating supply. The market cap is an indicator that many investors pay close attention to. It can be a good indicator of the token’s value, even in the long run. Cryptocurrencies with small market capitalizations are typically riskier and more volatile because they are not as widely held. This is a simple issue of liquidity and volume.

What is the Token Model?

Every token has a model that it follows. This model can either be inflationary or deflationary. An inflationary token does not have a max supply and can keep being mined well into the future. Deflationary tokens are tokens with a limited supply and, therefore, can be much more valuable due to scarcity.

The Token’s Price Stability

Tokenomics also has implications for the price stability of a cryptocurrency. As cryptocurrencies are known to be very volatile, stability may not necessarily work in the investors’ favor. Fluctuations in price can lead to falling interest among investors, but fluctuations can also restrict networks as fewer people hold tokens. 

Inflation and Deflation in Tokenomics

Tokenomics is very similar to the traditional study of asset valuations. As a general rule, prices tend to react to supply and demand factors, which directly impact asset valuations. 

For example, central banks will regulate the supply of money from countries. The US Federal Reserve reports various money supply metrics, which are leading indicators of the value of the US dollar. The Bank of England does the same thing, as do all other major central banks.

Inflationary Token

Inflation is a measure of how much more expensive a set of goods or services will become over a certain period of time. Inflation is a loss in purchasing power of a currency, be it fiat or crypto. The phenomenon of inflation can have a detrimental impact on asset values, employment, economic output, and the general economy overall.

There are two widely accepted forms of inflation in conventional finance: 

• Demand pull: If demand increases but the supply of a good, currency, or other asset remains the same, asset prices increase due to demand pull inflation.
• Cost Push: When production costs rise, be it through the manufacturing process, input costs, or anything else, it can diminish supply and raise the cost of that supply.

Both of these types of inflation will influence an asset’s value, be it a commodity, a national currency, or a cryptocurrency. Tokenomics addresses these factors in relation to a coin being classified as either an inflationary or deflationary token.

Deflationary Token

Deflation occurs when the inflation rate becomes negative, and asset prices become depressed. Deflation can occur for many different reasons but typically is a product of a lack of demand. Prolonged deflation can cause recessions and high unemployment in economies. 

However, in tokenomics a deflationary token has a finite number available. Bitcoin will only have 21 million minted, making demand outpace the supply, giving it value due to scarcity.

Examples of Tokenomics in Action

To understand how tokenomics can influence your investments, you should look at a couple of examples to give you an idea of how things can change based on these inputs.

Bitcoin

Bitcoin (BTC) was designed so that a certain amount of tokens can enter the network through block rewards. After a  miner has successfully validated a block, the miner will receive newly minted Bitcoins. Another 101 blocks must be confirmed before they receive their reward, which incentivizes them to stick around and continue validating.

Ethereum

Tokens on the Ethereum (ETH) blockchain are distributed by block rewards continuously. During its ICO in 2014, Ethereum sold approximately 7 million Ether to help kickstart its adoption. There is no hard supply cap on Either, meaning that the token supply can continue to grow as the network expands. The tokenomics may or may not change as the network transitions to a proof-of-stake consensus system.

Tron

Tron (TRX) is governed at various levels to keep decision-making decentralized but effective. Automated mechanisms are responsible for determining how tokens are added to the network to ensure enough is in circulation, but the price remains relatively stable. However, the community can decide whether to increase or lower the amount.

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What Are the Advantages of Tokenomics?

Tokenomics should be thought of as a fundamental analysis of crypto. It provides a complete analysis of the network and the coin, so it should be paid close attention to. Some of the things that make it advantageous include:

• ICO conditions: ICO conditions, or the Initial Coin Offering, can give you an idea of how many coins will be given to insiders and how many will be dumped on the public.
• Yields: Understanding whether or not yield is possible holding a token can go a long way to determining whether people are likely to hold it for the long term.
• Supply: Supply is a massive part of tokenomics and significantly influences whether or not there will be scarcity. Coins both in demand and scarce tend to be the most valuable ones. Without knowing the supply/demand equation, you have no idea whether or not the value should rise over time.
• Understanding vesting periods: It is worth understanding how long insiders are forced to hang onto a token after the initial offering because it can significantly influence price along the way.

What Are the Disadvantages of Tokenomics?

While tokenomics can give you an idea of how the market should behave, the reality is that it does not always behave as expected. There are some disadvantages that you need to pay attention to include: 

• It can be ignored: Unfortunately, regardless of the potential longer-term value of an asset, there are times when external factors come into the picture. This may have nothing to do with crypto, as seen in 2020, when almost everything sold off due to the pandemic and global economic concerns.
• Popularity: Quite frankly, the tokenomics of a particular coin might be great, but if the blockchain does not become very popular, none of this matters. In other words, tokenomics cannot be looked at in a vacuum and should be thought of as just one part of the analysis. After all, buggy whips are relatively rare, but they aren’t in demand either.

Conclusion

Hopefully, you have seen the importance of tokenomics when trying to value an asset. If you understand that a token has a limited supply, it makes sense for it to rise in value over the longer term assuming that people are interested in the network. The simple inflation/deflation model can be a considerable influence. 

It’s also worth noting how long the insiders are forced to hold a token after the ICO because it is common for the initial investors to dump initial shares of a company into the market as a reward for early investment. This is quite common in the crypto world as well. This can negatively influence price, even if it’s just temporary. 

However, tokenomics does not answer every question. After all, the reality is that almost all cryptos are traded in tandem, and in times of concern, differentiation is left outside. In 2022 we have seen all crypto get slaughtered, even though some have more use case scenarios than another. 

Nonetheless, the reality is that you need to understand the fundamentals and technicals in any asset, and crypto will be no different.