Tokenomics, or token economics, is officially the study of how crypto tokens create economic value. But from a less academic standpoint, it's the study of what makes crypto useful and valuable. Assessing a project's value, adoption, and long-term viability is much easier if you understand its underlying token distribution, supply, and utility.
This article looks at the critical components of tokenomics, discusses factors influencing success, and explores some real-world examples of tokenomics in practice.
A Look Under the Hood
A crypto token's value primarily depends on its distribution, supply, and utility. It's essential to consider each factor carefully when starting, using, or investing in a crypto project.
Token distribution involves allocating and distributing new tokens among various stakeholders, including investors, developers, and users. When well-thought-out, token distribution strategies ensure a fair allocation of tokens, promote decentralization, and prevent market manipulation. But they can also cause problems for users and investors.
The three most common distribution strategies include the following:
- Initial Coin Offerings (ICOs) – Many crypto projects raise capital through an ICO, selling new tokens in exchange for cryptocurrencies or other items of value.
- Pre-Sales – Pre-sales are similar to ICOs but occur before a public offering. They typically target venture capitalists or early supporters, giving them discounted ownership.
- Airdrops – Airdrops are a marketing strategy where users receive free tokens by meeting specific criteria. Often, projects use airdrops to attract early users and promote token usage.
Market manipulation and centralization are two common distribution challenges. For example, the limited distribution of Axie Infinity priced many players out of the market, limiting their audience. Meanwhile, projects where a handful of individuals control most of the tokens are subject to manipulative market behaviors.
Most conventional economics focuses on supply and demand – the same applies to tokenomics. The scarcity or availability of a token has an enormous influence on its price. Well-run projects manage a token's total and circulating supply to balance the needs of users and investors and create a sustainable and vibrant token economy.
The primary factors influencing supply include:
- Total Supply – The total supply is the maximum number of tokens possible. Typically, a project's whitepaper lays out the total supply within the context of the smart contract protocol.
- Circulating Supply – The circulating supply is the number of tokens available in the market. Often, these numbers depend on distribution events, lock-up periods, and token burns.
- Token Burning – Token burning involves permanently removing tokens from circulation. Usually, projects burn tokens to control inflation, increase scarcity, and improve a token's value.
Some crypto projects are inflationary with no limit on total supply, while others are deflationary with a stiff upper limit. For example, Bitcoin's value relies on scarcity, with an upper limit of 21 million tokens. On the other hand, Ethereum has no upper limit on its supply. However, it aims to create more value over time through its vibrant ecosystem.
Token utility refers to the value it provides to the blockchain ecosystem. For example, the Brave browser's Basic Attention Token (BAT) connects advertisers to and rewards Brave users for their attention. The token's utility is the value that advertisers and users get out of the token as a way to reshape how conventional advertising works.
There are several ways tokens can provide value:
- Governance Tokens – Governance tokens give token holders more control by enabling them to participate in decentralized decision-making by making or voting on proposals.
- Utility Tokens – Utility tokens provide access to products and services within an ecosystem. In particular, they may serve as a way to pay for transactions, earn rewards, or access features.
- Security Tokens – Security tokens represent ownership of an underlying asset, such as an ownership stake in a business or physical real estate, bringing liquidity to a market.
In decentralized finance (DeFi), token rewards and yields are among the most significant factors influencing adoption. As a result, projects offering investors higher yields or users lower prices tend to become the most vibrant ecosystems. However, some ecosystems prove unsustainable and collapse, so investors should always be cautious when evaluating options.
Tokenomics data is accessible in many places depending on the specific information and token.
CoinMarketCap provides easy access to token supply (including circulating supply, total supply, and max supply), a calendar with upcoming ICOs and airdrops, and a link to each token’s whitepaper where you can find utility-related information. In addition, you can view things like a DEX/CEX breakdown and other statistics to help support any analysis.
Of course, every token provides in-depth information directly on the blockchain, making it accessible to anyone. If you have the technical skill sets and knowledge to directly aggregate the data or are familiar with blockchain explorers, you can dig into how these tokens trade, where ownership lies, and assess the overall liquidity.
Opportunities & Challenges
Tokenomics plays a central role in blockchains, but today's applications only scratch the surface of what's possible.
Tokenomics is best known within the DeFi ecosystem, where it plays an essential role in incentive mechanisms, governance models, and token utility. While today's DeFi market is already worth more than $50 billion, it's revolutionizing markets worth several trillion dollars, creating an opportunity for much more growth and innovation.
In addition to DeFi, tokenomics is becoming vital to the metaverse and digital asset universe. For instance, tokenomics lays the foundation for virtual land, in-game economies, and collectible NFTs. As virtual reality and other technologies mature, these developing markets could experience rapid growth over the coming years.
However, despite this growth, tokenomics is not without its criticism and challenges from a regulatory and technical standpoint.
Most regulatory scrutiny has focused on whether tokens are securities under the Howey Test. If so, they may be subject to securities laws and other financial regulations. Meanwhile, stablecoins and other tokens may constitute a bank and be subject to banking regulations – including validation of reserves backing their assets.
From a technical standpoint, tokenomics could introduce centralization to decentralized blockchains. For example, a development team or investor may hold a high percentage of the circulating supply, enabling them to make decisions at the expense of other users. The subsequent reduction in fairness and inclusivity could undermine some crypto projects.
The Bottom Line
Tokenomics is essential for founders, users, and investors to understand before interacting with, investing in, or using crypto projects. From the multi-billion dollar DeFi ecosystem to potential central bank digital currencies (CBDCs), tokenomics has the potential to change the way the world operates on a fundamental level.
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This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.