What Is Tokenomics in Crypto?
May 25, 20225 min read
Understanding tokenomics is perhaps the main point in the analysis of the project. So a well-thought-out tokenomics can help a crypto project to break out into the leaders or slide into the abyss, as happened with the Terra project. Therefore, investors who want to diversify their crypto portfolio have to consider the aspects that tokenomics includes. Otherwise, there is a risk of suffering significant financial losses.
What Is Tokenomics?
The main factor influencing the success of any project is its value, that is, what benefits it can bring, what incentives investors have to invest, and how the project differs from competitors. In a traditional economy, fiat currencies have value because of citizens’ trust. For example, the US dollar has value because it is a universally recognized world currency and has guaranteed support from the USA Government. Since the USA has a reasonably developed economy, this allows the US Dollar to remain a valuable and stable currency, unlike the currencies of countries such as Venezuela or Zimbabwe. Due to a poorly established economy and several economic crises, these countries face the problem of the depreciation of national currencies. This happens when, for example, as a result of a crisis, the country’s central bank is forced to issue more money to cover expenses. Unfortunately, due to the issuance of more money, these countries eventually face inflation and devaluation of national currencies.
In the case of cryptocurrency, it gets value due to users’ trust, and its price depends directly on supply and demand. However, there is a significant difference between fiat and cryptocurrencies. Cryptocurrencies have a transparent and pre-established emission schedule. This gives the crypto community some advantage because it can predict how many coins will be in circulation by a particular time. Project developers use specific protocols to control the emission of new tokens and the total amount of currency in the system. The limitations imposed by the developers help to preserve the value of the cryptocurrency by creating a sense of scarcity among users. However, suppose the token does not have any valuable functions within the framework of the project and does not encourage users to operate with it. In that case, it remains useless, even with a limited emission. Ultimately, you can see how tokenomics largely depends on the value of tokens. Thus, we have come to the main aspects that tokenomics includes:
Each project should have a distribution schedule. If the project fails to distribute coins to interested users, then it will simply exist, and no one will be able to use the project’s tokens. For example, new tokens can be mined and added to the circulating supply with the help of miners. On the other hand, some projects prefer to sell part of the tokens to interested users via an ICO (Initial Coin Offering).
In this path, it is crucial to track what percentage of tokens are owned by the project team and how many tokens are in the wallets of venture capitalists and public investors. The more tokens are in the hands of the users themselves or will be after the release, the safer and more reliable the project is.
The investors wish the tokens not just to gather dust in their wallets but to generate profit for them. It is essential to study which project provides token use cases in this aspect. For example, in the Ethereum network, ETH is used to pay for gas to process the transactions and to pay fees for creating decentralized applications. With the transition to the PoS consensus algorithm, ETH will also be used for staking to protect and ensure the operation of the network. If the token is strongly intertwined with the project itself and has a significant role in its functioning, its value will also increase as the project grows.
When choosing an asset for investment, you need to study the issue model carefully. There are three main models:
- Limited pre-mined supply. Some cryptocurrencies are pre-mined before they enter the market. It is profitable to invest in such coins at an early stage. Under favorable conditions (a sought-after product, a strong team), the asset will grow in price. In addition, pre-mined cryptos are practically not subject to inflation due to the excess of supply over demand. Developers lock part of the tokens to gradually release them into circulation, thereby creating an artificial shortage and price increase.
- Limited supply. According to this principle, most popular digital currencies (Bitcoin, Litecoin, Dash) work. The limited emission of Bitcoin is due to mining. New coins appear on the market gradually. The mining speed is pre-determined by the PoW algorithm. The total number of coins cannot exceed the established limit. Such a mechanism keeps supply and demand approximately at the same level, or the first exceeds the second. As a result, the coin’s value grows, and its price increases. The deficit is also ensured by regularly reducing the reward that miners receive for each block. The reward is halved approximately once every four years.
- Unlimited supply. In some networks, the issuing of new coins can continue indefinitely. For example, this mechanism is implemented in Ethereum, Dogecoin, Solana, and other projects. However, experts fear that unlimited supply may lead to the depreciation of assets in the future. Therefore, developers are gradually increasing the complexity of mining or burning coins.
In conclusion, it becomes pretty evident that the analysis of the project tokenomics is paramount for investors. A carefully developed token distribution model, a wide range of token use cases, and a token issuing model that’s what you should pay attention to before investing. If your main goal is to increase your capital, it is recommended to pay attention to projects with the following characteristics:
The distribution of tokens should be clear and transparent. Most of the tokens should not be owned by the project team and venture capitalists. It is crucial to independently analyze how successful the token distribution model is. What percentage goes to marketing, development, operating expenses, etc. Does the project have a treasury, and for what purposes is it used?
Tokens with a limited supply will always cost more than those with an unlimited one. In this context, it is essential to understand what goals the project developers pursued by setting unlimited supply. In addition, it is worth exploring what methods are used to counter inflation, for example, encouraging users to lock tokens in staking (thereby removing them from circulation and ensuring price growth) or burning tokens.
Studying the tokens’ use cases within the project is also essential. The more use cases there are, the more valuable the token is for the platform. Use cases can include the payment of network fees, the stabilization of volatility, governance, staking, yield farming, and much more.