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What Is Tokenomics and why is it important?

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What is tokenomics?

Tokenomics is an abbreviation of “Token Economics” and it refers to a whole series of metrics relating to cryptocurrency coins or tokens such as supply, allocation, distribution and utility.

It is also important to note that although they are often used interchangeably, cryptocurrency coins and tokens are actually two very different things. Coins are more like traditional currencies and are native to their own blockchains. By contrast, tokens can exist on multiple blockchains at the same time like Tether (USDT) that exists on Ethereum, Tron, Omni, Solana etc and can also  be used to represent other things or assets. In this post, we’ll look at some of the common tokenomics related questions. 

What is market cap and why is it important?

Market Capitalisation or “Market Cap” is one of the most important metrics and is very often misunderstood by beginners in the space.  It is a representation of the total value locked into a coin or token and is equal to the price of a single coin or token multiplied by the number of coins in circulation. For example, some cryptocurrencies like XRP have a massive supply and market cap even though the dollar value of each coin is low. Other cryptocurrencies like yearn.finance’s YFI token have a small supply (36,666), and this is why 1 YFI has a similar price to 1 BTC at the moment. It’s easier to double the market cap of a smaller cap cryptocurrency like YFI than the market cap of a cryptocurrency like XRP.

This is why you should always pay attention to a cryptocurrency’s market cap rather than just the actual dollar value of the coin or token, and think in percentage terms rather than dollar terms. Dollar price of a coin means little in regards to the performance of the coin.

New investors often suffer from unitary bias and want to buy 100 or a 1000 of a coin like XRP instead of buying just a part of a Bitcoin in the false belief they are getting “ better value” by owning more of one token type.

What is token allocation?

Cryptocurrencies can be created by “fair launch” or by “pre-mine”. A fair launch is when a community of people starts collectively mining a coin or token from zero. Allocation is relevant to any cryptocurrencies that were pre-mined. A pre-mine is when the team behind the project mint some or all of the coins or tokens that they have control over before opening up the network to the public. A portion of these coins is usually sold prior to the launch of the network to cover the cost of building it. It is also common for a portion of the pre-mine to be allocated to the development team and private investors. You can usually see how the tokens were allocated by checking the ICO details for the coin or token you are researching. Pay attention to the big allocations and release schedule of the locked tokens as this may impact the future price and long-term value.

What is token distribution?

One of the interesting characteristics of most Blockchain networks is that they are built on a transparent public ledger that everyone can see. Once you have a sense of how coins or tokens are allocated, you can use blockchain explorers to see how the coins or tokens are currently distributed. Or to put it plainly you can use the public characteristics of a blockchain to check if the distribution is relatively fair. For example, if only a few whales ( owners of large wallets of the coin ) control the significant supply they could manipulate the price. Take the example of Dogecoin that has 1 address that holds about 25% of the total supply of the coin even though it was a “fair-launch” Cryptocurrency. This is not necessarily a bad thing as someone could just have a strong belief in the future of the project but it could represent a risk to the future token comic metrics.

What is token supply inflation and deflation?

As explained in the previous section different coins and tokens have a different total amount available. Some coins like Bitcoin will only ever have a maximum supply of 21 million whereas other projects like Dogecoin have an ever-increasing supply of coins being mined. 

As you may have expected, inflation refers to the increase in the coin supply by minting or mining, while deflation refers to the decrease in the token supply by “burning” or even loss of the coins. Cryptocurrency protocols can be either inflationary or deflationary. If a cryptocurrency has too much inflation, it can reduce the value of the coins or tokens already in circulation over time.

Some Proof-of-stake (POS) coins are inflationary coins to incentivize people to stake, and many Defi tokens use inflation to reward the users of the network like liquidity providers and yield farmers. Deflationary currencies can often mean that the reduction (or stagnation) of the supply will increase the value of the currency over time. Bitcoin is an example of a deflationary cryptocurrency because its supply is limited to 21 million. Ethereum could become deflationary after EIP1559 when a portion of transaction fees will be burned and hence removed from the supply.

What is token utility?

Utility refers to what a coin is used for or what products/services it provides access to. Bitcoin’s current utility is to be a store of value like gold. Coins like XRP plan to make cheap and fast Interbank value transfers while Ethereum’s primary utility is to be a platform for smart contracts and distributed computing. Some projects and chains offer to stake their coins for different reasons. It usually involves locking a token in a smart contract for a predetermined period of time and receiving staking rewards. This also means that the staked tokens are not a part of the currently circulating supply and can’t be sold. At times when the price changes rapidly, this can help price stability. On the other hand, some coins like Cardano (ADA) have no lockup period and can be moved instantly. Some projects like Decred use tokens as votes to create governance mechanisms where users of the network can decide on the future of the network and rules of the community.

Conclusion

Tokenomics is an important topic and one of the many factors you should understand before investing in crypto. It might seem like a complicated topic, but it’s fundamentally built on basic economics 101 principles like supply and demand and brings fascinating new options and paradigms due to the unique properties of Blockchains and distributed ledger technologies. 

If you have any questions or want to know more, reach out to Boinnex

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Ozzak

Ozzak

Ozzak discovered blockchain technology in early 2017 and decided that this is exactly what he wants to do with his life. In 2018 he was accepted in the Computer Science course at University College Cork. He's now in his 3rd year working for Boinnex as a part of his internship. As you may imagine he's deeply passionate about everything blockchain. Ozzak's other interests include calisthenics, blues harp and Austrian economics. He also has an impressive collection of tarantula spiders.

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