Tokenomics in crypto refers to the study of the economic models underlying cryptocurrency tokens. The term encompasses various aspects such as token supply, distribution, utility, and incentives, which collectively influence a token’s value and functionality within its ecosystem.
Investors analyze tokenomics to assess if a cryptocurrency has a sustainable economic design. Projects with robust tokenomics are more likely to attract investment and succeed long-term.
In this article, we’ll explore every aspect of tokenomics that every stakeholder should know, whether you are a founder, investor, or a DeFi passionate.
What is Tokenomics? Tokenomics Explained
Tokenomics, the combination of the words “token” and “economics,” is the science that studies the factors that drive a token’s value in crypto projects.
It refers to the token’s total supply, circulation, distribution, utility, and market capitalization, providing a comprehensive framework for stakeholders to understand the crypto asset’s inner workings.
Supply and demand characteristics play a crucial role in understanding the economics of a crypto project. These characteristics include factors like issuance, distribution, and market demand. Such factors differentiate crypto tokens from traditional currencies, which are primarily influenced by government monetary policies.
Smart contracts that ensure transparency and predictability in token issuance and distribution govern each crypto project's operation as a micro-economy with its own monetary policy.
What is a Token?
Tokens are digital assets created and managed on existing blockchains, primarily using smart contract technology. Unlike cryptocurrencies such as Bitcoin or Ether, which have their own blockchains, tokens are built on top of these existing networks. They serve various purposes in the crypto space, ranging from representing value to granting specific rights or access within a project's ecosystem.
They can represent real-world assets, governance tokens, access to specific project features, or even non-fungible tokens (NFTs). This flexibility has fueled innovation in decentralized finance (DeFi) and other crypto projects.
Why is tokenomics important in crypto?
Tokenomics is a critical aspect of crypto projects (that are in business for the right reasons), serving as the foundation for sustainable growth and long-term viability. It’s one of the things that can make or break your crypto project.
Understanding tokenomics is crucial for investors, especially when considering investments in altcoins or new crypto projects. It provides insights into a token’s potential value and how it might perform in various market conditions.
Additionally, understanding a token's supply is essential as it influences the value of a cryptocurrency, including factors like issuance process, allocation among stakeholders, and potential market impacts.
A well-designed tokenomics model can incentivize user behavior, ensure network security, and foster long-term growth. Conversely, poor tokenomics can lead to imbalances, manipulation risks, and a quick death of the project.
What are the key features of tokenomics?
When designing a sustainable token economy for a crypto project, there are seven core features of tokenomics that you should keep in mind:
- Issuance and Supply: Consider the initial circulating supply as a key feature, as it impacts the overall strategy for managing the cryptocurrency supply.
- Distribution
- Security
- Pricing and Valuation
- Utility
- Demand
- Burning
1. Token Issuance and Maximum Token Supply
Issuance and token supply are fundamental aspects of tokenomics that significantly impact a crypto project’s value proposition and market dynamics. Unlike fiat currencies, crypto token supply is typically transparent and predetermined.
A token’s maximum supply defines the maximum number of tokens that will ever exist, while the circulating supply represents the number of tokens currently available in the market. The initial circulating supply is particularly significant as it sets the stage for a token's market entry and early trading dynamics. For instance, Binance managed its cryptocurrency supply by committing profits to buy back and burn tokens, with 40% of its tokens being part of the initial circulating supply.
The gap between maximum token supply and circulating supply is crucial for investors/token holders, as a big difference between these two figures can signal potential future dilution as new tokens enter circulation (this means that the tokens can drop in value).
Projects like Bitcoin have a fixed supply of 21 million coins, creating scarcity, while others like Ethereum have an unlimited but controlled issuance.
If we talk about NFTs, token issuance and supply strategies are interesting to observe. Unlike fungible cryptocurrencies, NFT projects often rely on extreme scarcity (among other factors) to drive value.
For example, collections like CryptoPunks and Bored Ape Yacht Club have capped supplies of 10,000 and 9,999 tokens respectively. Rarity is a core component of their tokenomics, appealing to collectors looking to invest in unique or rare digital assets.
2. Token Distribution
Token allocations fall into two main categories: pre-mined and fair launch. Pre-mined tokens are created before public release, with a portion of the token supply distributed among early investors, venture capitalists, and the founding team. However, this approach can raise eyebrows about centralization and potential price manipulation if a significant portion of the circulating supply is concentrated in a few hands.
Fair launch distributions aim to level the playing field. These often involve airdrops to early users or open sales where all participants buy in at the same initial coin offering (ICO) price. Initial coin offerings might be preferred by the project's community and this method also reduces the risk of pump and dump schemes by early investors.
A well-designed distribution model needs to balance the needs of various stakeholders while ensuring the project doesn't run out of gas. Key considerations include:
- Vesting periods for team and early investor tokens allocated
- Transparency in token allocation percentages
- Mechanisms to prevent excessive concentration of the total supply
- Incentives for long-term hodlers and ecosystem participation
In the current crypto market, projects that demonstrate a fair and transparent distribution model, with appropriate lockup periods for large stakeholders, will gain more trust and support from the community.
3. Token Security
In the crypto space, we can't stress enough how important trust and security are. Conduct regular and transparent security audits with reputable third parties, to establish credibility and enhance reputation. This protects both your project, and gives your stakeholders peace of mind that your project won't go bust.
Security audits subject the token's underlying technology and infrastructure to rigorous examination, identifying vulnerabilities, weaknesses, and potential attack loopholes. These audits are crucial for safeguarding the token's utility and protecting token holders from risks that could impact the token's price and overall market value.
4. Token Pricing and Valuation
Token pricing refers to the process of determining the monetary value of a token, while valuation involves assessing the overall worth of a token based on various factors including utility, market demand, and project potential.
Nailing your token's price is a delicate dance. Your token's valuation is not slapping a price tag on your digital asset; you need to come up with a token price that resonates with both early investors and the broader crypto market.
Pre-listing, you might offer a taste of your token's utility at a discount for early investor. As you progress through funding rounds, you're building a staircase of value, each step a bit pricier than the last.
Post-listing, you'll need to manage the inevitable rollercoaster. You might face some selling pressure as token holders cash in on their gains, but don't panic, as this is all part of the token economics game. Focus on creating real value.
5. Token Utility
"What is the utility of your token?" is the million-dollar question that keeps Web3 project founders up at night, and for good reason.
Token utility can take many forms. It might involve granting governance rights, allowing holders to participate in decision-making within a decentralized network (this is called a governance token). It could also facilitate staking, enhancing network security.
Some tokens are specifically designed to provide liquidity in decentralized exchanges (DEXs), playing a crucial role in maintaining efficient markets and enabling a smoother trading experience for users.
6. Token Demand
Token demand is the standing ovation every project dreams of. Generating demand requires a strategic combination of utility, technology, and community engagement.
Your token must serve a clear, practical purpose within the ecosystem. Whether it's used for governance, staking, or as a medium of exchange for services, the token's function should be integral to the platform's operations. Make sure your token is easily tradable by securing listings on reputable exchanges and considering the creation of liquidity pools on decentralized exchanges.
Community excitement for your project and the perceived value are also key in driving demand. A great marketing strategy is doing collaborations with established projects in the crypto space, expanding use cases and user base exponentially.
7. Token Burning
Token burning is a deflationary mechanism employed by cryptocurrency projects to reduce the token's supply in circulation, potentially increasing the value of remaining tokens. This process involves permanently removing a certain number of tokens from circulation, effectively "destroying" them and making them inaccessible to anyone. Tokens are sent to a wallet address that is provably inaccessible, often called a "burn address" or "eater address."
Some examples of burn mechanisms in practice are:
- Binance commits to using 20% of quarterly profits to buy back and burn BNB tokens. Their goal is to destroy 50% of the total supply (100 million BNB).
- With the implementation of EIP-1559, Ethereum now burns a portion of the transaction fees paid by users. This mechanism not only helps manage network congestion but also introduces a deflationary aspect to ETH's tokenomics.
What are the different tokenomics models?
There are two types you can select for your tokenomics model: Inflationary and Deflationary.
Inflationary tokenomics models have no hard cap on maximum supply, allowing it to increase over time. With inflationary supply, tokens typically experience a decrease in purchasing power. This model can be employed in proof-of-work or proof-of-stake systems, where new tokens are created as rewards for mining or staking.
Inflationary tokens generally provide higher liquidity thanks to their high circulating supply, making them more accessible for day-to-day and frequent transactions. Examples include Dogecoin (DOGE) and Ethereum (ETH) before the implementation of EIP-1559.
Flipping the script, deflationary tokenomics models feature a hard cap on the total number of tokens that can be created, and the token supply decreases over time through mechanisms like token burns (which we discussed earlier).
The primary goal of a deflationary model is to create scarcity, potentially driving up the token's value. However, this can lead to lower liquidity due to a reduced circulating supply. Deflationary tokens may also be more susceptible to market manipulation by whales.
Bitcoin (BTC) and Binance Coin (BNB) are notable examples of cryptocurrencies employing deflationary models.
The choice between inflationary and deflationary models depends on your goals, intended use cases, and long-term economic strategy. Inflationary models are often preferred for tokens designed as a medium of exchange, while deflationary models are typically chosen for tokens intended to serve as a store of value.
How do you design a project's tokenomics?
To design sustainable tokenomics, consider these key factors:
- Clear utility: define specific use cases for the token within the ecosystem.
- Balanced allocation: distribute tokens fairly among stakeholders (team, investors, community, treasury).
- Transparent vesting schedules: implement and disclose clear release schedules for all holders.
- Security audits: conduct third-party audits of smart contracts and code.
- Existing user base: design tokenomics for an established platform or community when possible.
- Full disclosures: provide transparent information about token sales, pricing, and promotions.
- Demand drivers: implement mechanisms to drive ongoing token demand (e.g., staking, governance).
- Supply control: use deflationary mechanisms like token burns if appropriate.
- Long-term incentives: align holder interests with project success through governance rights or revenue sharing.
- Regulatory compliance: ensure the token model complies with relevant regulations.
Game theory is a popular strategy in tokenomics design. It's all about understanding how and why people make decisions in your ecosystem. Mechanisms like token lockups can be powerful tools for incentivizing long-term holding.
The Curve protocol is a good example, offering increased rewards for longer token lock-up periods, encouraging sustained participation.
What are some examples of tokenomics?
The best way to learn tokenomics is studying the great ones. Here are three examples of beautifully-designed models:
- SUI tokenomics
Sui has a fixed supply of 10 billion SUI tokens. This cap creates a predictable scarcity, which is fundamental to the token's long-term value proposition. Demand for SUI tokens is driven by several factors, such as gas fees, staking, governance and utility within the Sui ecosystem. SUI distribution is designed to balance initial funding needs with long-term ecosystem growth.
- Arbitrum tokenomics
The ARB token, with an initial total supply of 10 billion, and a maximum annual inflation rate of 2%, ARB is designed to maintain a controlled and sustainable token economy. ARB is primarily used for governance within the Arbitrum ecosystem. The distribution of ARB is allocated across investors, DAOs, individual wallets, and the Arbitrum DAO Treasury, with a big portion (55.53%) managed by the community. This structure empowers ARB holders to influence the future of Arbitrum, including electing members to the Security Council, which oversees the network's treasury.
- Chainlink tokenomics
LINK has a total supply of 1 billion tokens. LINK's non-inflationary nature, coupled with increasing use cases such as staking, where holders can earn passive income, contributes to its potential for price appreciation as demand grows. The distribution of LINK is designed to support the network's security, development, and ecosystem growth.
While studying tokenomics to build a viable and attractive model for your project is a valuable use of your time, as this knowledge is crucial, consider working with token design experts who have battle-tested their skills to ensure you don't overlook any important aspects that could affect your project down the line.
How does tokenomics fit into my marketing strategy?
Tokenomics is essential in crypto marketing as it shapes a cryptocurrency's economic structure and influences investor behavior. It informs marketing strategies by emphasizing scarcity, utility, community engagement, and incentive programs.
A well-defined tokenomic model can attract investors by highlighting limited supply, practical applications, governance participation, and rewards for user engagement. Understanding these elements is crucial for crafting effective marketing campaigns that resonate with potential users and drive long-term success in the competitive crypto market.
