Tokenomics 101: Understanding the Economics of Cryptocurrency Tokens
Unraveling Tokenomics: The Foundation of Crypto Token Valuation photo
By: Natali

Unraveling Tokenomics: The Foundation of Crypto Token Valuation

Table of Contents

Cryptonomics, economics, psychology…You may wonder where are you: at the crypto blog or in some university online library? You are still in the Defiway blog, but now it’s time to talk with you about science.

The blockchain industry is constantly evolving and becoming more complex and regulated. So there was just a question of time before crypto economics started to become more and more similar to traditional economics with strict rules and institutional activity. And this time has come in 2020-2023!

As of now, tokenomics has become a crucial aspect of the blockchain industry. It’s the new social-economic science that mixes traditional economic principles with modern crypto innovations. So, I've decided to write a capacious Tokenomics 101, where I explain this new field of study/new industry in detail. Forget about long and paid courses: here you’ll get all you need to know about it FOR FREE!

What is Tokenomics?

If I were a teacher, I would tell you that tokenomics is the study of the economic factors influencing crypto value. But since I am a crypto expert, I want to tell you that it’s more than that. Tokenomics mixes knowledge from finance, crypto industries, and social studies.

It’s a new branch of economics that studies everything related to crypto: from token distribution and supply to the underlying social factors that drive economic and cybernetic changes.

The term "tokenomics" was first coined in 2014 by Vitalik Buterin, Ethereum co-founder. He was inspired by the Friedrich Hayek and Milton Friedman economists, who argued that markets are most efficient when they are driven by free and voluntary interactions.

Tokenomics is a new field, but it has already found its place under the sun. Many crypto investors use tokenomics rules to evaluate a crypto project. Here are 3 key elements of this new study:

  • Token supply and distribution. Investors should understand the total token supply and its distribution among stakeholders to find out the level of the token’s popularity and rarity. For instance, limited tokens are far more likely to become highly valuable than tokens with an unlimited supply. It’s a supply-demand law from traditional economics.
  • Token utility. Investors should consider potential use cases for the chosen token. If it has a clear and valuable utility, this token is more likely to get popular. It increases token demand, and due to the limited supply investors will see the increased price.
  • Token incentive mechanisms. Crypto projects tend to use incentives, encouraging users to use their new tokens. Some projects offer staking rewards to users who lock up their tokens for a while. It eases access to the coin, impacting the token’s price.

Tokenomics can help investors make more informed decisions. Once they understand the underlying processes of the project, they can precalculate the potential success and decide whether or not to invest in it.

On the other hand, you should understand tokenomics to build long-term predictions about chosen crypto projects.

The Role of Supply & Demand in Tokenomics

As I said before, supply and demand principles play a crucial role in tokenomics. Once you’ve decided to invest in some project, whether it’s the exchange, bridge, or decentralized game, look for a token supply value. It is the total number of their tokens in circulation. Demand represents the number of people with a strong desire to buy it.

Just like in any economic field, the token price is determined by the supply and demand interactions. When demand is higher than possible supply, we will see increased prices. When the network can supply more tokens that investors need, we will see decreased prices. So, it’s just high-school economics.

The overall token supply is predetermined by the project's tokenomics. Some projects have a fixed supply, while others have an unlimited one. Tokens with a fixed supply are generally more valuable.

New token listing is one of the most common reasons for an increased price demand. More people start to adopt it, leading to increased demand while the project has the same supply. Another way to drive up a token price is to artificially lower the support with token burning.

Utility: The Functionality of Tokens

The token is far more than just money in traditional economics. Tokens can act like stocks and bonds, replacing even valuable papers. Here are just some of the most common examples:

  • Payment tokens. Use them as money to pay for goods and services within a platform or ecosystem. Ether (ETH) is the native payment token of the Ethereum chain.
  • Access tokens. These tokens are different: usually, they provide access to specific features within a platform or ecosystem. They act more like credits in games. You can use that “money” only in this system.
  • Governance tokens. These tokens act more like valuable papers with the right of voice. The Aave (AAVE) token is used to vote on changes to the Aave lending protocol.
  • NFT tokens. They represent ownership in the web3 world. When a project sells you digital or physical goods, it provides you with its NFT as well. If you want to sell this product to another person, you sell it in a bundle with NFT.

As you see, utility tokens are more than just money. They can represent ownership or even carry governance rights, unlocking new opportunities for platforms and investors.

Token Distribution and Allocation

It is the process of allocating tokens to the stakeholders. It can be done in various ways, including but not limited to

  • Initial coin offerings (ICOs). It is the most common way to raise funds. Here the project team sells a part of tokens to investors.
  • Token sales. They are ICOs for the small and more focused on a specific group of investors. Many projects prefer to launch token sales for accredited investors at first and shortly after releasing a public sale.
  • Team allocations. Crypto projects often offer their teams a part of the total token supply.
  • Staking rewards. These are rewards for users who decided to lock their tokens for a long time (3+ weeks). It helps to secure the network, so developers provide incentives to users who have decided to help their project by staking.
  • Liquidity mining rewards. These rewards are given to users who provide liquidity to decentralized exchanges (DEXes). These users improve DEX’s liquidity, so the service provides incentives to them.

Airdrops are another interesting way to distribute tokens to the most active community members. Developers send airdrops to users who are interacting with a project. It can be staking, governing, or another direct action. Retroactive airdrops are the way to support early adopters: developers send tokens to the wallets of those users who have interacted with the project in the past.

Once you decide to evaluate the crypto tokenomics of some project, consider the token’s usage cases, lockup schedule, and ratio. Ask yourself whether the chosen token has a clear and valuable utility, whether our team's and investors' tokens are subject to a lockup schedule, and the overall fairness of distribution.

Incentives and Governance

Properly written project tokenomics is crucial for stimulating positively acted behaviors within a crypto ecosystem. That way the developer's team encourages users to participate in various network activities: from general usage to governance processes.

I previously mentioned airdrops, staking, and mining rewards. They are the most common ways of foresting activity in the given crypto ecosystem. People can get tokens for their activities, and they gladly do it.

But what do people like more than money? It’s governing someone or something! Crypto projects empower them, providing vote rights to certain token holders. That way users can have their voices and share their points of view with the project’s team.

A properly designed governance model can ensure that the project is fair, transparent, and aligned with the interests of all stakeholders. If the project's team and investors take a large share of the token supply, it can lead to a monopoly that negatively affects everyone involved.

Once you decide to evaluate the crypto tokenomics of some project, consider the token’s usage cases, lockup schedule, and ratio. Ask yourself whether the chosen token has a clear and valuable utility, whether our team's and investors' tokens are subject to a lockup schedule, and the overall fairness of distribution.

Valuation: Factors Influencing Token Price

A token’s price can drastically change within a few hours. It happens due to the simultaneous influence of multiple factors. So, before investing in some token, you should understand the factors influencing the price. There are two major groups of factors: internal and external.

The first group is inherent to the chosen token. It is a supply and demand factor, utility cases, and the team behind the project. If the CEO or CFO of some project goes to jail, it affects the token’s price. The strong and law-abiding team shows investors that a project is worthy of attention.

The second group of factors reacts to external events like market conditions, regulatory landscape, and media coverage. The overall market conditions have a significant impact on all projects within it.

When the market is bullish and everything grows, investors are more likely to continue investing, which drives up token prices. In a bearish market, people are more likely to sell their tokens, which lower prices through all markets. It creates a deflationary cryptocurrency situation.

The regulatory changes also have an impact on prices. If some government launches strict regulations on crypto, it impacts the crypto community since they are losing a part of the investors and developers.

Media coverage is the third external factor that affects the token price. Positive coverage can generate interest in a particular project, driving up the demand for the token. Negative hype damages the reputation of a project, driving down token prices.

Pitfalls and Challenges in Tokenomics

Tokenomics is a challenging field. Each person who decides to become a part of it should understand its potential challenges. It is hard but crucial to design a fair token distribution. If the project team or investors get the control packet share, it leads to centralization and a conflict of interest.

On another hand, it's vital to balance supply and demand to create a safe environment to grow. If the company provides too many tokens, it leads to a price decrease. If the supply is too low, the token price becomes too volatile dependent on external factors.

If you are a part of the project’s developer team, you should design the tokenomics that way so it will be sustainable in the long run. Ensure that your tokenomics align with the overall project goals.

Write a clear and concise token whitepaper that explains the tokenomics of your project in detail. Make a few whitepapers for different audiences: investors, active, and general users. That way stakeholders will be aware of what they should expect from the project.

Real-world Examples of Tokenomics in Action

Properly written tokenomics can help to align the interests of the multiple stakeholders in a project. Here I want to show you real-world tokenomics examples.

Uniswap DEX uses liquidity mining to stimulate users’ activity. Users who actively provide liquidity get rewarded with UNI tokens. Later, they can use those tokens to vote on project changes.

Coinbase's tokenomics is relatively simple. There is a fixed supply of 2.5 billion COIN tokens, and new tokens are not created. They use tokens to reward users for participating in the Coinbase ecosystem.

For example, users can earn COIN tokens by staking their assets on Coinbase, referring new users to the platform, and completing certain tasks, such as taking educational quizzes. It leads to constantly improving Coinbase QOQ (quarter-over-quarter) results, making it one of the most successful projects worldwide.

Speaking about cryptocurrencies, I want to talk about Ethereum and Bitcoin tokenomics. They are the two most popular tokens, so they will be a fine example of properly written projects. Bitcoin has a relatively simple tokenomics model with a fixed supply of 21 million BTC. New tokens are added through the mining process, where miners get rewarded with BTC tokens for verifying transactions and adding them to the main chain.

Ethereum has more complex tokenomics since it’s a smart contract platform for many dApps and layer-2 projects. It has a limited supply of 180 million ETH, where miners add new tokens to the chain through mining. However, part of ETH gas gets burned, removing permanently from the chain. It lowers the initial supply, making each token even more valuable over time.

These are the best crypto tokenomics examples that show how businesses can retain users by providing multiple stimuli simultaneously.

The Future of Tokenomics

Tokenomics implementation will change the modern crypto world, making it the same obligated aspect of creating a web3 project just like a SWOT analysis or WBS planning.

We will see the evolution of blockchain technology and new tokenomics approaches tailored to even more specific needs. It will lead to increased crypto adoption both for business and personal purposes. Crypto wallet usage will become just as common as PayPal or Venmo.

It will launch bullish market tendencies, changing the regulatory landscape. So, businesses should be prepared for new regulations that potentially impact their tokenomics. It will lead to even more complex tokenomics models as businesses will be obligated to adjust to fit new laws.

Wrapping Up

Tokenomics is a relatively new branch of economics that studies how different economic and social factors impact the crypto industry and token prices. Once you decide to join the crypto industry, you should understand the underlying tokenomics processes. It will help you to make more informed decisions.

Investors should understand the project tokenomics to predict its success potential. On the other hand, the project’s team needs to write its tokenomics to understand what to do to achieve long-term success.

As you see, it’s crucial to understand the underlying processes. It helps you distribute your efforts effectively, whether you are part of the tokenomics crypto project, an investor, or a user who wants to earn some money legally. Stay with Defiway to get informed about the latest crypto updates so you will always know when and how to invest your time properly!