What are Tokenomics? | An Investor’s Guide

Key Takeaways

• Tokenomics is a crucial factor in the success of blockchain projects by defining how tokens are created, distributed, and utilized.
• Tokenomics involves several key elements, including issuance schedules, supply, inflation, distribution, burning, incentives, utility, and technical aspects.
• Bitcoin is the first and most well-known cryptocurrency. It has a well-defined tokenomics model with utility and a fixed supply of 21 million coins.
• Assessing a project’s tokenomics is essential for investors and developers to understand the potential risks and rewards.

As of 2024, the global market capitalization of cryptocurrencies has reached over $2 trillion with over $85 billion locked in decentralized finance. In this expansive ecosystem, tokens serve as the lifeblood, powering transactions, enabling decentralized applications, DeFi, and transferring value across projects.

Tokenomics refers to the economic structure of a token. Nowadays, anyone can launch a crypto project, making tokenomics a critical aspect for anyone involved in the space. In this article, we’ll explore tokenomics, their features, and what makes them important, and look at some examples.

What Does Tokenomics Mean?

Tokenomics is the economic structure and model of a cryptocurrency, encompassing how tokens are created, distributed and removed. It can directly influence the value and utility of a token and the ecosystem behind it.

Well-crafted tokenomics can lead to sustainable growth, strong user adoption, and a thriving ecosystem. Poor tokenomics can result in inflation, centralization of power, and, ultimately, the collapse of a project.

Main Features of Tokenomics

Tokenomics is composed of several key elements that collectively determine the behavior and value of a token. Each of these features plays a role in shaping the overall economy of the token.

Issuance (Mining) or Vesting Schedule

The issuance or vesting schedule of a token refers to how new tokens are released into circulation. This process can vary significantly depending on the blockchain’s consensus mechanism and the specific design of the project. 

For example, in a Proof of Work (PoW) system like Bitcoin, tokens are issued through mining, where participants use computational power to solve complex puzzles and validate transactions. In a Proof of Stake (PoS) system, tokens are issued based on the amount of cryptocurrency that validators stake as collateral.

Some projects create all of their tokens at the beginning and issue them according to a vesting schedule. This schedule determines when and how tokens are released to stakeholders, including founders, developers, and early investors. Each blockchain or project has its own approach and you can typically read about it in the project’s whitepaper.

Maximum Supply, Circulating Supply, and Market Capitalization

Three of the most critical metrics in tokenomics are maximum supply, circulating supply, and market capitalization. The maximum supply is the total number of tokens that will ever be created for a particular cryptocurrency. The circulating supply refers to the number of tokens that are currently in circulation and available for trading. Market capitalization is calculated by multiplying the circulating supply by the current price of the token.

These metrics provide insights into the scarcity of a token, which can significantly influence its value. A token with a low maximum supply and high demand is likely to see its price increase, while a token with a high circulating supply and low demand may struggle to gain value.

Inflation

In the context of tokenomics, inflation refers to the increase in the supply of tokens over time. Some cryptocurrencies are designed to be inflationary, meaning that new tokens are continuously added to the supply. Others are deflationary, with mechanisms that reduce the supply over time, increasing the value of remaining tokens.

Projects with high inflation rates may face challenges in maintaining value, while deflationary tokens may become more valuable over time.

Token Distribution and Fair Launching

Token distribution refers to how tokens are allocated to the various stakeholders. A fair launch is when tokens are distributed in a way that ensures equal opportunity for all participants, often through mechanisms like airdrops or public sales.

The fairness of a token’s distribution can impact the perception of the project. Projects that allocate a significant portion of tokens to insiders or early investors may face criticism for centralization and lack of transparency.

Burning

Token burning is a mechanism used to permanently remove tokens from circulation, typically by sending them to a dead address that can only receive tokens but not send them out. This process reduces the total supply of tokens, which can increase scarcity and potentially drive up the token’s value. Burning is often used as a deflationary measure to counteract inflation.

DeFi Incentives

In the space of decentralized finance, incentives play a crucial role in attracting users to a platform. These incentives can include rewards for staking, providing liquidity, or participating in governance. The design of these incentives is a key aspect of tokenomics, as they directly impact user engagement and the growth of the platform.

For example, a project may offer high rewards for early participants, creating a strong initial user base. However, if the rewards are unsustainable, the project may struggle to maintain user interest in the long term.

Utility

The utility of a token refers to its practical use within a blockchain ecosystem. A token with strong utility has clear and meaningful use cases, such as serving as a medium of exchange, enabling access to services, or participating in governance. Higher token utility usually corresponds to higher token value.

Utility is a critical factor in the success of a token, as it determines the real-world value and applicability of the token. Projects with limited or unclear utility may struggle to gain traction and maintain value over time.

Technical Aspects

The technical aspects of tokenomics refer to the underlying technology and protocols that govern the behavior of the token. This includes the blockchain platform on which the token is built, the consensus mechanism, and any smart contracts or other technical features that influence the token’s behavior.

Technical aspects can impact the security, scalability, and functionality of a token. For example, a token built on a secure and scalable blockchain platform is likely to be more reliable and widely adopted.

Understanding the First Tokenomics Model: Bitcoin

Bitcoin is the first and most well-known cryptocurrency. Its tokenomics model has served as the foundation for many subsequent projects. Here’s a look at Bitcoin’s tokenomics.

Supply

Bitcoin has a predetermined maximum supply of 21 million coins. This limited supply is crucial, as it creates scarcity and guarantees that Bitcoin remains a deflationary asset. New bitcoins are introduced into circulation through mining, with the reward for mining new blocks halving approximately every four years. This process, known as halving, reduces the rate at which new bitcoins are created, further increasing scarcity over time.

Distribution

Bitcoin’s distribution is determined by the mining process, which rewards miners with new bitcoins for validating transactions and securing the network. This decentralized distribution model ensures that no single entity controls the supply of Bitcoin, making it a truly decentralized cryptocurrency.

Utility

Bitcoin’s primary utility is as a store of value and medium of exchange. It is often referred to as digital gold due to its deflationary nature and its use as a hedge against inflation. Additionally, Bitcoin is used for peer-to-peer transactions, enabling users to transfer value without the need for intermediaries.

Businesses and individuals are also using Bitcoin for payments, remittances, and as a long-term investment.

Why Is Tokenomics Important?

Tokenomics is a critical aspect of any cryptocurrency project, as it determines the economic viability and sustainability of the token. By understanding tokenomics, investors and project developers can make more informed decisions.

For Investors

For investors, tokenomics provides insights into the potential value of a token. By analyzing factors such as supply, distribution, utility, and inflation, investors can assess a project’s long-term viability. Sound tokenomics can lead to strong returns on investment, while poor tokenomics can result in significant losses.

For Projects

For projects, tokenomics is crucial for attracting users, maintaining engagement, and ensuring sustainability. A well-designed tokenomics model can help a project grow its user base, incentivize participation, and create a thriving ecosystem. Poor tokenomics can lead to inflation, centralization, and failure.

Assessing Risk – Good and Bad Tokenomics Examples

Not all tokenomics models are created equal. Some projects have successfully implemented sound tokenomics that have led to sustainable growth and strong user adoption. Let’s have a look at some of the green and red flags.

Green Flags

Security Audits

A comprehensive security audit from a reputable firm is a solid green flag. It proves that the project’s smart contracts and code are secure, reducing the risk of vulnerabilities that could be exploited by malicious actors.

Existing User Base

A project with an active and growing user base is a positive sign. It indicates that the community values the project. Having a strong user base also suggests that the project is delivering on its promises and that users are engaged with the platform.

Token Disclosures

Transparent token disclosures are essential for building trust with the community. Projects that provide clear information about token allocation, vesting schedules, and the total supply of tokens demonstrate a commitment to transparency and fairness. 

Clear Distribution Roadmap

A well-defined distribution roadmap outlines how and when tokens will be released into circulation. This helps investors understand the project’s long-term vision and how the token supply will be managed over time. A clear roadmap reduces uncertainty and helps prevent sudden drops in token value due to large token releases.

Red Flags 

Skewed Token Allocation

Projects where a significant portion of the token supply is allocated to insiders, such as founders, developers, and early investors, can be a red flag. This skewed allocation can lead to centralization of power and may result in large sell-offs, negatively impacting the token’s price.

Bogus Use Cases or No Utility

A token with little to no real utility is unlikely to gain long-term traction. Projects that struggle to define the token’s purpose within the ecosystem may be trying to capitalize on hype rather than delivering real value.

Opaque Release Schedule

A lack of transparency regarding the token release schedule can be a red flag. Without clear information on when and how new tokens will be issued, investors are left in the dark, increasing the risk of unexpected market impacts.

Unverified Token Contract

An unverified or poorly audited token contract is a significant red flag. This indicates that the project’s code has not been thoroughly reviewed, increasing the risk of bugs or vulnerabilities that could be exploited. Projects with unverified contracts may also be more prone to rug pulls or other types of fraud.

Sound Tokenomics: Example Projects

Some of the biggest blockchain projects in the world became successful due to their tokenomics models. Ethereum’s smart contracts platform, Binance’s chain and native coin, and Uniswap’s decentralized exchange token wouldn’t be where they are today without proper tokenomics. The models utilized by these projects have withstood the test of time.

Ethereum (ETH)

Distribution

Ethereum‘s initial distribution involved a public crowd sale, distributing a large amount of tokens to a diverse group of participants. This fair distribution helped establish a strong and engaged community early on.

Utility

Ethereum’s utility is multifaceted, serving as the foundation for decentralized applications, smart contracts, and decentralized finance platforms. The introduction of Ethereum 2.0 and the transition to Proof of Stake (PoS) have further enhanced its utility by improving scalability and energy efficiency.

Supply

Ethereum’s supply model has evolved with the introduction of Ethereum Improvement Proposal (EIP) 1559, which introduced a burning mechanism for transaction fees. This deflationary measure helps control the supply of ETH.

Binance coin (BNB)

Distribution

Binance Coin (BNB) was initially distributed through an Initial Coin Offering (ICO), with a portion allocated to the Binance team and early investors. Over time, Binance has conducted token burns to reduce the total supply, increasing scarcity and potentially boosting the token’s value.

Utility

BNB has a wide range of use cases within the Binance ecosystem, including trading fee discounts, participation on Binance Launchpad, and paying fees on Binance Smart Chain (BSC). The token’s utility has grown as Binance has expanded its ecosystem.

Supply

Binance has committed to burning a portion of BNB tokens every quarter until 50% of the total supply is permanently removed from circulation. This deflationary model helps support the token’s value over time.

Uniswap (UNI)

Distribution

Uniswap’s UNI token was distributed through a community airdrop, giving early users and liquidity providers a share of the tokens. This fostered a strong and loyal community.

Utility

UNI serves as the governance token for the Uniswap protocol, allowing holders to participate in decision-making processes, such as proposing and voting on protocol upgrades.

Supply

Uniswap has a fixed supply of 1 billion UNI tokens, with a portion allocated to the team, investors, and future initiatives. The supply model provides clarity for investors and helps maintain value over time.

Unsound Tokenomics: Example Projects

Poor tokenomics can lead to the downfall of a project, resulting in significant losses for investors and a loss of trust in the project. Here are two examples:

Terra Luna (LUNC)

Terra Luna was a highly ambitious project that aimed to create a stablecoin ecosystem powered by the LUNA token. However, the project experienced a catastrophic collapse, caused by a depeg of the ecosystem’s stablecoin UST. The result was roughly $300 billion in losses for the entire crypto market.

Distribution

Terra Luna’s distribution model involved the continuous issuance of LUNA tokens to maintain the peg of its stablecoin, UST. This inflationary approach led to an oversupply of LUNA tokens, contributing to the project’s downfall.

Utility

The utility of LUNA was tied to the stability of UST, with LUNA tokens being burned or minted to maintain the stablecoin’s peg. However, this mechanism proved unsustainable during prolonged periods of uncertainty in the market.

Supply

The rapid increase in LUNA’s supply during the project’s collapse resulted in extreme dilution, causing the token’s value to plummet.

Celsius (CEL)

Celsius was a centralized lending platform that offered high yields on cryptocurrency deposits. The native token, CEL, played a central role in its ecosystem, but poor tokenomics and mismanagement led to its eventual downfall.

Distribution

A significant portion of CEL tokens was allocated to insiders. This centralization raised concerns about the potential for manipulation and large sell-offs.

Utility

CEL’s utility was primarily tied to earning higher interest rates on deposits and receiving discounts on loan interest.

Supply

The lack of transparency around CEL’s supply and distribution further eroded trust in the project. As the platform faced liquidity issues, the value of CEL plummeted, leading to significant losses.

How To Research Tokenomics

To make informed investment decisions, it’s essential to thoroughly research a project’s tokenomics. Here are some key resources and tools that can help you.

Study the Project Smart Contract (Etherscan)

Etherscan is a blockchain explorer that allows you to view the details of a project’s smart contract. Through it, you can verify the total supply of tokens as well as get information on token holders, enabling you to assess the concentration of ownership and identify potential whales.

Study Price Tracking Platforms

Price tracking platforms like CoinMarketCap and CoinGecko provide valuable data on a project’s market capitalization, circulating supply, and price history. These platforms also offer insights into trading volume, market sentiment, and liquidity, helping you assess the token’s market performance.

Project White Paper

The project white paper is a comprehensive document that outlines the project’s vision, goals, and technical details. It typically includes information on the token’s utility, distribution, issuance schedule, and governance model. By reviewing the white paper, you can gain a deeper understanding of the project’s tokenomics and evaluate its long-term viability.

Closing Thoughts – You Have the Power

Whether you’re an investor seeking to maximize returns or a developer building the next big project, a solid grasp of tokenomics can provide you with a competitive edge. By researching tokenomics and staying informed about industry trends, you can navigate the crypto space and make decisions that align with your goals.

FAQs

What is a Token?

A token is a digital asset created on a blockchain that can represent a variety of assets, such as currency, property, or access rights. Tokens are often used in decentralized applications and can be traded on cryptocurrency exchanges.

What’s a Crypto Whale?

A crypto whale is an individual or entity that holds a large amount of a particular cryptocurrency, typically enough to influence the market. Because of their substantial holdings, the buying or selling actions of whales can cause significant price movements in the cryptocurrency market.

What Is Token Supply?

Token supply refers to the total number of tokens that exist for a particular cryptocurrency. It can be broken down into three categories: maximum supply (the total number of tokens that will ever be created), circulating supply (the number of tokens currently available in the market), and total supply (the total number of tokens that currently exist, including those not yet in circulation).

Where Can I Find a DeFi Project Roadmap?

You can find a DeFi project’s roadmap typically on its official website, within its white paper, or on its community forums or GitHub repository. The roadmap outlines the project’s planned milestones, developments, and future updates, providing insights into its long-term vision and goals.