Key elements of Tokenomics

Key elements of Tokenomics

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Introduction

As a catch-all term for a wide range of factors influencing a cryptocurrency’s value, “tokenomics” refers first and foremost to the structure of a cryptocurrency’s economy as designed by its creators. Here are some of the most important factors to consider when looking at a cryptocurrency’s tokenomics.

Key elements of Tokenomics

Token supply

Token utility

Incentive mechanisms

Analyzing token distribution

Examining token burns

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Analyzing token distribution

Aside from supply and demand, it’s essential to look at how tokens are distributed. Large institutions and individual investors behave differently. Knowing what types of entities hold a token will give you insight into how they are likely to trade their tokens, which will in turn impact the token’s value. There are generally two ways to launch and distribute tokens: a fair launch and a pre-mining launch. A fair launch is when there is no early access or private allocations before a token is minted and distributed to the public. BTC and Dogecoin are examples of this category. On the other hand, pre-mining allows a portion of the crypto to be minted and distributed to a select group before being offered to the public. Ethereum and BNB are two examples of this type of token distribution. Generally, you want to pay attention to how evenly a token is distributed. A few large organizations holding an outsized portion of a token are typically considered riskier. A token held largely by patient investors and founding teams means stakeholders' interests are better aligned for long-term success. You should also look at a token’s lock-up and release schedule to see if a large number of tokens will be placed into circulation, which puts downward pressure on the token’s value.

Token utility

Token utility refers to the use cases designed for a token. For example, BNB’s utility includes powering the BNB Chain, paying transaction fees and enjoying trading fee discounts on the BNB Chain, and serving as community utility token on the BNB Chain ecosystem. Users can also stake BNB with various products within the ecosystem to earn additional income. There are many other use cases for tokens. Governance tokens allow the holder to vote on changes to a token’s protocol. Stablecoins are designed to be used as a currency. Security tokens, on the other hand, represent financial assets. For instance, a company could issue tokenized shares during an Initial Coin Offering (ICO), granting the holder ownership rights and dividends. These factors can help you determine the potential use cases for a token, which is essential in understanding how the token’s economy will likely evolve.

Examining token burns

Many crypto projects regularly burn tokens, which means pulling tokens out of circulation permanently. For example, BNB adopts coin-burning to remove coins from circulation and reduce the total supply of its token. With 200 million BNB pre-mined, BNB’s total supply is 165,116,760 as of June 2022. BNB will burn more coins until 50% of the total supply is destroyed, which means BNB’s total supply will be reduced to 100 million BNB. Similarly, Ethereum started to burn ETH in 2021 to reduce its total supply. When the supply of a token is reduced, it’s considered deflationary. The opposite, when a token’s supply keeps expanding, is deemed inflationary.

Incentive mechanisms

A token’s incentive mechanism is crucial. How a token incentivizes participants to ensure long-term sustainability is at the center of tokenomics. How Bitcoin designs its block subsidy and transaction fees is a perfect illustration of an elegant model. The Proof of Stake mechanism is another validation method that is gaining prevalence. This design lets participants lock their tokens in order to validate transactions. Generally, the more tokens are locked up, the higher the chance to be chosen as validators and receive rewards for validating transactions. It also means that if validators try to harm the network, the value of their own assets will be placed at risk. These features incentivize participants to act honestly and keep the protocol robust. Many DeFi projects have used innovative incentive mechanisms to achieve rapid growth. Compound, a crypto lending and borrowing platform, lets investors deposit cryptos in the Compound protocol, collect interests on them, and receive COMP tokens as additional reward. Moreover, COMP tokens serve as a governance token for the Compound protocol. These design choices align the interests of all participants with that of Compound’s long-term prospects.

Token supply

Supply and demand are the primary factors impacting the price of any good or service. The same goes for crypto. There are several critical metrics measuring a token’s supply. The first is called maximum supply. It means that there is a maximum number of tokens coded to exist in the lifetime of this cryptocurrency. Bitcoin has a maximum supply of 21 million coins. Litecoin has a hard cap of 84 million coins, and BNB has a maximum supply of 200 million. Some tokens don’t have a maximum supply. The Ethereum network’s supply of ether increases every year. Stablecoins like USDT, USD Coin (USDC), and Binance USD (BUSD) have no maximum supply as these coins are issued based on the reserves backing the coins. They theoretically can keep growing without limits. Dogecoin and Polkadot are two more cryptos with uncapped supply. The second is circulating supply, which refers to the number of tokens in circulation. Tokens can be minted and burned, or be locked up in other ways. This has an effect on the price of the token as well. Looking at the token supply gives you a good picture of how many tokens there will be ultimately.