What Is Tokenomics? Understanding Crypto Valuation

At the very basic foundation of the cryptocurrency and blockchain industry are cryptocurrencies, otherwise known as tokens. These tokens serve varying functions within the network ecosystem, and it is no wonder that many decisions are made regarding their varying characteristics, such as supply, burning mechanisms, and more. The token of a project or network often represents how well a project is doing, and most times, the structure of the token gives an insight into whether or not the project is worth your investment.

What is Tokenomics?

Tokenomics, a merger of token and economics, is a concept used to describe a cryptocurrency’s characteristics that contribute to its value and investment potential. These characteristics range from the supply and utility of the token to its burning mechanism.

When a new project hits the market, investors start by performing research on the project. They determine whether the project’s token is built to withstand and succeed in the volatile cryptocurrency market. Making wrong decisions on a token’s economics, such as releasing too much of the token into circulation too quickly or not burning enough, can devalue the token and make it less attractive to investors.

Types of Tokens

There are a couple of ways to categorize crypto tokens. The first and most popular is categorizing crypto tokens by their functions. Under this category, the types of tokens include:

• PlatformTokens: These are tokens built to support a specific decentralized application on the blockchain. For example, SUSHI is the platform token for Sushiswap, a decentralized exchange built on Ethereum. Platform tokens
• Security Tokens: Security tokens are essentially normal securities but in blockchain form. Crypto projects issue security tokens to show that a person owns an interest in that company. Some examples include Polymath and Harbor.
• Utility Tokens: Like the name, utility tokens facilitate the execution of transactions on a blockchain protocol. The most common use case for this token is transaction fees. For example, ETH is the utility token for the Ethereum network.
• Governance tokens: These have one function; to give token holders the right to vote on decisions affecting a particular project. An example is MKR, the governance token for the Maker Protocol.

Tokenomics, the rules guiding the supply, utility, and value of a token, also categorizes tokens into two types:

Inflationary Tokens: Inflationary tokens are governed loosely by the rules of inflation. These tokens have predetermined inflation rates and supply constraints that work together to support the token’s value. With inflationary tokens, the circulating supply gradually increases over time, and the predetermined inflation rate specifies how many tokens enter circulation at a time. Inflationary tokens often have a maximum supply, but in some cases, the network members can vote to extend or remove it altogether.

Deflationary Token: Deflationary tokens do the opposite of inflationary tokens. While inflationary tokens have set rules to increase the circulating supply over time, deflationary tokens have a deflation rate that cuts down on its supply. To remove part of the tokens in supply, deflationary tokens apply token-burning mechanisms. The most common method involves sending tokens to a wallet address without a private key, making the tokens permanently inaccessible. BTC uses ‘halving,’ an event in which the mining rewards are cut in half every four years.

What Factors Are Considered in Token Economics?

The tokenomics of a crypto coin heavily depends on some elements explained below.

Token Supply

Like assets in traditional finance, crypto assets are ruled by the most important rule in economics, which is the rule of demand and supply. In the absence of supply, demand, and price goes up; in the lack of demand, supply goes up, and price falls. When it comes to cryptocurrency, there are three types of supply.

1. Maximum supply: This is the total amount of a cryptocurrency that can be mined. It is a very important element in calculating a coin’s market cap and fully diluted market cap. When a coin reaches its maximum supply, new coins will not be minted, and it can usher in market scarcity and lead to deflationary or inflationary conditions. An example is Bitcoin, which has a maximum supply of 21 million tokens. Bitcoin’s issuance procedure involves dividing the number of tokens created by mining every four years, known as the halving method.
2. Circulating supply: The circulating supply refers to the total number of tokens available on the market. All these tokens have already been minted and are in use or otherwise in some way. The circulating supply can drive up or down the price of a token depending on whether there is a disparity.
3. Unlimited supply: Sometimes, a token will not have any supply cap. The Dogecoin network, for example, is designed to issue the same amount of tokens for every new block created; this figure does not change. At the time of writing, Dogecoin’s circulating supply stands at 140.55 billion according to Coinmarketcap, and no specifications as to a maximum supply.

Token Demand

While token supply is important, supply alone does nothing for the value of a token. The rule of economics says that supply without demand makes an asset worthless. People need to understand what benefits they get from buying a token. Usually, a network generates this demand by incorporating certain things into the token’s utility. For example, buying the MKR token gives a user the right to contribute to governance decisions for the MakerDAO platform. As an investor, you also need to learn to examine a token to determine whether the token is valuable enough to invest in. For your evaluation, determine the token’s ROI (return on investment). ROI refers to the profit you gain by buying and holding the token. For example, Avalanche (AVAX) holders receive staking rewards, and users who hold Sushiswap (SUSHI) get a percentage of the protocol’s earnings.

Token Utility

Also known as use cases, token utility refers to the various methods a token can be used. A token’s utility can range from exchange to gas fees. For example, Gate.io’s utility token is GateToken (GT), which functions as the utility coin for Gate Chain. Since it’s a cryptocurrency that holds value, GT can be used as a medium of exchange, but its main purpose is to pay transaction fees on the GateChain network. Gate chain users looking to make more with their GT can stake the token for awards.

Another utility for a token is governance. In the decentralized finance space, it is common practice to allow holders of the governance token of a project to participate in making important decisions for the project. For example, the governance token for Maker DAO is MKR.

Incentive Mechanisms

Incentive mechanisms are methods a blockchain network uses to reward its users for activities performed. In some cases, incentive mechanisms come from the network’s consensus mechanism. For example, Bitcoin uses the proof of work consensus mechanism, which rewards miners for validating and adding blocks to the network. Similarly, the proof of stake mechanism on Ethereum rewards participants who lock up their ETH in return for the chance to validate transactions and gain rewards.

Apart from consensus mechanisms, up-and-coming DeFi projects use a staking mechanism that requires users to deposit their crypto into the protocol in exchange for interest on their token and, in some cases, utility tokens of that project. A good example of such a DeFi project is Compound Protocol.

Token Burning

As established earlier, crypto projects must implement mechanisms to control how many tokens are circulating. To curb excess supply, the project needs to incorporate a mechanism to remove some tokens in circulation and regulate the balance between the demand and supply of the token. This is known as token burning. The most common method of token burning is sending tokens to a wallet without a private key. Wallets without private keys can only receive coins, so sending coins to the wallet makes them inaccessible, thus taking them out of circulation. A token-burning mechanism is implemented to increase the token value and maintain mining efficiency. Examples of token-burning mechanisms include:

• Ethereum (ETH): The EIP-1159 upgrade introduced in 2021 restructured Ethereum’s burning mechanism so that tokens would be burned with each transaction. Currently, the ETH burn rate stands at an average of 1.35 ETH/min in 24 hours. Over time, the network has successfully burned over 3.5 million ETH since implementing the EIP-1159 upgrade.
• Gate token (GT): Gate previously used a quarterly buyback and burn mechanism, which involved manually buying a portion of the circulating supply and removing it from circulation. Since 2019, Gate has successfully burned up to 160 million tokens with this method. More recently, the network introduced an auto-burning mechanism resembling Ethereum’s. Now a portion of gate tokens will be burned in proportion to the on-chain activity.

Token Allocation and Vesting

During the prelaunch stage of a token, usually, before the team launches the whitepaper, they discuss the allocation and vesting of the token. Portions of the total supply of the token will be allotted to initiatives and or departments of the larger team working on the project. This allocation will also include the portion for investors who bought into the project during the early funding rounds. Token vesting is the procedure to distribute tokens within a timeframe. It’s already been established that releasing the total supply of a token all at once will completely obliterate the token’s value. For this reason, a project team will make decisions for the vesting plan. Vesting can be linear (the distribution of tokens is in equal parts within a set time frame. e.g., days, weeks, or months) or twisted (random distribution).

Image source: https://www.liquifi.finance/post/token-vesting-and-allocation-benchmarks

Alt text: Example of token allocation chart

Base Layer and Cross-chain accessibility

While the blockchain industry is often referred to in general terms, it’s important to remember that within the industry, there are thousands of projects in the form of exchanges, tokens, and blockchains. A crucial part of a token’s economics is its accessibility. This answers the question of where (that is, on what chain) the token can be used. So a token can be created on a base layer network but made accessible through bridging infrastructure. This is normally done using a token on the alternative network that is pegged to the value of the main token. It often comes in the form of a wrapped version of the token. In some cases, though, where the secondary and primary chains are of the same infrastructure, for example, EVM compatible, the tokens built with the ERC-20 standard will be transferable across such chains.

Why Are Tokenomics Important?

Tokenomics give investors an insight into a token’s programming, which dictates how the token will withstand external factors like a bear market to inflation. Investors tend to examine the tokenomics of a project first to know what kind of token they are investing in and second to predict or form a vague prediction of the success or otherwise of the token.

Tokenomics also add an element of credibility to a project. In an industry where anyone can build anything and deploy on the blockchain for marketability, it’s important to look out for those little factors that reveal that the project is well thought out and can be trusted.

How to Evaluate a Crypto Token

As we’ve established, it’s a good idea to research the tokenomics of a new token you want to invest in. While there is no clear-cut formula on what makes a profitable token, there are some red flags that, if noted, should steer you away from such a project.

1. Unlimited or huge supply: Tokens without an unlimited or huge maximum supply of tokens can signal trouble. The reason is simple– economics. When there is excess supply compared to demand, the price of the crypto asset drops. As an investor, it’s a good idea to watch for a token with a limited number of tokens that can be minted or, in the absence of that, a token-burning mechanism. For example, Ethereum has an infinite supply, but the network manages inflation with its token-burning mechanism.
2. Premature token distribution: When a project is about to launch, it goes through many stages, the larger part of which processes are to acquire funding. Apart from seed funding rounds, crypto projects often put out an initial coin offering (ICO), where they sell their token to raise money from investors. If a project launches its ICO too early with excessive tokens for sale, it can point to a lack of credibility.
3. Deceptive use cases: In some cases, a token without a clear use case is a pointer to fraudulent activity surrounding the project. The token must perform a core function within the major product attached to the token. So it’s a good idea to avoid a token if you can’t draw a connection between the token’s utility and the core product.
4. Vague release schedule: Just as a token with infinite supply and no burning mechanism spells bad news, tokens with private release schedules are shady and should be avoided. It may imply that the team will make erratic releases that affect investors adversely and possibly the token’s price.

Now that you know what to run from, some features increase a token’s credibility. They include:

1. Security audits: Every project and action built on the blockchain runs in code, whether Solidity, Move, or Rust. A customary procedure for blockchain projects is enlisting a third party to perform security audits on the project’s code and smart contracts. A successful audit assures investors that the project will not illegitimately take control of the users’ tokens or issue tokens separate from the token total.
2. Existing user base: Cryptocurrency is designed in such a way that makes it dependent on a user base. As such, the more a project’s customer base grows, the more the project and the token’s value grow. As such, a project with an existing user base has a better chance of staying around in the dynamic market. For example, the popular decentralized exchange, UNISWAP, spent three years pre-launch growing and maintaining a user base before its launch in 2018.

Conclusion

In simple terms, tokenomics helps us understand how cryptocurrencies get their value. It’s like looking at the puzzle pieces that make up their worth, such as how many are available, how much people want them, and what they can be used for. Learning about tokenomics is important if you’re interested in investing in or using cryptocurrencies, as it gives you a clearer picture of how they work and why they’re valuable.