Tokenomics

Tokenomics is a portmanteau of "token" and "economics" and is the term used for the process of evaluating a cryptocurrency or blockchain for its value for investors. This study of the economics of the cryptocurrency includes the token's supply, what utilities it is attached to, and the utility of the underlying program or blockchain. This also includes the study of the incentives of buying or holding a token or if the token is built to be traded only. The study of tokenomics is largely based on theories and mathematics previously developed in the realm of economics, such as those found in Seth Klarman's investment book Margin of Safety and other studies that attempt to break down the mechanics involved in economics and tokens and how they impact the viability for investment into a given token.

Many individuals will invest in cryptocurrencies with success without ever encountering or engaging in tokenomics, which could call into question the importance of the practice of tokenomics. However, tokenomics offers individuals and investors a study of the factors that will impact a token, an understanding of how the digital currency will be used, if there is a link between usage of the platform or service being built, and how these factors may or may not impact the value, positively or negatively, of a token over time. The following are some questions tokenomics looks to answer or understand:

• How many coins or tokens currently exist?
• How many will exist in the future, and when will they be created?
• Who owns the coins, and are there some set aside to be released in the future to developers?
• Is there any information to suggest a large number of coins has been lost, burned, deleted, or somehow unusable?

One potential negative of tokenomics is the assumptions often made about the market and when outcomes deviate from the tokenomic study. The tokenomic study can be incorrect due to insufficient information about a coin's network, the token's target market, the market for the token, the liquidity of the token, and the potential profitability of the token. Many of these rely on the market, and technical analysis or tokenomics cannot always provide a clear answer.

Tokenomics requires understanding what a token is and what kinds of tokens there are. At the most basic, tokens are a digital unit designed to be used as a specific asset or represent a particular use on the blockchain. Tokens have use cases, such as security, utility, or governance. Often tokens built on blockchains have pre-set, algorithmically created issuance schedules that can be predicted by buyers when new tokens will be minted. This predictability can give investors a sense of security as they know to what degree their asset will be impacted and when, compared to the unpredictability of governments creating money.

The structure of tokens can be classified primarily into Layer 1 and Layer 2 tokens or classified based on their usage category. They can also be categorized as either fungible or non-fungible. Perhaps the first part of a tokenomic analysis is understanding the type of token an individual is intending to invest in.

Layer 1 tokens are native for a specific blockchain while also powering all services on the blockchain. One notable example of a Layer 1 token is Ether (ETH) on the Ethereum network. These tokens can validate and finalize transactions without need for another network.

The Layer 2 tokens are used in the case of decentralized applications in a particular network. For example, a decentralized project built on the Ethereum network would use a Layer 2 token in the project's uses. In this sense, the Layer 2 token refers to a token used for a network built on top of another network.

Security tokens are referred to as investment contracts and have to fulfill many conditions for the same. Security tokens require a money investment, common enterprise, and profitability with computation efforts from different contributors. These are often used for various verifications, such as contract or identity verification. These tokens have limitations as there is often little supply and liquidity and the tokens are not easily exchanged.

Utility tokens are used for financing a network and are often issued through an initial coin offering (ICO). The ICO is important for funding project development. These tokens are also used to allow specific actions on a network. And the actions a token enables depend on the ecosystem. For example, the Brave's Basic Attention Token (BAT) can only be used to tip content creators through the browser and has no use beyond speculating its value.

Commodity tokens are used to represent a real-world commodity. Also known as the tokenization of commodities, these tokens are generally tied to the price of a given commodity, such as platinum, gold, oil, or wheat, and could also be used to trade the actual commodity. These tokens can also be used to trade, where possible, for other goods or as collateral for loans as they represent specific assets.

As their name implies, asset tokens are backed by a physical asset. Put another way, they are a digital representation of a claim on a physical asset. Unlike commodity tokens, which can be considered a type of asset token, or vice versa, asset tokens generally focus on larger assets or parts of larger assets. And the asset token's value will be directly affected by the worth of the underlying asset. These tokens can be classified as a security by financial regulators.

Similar to an asset or commodity token, which peg their value to a real-world asset, a stablecoin is a cryptocurrency that pegs or ties its value to that of another currency, often a fiat currency. Technically, asset and commodity tokens can be considered stablecoins. Stablecoins aim to provide an alternative to the volatility of the most popular cryptocurrencies that have made investments less suitable for use in everyday transactions.

Often stablecoins are fiat-collateralized, maintaining their value on a fiat currency, such as the U.S. dollar, by maintaining a reserve of that currency. Another type can be collateralized on cryptocurrencies, using a reserve of cryptocurrency, which, due to the volatility of cryptocurrencies, has to have more extreme reserves to ensure the value and stability of the stablecoin.

Another type of stablecoin is the algorithmic stablecoin. These may or may not hold reserves, with a strategy of keeping the stablecoin's value stable by controlling its supply through an algorithm. This is not so different from currencies issued by central banks, with an algorithm defining a stablecoin's monetary policy.

Fungible tokens are generally known for having the same value along with the facility for replication. These tokens will have the same value; for example, one ETH on Ethereum could be replaced with another, as they have the same value. Put another way, these are divisible and non-unique, similar to fiat currencies.

Non-fungible tokens (NFTs), on the other hand, are unique and non-divisible. They cannot be replicated, and they do not share the same value. NFTs have gained attention and have driven interest in tokenomics, especially with high-profile NFT auctions. NFTs can be used for the tokenization of assets such as pictures, collectibles, real estate, and artworks, offering a chance for digital ownership while, for some, showcasing the potential of tokens.

Understanding the characteristics of a cryptocurrency or related token requires an analysis of the various attributes of the cryptocurrency. This analysis, tokenomics, includes an analysis of the distribution of the token, the supply (and demand) of the token, the mint and burn schedule of the token, and the utility of the token. The analysis undertaken will differ depending on the kind of token. For example, the analysis will differ for a cryptocurrency versus a non-fungible token versus a governance token. Tokenomics is especially important for blockchain projects that work to create micro-economies, as they need to become self-sustaining and therefore understand how the tokens will work in that ecosystem. Tokenomics can help both investors and blockchain developers to either invest in or design a successful and attractive token.

Further, tokenomics is important to understand whether a project is a fraud, such as a rug pull scheme, and to help investors understand whether a token will continue to increase in value over the long term. Meanwhile, for the token designers, it offers a chance to incentivize early adopters of the coin through the use of strong tokenomics, which can, in turn, increase the token's growth.

Many analyses begin with understanding the allocation and distribution of the token. This can mean understanding whether the token is a pre-mined token, in which investors, developers, and select individuals are granted tokens before the public offering; or if it is a fair launch token. There is nothing inherently bad about a pre-mined token, and it is a common practice But a pre-mined token with a bunch of "whales," individuals with large amounts of the token, can indicate a potential pump-and-dump scheme. While in a fair launch, there are no early access tokens and no private allocations prior to the token being made publicly available. When looking at the allocation and distribution, a wide pool of numerous participants tends to be a good indicator the project has sound footing.

The mint and burn schedule relates to adding and removing tokens from circulation. This schedule will influence whether a token is an inflationary or deflationary token—as discussed below—which will impact the overall price and value of the token in the short and long term. Further, the schedule for minting and burning a token, if well established, can give potential token investors greater insight into any fluctuations that may occur in the price during the life of the token.

Depending on the token an investor intends to purchase, understanding either the founding principles (if the token is attached to a DeFi project) or the token model is important, especially as documentation can espouse the founding principles, goals, and governance. This can reveal structures underneath the token, such as a governance structure, and can allow an individual to understand how decentralized or centralized a structure is and even give them insight into the potential success of a token. Further and related documentation can reveal important information about a token's founders, team, advisors, and related data points.

The token model is important because most of the decisions about how the token is intended to be used, whether it will have a mint or burn schedule, whether it is inflationary or deflationary, and other factors that impact the longevity and growth in value of a coin will be developed by the original developers of the token, will have decisions made at the protocol level, and will often be included in the code of the token. Much of this information will be included in a token's whitepaper, which can be a great resource for understanding the way a token is intended to work. However, not all tokens will behave as their whitepaper suggests, and the rest of the tokenomic analysis retains its importance.

Governance is another factor, often related to the founding principles, in tokenomics. Lots of tokens function as governance tokens, giving holders a voting right to influence future roles and decisions. Understanding who holds the tokens and how to invest in them can change the viability of a token. Often the governance token should be thought of as something closer to a stock or security in a public company, except in the case of a decentralized finance platform, there is not necessarily a CEO. Because of this, the tokenomics are more crucial to the success of a project, as the governance in the tokenomics will allow the user community to make decisions on the direction of the project, which can lead to success or failure.

The utility of a token, or the use case or problem it is designed to solve, can be the most important part of a token's evaluation. If the project does not have any reason to exist, other than to be traded or be a part of a meme, then the longevity and value of the token can be brought into question. It is often a clear sign to steer clear of the token. Whereas, if the token has a clear aim and problem it is attempting to solve, or solution it offers, the token is more likely to increase in value over time.

The market capitalization of a token shows the amount of funds that have been invested in a project or token so far and can include the fully diluted market capitalization of a project or token. This fully diluted market capitalization can be considered the theoretical market capitalization of a token if the maximum token supply is already in circulation. This gives an individual an idea of how a token should be valued, with the higher a token's market cap and lower its circulating supply, the more likely the token will increase in value over time.

A criterion of tokenomics is the supply of coins. This can include the circulating supply and the total supply. For example, Bitcoin has capped the supply of the token at 21 million coins, with the last coin expected to be minted around the year 2140. Other coins may have a much higher total supply of coins. In the case of a non-fungible token, projects will restrict the tokens to be minted. In terms of supply, there are circulating supply, total supply, and max supply. Circulating supply is the number of tokens in circulation at a given time; the total token supply is the number of tokens existing at a given point in time, which could exclude burned tokens; and the maximum supply is the greatest number of tokens that can be generated.

Token supply follows the traditional economic understanding of supply of a currency, with the theory applied to tokens to understand how desirable a given token is. This includes determining whether the value of the token will increase in real terms or be inflated away. This includes the amount of tokens intended to be minted, which will decrease the overall value, also known as inflation. There are also tokens that will decrease their supply over time, either through burning or destroying, to maintain the value of the token, which is also known as deflation.

As the name suggests, tokens can include lock-up periods, or stages when a token cannot be traded. Pre-sold tokens can be locked up for a year or more, with conditions such as longer-term periods if the token is sold in one region over another; for example, a token sold in the United States or to a citizen of the United States may be subject to different lock-up terms compared to a token sold offshore. This can be based on local or international restrictions and regulations, in some cases.

Often a lengthy lock-up is viewed as a positive for a token value because it implies there will not be a pump-and-dump scheme, and there will be a base of token holders underneath the fluctuations in purchasing during an initial period, which is intended to provide a floor for the price of the token. Although, these lock-up periods can be important to know, as the end of a lock-up period can see a period of intense selling, despite the value of the token (as some attempt to make money on the holding of their token, or seek to limit their losses), which can drive the price down.

The supply side, although important, does not in itself create value. The value of a token indicates the demand; as demand for something increases, the value increases. A fixed supply, however, does not automatically translate into value; for example, if a person has a fixed supply of something no one wants, there remains no demand and therefore no value for said object. People need to believe the token will have value, and that value will carry into the future. To determine whether a token has demand, there are a few things that are analyzed in tokenomics, including return on investment, memes, and game theory.

Return on investment (ROI) refers to the cash flow a token is expected to generate for someone to hold it. This can include whether a holder of the token can stake their token to secure a given network and earn in the process, which can increase the token's perceived value (if the network has no inherent value, then staking a token in the network will not necessarily increase the network's value, the token's value, or offer further earnings). However, if a token has no inherent ROI, then people have no incentive to hold it. Although there may be other reasons a token is considered to have value.

Also considered community enthusiasm, tokenomics investigates the community around a token and the belief of people who have staked their funds or emotions into the token. The energy levels on various platforms where a community may congregate, such as Discord or Twitter, can help an investor determine the activity level of a community. This can include understanding if token holders make the token a part of their identity. Often community energy can be a driver of future demand for the token, especially as people's belief in a token can drive the token, such as the Dogecoin example.

Game theory is a fundamental mechanism in any economic analysis. It is the systematic study of how and why people make decisions, using mathematical models of conflict and cooperation in order to understand the behavior of decision-makers. For tokenomics, it can be applied to better understand the process of decision-making by stakeholders. This can include the incentivization structure of the coin, such as lock-ups that have proven to be a good game theory in tokenomics. This has the protocol incentivize token holders to lock tokens in a contract and receive rewards for doing so and can further incentivize longer-term lock-ups, as unlocking tokens can be seen as a negative in some contexts. While longer-term lock-ups can increase the demand of the token by limiting supply and rewarding token holders.

As the name implies, price stability is a longer-term evaluation of the fluctuations in the price of a token. With cryptocurrencies, or tokens, which are notorious for their price volatility, price stability can be especially important, as speculators may look to a token to buy and sell en masse, to drive the price of a token up, and sell the token on the up curve (also known as a pump-and-dump scheme). The token or project can combat this through token distribution and allocation, among other schemes, which can create a stable price for the coin and encourage people to use the token as intended, which should further stabilize the price of the token and increase that token's value over time. A stable price of a token over time can indicate such structures, although sometimes a stable price over a longer term can also indicate a lack of interest in a token.

The demand of a token, and therefore its value, will be impacted by the cost of making a transaction on the associated network, how that cost is calculated, who earns it, and how fast a transaction is processed on the network. The fees and validator (or miner) revenue are two sides of the same coin and can be considered one key indicator of the overall health of a blockchain.

For example, low fees can incentivize usage, with a growing user base capable of attracting more validators or miners to the network who want to earn fees on those transactations, creating a network effect and generating value for all participants. The fees are important as they pay for computational power, not just the processing of transactions. However, fees can price out all but the wealthiest users, as happened with Ethereum and its GAS fees. How a network or token deals with these impacts can further provide insight into the long-term success for the network. Such as Ethereum burning a portion of fees, turning into a deflationary model. In this way, consensus models and fee structures are important in terms of incentivizing participation in the blockchain ecosystem and for the supply of the token.

Other important influences, such as the way a token is launched, include the following:

An initial exchange offering (IEO) puts the power in the hands of a larger exchange, who will pick and choose coins they anticipate demand for. But as cryptocurrencies are often about removing the middleman and regulatory frameworks, IEO has seen a development towards a different type of exchange offering and initial decentralized exchange offering (IDO).

An initial decentralized exchange offering (IDO) is a programmatic way of listing a new token on a decentralized exchange, as implied in the name, and using Ethereum smart contracts and mathematics to shape incentives for buying and selling.

Bonding curves work to create a fixed price discovery mechanism based on supply and demand of a new token. This is done relative to the price of Ethereum. These bonding curves are complex but are intended to incentivize the timing of investment. This is a mathematically complex way to incentivize investment, but there are other, often cruder ways of providing interest in tokens to encourage early investment.

Another way to incentivize holders in terms of them using the token as intended, Airdrops allow token projects to randomly reward users who are active in the network and using the token. These financial rewards are often financed from a token's initial treasury but are often not built into roadmaps and are not telegraphed to a community, as it would be self-defeating. It could cause users to engage in a platform for the hope of an airdrop, rather than to use it for its intended purpose. However, airdrops are still relevant to tokenomics, as they will impact the distribution of a token and its engagement.

Good tokenomics do not guarantee a project will succeed. Nor does a blatantly vague token model doom a coin to failure. Further, a project with good, or inherently good, tokenomics, such as transparent supply schedules, good governance, or healthy incentives, does not guarantee success. While at the same time, a network with fuzzy or non-existent logic does not guarantee a coin will fail. Tokens like Dogecoin and Shiba Inu have been examples of this, where the underlying tokenomics did not suggest the growth the tokens would later experience. However, tokenomics does provide a user with a rational framework to understand the intent behind a coin and should be part of an investment decision.

As in any area where, regardless of the level of analysis done, there is a chance an investment can lose, there are claims that the investment may be part of a ponzi scheme. Tokenomics often has some complaining that it is nothing but a new kind of glorified ponzi scheme. In some cases, the use of tokenomics can uncover some "ponzi scheme" tokens, or at least tokens that have very little behind them. For example, many tokens have no use besides incentivizing users to buy and stake the coin to generate early liquidity, which does not reward positive behavior, but rather offers a race to the bottom, with users chasing returns and then dumping coins before the price crashes. This has largely been nicknamed ponzinomics.

Incentives are part of the tokenomics and most token models, as these are part of the tools used to get users active on a given network and to give the tokens a chance to survive in the cluttered cryptocurrency and blockchain ecosystem. Incentives generate value, which can be defined as the quality of a token or network that helps an individual to get more out of their life. However, those incentives can not work; for example, the "stake for rewards" or staking for yield farming does not create value, but is a common scheme to bring new users to a token.

The reward model can work, in some cases, when the supporters of a community contribute something more, such as what happened with early users of Facebook and YouTube, whose presence and activity created the attraction for other users and helped the platforms scale. So in the case of a project or token that could benefit from these kinds of early network effects, the use of stake for yielding farming could bring those users to the platform and create the network effects that could increase users on the platform until the platform can stand on its own. This is a common strategy used in various marketing strategies, such as for ordinary retail.

Digital assets, such as tokens and NFTs, are used in blockchain games or GameFi to create internal economies within games. These in-game economies are often tied to a play-to-earn (P2E) business model increasing in popularity. In this model, users are encouraged to play a game to earn money through the in-game economy, such as the popular game Axie Infinity, in which players create NFTs that are sold in-game, and for which sale they receive AXIE tokens, the base asset, which can then be unloaded through a crypto off-ramp. In the case of Axie Infinity, this basis created a large selling pressure, especially as players used the game as a replacement for their job, and the constant selling pressure (with the cryptocurrency market downturn) saw prices and valuations decrease and a crash for Axie Infinity.

P2E games have been suggested to be unsustainable, especially as they can create value and attract capital in-flows as investors, traders, and speculators increase the token value. However, this happens without sustainability giving out money to users, and without the undergirding of more money coming in from those users. Essentially, this follows a policy that if it is easily earned, it is easily sold. A potential solution or model for sustainability in P2E games that GameFi could follow is that of poker, where at a table of nine players, the top two to three players earn money while the remainder loses, paying their money to those top players. In GameFi, this could look like the top 10 percent of players making money and the top 1 percent making a living from the game.

This model would, likely, lose out to free-to-play models over time, as the upfront cost for new players would put GameFi at a disadvantage. However, one option could use sales proceeds to buy and mint an initial balance of tokens for new users. Or for a particularly popular game, an initial sales cost for the game could be charged, a portion of which could be included as an initial player balance. This would, potentially, create token buying pressure for each new player, and a certain percentage of bad players would continue to purchase tokens when their balance hits zero or as they want to advance through the game, while the best players will see balances increase. Although, making the game competitive, such that the majority of players can at different points earn more tokens, or "win" as the game defines it, would be necessary to continue to create interest in the game to create those returning bad players.

Most dual-token GameFi projects use a model of "input game token and output game token," which uses a governance token, for example, to start a game and yields utility tokens as returns. The cost and returns of any of these tokens in-game are highly correlated to the model's token price. Often these games will also use early NFT sales on an official platform or partner platform, such as Binance or Opensea, to accumulate initial players. While in-game mechanisms are used to encourage players to mint more NFTs, which can further fuel consumption, which has been, so far, the more sustainable GameFi economies. These include the following:

The breeding model uses second-generation NFTs and subsequent NFTs coming from the breeding of original, or Genesis, NFTs with no more blind boxes sold. This requires the burning or spending of tokens to mint the new NFTs, which allows the game to influence the selling pressure on the tokens depending on the price of minting.

Simpler than the breeding model is the blind box model, in which a team sets a number of NFTs in the game, and when the market is good, or consumption increases, players are expected to sell more, which should increase the price of tokens because they are required to buy the NFTs.

With decentralized autonomous organizations (DAOs) working to provide value for communities without the centralized power structures that can divert a product from the user base, or from its original use cases, tokens are required for the organization to function. Similar to GameFi projects, DAOs tend to launch with a token. This token is used similar to securities or shares in a corporation, in that they offer a chance for the organization to raise money by issuing the tokens, and they allow investors to buy and sell those tokens (as they would shares) with prices determined by supply and demand factors, as well as the perceived value of the offerings of the DAO.

Except, where shares present a potential for concern on behalf of the controlling factor of a company, where the sales of shares represent a loss of control, in DAOs and Web3, the tokens give equal access to real investors and allow for a transfer of ownership, while the organizations work to be decentralized. Depending on the product of the DAO or the platform, there may be two types of tokens: utility tokens and security or governance tokens:

The utility token, in this case, acts similar to chips in a casino. They are used as currency on the platform, enable holders to play games and tip dealers, and can be converted back to fiat currency at the end of a session. However, these tokens do not offer the holder any stake in the organization, nor do they entitle the holder of the token to any of the profits of the organization, let alone voting on the direction of the organization.

The security or governance token are closer to owning a share or security in a company itself. This allows the token holder to earn a profit when the DAO earns a profit, offered through profit payouts or distributions, and gives the holder of the token essentially an ownership position in the DAO and its associated platform or ecosystem. This also offers the token holder a chance to vote or otherwise impact the direction of the DAO and decision-making in the DAO.

In a DAO, a token has been seen to be more than a token in perhaps other environments. For example, token holders in a DAO are more likely to participate in the platform, driven by their own self-interest in their investment being successful. And token holders will change the contribution quality towards a DAO. The tokenomics of a DAO include the following:

• Raise money: this includes minting tokens and distributing those tokens to investors to raise money
• Raise time: DAOs use this to pay contributors for the time they spend working for the DAO, which can also be used to encourage members to create value for the DAO
• Represent ownership: in a DAO, owners or token holders offer a chance to market for a DAO, which may otherwise have no marketing department, as members will be motivated by self-interest to tell others about the DAO, the community, and its mission
• Market valuation: a token can be added to and traded on exchanges at almost no cost, where supply and demand will set the token price. However, this can be a disadvantage for a token, as live price action may make holders constantly evaluate their position, putting the larger project at risk
• Coordination: tokens can help coordinate members of a DAO toward a single goal
• Governance: while voting by token is not a must, it is often an easy way and commonly used way of engaging the community on the direction of the DAO
• Community status: a token and holding a certain number of DAO tokens can create a sense of belonging and further incentivize token holders to support a given DAO

For token holders, even governance or security tokens are, as noted above, subject to the price action of the valuation, or supply and demand, of the DAO. This can create or lose value of the DAO or project, and so when looking at DAOs to invest in, there are certain areas of the DAO or its related platform to investigate as they tend to be the drivers of the token's value. These include the following:

• Value of the DAO: the tokenomics of the DAO have value, such as being valuable for the people who are engaging with the community; or is it something offered elsewhere, either better or easier to use
• Expected value of the DAO: if it's agreed that the DAO project has value, then it is important to decide whether the potential investor believes the DAO's project will continue to hold value in the future or grow in value
• Ownership: this includes understanding what owning a governance token offers for users in terms of organizational decisions and responsibilities, if any
• Stake for access to value: tokens can also be a way for DAOs to encourage users to stake for access to a project and create more value
• Fees: these, as noted above, can have an outsized impact on the popularity of a project or a token and are important for potential investors to understand, as these fees can help support the DAO treasury, could be paid out to token holders, or could be used for buybacks and token burns to increase the demand of a token