Summary
Token economics is the study of the economic operation model of tokens. Token economics describes the factors that affect the use and value of tokens, including but not limited to the creation and distribution of tokens, supply and demand, incentive mechanisms and token destruction schedules. For cryptocurrency projects, a sound token economic model is the key to success. Investors and stakeholders must carefully evaluate the token economics of a project before deciding to participate in it.
Introduction
The word tokenomics is a combination of "token" and "economics". Understanding tokenomics is a very important part of doing basic research on cryptocurrency projects. You should not only pay attention to white papers, founding teams, roadmaps, and community development, but also understand tokenomics, as it is the core of evaluating the future prospects of blockchain projects. When developing cryptocurrency projects, the economic model of the token should be carefully designed to ensure long-term sustainable development.
An Initial Look into Cryptocurrency Economics
Blockchain projects design their operating mechanisms around tokens to encourage or discourage various user behaviors. The principle is similar to how central banks encourage or discourage consumption, lending, savings, and money flows by printing money and implementing monetary policies. Note that the term "token" here covers both cryptocurrencies (coins) and tokens. Click here to learn the difference between the two. Unlike fiat currencies, the rules of token economics are implemented in code. These rules are transparent, predictable, and difficult to change.
Let’s take Bitcoin as an example. The total supply of Bitcoin is pre-set at 21 million. The coin is generated through mining and enters the circulation market. Miners can mine a block every 10 minutes or so and get some Bitcoins as a reward.
The reward, also known as the block subsidy, is halved every 210,000 blocks mined. According to this schedule, the reward is halved every four years. Since January 3, 2009, when the first block on the Bitcoin network (the genesis block) was mined, the block subsidy has been halved three times, from 50 bitcoins to 25 bitcoins, to 12.5 bitcoins, and currently stands at 6.25 bitcoins.
According to these rules, it is easy to deduce that about 328,500 Bitcoins will be mined in 2022. The calculation is to divide the total number of minutes in a year by 10 (a block is mined every 10 minutes), and then multiply by 6.25 (6.25 Bitcoins are issued as a reward for each block). From this, we can calculate the number of Bitcoins mined per year, and the last Bitcoin is expected to be mined around 2140.
Bitcoin’s token economics also include transaction fees. When a new block is verified, the miner receives a transaction fee. As the transaction size increases and the network becomes more congested, transaction fees will increase. This design helps prevent spam transactions and incentivizes miners to continue verifying transactions as the block subsidy continues to decrease.
In short, the operating mechanism of Bitcoin is designed to be simple and ingenious. Everything is transparent and predictable. The incentive mechanism designed around Bitcoin gives participants the motivation to continuously inject value into the cryptocurrency and keep the network running stably.
Key Elements of Token Economics
The term token economics encompasses a wide range of factors that influence the value of a cryptocurrency. The term primarily refers to the economic structure of a cryptocurrency as designed by its creators. Here are some key elements to look at when studying the token economics of a cryptocurrency.
Token Supply
For any good or service, supply and demand are major factors that influence price. The same is true for cryptocurrencies. Here are a few key metrics for measuring a token’s supply.
The first is the maximum supply, which is the upper limit of the number of tokens set by the preset code. Bitcoin has a maximum supply of 21 million. Litecoin has a hard cap of 84 million, and Binance Coin has a maximum supply of 200 million.
Some tokens have no supply cap. The Ethereum network's supply of ether increases every year. Stablecoins such as USDT, USDC, and BUSD do not have a maximum supply because they are issued based on backing reserves. In theory, the supply of these coins can continue to increase. Dogecoin and Polkadot are two other cryptocurrencies that do not have a supply cap.
The second metric is the circulating supply, which is the number of tokens in circulation. Tokens can be minted and destroyed, or locked up in other ways. This also has an impact on the price of the token.
By looking at the token supply, you can get a rough idea of how many tokens will eventually be generated.
Token Utility
Token utility refers to the intended use of a token. For example, the utility of Binance Coin includes powering the BNB chain, paying transaction fees and enjoying transaction fee discounts on the BNB chain, and serving as a community utility token on the BNB chain ecosystem. Users can also earn additional income by staking Binance Coin through various products within the ecosystem.
There are many other use cases for tokens. Holders of governance tokens have the right to vote on changes to the token protocol. Stablecoins can be used as currencies, while security tokens represent financial assets. For example, a company can issue tokenized shares during an initial coin offering (ICO), granting holders ownership rights and dividends.
These can all help you identify a token’s potential use cases and are crucial to understanding where the token is headed in the future.
Analyzing token distribution
In addition to supply and demand, it is also important to understand how tokens are distributed. Large institutions and individual investors behave differently. Once you understand the type of entities holding tokens, you can further infer how holders are likely to trade, which will influence the value of the token.
Generally speaking, there are two ways to launch and distribute tokens: fair launch and pre-mine launch. A fair launch means that no one gets to play first or there is a small distribution before the tokens are minted and distributed to the public. Both Bitcoin and Dogecoin have adopted this launch method.
The second type of pre-mining involves minting a portion of a cryptocurrency and allocating it to a specific group before it is made available to the public. Ethereum and Binance Coin have undergone pre-mining.
In general, you need to pay attention to whether the distribution of tokens is even. Generally speaking, having a majority of tokens held by a few large institutions means greater risk. If patient investors and the founding team hold the majority of tokens, the interests of holders will be more aligned and long-term success will be more likely.
You will also want to look at the lock-up and release schedule of the tokens to see if a large number of tokens will enter circulation, putting downward pressure on the value of the token.
Understand the destruction of tokens
Many crypto projects regularly destroy tokens, which means some tokens are permanently removed from circulation.
For example, Binance Coin uses the method of destroying tokens to remove some tokens from circulation, thereby reducing the total supply. The pre-mining amount of Binance Coin is 200 million. As of June 2022, the total supply of Binance Coin is 165,116,760. In the future, a large number of Binance Coins will be destroyed until the remaining amount is 50% of the initial total supply. This means that the total supply of BNB will be reduced to 100 million. Similarly, Ethereum also began to destroy Ether in 2021 to reduce its total supply.
Reducing the supply of tokens is deflation. On the contrary, continuously expanding the supply of tokens is inflation.
Incentives
The incentive mechanism of the token is crucial. How to incentivize participants to ensure long-term sustainable development is the core issue of token economics. The block subsidy and transaction fee design in Bitcoin is a good example of a simple model.
Proof of Stake is another increasingly common verification method. Under this design, participants need to lock tokens to verify transactions. Generally speaking, the more tokens locked, the greater the chance of being selected as a validator and receiving rewards for verifying transactions. This also means that if the validator tries to disrupt the network, their own assets will be at risk. These settings incentivize participants to act honestly and can maintain the robustness of the protocol.
Many DeFi projects have used innovative incentive mechanisms to achieve rapid growth. On the cryptocurrency lending platform Compound, investors can deposit cryptocurrencies in the Compound protocol, collect interest, and receive COMP tokens as additional rewards. In addition, COMP tokens are also the governance tokens of the Compound protocol. These designs coordinate the interests of Compound and all participants, which is conducive to the long-term development of the project.
Where is token economics heading?
Token economics has come a long way since the creation of the Bitcoin network’s genesis block in 2009. Developers have explored a variety of token economic models. Some have succeeded, and some have failed. Bitcoin’s token economic model has stood the test of time and is still working. Other tokens with poorly designed models have struggled.
Non-fungible tokens (NFTs) use another token model based on digital scarcity. The tokenization of traditional assets such as real estate and art may give rise to new token economics innovations in the future.
Summarize
If you want to get into the cryptocurrency space, token economics is a fundamental concept you must understand. Token economics covers the main factors that affect the value of a token. It is important to note that you cannot generalize when evaluating. You should take into account as many factors as possible and conduct a holistic analysis. Token economics can be combined with other fundamental analysis tools to help you more fully judge the future prospects of a project and the price of its token.
Ultimately, the operating model of a token will have a significant impact on its usage, how easy it is to build a network around it, and how likable users will be to the token.