What is Token Economics? Why is it important?

Token Economics studies the economic operation of tokens. Token economics describes the factors that affect the utility and value of tokens, including but not limited to token creation and distribution, supply and demand, incentives, and token burn schedules. For cryptocurrency projects, a sound token economic model is the key to success. Before deciding to participate in a project, it is important for investors and stakeholders to carefully evaluate the token economics of the project.

The term Tokenomics is a combination of "token" and "economics". Understanding token economics is an important part of doing basic research on a cryptocurrency project. You should not only pay attention to the white paper, founding team, roadmap and community development, but also understand the token economics, because it is the core of evaluating the future prospects of blockchain projects. When developing a cryptocurrency project, the economic model of the token should be carefully designed to ensure long-term sustainable development.

A Preliminary Study of Cryptocurrency Economics

Blockchain projects design their operating mechanisms around tokens to encourage or discourage various user behaviors. Its principle is similar to that the central bank encourages or inhibits consumption, loans, savings and currency flows by printing currency and implementing monetary policy. Note that the word "token" here covers both cryptocurrencies (coins) and tokens (tokens). Click here to learn the difference between the two. Unlike fiat currencies, the rules of tokenomics are implemented in code. These rules are transparent, predictable, and difficult to change.

Let's take Bitcoin as an example. Bitcoin has a preset total supply of 21 million coins. The currency is produced by mining and enters the circulation market. Miners mine a block every 10 minutes or so and are rewarded with some bitcoins.

Rewards, also known as block subsidies. Every 210,000 blocks mined, the reward is halved. Following this schedule, rewards are halved every four years. Since January 3, 2009, the first block on the Bitcoin network (the genesis block), the block subsidy has been halved three times, from 50 bitcoins to 25 bitcoins and then to 12.5 bitcoins. Bitcoin, currently at 6.25 bitcoins.

Based on these rules it is easy to conclude that approximately 328,500 bitcoins will be mined in 2022. It is calculated by dividing the total number of minutes in a year by 10 (a block is mined every 10 minutes) and multiplying by 6.25 (6.25 bitcoins are issued as a reward per block). From this we can extrapolate the number of bitcoins mined each year, with the last bitcoin expected to be mined around 2140.

Transaction fees are also included in Bitcoin's token economic model. When a new block is validated, the miner receives a transaction fee. As transaction sizes increase and the network becomes more congested, transaction fees will also increase. This design helps to eliminate spam transactions and incentivizes miners to continue validating transactions as block subsidies continue to decrease.

In short, Bitcoin's operating mechanism is designed to be both simple and ingenious. Everything is transparent and predictable. The incentive mechanism designed around Bitcoin gives participants an incentive to continuously inject value into the cryptocurrency and keep the network running stably.

Key Elements of Token Economics

The term tokenomics encompasses various factors that affect the value of cryptocurrencies. The term first refers to the economic structure of a cryptocurrency designed by its creator. Here are some key elements to examine when researching the token economics of cryptocurrencies.

Token Supply

As with any good or service, supply and demand are the main factors affecting price. The same goes for cryptocurrencies. Below are a few key metrics for measuring token supply.

The first is the maximum supply, which is the upper limit of the number of tokens stipulated by the preset code. Bitcoin has a maximum supply of 21 million. Litecoin has a hardcap of 84 million and Binance Coin has a maximum supply of 200 million.

Some tokens have no supply cap. The supply of Ether on the Ethereum network is increasing every year. Stablecoins such as USDT, USDC, and BUSD do not have a maximum supply because these coins are issued based on backing reserves. Theoretically, the supply of these coins can keep increasing. Dogecoin and Polkadot are two other cryptocurrencies that have no supply cap.

The second metric is circulating supply, the number of tokens in circulation. Tokens can be minted and burned, or otherwise locked. This will also have an impact on the price of the token.

Looking at the token supply gives you an 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 and receiving 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 BNB 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 function as money, while security tokens represent financial assets. For example, a company could issue tokenized shares during an initial coin offering (ICO), granting holders ownership rights and dividends.

These can help you identify potential use cases for a token, and are critical to understanding where the token is headed in the future.

Analyze Token Allocation

In addition to supply and demand, it is also necessary to understand how tokens are distributed. Large institutions and individual investors behave differently. Once you understand the type of entity holding the token, you can further infer how the holders are likely to trade, and how they trade will determine the value of the token.

In general, there are two ways of launching and distributing tokens: fair launch and pre-mined launch. A fair rollout means that no one gets a first-hand or small distribution of tokens before they are minted and distributed to the public. Both Bitcoin and Dogecoin have taken this launch method.

Premining in the second way refers to minting a portion of the cryptocurrency and distributing it to a specific group before making it available to the public. Ethereum and Binance Coin are pre-mined.

Generally speaking, you need to pay attention to whether the distribution of tokens is even. Typically, having a majority of tokens held by a few large institutions means greater risk. If patient investors and founding teams hold a majority of tokens, holders' interests are more aligned and long-term success is more likely.

You also have to look at the token lock and release schedule to see if there will be a significant amount of tokens coming into circulation, putting downward pressure on the value of the token.

Understand the destruction of tokens

Many crypto projects regularly burn tokens, which means some tokens are permanently withdrawn from circulation.

For example, Binance Coin uses token burning to remove some tokens from circulation, thereby reducing the total supply. The pre-mined amount of Binance Coin is 200 million. As of June 2022, the total supply of Binance Coin is 165,116,760 coins. 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. Likewise, Ethereum also started burning Ether in 2021 to reduce its total supply.

Reducing the token supply is deflationary. On the contrary, the continuous expansion of token inflation is inflation.

Incentive Mechanism

The incentive mechanism of the token is crucial. How to motivate participants to ensure long-term sustainable development is the core issue of token economics. The design of the block subsidy and transaction fees in Bitcoin is a good example of a simple model.

Proof-of-stake is another verification method that is increasingly common. Under this design, participants need to lock tokens to verify transactions. In general, the more tokens locked, the better the chances of being selected as a validator and rewarded for validating transactions. This also means that if validators try to disrupt the network, their own assets are at risk. These settings incentivize participants to act honestly and maintain the robustness of the protocol.

Many DeFi projects have utilized innovative incentive mechanisms to achieve rapid growth. On the cryptocurrency lending platform Compound, investors can deposit cryptocurrencies in the Compound protocol, receive interest, and earn COMP tokens as an additional reward. In addition, the COMP token is also the governance token of the Compound protocol. These designs coordinate the interests of Compound and all participants, and are conducive to the long-term development of the project.

Where is token economics headed?

Token economics has come a long way since the genesis block of the Bitcoin network was created in 2009. Developers have explored various token economic models. There are successes and failures. Bitcoin’s token economic model has withstood the test of time and is still working. Other tokens with poorly designed models have struggled.

Non-fungible tokens (NFTs) adopt another token model based on digital scarcity. The tokenization of traditional assets such as real estate and art may lead to new innovations in token economics in the future.

Summarize

Token economics is a fundamental concept you must understand if you want to enter the cryptocurrency space. Token Economics covers the main factors that affect the value of tokens. It should be noted that the evaluation cannot be generalized. As many factors as possible should be taken into consideration for a holistic analysis. Token economics can be combined with other fundamental analysis tools to help more fully judge the future prospects of a project and the price of its token.

At the end of the day, how a token works will have a big impact on what it is used for, how easy it is to build a network, and how popular it is with users.