Tokenomics: A Beginner's Guide

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INTRO

Token economics, or ‘tokenomics’ refers to the design of a crypto token and its purpose within a specific project. This can encompass a variety of factors, including parameters such as a token’s supply, inflation schedule, initial distribution and more.

The role of a token within a specific ecosystem can at least partially be determined by its tokenomics and long-term value proposition. Traders will often study a project’s tokenomics before choosing to take out a position in its relevant token, in order to identify potential supply overhangs and/or build a thesis around a project.

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TL;DR

• Tokenomics refers to the mechanisms and design surrounding a project’s token.
• A project’s tokenomics generally includes the supply distribution and vesting schedule, token utility, and any in-built incentive mechanisms.
• Traders may monitor tokenomics data in order to identify periods of supply overhang or potential sell pressure, and/or a token’s long term value proposition
• Projects vary in terms of the complexity of their tokenomics, with some projects launching a token to act mainly as a speculative vehicle, while others create a multitude of token use cases within their ecosystem.

WHAT IS TOKENOMICS? 

Tokenomics refers to both the study and design of the economic systems surrounding cryptocurrencies and other digital tokens. Tokenomics includes everything from the creation, distribution, and supply of tokens to their utility and incentives for either holding or using these tokens.

Simply put, the tokenomics of a cryptocurrency helps one understand how the cryptocurrency has been distributed to its community, how much of the supply is locked, vested or circulating, and any relevant information on the concentration of holdings among the team or investors.

KEY COMPONENTS OF TOKENOMICS

TOKEN SUPPLY

Token Supply refers to the amount of tokens in existence, for any particular cryptocurrency. There are three different numbers that can refer to Token Supply: Total Supply, Circulating Supply and Max Supply.

Circulating Supply refers to the amount of tokens that are currently unlocked and tradeable.

Total Supply refers to the total amount of tokens currently in existence. This includes the circulating supply, in addition to locked and vested tokens (e.g. team or investor tokens).

Max Supply refers to the maximum amount of coins that can theoretically be created in the lifetime of the cryptocurrency. For instance, the Max Supply of Bitcoin is 21 Million, although not all of those coins have been created yet. Ethereum, on the other hand, does not have a Max Supply - as ETH will be perpetually minted in order to reward validators. 

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Some coins have a Total Supply and a Max Supply of exactly the same amount. Most often, this is because the entire supply was minted at the Token Generation Event (TGE) and is not mintable. The Circulating Supply is always equal to or smaller than the Total Supply, which is always equal to or smaller than the Max Supply.

Generally, traders will pay attention to Circulating Supply relative to Total Supply - which represents how much of the token supply is unlocked and tradeable, vs locked and held by investors or team. The percentage of circulating tokens is called the ‘float’.

DISTRIBUTION

Token distribution refers to how an individual project’s tokens are allocated and released.

Mining and Staking Rewards: In many blockchain networks, tokens are distributed as rewards to miners or stakers who help secure the network by validating transactions and blocks. For example, when Bitcoin miners mine a new block on the Bitcoin blockchain, they are rewarded with Bitcoin for mining the block, as well as the fees for any transactions that they include.

Initial Coin Offering: Similar to an initial public offering (IPO) in equities, an ICO is a way for cryptocurrency projects to raise money by selling a portion of their tokens to investors. ICOs were a very popular fundraising tactic in 2017-2018, with multiple multi-billion dollar ICOs. However, ICOs have become less prevalent in recent years after some legal cases were brought against prominent ICO projects, such as Block.one, who conducted the largest ICO ever for the token EOS.

Airdrops: Tokens are distributed for free to a cryptocurrency’s community, either being sent directly to the wallets of community members, or manually claimed. Projects may use a list of early users to determine airdrop criteria, or alternatively allocate tokens based upon a system of ‘points’, which users publicly accumulate by using the protocol in different ways.

Airdrops can be thought of as a project exchanging a portion of their token supply to attract attention, reward early users, and grow a community. Airdrops are perceived to be less legally risky than ICOs due to the lack of monetary investment from the recipients - and are much more common today as a result.

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Investor/Team Allocations: Often, a cryptocurrency will allocate a portion of its supply to the team/investors of a project, in order to fund and incentivise continual development. This portion of the supply is often locked and/or vested over multiple years, in order to theoretically align teams and investors with long-term value creation. However, locked and/or vested tokens often represent overhanging sell pressure upon unlocks - with many traders marking these unlock dates as points of considerable price volatility.

Community Grants/DAO Allocation: Occasionally, a project will allocate a portion of its supply to a ‘DAO’ co-owned by all tokenholders. This allocation is most often used to fund grants for projects building on top of or alongside the token project. This portion of the supply may have a different vesting schedule to team or investor allocations, and may be included in the ‘community’ allocation of a project’s tokenomics.

Traders often check a token’s distribution before they enter into a position, as this will inform them of when new supply will be released into the market, how much of the total supply is left to unlock, and who the likely holders of circulating supply are.

UTILITY

The utility of a token refers to its practical use cases and value propositions. Tokens are often valued based upon some combination of speculation on future price movements, and the token’s present utility. For example:

Transaction Fees: Many cryptocurrencies can be used to pay for transaction fees on a blockchain. For example, Ether (ETH) is used to pay for gas on the Ethereum blockchain, which allows an individual to use Ethereum blockspace.

Access and Membership: Some tokens allow their holders to gain access to specific features, services, or membership within a platform or community. For example, a community can ask members to verify their token holdings as a requirement to join. ‍

Staking: Some tokens can be staked to earn rewards and/or participate in network governance. Staking tokens involves locking up one’s tokens to support network operations in return for staking rewards, typically in the form of additional tokens or airdrops.

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DEMAND AND INCENTIVES

Demand refers to the amount of willing buyers of a token at various price points. Teams can attempt to influence demand through a number of methods, with varying success rates.

Incentive Programs: These programs offer rewards to users who perform certain actions, such as onboarding new users, participating in governance by voting, or contributing to network security.‍

Burn Mechanisms: Many projects choose to perform token burns, where a portion of tokens are permanently removed from circulation, lowering the total token supply. Some projects such as MakerDAO perform continual buyback-and-burn using protocol revenue, which provides a constant level of buy-pressure on their token.

Liquidity Mining: Liquidity Mining was popularized during ‘DeFi Summer’ in 2020. Liquidity Mining consists of a project streaming token rewards to users either depositing assets in their protocol, or providing liquidity for the project token against another token, usually ETH or USDC. The term ‘Liquidity Mining’ was popularized by Compound Finance in June 2020. Users who deposited assets to Compound were rewarded with COMP governance tokens. This process of users acquiring governance tokens by depositing assets to DeFi protocols is also known as Yield Farming.

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GOVERNANCE

Governance is the process in which decisions about a cryptocurrency’s future are made. Some crypto protocols attempt to use ‘governance’ as a method to drive value to their token, with varying success.

In a centralized governance process, a single entity (such as a company) makes all the decisions relevant to a protocol or project’s future. In decentralized governance, decisions are made by a community of tokenholders, typically through an on-chain voting system.

Decentralized governance is commonly performed by Decentralized Autonomous Organizations (DAOs). These DAOs may also be granted an allocation of tokens by the project, in order to fund future development and/or provide grants to other projects bringing value to their ecosystem.

REAL-WORLD EXAMPLES

BITCOIN (BTC)

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Supply: Bitcoin has a max supply of 21 million tokens, and a current circulating supply of roughly 19.7 million tokens. The circulating Bitcoin supply gradually increases every block as miners produce new Bitcoin.

Distribution: Bitcoin is distributed through mining rewards, where Bitcoin miners solve complex mathematical problems to validate blocks of transactions and are rewarded for their efforts with new Bitcoin. The rate at which miners are rewarded with Bitcoin decreases by ½ every 210,000 blocks (approximately 4 years). So far there have been 4 ‘halvings’, and the current reward rate of Bitcoin is 3.125 BTC per block.

Utility: Bitcoin has no in-built utility - however it is primarily used as a store of value, a vehicle for speculation and occasionally a medium of exchange. Bitcoin is sometimes referred to as “digital gold” due to its low and predictable inflation schedule.

‍Demand and Incentives: Bitcoin's demand is driven by its perceived value as "digital gold" and as a hedge against inflation. Users are incentivized to hold Bitcoin because new Bitcoin will only get harder and harder to produce with each halvening.

‍Governance: Bitcoin is maintained by a team of developers as part of Bitcoin Core - but any changes to Bitcoin in practice must be approved by a large community of users and miners.

ETHEREUM (ETH)

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Supply: Ethereum has a variable total supply. New ETH was originally created through mining, but Ethereum switched to a Proof of Stake model with the merge. As a result, new ETH is now rewarded to validators who stake ETH in order to validate new blocks on Ethereum. EIP-1559 introduced the ‘BASEFEE’ - a minimum transaction fee that is burned instead of being rewarded to validators. This burn helps lower the circulating supply of Ethereum, making it deflationary at certain periods of high activity.

Distribution: Initially, ETH was distributed through an ICO in 2014. 83.3% of the supply was sold in a crowdsale, with 16.7% of the supply reserved for the Ethereum Foundation and core developer team. Currently, new ETH is distributed through staking rewards.

Utility: ETH is used to pay for blockspace on the Ethereum network, which is essential for performing transactions and interacting with smart contracts.

Demand and Incentives: Demand for ETH is driven by a combination of price speculation, and its uses within the Ethereum ecosystem, for example purchasing blockspace, using DeFi applications, and trading NFTs. ETH is commonly used as a pairing in token trading pools, which allows users to buy other tokens on Ethereum by paying ETH.

Governance: Due to the existence of the Ethereum Foundation, Ethereum's governance is more centralized than Bitcoin. Most decisions are proposed through EIPs (Ethereum Improvement Proposals), where they are first discussed and subsequently implemented by Ethereum’s community of developers.

UNISWAP (UNI)

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Supply: UNI has a total supply of 1 billion tokens. 60% of the supply was earmarked for the Community (with 43% retained by the Uniswap DAO) and 40% going to Advisors, Investors and Team.

Distribution: 15% of all UNI tokens were distributed through an airdrop to users who had interacted with the Uniswap protocol through swapping or providing liquidity. A minimum of 400 UNI tokens were airdropped to ~300K addresses that had interacted with Uniswap before September 2020.

Utility: The UNI token is used for governance, allowing holders to vote on proposals regarding the protocol's future development.

Demand and Incentives: Demand for UNI is driven by both its governance utility and the success of the Uniswap platform as the top decentralized exchange on Ethereum. UNI tokenholders can vote to enable a “fee switch”, which would route a portion of the revenue that Uniswap generates to tokenholders. However, this has not been implemented yet.

Governance: Uniswap operates as a DAO. UNI holders can vote on proposals and changes to the protocol.

CONCLUSION

Tokenomics is an important factor to consider for any trader before they take out a crypto position. Most commonly, the supply distribution and vesting schedule can influence trading decisions quite dramatically, with certain vesting schedules and unlock dates providing critical indications of sell pressure or supply overhangs.

Tokenomics will also provide traders with an idea of a token’s long-term value propositions and potential future sources of demand, which may influence future inflows or outflows from a token’s holder base.