Tokenomics 1/2: The Basics of Token Economics

Tokenomics could also be called the "rulebook" of a cryptocurrency or a blockchain project in general. Before making an investment in a new cryptocurrency or setting up a decentralized autonomous organization (DAO), it is worth looking into this topic a little deeper. The study of tokenomics is essentially about what makes a cryptocurrency valuable and whether its value is likely to be stable, increasing or decreasing. A correspondingly large influence on the long-term performance of a blockchain project is the fundamental set of rules, i.e. tokenomics. Of course, less influenceable factors such as the general economic situation, positive or negative news in the crypto market, as well as the assumed future prospects of blockchain and Web3 technologies also have a substantial impact on the short-, medium-, and long-term value and performance of a blockchain project.

The term tokenomics is composed of "token" and "economics." In simpler terms, I would refer to the "rulebook" and "monetary policy" of a blockchain project.

What has Tokenomics got to do with economics? 

Tokenomics can be (somehow) compared to a certain extent with the monetary policy of a national bank or a monetary policy, which includes all measures and activities concerning the circulation of money, the supply of money and the supply of credit in an economy. As a rule, the most important goal of monetary policy is to safeguard a particular currency, i.e. to maintain the value of money within the economy (price level stability), as well as the stability of purchasing power vis-à-vis other currencies. Since the price of a currency has a lot to do with demand and supply, as well as general market economy theories, it is clearly also an economics topic. 

However, compared to traditional monetary policy, tokenomics are generally not as "flexible "or adaptable in the short term, but rather an initially defined "set of rules". Probably the most obvious difference between general economics and tokenomics is that in crypto projects, the timing of token issuance is predetermined and algorithmically generated. We can often predict the number of coins in circulation at a given point in time quite accurately, which is by no means the case with classic currencies such as the USD, the Euro or the Swiss Franc. The distribution of coins among the various parties involved is also planned in advance to a large extent and communicated publicly. Although it is technically possible to change the plan, respectively the tokenomics of a cryptocurrency, the process is more difficult to implement than to change the monetary policy of a national bank.

The term tokenomics was first used by Harvard psychologist B.F. Skinner back in 1972. His thought was that token economic models could be beneficial for guiding behavior in this industry. In a good tokenomics model, all costs and benefits should be internalized (no externalities) as much as possible, making it very difficult to manipulate the ecosystem, which is of course an important aspect of tokenomics.

Why is Tokenomics important for your crypto project?

The cryptocurrency market has experienced very rapid (albeit volatile) growth in recent years. As it grows (sometimes is hyped 🤣), new opportunities to invest in a wide variety of projects regularly arise, with the number of different tokens and coins on the market growing to many thousands and likely to continue to grow. Disclaimer: this post should in no way be interpreted as a general recommendation to invest in one or more cryptocurrencies. As the case of FTX clearly shows, there is hardly any security. For each and every crypto investor, just as in quite a few cases with other crypto project plans, tokenomics is an important topic to consider when deciding for or against the future potential of a project (Crypto, DAO, Metaverse, etc.).

Investing in a crypto project without knowing the tokenomics of the blockchain tech project is like investing in a company without knowing how the business model of that organization works. The tokenomics are usually made publicly available in so-called "whitepapers" even before the Initial Coin Offering (ICO) of a new cryptocurrency, or of course a Decentralized Autonomous Organization (DAO) project. 

Tokenomics Analysis

Just like in the real economy, supply and demand of cryptocurrencies are the key determinants of a currency's price. For this reason, in the next part of this article, I will examine how supply and demand for tokenomics are developed and what the important factors are.

Supply of Tokens or Coins

The supply of coins, respectively the supply side of tokenomics is an important success criterion. This includes the definition of the total supply of coins as well as the number of circulating coins. With regard to the total stock of coins, there are two very different approaches. There are crypto currencies like Bitcoin (BTC), which have a clearly defined limit of maximum supply defined (BTC = total supply 21 million coins) and others like Ethereum, which do not have a predefined maximum number of coins. However, Ethereum has an integrated burning mechanism with the objective to make the cryptocurrency deflationary. 

By the way, the same is true for NFT projects where the number of tokens to be mined is often limited. 

Hint: Good inflationary tokenomics models do not print (provide, mine) tokens and coins too fast in order to prevent hyperinflation.

Token Allocation and Vesting Periods

Another important criterion to look at when analyzing tokenomics is the token allocation and vesting periods. Token allocations to stakeholders is pretty much normal for most crypto projects with the idea to ensure the credibility of the product and reward those who believe in the project in the funding period. Those tokens allocated to venture capitalists or developers are very often connected with a lock-up period (also called vesting period). This so called crypto vesting occurs when tokens are locked for project members and early investors for a specific amount of time, and are to be released after. The reason for a vesting period is to protect investors against the so called "pump and dump" attacks from developers / founders.

Staking and Mining of Coins or Tokens

Many blockchains like Bitcoin incentivize the community of miners with tokens for validating transactions. This type of consensus to validate a transaction is called proof-of-work (PoW). Miners (people who validate transactions by figuring out the nonce) have to use a pretty high computing power to create (mine) new blocks and add them to the blockchain. In the proof-of-stake (PoS) approach to validate blocks, rewards go to those who have locked away a certain number of coins in a smart contract. Ethereum changed from a PoW to a PoS consensus. 

Yield Farming

Owners of cryptocurrencies can earn additional tokens through yield farming by lending money to anyone who wants a loan. In return, they receive interest and capital in the form of tokens. Usually, this is implemented fully automatically via smart contracts. Yield farming offers huge pools of yield in decentralized exchanges (DEXs). Similar to staking, yield farming is a form of passive income generation. You provide your own liquidity of assets and earn additional assets in return.  

Instead of just letting your own crypto assets sit in your wallet, you can earn more cryptocurrency with your existing assets through yield farming. As a yield farmer, you can earn from price increases, token rewards, transaction fees, and interest. Yield farming is not only an alternative to staking but also a generally cheaper alternative to Bitcoin mining, as yield farming does not require the purchase and operation of costly mining equipment.

Token Burns

As already mentioned, an important instrument for controlling a currency is the overall supply of tokens / coins. Since the price of a currency levels off at the intersection point of the supply and demand curves (see chart), a reduction in the overall supply of a currency will affect the price of that currency. To prevent inflation of a crypto currency, tokens are burned and thus permanently taken out of circulation. Without burning cryptos, the number of coins would continuously increase due to mining, which leads to a value decrease of a currency, unless demand increases more than supply and offsets this effect. If the number of tokens in circulation becomes scarcer, the price is likely to go up. This is exactly why most cryptocurrencies burn their own tokens at defined intervals. This creates a balance to mining. In relation to tokenomics, it is important to understand how total supply (limited or not defined), mining as well as burning tokens and coins is implemented.

Those who have studied some economic theory know that the value of a token is supposed to increase if there are fewer tokens in circulation which is called deflation. On the contrary, if the total supply of tokens increases, the value will decrease which is called inflation.

The Economic Model of Supply and Demand Explains the Price of a Cryptocurrency

As you can see on the following graphic, the amount of supply has an effect on the price. Also the amount of tokens demanded will impact the equilibrium price of any currency, token, coin or also product. Of course this is very simplified but it is the most important core concept to understand. After we now elaborated the most important factors that influence the supply side, it is time to look at the factors that highly influence the demand side of a crypto project.

Demand Side

In order to fully understand the tokenomics of a crypto project, it is important to also look at the factors that influence demand. The supply side is certainly very relevant, but this alone does not create value. Basically, it is mainly the demand side that influences the value of a token or coin. In the following section, we will look at the factors that influence demand. 

A first important point to understand is that just limiting the number of tokens of a cryptocurrency does not automatically lead to a price increase. Probably the most important aspect for demand is people's confidence and belief that the project currently has a lower value than it will have in the future. The most important factors to somewhat anticipate whether a token or coin will be in demand in the future is the expected return on investment (ROI), the applied game theory and also the extent of the hype around the use case of this project.

Return on Investment - ROI

By return on investment we refer to the cash flow that a token or coin is expected to generate for someone who simply holds it in their wallet. One way to make the potential ROI of a cryptocurrency more interesting is through something called staking. Staking a cryptocurrency brings rewards because the blockchain leverages your stake. Cryptocurrencies that allow staking use a "consensus process" called Proof of Stake. By staking, these currencies ensure that all transactions are verified and secured without the use of an intermediary such as a bank. When you stake your cryptocurrencies, you participate in this process.

If, when analyzing the tokenomics of a crypto project, you notice the token itself has no inherent ROI, you too will find little reason for holding that token. However, if you realize when evaluating the tokenomics that others trust that the token is stable in value, possibly you too will be willing to invest something in this project. 

Hype Level of the Community

Just as with traditional investments in companies or currencies on the stock market, the level of enthusiasm of the community has a great influence on the demand and thus the value of a token. The hype level provides information about how convinced the target group is about the project and to what extent they will already be willing to invest money in a token. When checking tokenomics and specifically the hype level, the communication channels in which this project conveys its information are very important sources. In many cases this would be Discord, Twitter, Reddit and of course other social or even traditional media. In addition to the opinions expressed by the community, it is also important to check how long people have been active in this community. If you notice in this analysis that people are willing to invest and sacrifice their shirts for this opportunity, then this would be a possible sign that the currency is getting a great demand and therefore a good price. But beware, exactly this part of tokenomics is not without danger, because the hype level can also be manipulated quite well with the necessary marketing budget. Just because everyone is now hit by the hype, this should absolutely not be your only factor to evaluate the medium and long-term potential of a blockchain project.

Game Theory

Another important factor for tokenomics on the demand side is the game theory and how it is applied. Sure, game theory is mostly used consciously in economics, but it plays a central role in tokenomics and crypto projects in particular. By definition, game theory is a branch of mathematics that studies strategies in competitive situations where the outcomes for the players involved depend critically on the actions of the other players. 
However, on this topic I could write another couple of hundred words, which is why we will explore it in detail in the next part of this blog series. 

Recap of Tokenomics part one and Outlook on Part Two

Tokenomics is a very essential part of any crypto project. As it is in the basic theories of economics, the price of a currency or product is determined by supply and demand for this particular currency. This is why we dug a bit deeper into the aspects of supply and demand for blockchain projects. In summary, for this part of the supply and demand relationships affecting the tokenomics models, we can state the following:

• If the supply of tokens decreases (due to the burning of tokens) and at the same time the demand increases, then the price will tend to increase as well.

• If the supply remains the same (fixed number of maximum tokens), but the demand increases, then the price tends to increase

• If the supply increases (mining) and the demand also increases, then the total number of tokens per se increases and the price remains more or less the same (insofar as the increase behaves in the same way as the increase in demand).
  

Not yet elaborated in detail has been the influence and application of game theory for tokenomics. In the next part of this blog series you will read about Game Theory, Examples and Token Types. Also we provide some examples of tokenomics of existing blockchain projects to make sure you understand it well. Please do not hesitate to give us feedback on this post and let us know if you have any questions or needs in terms of tokenomics for your own purpose.