The What and Why of Tokenomics

In the fundamental analysis of crypto projects, several factors determine whether or not a coin or token will perform well after its launch. These factors include the whitepaper, founding team, project roadmap, tokenomics, etc. Among these factors, tokenomics sits at the top of the list in descending order of importance, yet very few people pay attention to it.

Tokenomics is essential in evaluating a project’s long-term performance, and the word is derived from two English words - Token and Economics. In the remaining part of this article, I will try my best to help you understand how tokenomics gives us a glance into a project’s future and helps us play the long game of crypto.

To understand the concept of tokenomics, let’s examine the words that form the word.

TOKEN: A token is any cryptocurrency functioning on a blockchain that is intended to perform specific utility functions. Tokens are slightly distinct from crypto coins, but this article addresses both of them as “Tokens.”

ECONOMICS: Wikipedia defines economics as a social science that studies the production, distribution, and consumption of goods and services.

Putting both definitions together, we can extrapolate that tokenomics is concerned with a token's production, distribution, and consumption. Or simply put, tokenomics refer to the economics of a token. It is a well-thought-out plan that aims to influence how users interact with a coin or token.

Does Tokenomics Exist in Traditional Finance?

In the traditional setting where money flows within an economy, specific organizations oversee and control this movement of money within an economy. A project’s tokenomics is synonymous with the fiscal policies implemented by a central bank and other financial institutions to control cash flow. These fiscal policies encourage or discourage people from spending, lending, saving, cash flow, etc.

However, tokenomics distinguishes itself from government policies in the following ways.

1. Implemented through codes: Tokenomics details are written in codes and uploaded on the blockchain, making them instant, highly effective, and easy to adopt.
2. Transparency: Tokenomics transactions are easy to track, meaning you can follow money trails from the point of origin to its location at any point. Transaction details are disclosed to the general public, and anyone can access any record.
3. Predictability: Since they are implemented through rigid codes, people can correctly use the code information to know what will happen to a token at a specific time.
4. Immutability: Once tokenomics codes are written and uploaded to the blockchain, it is impossible to edit them, even if you are the creator.

Bitcoin as a Case Study

To further explain tokenomics, we’ll look at Bitcoin - blockchain’s most prominent cryptocurrency - as a case study. The design of Bitcoin’s tokenomics is such a masterpiece, and considering that it was created in the early days of the blockchain, it goes without saying that Satoshi Nakamoto, Bitcoin’s creator, is a genius.

Bitcoin was created in 2008, and its total supply was programmed to be 21 million coins. However, not all of these coins were released into circulation. Instead, new Bitcoins are added to the blockchain every ten minutes to reward miners for mining a new block. But there’s more.

This reward is halved after 210,000 blocks have been minted to slow the release of new Bitcoins into the blockchain. By estimate, it takes about four years to 210,000 blocks (which reiterates the predictability characteristics of tokenomics). The halving event has occurred thrice since Bitcoin was created.

In 2008, the reward for miners was 50ETH. It was reduced to 25BTC in 2012, 12.5 BTC in 2016, and 6.25BTC in 2020. By estimate again, the next halving is scheduled to happen in April 2024, and all 21 million Bitcoins will be minted by 2140,\

Why is Halving Important?

Reducing miners' rewards will discourage them from mining and eventually affect the blockchain. However, miners and everyone else in the Bitcoin ecosystem can enjoy the halving because;

• It creates scarcity.
• Scarcity leads to an increase in demand.
• An increase in demand causes a price increase.
• A price increase secures a cryptocurrency’s sustainability.

Elements of Tokenomics

From Bitcoin tokenomics, we can deduce a few elements that are core to taken development and should exist in the tokenomics of any project on the blockchain.

1. Supply

Supply in cryptocurrency exists in two forms.

• The total amount of a coin or token that is created and added to the blockchain - The maximum Supply
• The total amount of supply in circulation - Circulating Supply.

Bitcoin, as you know, has a maximum supply of 21 million coins, but the circulating supply at the time of writing is about 19.2 million. There are also tokens like Ethereum, USDC, USDT, etc., that do not have a maximum supply. Tokens can be categorized into inflationary and deflationary tokens depending on their maximum supply.

2. Utility

Utility refers to the specific purpose(s) for which a coin or token was created. Bitcoin, Ether, and BNB were all created to exchange and store value on the Bitcoin, Ethereum, and BNB blockchains. Tokens can also serve other purposes like staking, lending, farming, voting, etc.

3. Distribution

To release a token or coin into the blockchain, it is distributed among interested holders. This distribution can occur in two ways;

• A pre-mining launch: Here, selected investors can buy the token before it is circulated.
• A fair launch: The general public can buy the token simultaneously without prior access.

When studying a token’s distribution, you must check the percentage held by creators and investors. It is important because when these investors and creators are major stakeholders, it hints that they believe in the long-term success of a project. However, if a large portion of a token's supply is distributed among the public, that’s a Japan (A red flag.)

4. Burning

Cryptocurrencies are burned - not in an incinerator or campfire. Burning refers to the removal of cryptocurrencies from the blockchain, and it is used to reduce the supply in circulation and trigger price increases. It also helps to keep the blockchain up and running.

For example, BNB adopts coin-burning to remove coins from circulation and reduce the total supply of its tokens. With 200 million BNB pre-mined, BNB’s total supply is 165,116,760 as of June 2022. BNB will burn more coins until 50% of the total supply is destroyed, which means BNB’s total supply will be reduced to 100 million BNB. Similarly, Ethereum started to burn ETH in 2021 to reduce its total supply.

5. Incentives

Have you ever heard that crypto rewards active participation? Yes. By using a blockchain consistently, users stand a chance to get incentives. Incentives encourage crypto enthusiasts to continue using the blockchain, ensuring the blockchain’s survival in the long term.

In Bitcoin, miners get rewards every time a block is minted, encouraging more people to mine, and this mechanism is known as Proof of Work. In Proof of Stake, which Ethereum uses, tokens are locked and used to validate transactions. People who lock their funds are known as validators and receive rewards every time a block is minted.

Final Message

Since the creation of Bitcoin’s tokenomics, the concept of tokenomics has continued to evolve, gaining relevance in other use cases of the blockchain like DeFi, NFT, etc. All of the elements of tokenomics are intertwined and connected, and no one exists on its own. By studying a project’s tokenomics, you can predict how well it will perform in the short and long term and how much people will be interested in the tokens. As important as it is, tokenomics is only one of the many factors to consider when doing fundamental analysis. You must still consider other factors like the whitepaper, project founder(s), etc.