An Introduction to the World of Tokenomics
Wherever there is a token, there is token economics (or short – tokenomics). Tokemonics is quite a popular and inseparable component of the blockchain space. The term being self-explanatory in nature encompasses two words, token and economics. Though there have been multiple attempts to interpret the word in a plethora of narrow as well as broader perspectives, all the definitions revolve around one common logic of economic principles and factors governing the structuring of tokens and respective economies. Tokenomics not only plays a crucial part in the success of any protocol, but also serves as an important parameter for individuals to make informed investment decisions. This article is another humble attempt to equip readers with comprehensive knowledge of tokenomics and how it can assist them in better decision making.
Components of Tokenomics
Without assigning any fancy half-baked definition to the term, tokenomics can simply be understood by all the components comprising it: Token supply, token characteristics, and token allocation and distribution, among other functions, all of which can provide an insightful window into the vision of the token creators.
Efficient and inefficient tokenomics can serve as a proxy for the sincerity of the people behind a blockchain-based product. Poorly or effectively designed tokenomics are potential red flags regarding the true intentions of the project founders. However, bear in mind that tokenomics is just one of the criteria, not any universal holy grail fundamental indicator.
Token Supply
Ever been to CoinMarketCap, hovering over various “Supply” metrics and getting eternally confused as to what each of them means? Wondering how Maximum Supply differs from Total Supply? What role does Circulating Supply play? Well, you’re not alone. This might be one of the most common queries that crypto enthusiasts undertake after spending relative time in the industry.
Surprisingly, it’s not what any long-term crypto enthusiast may term a “beginner’s query” because come on! How many people new to crypto have you seen discussing DOGE or SHIB supply before investing? Or even after investing? Because if they had undertaken DYOR (do your own research ;)) seriously, one wouldn’t be unsarcastically asking, “Will $SHIB hit $1?” or “When will $SHIB reach $1”? as the answers would have been as clear as day to these famous queries. Those sweet lill’ answers being, NO!, Not in this lifetime at least. Now the optimist within you will still be interrogating the why? Here’s a simple reason, it boils down to Tokenomics!! The humongous circulating supply of SHIB will certainly never allow it to reach the most awaited dollar one. As for it to defy these odds, it would require more money than anyone has ever witnessed on earth. Just a bit over $550 trillion!
One can still go on and believe the prophecy of SHIB doing the unthinkable, relishing the fact that Bitcoin faced the fate of similar lingering doubts about its potential once. However, here’s a thing, even in an alternate reality, where SHIB could do everything Bitcoin would, the answer will remain No, because there is one key metric separating SHIB from Bitcoin, and that’s tokenomics of supply!! That’s how important the role of supply is. But what exactly is tokenomics of supply? Below is the breakdown.
In most straightforward forms, supply can be divided into three categories: Maximum, Total, and Circulating Supply. Maximum Supply refers to the highest possible number of tokens that will ever exist. It is the sum of Total Supply, coins yet to be mined and coins burned or destroyed. Total Supply is the combination of tokens already in circulation in addition to all the assets locked or staked. And Circulating Supply consists of all the coins and tokens available in the market for trade. The supply design of various tokenomic models allows investors to find answers to various questions; How many coins can ever flood the market? How many coins are currently available for trade? Whether the tokens are deflationary or inflationary? or What’s the rate of this inflation or deflation?.
The example of SHIB and Bitcoin clearly illustrates why finding answers to these questions before making any commitment is absolutely crucial.
Furthermore, it is to be noted that not all cryptocurrencies have a capped supply – think deflationary and inflationary tokens (addressed further below).
Market Capitalization
Before we learn more about the inflationary and deflationary properties of certain cryptocurrencies. Here’s a brief note on understanding the role of Market Capitalization (Mcap). Mcap is the product of the current price of a crypto asset and its circulating supply, and Fully Diluted Mcap is derived by multiplying the current price of a crypto asset by its Maximum Supply, that is, the price of an asset if all coins were in circulation. In case the Maximum Supply isn’t available, the Total Supply replaces it in the equation. Mcap plays a vital role in predicting the potential trajectory of a token. It represents the value of a product and the trust of investors in that corresponding project.
The metric is a big factor in understanding the issues of a commonly prevalent investment behavioral phenomenon called Unit Bias, which refers to the practice of people preferring to own 100,000 units of tokens valued at nominal prices, say 0.15 – 0.30 per unit (A median value of 0.30 USD was found to gather behavioral investors attracted to low nominal prices) rather than holding one-third of a token unit for high ranges like $150 – $300. This is likely one of the reasons behind meme coins gaining such huge traction due to their extremely low attractive dollar value owing to huge supply.
Unit Bias eclipses the significance of taking into account the Mcap of any concerned assets. An asset with a high dollar value but low Mcap has more room to grow than a high Mcap asset with an extremely low dollar value. The counter to this miscalculated approach is to evaluate the value of cryptocurrencies in terms of percentage change, a suitable metric for calculating possible gains and losses.
Inflationary and Deflationary Tokens
Within the crypto space, cryptocurrencies with and without capped supply are termed deflationary and inflationary, respectively. For instance, many would consider Bitcoin, with a Maximum Supply of 21 million, a deflationary coin, implying that the scarcity of coins will not erode its value over time. With a circulating supply of slightly above 19 million at the time of writing this article, only ∼2 million coins remain to be mined. Given the current rate of mining, it is expected that the last Bitcoin will be added to circulation in somewhere around 120 years. This mechanism significantly minimizes the ill effects of inflation and nudges people to hodl (non-crypto folks would say hold :)) for long-term gains.
Additionally, the accidental losses are anticipated to surmount even more pressure on the limited availability of coins. Accidental loss refers to all the incidents, like forgetting private keys/passwords, losing access to hard drives, accidentally sending coins to a burning wallet, and more, where coins are permanently lost. (Remember, these losses are different from burning where coins are intentionally burnt). This Chainalysis report considers 20% of all Bitcoins to be lost.
Resultantly, in popular culture, assets with limited supply over time are regarded as better investment instruments than the ones with an unlimited supply. Though this logic holds for most assets in the market, there are various gray areas too. Neither the absence of capped supply makes all crypto assets inherently inflationary, nor do all inflationary crypto-assets have the same inflation rate or pressure. Consider Ethereum, which at first sight appears to be an inflationary asset due to the absence of any supply limit, still has a yearly mining cap of 18 million ETHs. This, coupled with Ethereum’s burning mechanism, where part of the transaction fee is burnt, allows the protocol to ease the inflationary pressure. Ever since the EIP-1559 update went live in 2021, over 2.2 million ETH (at the time of writing, 10/05/2022) has been sent to the burning address, thus being permanently removed from circulation. Experts believe that considering the demand for Ethereum, the Ether token burns may outpace the rate of mining, making the coin even deflationary.
Now coming back to the rate of inflation, it varies notably for different assets. Just examine the vast difference among annualized inflation rates for Dogecoin, MINA, and OKB, which stand at 3.9%, 12% (for initial two years), and a whopping 266%, respectively. Despite being characterized under one umbrella term of inflationary currencies, the disparity in inflation rates set them apart by miles (you can track inflation rates for all the cryptocurrencies here).
Another point to remember is that the utility of coins is an essential determinant too. DeFi assets are usually inflationary to award staking balances, liquidity providers, and yield farmers and to maintain high annualized yield percentages. Hence, it’s not only paramount to analyze whether the assets are deflationary or inflationary, but also equally vital to assess the other mechanisms like inflation rate, burning rate, utility, and/or time to be taken by the current Total Supply to reach the proposed Maximum Supply.
Token Distribution and Allocation
The fair and equitable distribution and allocation of tokens plays a considerable role in the success of any tokenomics model. Based on distribution metrics, tokens are bifurcated into “Fair Launch Cryptocurrencies” and “Pre-mined Cryptocurrencies”. Fair launch refers to the branch of coins and tokens, which are mined, earned, and owned by the community since inception, without any private allocations.
Bitcoin, Dogecoin, Yearn Finance, and Sushiswap are just some of the famous examples of Fair Launch Cryptocurrencies. Pre-mining is the mechanism where, either all or a substantial number of coins/tokens are already mined, distributed, and owned by an exclusive club that might consist of founders, developers, partners, early backers, and VCs before the public launch.
On the surface, fair launch protocols sound like a whole better deal to a section of the crypto industry, as it ideally provides the whole community with equal participation opportunities, proportional to their share of distribution since the onset of the project. But the approach has its limitations, which are addressed by the pre-mining mechanism to any extent. Pre-mining allows the protocols to secure funding and expertise necessary for the development of a product. It’s not a cakewalk to turn ideas into reality. Several great ideas die a premature death due to lack of funding. Pre-mining allocation acts as a required bridge between accredited investors and startups to save those ideas from fading into oblivion.
Therefore, this is a fair barter in this context. The founders not only secure the uninterrupted oxygen in form of funds for their projects, but also get access to other functional expertise like marketing, legal/compliance, and top-notch connections for takeoff. The high-net-worth individuals and institutional investors get lucrative deals commensurating with the huge risks assumed by them by betting on uncharted waters. And as they say, the higher the risk, the higher the rewards.
The job of the retail investor here is to assess how fair this barter mechanism is for them. And the assessment can only be performed by carefully studying the distribution of tokens. It is critical to estimate the percentage allocation done to seed sale, private sale, advisors, public sale, marketing, team, rewards, liquidity funds, and/or community.
If an entity has a major share of tokens assigned to private investors, developers, and other internal parties, then it can become complicated for other investors. The unbalanced allocation poses a risk of the market being flooded with token dumps, diluting the value of the token as soon as the project goes live (alert: this is where those dreadful VC and whale dumps come from). However, such risk is usually mitigated by Vesting. The vesting period refers to the duration for which tokens sold to early investors are prevented from being added to the circulating supply by a locking system. The schedule of unlocking these tokens and adding them to the market is called the Vesting schedule. A justly designed vesting schedule, ranging from months to years, is indispensable in safeguarding the interest of all shareholders.
Irrespective of the vesting period, the prerequisites for an ideal and genuine protocol include justifiable and balanced token allocation fulfilling the basic tenets of decentralization. You might wish to proceed extra cautiously with protocols allocating less than a single-digit percentage value of Total Supply to retail investors, as even healthy vesting schedules might not be very fruitful in protecting retail investor interests in such scenarios. If the founders are in for the tech, then the centralized dispersal of network resources doesn’t sound very convincing.
A transparent team must be able to provide answers to the following questions. How much of the percentage is vested in private investors? How much is owned by developers and founders? What’s the vesting schedule for such distribution? What’s the percentage available to the public? Is any singular wallet holding the majority of funds? And so on.
Conclusion
Analyzing a tokenomics model acts as an efficient tool in separating the wheat from the chaff, especially when the market is flooded with chaff disguised as gold. There are no strict parameters for evaluating the validity of any project, but above stated basic metrics can surely support you in understanding the soundness of a tokenomics model! And remember – always DYOR 🙂