What Is Tokenomics And Why Do They Matter?

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Tokenomics and its importance

Tokenomics is the science of the supply and distribution of tokens and the various underlying factors that control the existence of a token.

It defines how cryptocurrency works within the decentralized finance ecosystem. In this article, we take a detailed look at the different elements of Tokenomics. So let’s get straight into Tokenomics. But first, let’s see, what is a token?

What is a Token?

A token is the digital unit of cryptocurrency.

Tokens either represent a use on a blockchain or stand for a specific asset. Tokens are classified into sub-categories based on their use cases:

Security tokens

Security tokens are digital assets that represent and transfer ownership from real-world assets to that token.

Governance tokens

Governance tokens give their holders ownership of a centralized protocol and certain rights to influence that protocol’s management.

Utility tokens

Utility tokens help fund or capitalize projects, startups, or companies.

Fungible Tokens

Fungible tokens are divisible and non-unique. Examples include cryptocurrencies such as Bitcoin and fiat currencies like euros and dollars.

Non-Fungible Tokens

Non-fungible tokens or assets are unique and non-divisible. The uniqueness is ensured using smart contracts encrypted on blockchains.

Layer 1 tokens

A layer one network provides the basic infrastructure for protocols, applications, or networks to build upon. Each layer 1 network has a native token. This token gives access to the layer one network’s resources.

Layer 2 tokens

Layer 2 is a secondary protocol or framework built over an existing blockchain system. Tokens used on this layer are called layer 2 tokens.

What is Tokenomics?

Tokenomics refers to the science that defines a cryptocurrency’s monetary policy. It includes the creation of a coin, its supply and demand, management, and removal. In addition, tokenomics indicates the token’s role in the ecosystem and how it generates value.

Importance of Tokenomics for crypto investors

Tokenomics is a reliable indicator of how much a cryptocurrency would be worth in future.
If you’re a crypto investor, understanding tokenomics is important for multiple reasons:

To create trust

Public blockchains are open books—accessible to all, including bad players. It is tokenomics that brings together all players to strengthen the protocol and build trust using crypto assets. When tokenomics is good, it motivates more good players to participate. As a result, the value of the new cryptocurrency rises.

To understand their future worth

Tokenomics helps you understand an asset’s potential value in the future. For instance, Bitcoin follows solid rules and strictly adheres to them. Its strong tokenomics policies keep its value high in the crypto market.

Factors Influencing Tokenomics

There are 4 participants in blockchain projects—the founders, developers, investors, and consumers. Tokenomics aligns these players and lays down the foundation for a healthy ecosystem.

Here are the most influential factors in tokenomics:

Supply and demand

The first component of tokenomics is the supply and demand of a token.

Supply is the limit of tokens that can be in circulation. For instance, Bitcoin has its supply capped at 21 million bitcoins. Meanwhile, Ether has no capped supply limits. Still, these are two of the best crypto tokens ever because of the various use cases they offer. In addition, both tokens follow strict policies of tokenomics.

The other side of the coin is the demand for a token.

A token will be in demand if it offers valuable services to the user. For instance, UNI token holders get to vote over the protocol’s governance decisions. Similarly, Ether has multiple uses because of the vast number of decentralized apps that it supports on its blockchain.

Hence, the success of a token is a healthy balance between its supply and the demand for its services.

Token allocation

To attract early investors, developers, and skilful people to a project, the token’s creators allocate a certain number of tokens to these groups. This is done before the project goes live. The initial token allocation is a way to motivate contributors to join a project. Hence, it has to be sufficient enough to satisfy the initial participants.

Take the example of UNI token allocation. It set aside 60% for the community, 21.51% for the team, 17.8% for the investors and 0.69% for the advisors. Allocation is a challenging step as it involves pleasing all players involved.

Token distribution

Token distribution starts after the allocation step. It has two episodes—genesis and the following ones.

The genesis block is the initial block in the token’s blockchain. It is the step where all the participants get their pre-determined tokens to get the blockchain running. Participants include miners, validators, and users.

After the genesis phase of token distribution comes token inflation. It is the process of increasing the token supply and then distributing it to miners, validators, and the economy.

Token inflation

After the initial token distribution, token inflation starts. Inflation means new tokens are created and distributed to participants and the economy. It rewards participants and maintains the balance between demand and supply.

In the case of Bitcoin, the current reward for validators and miners is 6.25 BTC per block. This number halves every four years. The benefit of incentivizing participants is that they continue to work honestly and build trust, which is important to raise the token’s value.

Value generation

The final component of tokenomics is the value accrual of a token. Tokens accrue value when their blockchain or the supported dapps add further value to the token, thereby rewarding investors. Value accrual plays a crucial role in how the market behaves towards a token and affects its prices.

Let’s consider bitcoin, the oldest decentralized blockchain with trusted tokenomics. Further, it offers a permissionless system to transfer value. This is the reason behind its high value and its high market price.

Note that a few tokens create deflationary trends to increase their value. In this process called ‘burning’, the project buys back the tokens in circulation using its revenue. By doing this, they aim to reduce supply and increase the token’s price. Deflationary tokens include Bitcoin Cash (BCH) and Binance Coin (BNB).

Tokenomics in Action: Examples

Bitcoin

Bitcoin’s protocol allows new tokens to enter the network through block rewards. Once a miner successfully validates a block, they receive a fixed number of newly minted bitcoins. However, the miner must wait until another 101 blocks are added to the blockchain before getting the rewards.
Also, there is a limit to the number of tokens rewarded every time. This stops too many bitcoins from entering the market at once.

Ethereum

In the Ethereum blockchain, there is no upper limit to Ether tokens. Therefore, the token supply is free to keep growing as long as the network expands. The project sold 7 million Ether tokens during its Initial Coin Offering (ICO) in 2014.

Final Words

Above are the fundamentals of tokenomics. Remember, the best crypto tokens will have the best tokenomics. It is instrumental in deciding the fate of a blockchain or dapp because tokenomics influences the value of a new cryptocurrency token. Understanding tokenomics will help you make smarter investments in the best crypto tokens available.

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