What is Tokenomics? Understand Everything About the Token Economy

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What is Tokenomics? Understand Everything About the Token Economy
What is Tokenomics? Understand Everything About the Token Economy

Before investing in cryptocurrencies, it is essential to know how to decipher the Tokenomics of a project. This is essential to know everything that is going on behind a token and to put the odds on your side to make a wise investment.

What is Tokenomics?

The study of Tokenomics, contraction of the words “token” and “economy”, is one of the disciplines of the fundamental analysis of cryptocurrencies.

Indeed, there are two main types of analysis for an investor to carry out to maximize his chances of profit:

  • technical analysis, which involves observing price momentum on a chart to capture a trend;
  • fundamental analysis, which involves estimating the current and potential intrinsic value of an asset.

While technical analysis is predominant in short-term trading, fundamental analysis is more part of a long-term investment approach.

In this article, you will discover how to analyze the tokenomics of a cryptocurrency. You will then know much more than the majority of investors and avoid investing in projects that are doomed to failure.

Tokenomics: the game of supply and demand

Generally speaking, the price of an asset results from a balance between supply and demand. If the demand is greater than the supply, the price goes up and vice versa.

From this point of view, cryptocurrencies are no exception to the rule. However, it is in the characteristics of supply and demand that they stand out. Indeed, they do not work like any other financial asset.

Hence the appearance of this new science, the economy of tokens, the object of which is to fix on the one hand the quantity and the way in which the offer will be distributed and, on the other hand, to imagine the use cases that will generate demand.

The main difficulty is to avoid too great an imbalance between supply and demand. This is all the more difficult since it is impossible to anticipate the speed of adoption of a project and its cryptocurrency. This partly explains the high volatility of this asset class, the first projects having, as we say, “weathered the plaster”.

But to fully understand the difficulty of this balance, let’s start by seeing what characterizes the offer.

Supply, or what is supply in tokenomics?

As often in the world of cryptocurrencies, the terms used are in the language of Shakespeare. This is why you will regularly come across the word supply when discussing the token supply of a project.

The most reliable information regarding a token offering is always found in the whitepaper or project documentation.

However, an easy way to get detailed information is to use a data aggregator like CoinMarketCap or CoinGecko.

Figure 1: Display of Bitcoin tokenomics on CoinMarketCap

Let’s first review the metrics that measure the quantity of tokens.

The max supply, or maximum offer, represents the maximum number of coins or tokens that will be put into circulation. The most famous example is that of Bitcoin and its 21 million units. But not all cryptocurrencies have a maximum, in which case the Max supply is not indicated.

The total supply, or total offer, represents all the tokens already created minus those that have been burned – we will see this later – or withdrawn from circulation.

Finally, the circulating supply represents the fraction of the total supply that circulates freely on the market at time T. “Staked” tokens are excluded, as well as those held by the protocol itself or by the founders, for example.

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Figure 2: Diagram of the metrics relating to the quantity of tokens by Cryptoast

Finally, the last two metrics that must be understood are the market cap and the fully diluted market cap.

The market cap represents the market capitalization of a cryptocurrency. It is the equivalent of the usable money supply in an ecosystem at time T, because it is obtained by multiplying the circulating supply by the price of the token.

Market Cap = Circulating supply x token price.

For its part, the Fully Diluted Market Cap is a vision of the maximum money supply of an ecosystem since it is calculated by multiplying the Max supply by the price of the token.

Fully diluted MC = Max supply x token price.

Now that you have a better view of the important indicators, we can look at what parameters will impact these metrics and how this will positively or negatively influence the price of the token.

The evolution of supply over time, an essential aspect of tokenomics

It should be understood that, in general, anything that will tend to increase the supply will slow down the evolution of the price of a cryptocurrency.

Conversely, the mechanisms that reduce supply are likely to support its price. Let’s see this in more detail by studying the parameters that vary the amount of tokens in circulation.

Inflation

In most cases, tokens are issued gradually over time until the maximum supply is reached when it is set.

To return to the example of Bitcoin, new coins are created with each block to reward miners. There is, therefore, an inflation of the total supply, which at the time of writing this article is around 1.8% per year.

What puts the price of bitcoin in a long-term uptrend is that the demand for its adoption is far greater than its inflation, without forgetting that it is programmed to be halved every four years according to the halving cycles.

In summary, demand is growing much faster than supply, which creates upward pressure on the price.

Conversely, many cryptocurrencies have inflation rates that are too high, in particular, to offer impressive returns via staking or decentralized finance (DeFi) protocols. But that can be counterproductive.

Let’s take the example of CAKE from PancakeSwap to illustrate our point.

It is possible to get more than 60% return per year through staking. This seems interesting at first sight, but it is without counting on inflation of 66% of the number of tokens.

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Figure 3: Evolution of the number of CAKE tokens in circulation over time

This generates a phenomenon of dilution quite close to what can be observed during a capital increase on the stock market. The capitalization remains stable, but with the number of tokens being greater, its price is mechanically reduced.

This partly explains why the CAKE has been down more than 85% since its all-time high. Yet it is one of the most widely used decentralized applications (dApp) in the entire crypto ecosystem. This shows the decorrelation that can exist between the success of an application and the valuation of its token.

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Figure 4: Evolution of the price of CAKE tokens from your ATH

Deflation

Unlike inflation, there are mechanisms to reduce the quantity of tokens, which is then rather favourable in the long term to the increase in price.

The main techniques to achieve this are burn or buy-back. Simply put, it’s about withdrawing tokens from the circulating supply.

In detail, these techniques can be used to limit inflation, and we will then speak of disinflation or simply to reduce total supply. In this case, it will be said to be a deflationary token.

In all cases, the goal is to control or reduce the supply so that the demand is greater than the supply and create this famous tension in the price.

A very good example is BNB, the cryptocurrency used on the BNB Chain and the Binance platform.

Indeed, Binance has several burn mechanisms depending on the fees paid by users, both on the exchange and via the BNB Chain. In total, more than 36 million BNB have been burned since the beginning. At the current price (June 2022), that’s almost $15 billion. And it is expected to withdraw another 64 million over the next few years.

All the tokens having already been issued, it is not a question of limiting inflation but of reducing the total quantity of tokens in circulation. BNB is, therefore, a deflationary token, which should favour its long-term evolution.

The clothing

There is a last parameter which can temporarily influence the quantity of tokens in circulation. This is called vesting.

Tokens acquired during pre-mining by members of the founding team and advisors or by private or institutional investors during fundraising, for example, are often accompanied by a blocking period.

This is done to prevent these early investors, who have benefited from very advantageous prices, in return for their risk-taking, from being tempted to immediately sell the assets when listing the tokens on the exchanges. A sell-off would then immediately drop the price.

This is why there is most often an unlocking schedule to control this potential influx of new tokens.

If we take the example of the ILV, the token of the highly anticipated Play to Earn Illuvium, we can see a number of things on the schedule for the release of the token available on the Messari platform.

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Figure 5: Schedule for the release of ILV tokens 

The ILV tokens allocated to the team and investors will be gradually released over 12 months, starting in March 2022. The supply in circulation will be multiplied by 6, from 1 to 6 million tokens.

For information, pre-seed and seed investors bought their tokens respectively at $1 and $3, while it is currently worth more than $600. It seems obvious that as soon as they have the opportunity, they will want to collect all or part of their colossal capital gain.

This is why vesting is often penalizing for the price of a token because it introduces massive inflation over a short period, associated with profit taking by the first investors.

Only a strong demand could compensate for this situation. Perhaps the launch of the Beta version of the game scheduled for Q1 2022 could be a trigger, but nothing is less certain.

Accordingly, always check if there is a release schedule on Messari or in the project whitepaper before investing.

The usefulness of a cryptocurrency, the main component of demand

After supply, demand is the other elements that must be understood when reading the tokenomics of a cryptocurrency.

After the speculative demand that can drive up the price of a cryptocurrency in the short term, it’s the demand for its utility that will bring its long-term success.

This is why it is necessary to seek to find the different cases of use of the coin or the token. What is it used for? How can I use it?

We will review different use cases, knowing that a token can combine several.

Blockchain coins

Coins are a special type of token. These are the native tokens essential to the operation of blockchains. Impossible to make a transaction or execute a smart contract on Ethereum without using ETH, for example.

From this perspective, infrastructure blockchain coins have a good chance of having a steadily growing real demand as they are adopted.

The utility token of a platform or protocol

Utility tokens, as we can guess without mastering English at our fingertips, respond to specific use in an ecosystem. They are necessary to access or use a service, for example.

We could cite the CHSB, the utility token of the SwissBorg platform. The number of CHSBs held makes it possible to obtain different VIP levels, which are associated with advantages such as increased staking returns or reduced transaction fees.

A utility token often has use cases limited to the ecosystem on which it depends, and its value must be compared to the value of the service to which it provides access.

Payment of network transaction fees

Tokens can be used to pay service fees. The best example, but not the only one, are exchanges like Binance, FTX, KuCoin and others.

All have their own token. More often than not, there is an incentive, such as a reduced fee, to pay with the house token.

Use as Currency

Of course, cryptocurrencies are also exchange currencies, the most famous being bitcoin. Being able to use a cryptocurrency as a means of payment is a powerful demand factor, but there are actually quite a few of them who can take on this role.

Staking

Another use case is staking. Whether it is to participate in the consensus of a blockchain in Proof of Stake or to obtain staking rewards, it is necessary to own and immobilize tokens.

Decentralized Autonomous Organizations (DAO)

To be able to take part in the governance of a decentralized autonomous organization (DAO), it is necessary to hold the tokens of the organization. To participate in decisions, vote or receive rewards, it will therefore also be necessary to buy tokens.

Logically, a token combining use cases is more likely to benefit from sustained demand. The stronger the utility-related demand, the more the price will tend to rise in a healthy and steady way over the long term.

The case of Binance’s BNB, a token with multiple uses

To illustrate everything you have discovered previously, let’s take the example of BNB from the Binance ecosystem, which has many use cases.

First of all, the BNB token being usable within the Binance exchange, is one of the most popular utility tokens in the ecosystem.

Platform users have an interest in buying and holding BNB to benefit from various advantages:

  • 25% reduction in trading fees if paid in BNB;
  • Cryptocurrency is used to acquire NFTs on their marketplace;
  • Access to the Launchpad to invest in new projects;
  • Access to the Launchpool to receive airdrops of tokens;
  • Staking and farming to get returns on DeFi;
  • Etc.

For the record, Binance is by far the world leader among cryptocurrency exchanges, with 85 million customers at the end of 2021. All these users have an interest in buying and holding BNB to benefit from these many advantages, which creates a healthy and regular demand.

On the other hand, the BNB also serves as a native coin to the blockchain of the ecosystem, the BNB Chain. It is, therefore, a whole set of complementary use cases that are added to an already long list.

This, coupled with a supply already 100% issued and deflationary, undoubtedly explains why BNB is the 3rd most important cryptocurrency behind Bitcoin (BTC) and Ether (ETH).

Conclusion on Tokenomics

To sum up, it is thanks to the analysis of tokenomics that you will be able to estimate the long-term valuation potential of a cryptocurrency.

The goal is to determine if demand will be greater than supply to drive up the price. Because whatever the qualities of a blockchain or a decentralized application, if its tokenomics are poorly designed, the price of its token could be likely to drop in the long term.

This is why you should make the effort to consult the whitepaper of a cryptocurrency before investing, especially if you plan to hold for the long term.

And in general, we prefer tokens with low inflation or deflation and with several use cases likely to maintain regular demand.