Tokenomics for beginners

Tokenomics is the study of the economics of a token. Fundamentally, it involves studying the factors that impact the supply and demand of a given token but really, anything that changes the value of a token is part of Tokenomics.

If we go a bit deeper, it refers to the quality of a token and whether it can convince users or investors to adopt it, whilst helping to build the ecosystem around the token’s underlying project. 

The topic of Tokenomics is vast and continuously expanding as token projects find new and more efficient ways to develop. Nevertheless, it is one of the most important things to evaluate before investing in a token. Since there are many factors and components to consider, it’s useful to get familiar with the terms and start to understand how some projects have a greater chance of success than others. 

Supply and demand

Let’s begin with the essential concept of supply and demand. It explains why some things are more valuable than others, depending on how much of that ‘thing’ exists and how much people want it – gold is scarce and therefore expensive whilst water is plentiful and relatively cheap.

Unlike natural limitations, crypto projects can set their own supply – a project can decide how many tokens it creates, whether there will be a maximum amount, who will get the tokens, and whether it destroys or creates new tokens over time.

Due to the openness and transparency of blockchain technology, the information related to supply metrics is made public. Here are the important metrics related to a token’s supply and some examples of how they impact a token’s value;

Circulating supply: the number of tokens currently circulating in the market that can be owned and traded by market participants.  

This can be controlled by the project. For example, if project (X) plans to produce 100 billion tokens, it could choose to only release half of the tokens upon launch. If there are 50 billion tokens currently circulating, the project may choose to gradually bleed the remaining tokens into circulation over a period of time and in following with their Tokenomics plan. The plan is designed to incentivize different behaviors, typically related to platform use, validation and marketing.

Total supply:the total number of tokens in circulation minus the tokens burned (removed from circulation).  

It includes both the publicly available (circulating) supply as well as tokens locked through some other means. Examples of locked tokens include staking, farming, or those held by founders or early investors that are restricted from sale for a period of time. 

Maximum supply: the theoretical maximum number of tokens that can ever exist. 

Bitcoin is a good example. Inventor Satoshi Nakamoto capped the number of Bitcoin at 21 million. The aim was token scarcity and control of inflation, which would potentially arise from an unlimited Bitcoin supply.

Market cap: the total market value of a token’s circulating supply. 

You can calculate the market cap by multiplying the current price with the circulating supply. Market cap doesn’t directly affect a token’s price but it does reflect a project’s perceived value in the eyes of an investor. Over time, this can drive the price up. Market cap can indicate the growth potential of a token and whether it’s safe to buy in comparison to others.

Fully diluted market cap: the market cap of a token if the maximum supply would be in circulation. 

It can be a good indicator for long-term investors – It allows them to make better judgement on whether a project’s value is reasonable or not. For example, an extremely high fully diluted market cap means that there will be a lot more tokens coming into circulation.

Token analysis

You can analyze how the price of a token can be affected by an individual metric or by a combination of factors. For example, if a project has a scarce circulating supply but is in high demand, the price will undoubtedly increase. Alternatively, if the maximum supply is large and the project constantly releases new tokens into circulation, it would counter-act the high demand and limit the price’s upward potential. 

The demand side of this formula comes from the users’ side. Demand refers to how many users want to buy the tokens. It’s not directly controlled by the project or part of Tokenomics per se, but it may help you understand the totality of the token price structure. For example, a project can increase its demand by having a problem-solving product, a loyal community, exciting marketing campaigns and by providing other features that increase user-interaction.

Remember, no project is perfect. It requires a holistic approach to research followed by an informed decision. Check out What Token Should I Buy : Basic Crypto Research and Where Does Crypto Get Its Value From? to broaden your research further.

To inflate or deflate? That is the question

A token can be inflationary or deflationary. If the net circulating supply of a token increases over time, the token is inflationary. If it decreases over time, it is deflationary. You can find out if a project is inflationary or deflationary by finding out if the project is producing more tokens than it’s taking away from circulation.

Additionally, if the token has a maximum supply, it becomes deflationary by default. In Decentralized Finance (Defi), tokens are sometimes purposefully designed to be inflationary in order to pay high APYs (annual percentage yields), whilst other projects may strive to make their tokens deflationary.

In traditional finance, deflation is considered a bad thing as it means that products are losing their value. However, in crypto, deflation usually means that the underlying token will become more valuable over time. 

Token distribution

After grasping the basic economics of a token, you may want to find out how a project distributed its tokens in the first place, who is holding the tokens, and how many are being held. By doing this, you can ensure that the project is not a scam, that it’s fair to the supporters, and that it will have necessary resources for the project’s future development. 

Suppose a project allocates a significant number of tokens to founders, team members or early investors upon its launch. This would grant majority control to a small subset of people, meaning that the price of a token could easily be manipulated.

Some projects choose to avoid such allocations in order to maintain a ‘fair launch. However, in practice and over time,  it is still possible for a small group of investors to end up with the lion’s share.   

Tokenomics tips

Before investing in a token, you should at least consider the following; 

  1. How the initial tokens were distributed, and whom were they distributed to? – Some token distribution strategies are fairer than others – for example, a closed ICO may only allow a close circle of investors to participate in the sale of a token. On the other hand, crypto airdrops distribute tokens to all early contributors and users of the platform, resulting in a wider disbursement of coins – and it’s free!

  2. What percentage of the total supply is owned by “whales”? – Check if some wallets hold a significant amount of tokens. These whales can easily affect the prices by selling large quantities at a time.
  3. What happens to the token reserves? – Check if the project has token lock-ups and find out more about them. Look for info related to future project development and future  token distribution.

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