Tokenomics is an economic concept for understanding the supply, demand, distribution, and valuation characteristics of digital assets. Coined from two words, ‘token’ and ‘economics’, tokenomics refers to the economic framework and financial logic governing a digital token.
In the world of cryptocurrency, tokenomics encompasses the value, issuance, distribution, circulation, utility, longevity, economic stability, and burn mechanism of a cryptocurrency.
In the fast-paced world of digital currencies, understanding the economics behind tokens enables anyone interested or involved in cryptocurrency to navigate the market wisely.
For instance, tokenomics can critically influence market behaviours, protocol participation, and sustainability of the decentralized ecosystem. Also, investors can determine the future value of an asset from its tokenomics.
To further understand the concept of tokenomics, this article presents a detailed overview of tokenomics, including its main components, models, and importance in the crypto ecosystem.
What is a Token?
Since token supply is a fundamental aspect of tokenomics, it is important to take a look at what the term means.
A token is a digital unit or asset built on a pre-existing distributed ledger or blockchain. A token represents value or ownership within a decentralized system.
It is created and issued for various purposes - as a specific asset, to validate transactions, as proof of internal operations, as a governance token, or as an incentive mechanism.
Although tokens are issued for several use cases, the most common uses are as utility, security, and governance tokens.
- Just as the name suggests, Governance tokens holders have the power and privilege to vote. Holders can participate in internal operations like decision-making processes. For instance, the AAVE tokens, CRV tokens, and MKR (now SKY) tokens.
- Holders of Utility tokens are granted access to some specific products or services in a blockchain network. For instance, BAT (Basic Attention Token) from Brave Rewards is given to users as an incentive mechanism for viewing ads on the Brave browser. Users can then use BAT as tips and to make micropayments to content publishers.
- Security tokens grant ownership in an asset or company. They offer ways to tokenize traditional financial (TradFi) instruments like bonds and stocks. Please note that these types of tokens are subject to securities regulations.
Basically, tokens have pre-set, algorithmically created issuance schedules - tokenomics. Hence, the total number of tokens that would have been created by a certain period can be predicted with some level of accuracy.
Although it is possible to alter the issuance schedules, it is very difficult to implement because it usually requires the consensus of many people.
Knowing this tokenomics provides some security and comfort for crypto asset owners, who can predict to what degree their tokens will be created in a way that is much more predictable than the government’s FIAT money.
Main Components of Tokenomics
There are five main components of tokenomics, which are:
Token Supply
This is the amount of a particular token that will available in circulation. Some tokens are designed to have an infinite number of supplies, while some have a limited supply.
Three major terms that can refer to token supply, these are maximum supply, total supply, and circulating supply.
- Maximum supply: This is the maximum amount of token a project that produce in its lifetime. Once this amount is reached, more of the particular asset can no longer be minted. Note that not all tokens have maximum supply.
- Total supply: This is the number of a project’s token that is currently existing. This includes the circulating supply, locked supply, and vested tokens.
- Circulating supply: This is the number of the project’s tokens currently in circulation. That is the amount of token that is circulating in the public.
Generally, the circulating supply may be equal to or less than the total supply, which is also equal to or less than the maximum supply.
Token Distribution
The next component of tokenomics is token distribution, which refers to how a project’s tokens are released, distributed, and allocated.
After launch, tokens are often allocated to various stakeholders, such as developers, early investors, community members, etc., via a selected distribution strategy.
Some notable distribution strategies include Investor/Team Allocations, Security Token Offerings (STOs), Initial Coin Offerings (ICOs), Initial Exchange Offerings (IEOs), Airdrops, Mining and Staking Rewards, Community Grants/DAO Allocation, and so on.
The way a project's tokens are distributed can significantly impact the success of the project as well as the value of the token.
For instance, if a larger portion of a project’s crypto asset is allocated to developers, potential investors may be wary of or show concern about centralization and possible market manipulation.
Hence, to establish credibility, healthy asset distribution must be structured using certain instruments like vesting, staking, and other rewards.
Token Utility
Token utility refers to the practical usefulness or purpose of the digital asset within its ecosystem.
Some good token utilities include transaction fees, liquidity, governance rights, collateral for borrowing, network security, fee reduction, staking, access, and membership, etc.
Tokens with strong utility are prone to either maintain or increase their values after some times. For credibility, the token’s utility must not only align with the project's goals but also encourage user participation and add genuine value.
Conversely, overcomplicated utility, redundant utility, and forced adoption are all examples of bad utility.
Token Governance
This is the system whereby token holders can participate in decisions regarding the management and development of the token.
Token Security
Token security plays an important role in the world of digital assets. It reinforces the integrity and reputation of an asset and its associated project, contributing to its success.
One way to ensure the credibility of an asset is to subject it to regular, rigorous, and transparent security audits. This examination will help to identify potential attacks, weaknesses, and identifiable vulnerabilities.
Generally, security audits are essential for protecting the token’s utility and holders from irregularities in overall market value and risks that affect asset prices.
Token Burning
The last component of tokenomics on our list is token burning.
Token burning refers to the system of sending some tokens into an unusable wallet in order to permanently remove them from circulation.
Tokens are burned to prevent inflation, and the burned tokens become inaccessible to anyone. Burning is important because, as the number of tokens in circulation reduces, there is an increase in the market value of the remaining available tokens.
For instance, In November 2019, Stellar burned about 50% of its total supply, leading to a price increase of over 30%.
Similar to token burning is token sinking. Token sinking, on the other hand, involves using transaction fees to offset inflation. Just as burning, sinking also helps to control the token's circulating supply.
