What Is Tokenomics? A Complete Guide

Since the launch of Bitcoin (BTC) in 2009, the concept of digital currency has grown by leaps and bounds. In fact, the entire blockchain ecosystem has evolved from science fiction into being part of the financial mainstream. From collectibles like non-fungible tokens (NFTs) to the fledgling world of decentralised finance (DeFi), the blockchain and cryptocurrencies appear here to stay.

While the functionalities and applications of the blockchain are robust, valuing crypto assets involves significant guesswork. Accurately pricing crypto tokens involves weighing a multitude of factors such as the future role of crypto projects on the blockchain, regulatory governance, and the forces of supply and demand.

Establishing a benchmark value for digital assets can be problematic. That's why many investors turn to the study of tokenomics when deciding whether or not to hold crypto positions. Read on to learn more about this discipline and how it aids cryptocurrency aficionados address market volatility.

Tokenomics Defined

The world of crypto has a language all of its own. Terms like use cases, tokens and initial coin offering (ICO) are commonly found throughout the industry nomenclature. Tokenomics certainly qualifies, as it is a combination of "token" and "economics."

A great place to begin understanding tokenomics is to break down what each term means. According to the University of Buffalo Department of Economics, economics is defined as follows^[1]:

"Economics is the study of scarcity and its implications for the use of resources, production of goods and services, growth of production and welfare over time, and a variety of other issues of concern to society."

It's safe to say that most investors are familiar with the term economics. However, "token" is a different story. Crypto exchange and authority Binance describes a token as being^[2]:

"Non-mineable digital units of value that exist as registry entries on blockchains. Tokens may be used as currencies for specific ecosystems, to encode unique data, or for redemption for off-chain assets."

As it sounds, tokenomics is an abbreviation for token economics. Below is how crypto research company Coinmarketcap addresses this expression:

"Tokenomics, short for 'token economics,' is an umbrella term used by cryptocurrency enthusiasts to describe how a token is used inside the project ecosystem, or how the token will follow a monetary policy as the project grows over time."

Essentially, tokenomics is a catch-all phrase that addresses anything that may influence the value and functionality of a token. Similar to how economics focuses on how individuals (micro) and the broader economy (macro) financially interact, tokenomics is the study of the dialogue between individual coins, the marketplace and blockchain technology.

The Three Facets Of Tokenomics

Pragmatically, tokenomics addresses all key elements of coin or token value. Digital currency authority Coinmarketcap (an abbreviation itself of Coin Market Cap) views the area of study as having three parts: fundraising, governance and ownership.^[3]

Before becoming a token holder, it's a good idea to review the blockchain project's whitepaper. A whitepaper is similar to a stock or exchange-traded fund's (ETFs) prospectus. However, it states crypto-centric information such as the number of tokens it will issue, instead of shares to float. The whitepaper gives valuable details on the three facets of tokenomics.

1. Fundraising

One of the key areas of tokenomics is fundraising. Much like an initial public offering (IPO) for a stock, startup crypto projects are frequently launched via ICO.

An ICO is a way that early-stage cryptocurrency ventures raise capital. The process adheres to a crowdfunding model as a certain number of coins are minted and sold directly to the public.^[4] Not all blockchain ventures raise money via ICO; many are privately funded.

Tokenomics delves into the fundraising model and how a coin will be offered to the public. This can impact values in many ways by influencing token distribution, the total supply of coins, and the current circulating supply. Each factor impacts scarcity and abundance, which in-turn influences token pricing.

2. Governance

On the blockchain, token holders enjoy voting rights facing the operational standards of the network itself. Functionality issues such as mining rewards, hard forks and total token allocations are all directly addressed by blockchain governance.

Blockchain governance can play a premier role in the performance metrics of a cryptocurrency or project. For instance, the governance of the Ethereum (ETH) blockchain chose to transition from a proof-of-work (PoW) algorithm to a proof-of-stake (PoS) consensus mechanism.^[5] Under PoS, network validators are required to pledge an allocation of ETH or "stake" their Ether to the blockchain.

ETH's move to PoS is an example of how network governance can impact a coin's tokenomics. In the case of Ether, the PoS mechanism is to reduce barriers to entry, raise energy efficiency and promote anonymity by adding more nodes to the network.^[5]

The benefits created by PoS could improve ETH's token economy by providing more incentives to validators and streamlining the execution of smart contracts. The possibilities are truly endless, and reports of smart contract-enabled real estate sales in the Metaverse have already surfaced.^[6]

3. Asset Ownership

Digital assets are the representation of something of value in the digital atmosphere. In the arena of cryptocurrencies and fintech, value is defined in terms of tokens or coins.^[7] Thus, the holders of such assets benefit from a degree of ownership in the underlying blockchain project.

Typically, a crypto project discloses its token model in the official whitepaper. These allocation metrics include total projected token supply, distribution plan and max supply. Each of these factors can impact the token's market capitalisation, liquidity and value.

For instance, Bitcoin has a max supply of 21 million with mining rewards being cut in half every four years. Given this structure, BTC won't reach its maximum number of 21 million in circulation until 2140.^[8] Thus, BTC's value will be largely dependent on perceived scarcity stemming from limited supply.

Contrary to BTC, tokens like Dogecoin (DOGE) are minted on a consistent schedule in perpetuity. So, there is no max supply of Dogecoin and its tokenomics would reflect the enormous number of DOGE in circulation.

Inflation And Deflation In Tokenomics

Crypto authority Coinmarketcap defines tokenomics as "the topic of understanding the supply and demand characteristics of cryptocurrency."^[9]

Given this guidance, tokenomics isn't much different than the traditional study of commodity or forex currency valuations. Essentially, prices react to supply and demand disequilibrium, which directly impacts asset valuations.

In the case of currencies, central banking authorities such as the Bank of England (BoE) or U.S. Federal Reserve (Fed), report various money supply metrics. For instance, the BoE issues a monthly M4 report, which is an estimate of the private sector's holdings in the pound sterling (GBP)^[10] or the approximate quantity of the UK money supply.

As M4 grows, the value of the GBP may show weakness in relation to the inflated money supply. Conversely, the GBP may show strength when the money supply becomes deflated and M4 falls.

Tokenomics takes into account the inflationary/deflationary dichotomy as it relates to crypto. This is done by addressing two distinct types of coins: the inflationary token and deflationary token.

Inflationary Token

The International Monetary Fund (IMF) defines inflation as a measure of how much more expensive a set of goods and services has become over a certain period.^[11] In other words, inflation is a loss in purchasing power local to a currency. The phenomenon can have a detrimental impact on fiat currency values, employment and economic output.

In conventional finance, there are two types of inflation^[12]:

• Demand Pull: In cases where demand spikes but supply stays the same, asset prices increase due to demand pull inflation.
• Cost Push: Cost push inflation arises when production costs rise, diminishing supply and raising asset prices.

Both demand pull and cost push inflation have a bearing on a cryptocurrency's value. These factors are addressed by tokenomics in relation to a coin being classified as an inflationary token.

An inflationary token is to be continuously created over time with no cap or max supply,^[13] similar to a fiat currency. And, like fiat currencies, inflation due to demand pull and cost push factors can lead to devaluation. ETH is a prominent example of an inflationary token.

Deflationary Token

Deflation occurs when the inflation rate turns negative and asset prices become depressed. Deflation can arise due to a multitude of reasons but is typically a product of lagging demand. Prolonged deflation can spur an array of economic challenges including recession and high unemployment.

Within the realm of tokenomics, a deflationary token is one that has a finite number of coins to be minted. This governance model creates a deflationary currency scenario where demand outpaces supply.^[13] An example of a deflationary token is Bitcoin (BTC).

Many in the cryptosphere cite the lack of inflationary risk and inherent scarcity as making deflationary tokens superior investments to inflationary tokens. Detractors maintain that hoarders are incentivised and a reduced circulation may negatively impact the valuations of deflationary tokens.^[13]

Security Tokens Vs Utility Tokens

Like all other asset classes, crypto features a broad product line. Each type has a distinct application, purpose and valuation. Tokenomics recognises the differences in these designations and how a token's standing is impacted.

Two popular classifications of tokens are security and utility:^[14]

• Security: A security token affords the holder rights to a hard asset like shares or real estate. Security tokens are standardised investment products, only in digital form.
• Utility: A utility token furnishes the holder with exclusive rights. Utility tokens are frequently issued during ICOs and are used to access features on the local blockchain.

The biggest difference between security and utility tokens is that security tokens are regulated investments while utility tokens promote blockchain liquidity. Accordingly, the tokenomics for each asset is unique.

Summary

It's an undeniable fact: cryptocurrencies are becoming a part of the financial mainstream. Tokenomics is the study of the crypto ecosystem. It encompasses coin values, market drivers and asset pricing. It also addresses concepts such as inflation and deflation, as well as unique products such as NFTs, security tokens and utility tokens.

Tokenomics is focused on three vital factors: fundraising, governance and asset ownership. These elements are the key underpinnings of a token model that drive prices in both the short and long-term. Subsequently, tokenomics is an important discipline for active crypto traders and investors alike.

Ultimately, the responsibility falls upon the individual to decide if trading or investing cryptocurrencies is a suitable way of pursuing their financial goals.