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Understanding Tokenomics

Posted November 9, 2022 3:07 pm
7 min
By Deep In The Sesh

The world of cryptocurrencies and Web3 technology is an ever-changing, fast-paced environment. With new coins and tokens being released daily, it can be difficult to keep up and sometimes understand the differences between them. One of the most important and fundamental aspects to understand is the tokenomics behind cryptocurrencies. In this article we’re going to explain what is a token, what are tokenomics and why they matter. 

So let’s jump in. 

Crypto Tokenomics Explained

In the most basic sense, “tokenomics” is the study of how crypto tokens work within the context of a larger economy. It’s a relatively new field of study that is still being defined, but it generally looks at the ways in which crypto tokens can be used to create economic incentives and disincentives, as well as how they can be used to facilitate economic activity.

Crypto tokens can be used in a variety of ways to create economic incentives and disincentives. For example, a crypto token can be used to represent a unit of value that can be exchanged for goods or services. Alternatively, a crypto token can be used to represent a stake in a project or company, which gives the holder a claim on the project’s future earnings.

Tokens can also be used to create economic activity by serving as a means of exchange. For example, a crypto token can be used to purchase goods or services, or to pay for a service. In this way, crypto tokens can be used to grease the wheels of the economy, making it easier for people to buy and sell goods and services.

So far, crypto tokens have mostly been used to create economic incentives and disincentives, but there is potential for them to be used in other ways as well. For example, crypto tokens could be used to represent ownership of physical assets, or to represent a vote in a governance system.

What is a token?

Let’s back up and think about the what a token actually is. A token is a type of cryptocurrency that represents a digital asset or utility that is often found on a blockchain. A token can represent different things, but is generally used to represent something that can be traded for goods or services. For example, a company may release a token that can be used to purchase products on their website. Another example is the Bitcoin network’s underlying token is bitcoin which you can exchange for fiat currency or other cryptocurrencies.  

How Can I Analyze a Project’s Tokenomics?

A token is a digital asset that is built on top of a blockchain. There are two main types of tokens: utility tokens and security tokens. Utility tokens are used to access a product or service, while security tokens are investment contracts that give the holder an ownership stake in a company.

To analyze a projects tokenomics, you need to look at a range of different metrics including the total supply, distribution, vesting schedules, staking rates and the utility of the tokens. The total supply should be limited so that the tokens can increase in value over time. The distribution should be fair, with a large percentage of tokens being held by the team and a smaller percentage being held by early investors. The utility of the tokens should be clearly defined, and the tokens should be used in a way that benefits the project. Let’s take a deeper look.

Token Supply

Usually a project’s token will be capped at a certain amount or it can be inflationary. This is preprogrammed using smart contracts. 

If a project has a capped token supply there is a greater chance that it will hold value in comparison to an inflationary supply. For example, there will only ever be 21 million bitcoin and that gives investors confidence in its scarcity. 

Inflationary tokenomics is a type of tokenomics where the supply of tokens increases over time. This is similar to how fiat currency (e.g. USD, EUR, JPY) is printed and introduced into circulation. The main difference is that, with crypto tokens, the supply can be programmed to increase at a predetermined rate.

There are two main types of inflationary tokenomics: linear and exponential. Linear inflationary tokenomics has a constant rate of inflation, like 2% per year. Exponential inflationary tokenomics has an increasing rate of inflation, like 10% the first year, 20% the second year, and so on.

Inflationary tokenomics is often used to incentivize early adopters and investors, as they are rewarded with more tokens for participating early on. 

Token Allocations and Vesting Periods

Projects can determine how they want to allocate tokens when creating a tokenomics plan. However, there are usually industry standards that most crypto projects follow. There are various stakeholders a project can allocate tokens to including: 

  • Founders 
  • Incentives
  • Community Grants
  • Early investors
  • Advisors
Source: Uniswap

Vesting schedules determine how long a token holder (usually an insider that has a lockup agreement) must hold their tokens before they can sell them and at what frequency. Oftentimes, management teams that have long vesting periods help investors feel more confident. 

Token Staking

Staking a token allows you to earn a return on your staked amount. What’s happening is you are staking your tokens to help secure the network. This happens because networks that allow staking use a “consensus mechanism” called Proof of Stake. This is how networks ensure transactions are verified and secured without a bank or payment processor in the middle. One such example of this is Ethereum as they recently switched from Proof of Work to Proof of Stake. Staking is an important part of many tokenomic schemes. 

Token Burns

Token burns are a popular way to reduce the amount of a given cryptocurrency in circulation. By “burning” tokens, the team behind the project can reduce the total supply of tokens. Theoretically, this should help the value of the token as there are now fewer tokens available.

There are a few different ways to go about token burns. One popular method is to have a portion of each transaction “burned” or destroyed. So, for example, every time a transaction is made, 1% of the tokens involved are destroyed. This has the effect of reducing the total supply of tokens over time, as there are fewer and fewer tokens in circulation.

Another common method is to set aside a certain number of tokens to be burned at regular intervals. For example, the team behind a project may choose to burn 1% of the total supply of tokens every month. This also has the effect of reducing the total supply of tokens over time.

Token burns are a way to make the token more scarce which sometimes makes it more valuable. 

How do Tokenomics Work in NFT Gaming?

Tokenomics play a central role in NFT gaming. While there are many different types of tokenomic plans for various different games, we often see a governance token (usually capped) and also an in-game currency token that is inflationary. 

Usually, play-to-earn and play-and-earn games have an in-game token which players earn from gameplay and can be used to buy in-game items. This token is usually inflationary with no cap. The governance token theoretically allows holders to have a share of revenue and also vote in governance decision making. 

Other types of games such as play-to-own may only have one token or no token at all. Much of the value in those types of games is derived from the in-game assets such as NFTs.

We are still in the experimentation phase when it comes to NFT gaming tokenomics as the industry is still very nascent.  

Closing Thoughts

Tokenomics are a crucial aspect of any crypto project as they help determine how the market values a token. We’re still in the experimentation phase as different structures of tokenomics become more popular and then fizzle out. For example, in late 2021 the rebase tokenomic structure was extremely popular which was created by Olympus DAO. As of the time of writing this structure is nowhere to be found and is totally out of favor. Understanding a project’s tokenomics is an important task when trying to value a project. 

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