Tokenomics - The Complete 101
TL;DR: Imagine you are creating a new country. One of the critical aspects to consider is launching the country's own currency or a pseudo-currency. The monetary and fiscal policies determine how the country uses the new currency as a tool for value creation and value distribution.
Similarly, your Web 3.0 cryptocurrency project is a country with its own economy. You will launch a token (or a coin) to be used within your project. The monetary and fiscal policies you setup will determine the success or failure of the project.
Tokenomics (token + economics) is the tool to design and create a thriving Web 3.0 economic ecosystem supported by tokens. Tokenomics covers the project design, fund raising, token operations, token benefits, token destruction, the governance of the project, and more.
In this article....
What are Fiscal & Monetary Policies?
What are the branches of Tokenomics?
What are the benefits of Tokenomics?
What are the drawbacks of Tokenomics?
What factors are included in Crypto Tokenomics?
What are the various Token Models?
What are the Key Metrics for Tokenomics?
What are the Tokenomics Terminologies?
Tokenomics – An Introduction
In the beginning, people bartered goods and services. About 5,000 years ago in Mesopotamia, Shekel, the first known form of currency, was created. Then came the gold, silver, and metal coins. Followed by paper money.
Digital currencies came into existence in the 1990s. Cryptocurrencies are digital currencies. The cryptocurrencies, as we know today, started with Bitcoin network going live in 2009. Cryptocurrencies introduced coins and tokens, thus launching a new field of economics called as tokenomics. The field of tokenomics came into prominence around 2017.
Tokenomics (also referred to as token economics, or cryptoeconomics) are so new and rapidly evolving that there’s isn’t a common definition, consensus on terminologies, or best practices and guidelines available to apply to crypto projects.
However, what’s certain is the fields of cryptoeconomics and tokenomics are set to radically change the economic system around the world. In this blog, let us gain a deep understanding of tokenomics. Let’s start with tokens, the basic building blocks.
What is a Crypto Token?
Token is a privately issued currency. Yes, you read it right. It’s privately issued.
When the modern form of money came into existence, the power to issue money was only with the kings and the queens. Later, as democracy evolved, the power to issue money changed to the government. Even today, it is the government that can issue money in your country.
However, in real life you would have already come across privately issued tokens. For instance, when you go to a casino, you get tokens for real money. The tokens in your hand represent money within the confines of the casino.
Similarly, in cryptocurrencies, tokens represent privately issued currency for your web 3 project or platform. According to William Mougayar:
- Technically: A token is a programmable currency unit that is bolted to a blockchain and is part of smart contract logic in a specific software application.
- Non-Technically: A token is “a unit of value that an organization creates to self-govern its business model, and empower its users to interact with its products, while facilitating the distribution and sharing of rewards and benefits to all its stakeholders.”
The algorithmically created tokens on blockchain networks, have a pre-set logic to issuing the tokens, and offer more predictability than governments printing money.
Tokens by itself is a large subject to cover; they - come in various flavours, are different to coins, have multiple uses and dimensions.
Why Tokenomics is important?
Now that you have the power to create tokens (aka money), couldn’t you just keep issuing tokens as long as it’s needed and as much as needed? Well, it turns out that you have inflation as a baddie.
Countries get richer by making and selling things – whether goods or services. Money is used to buy the goods and services. If the money supply is faster than the output of the country, then inflation occurs. Since more money is chasing the same amount of goods, companies will simply jack the prices up. Too much money is bad.
Too little money is also bad. When the money supply is slower than the output of the country, there’s a shortage of money. Business cannot borrow money easily and pay people and run factories to increase the output. People don't have enough money in their hands to buy more goods and services. Too little money makes prices fall because of deflation.
As you would have realised by now, a balance between the supply and demand needs to be established. A country asks its Central Bank to closely monitor the economic activity and manage the money supply.
Let’s turn our attention back to your crypto project. Your project is a micro-economy producing output – goods and services. Your tokens are the money in your economy. Your role as a project owner, is the like the role Central bank – closely monitoring and controlling the supply of tokens vis-à-vis the platform output.
Get the drift? Tokenomics is the tool to help you manage the supply vs demand conundrum.
No two countries are the same. Similarly, no two blockchain projects are the same. Tokenomics as an essential tool helps the project teams to design and create a self-sustaining micro-economy using tokens.
What are Fiscal & Monetary Policies?
Chris Burniske and Joel Monegro suggested we can evaluate crypto assets in the same way economists evaluate the currencies of small emerging market countries: good governance, sound monetary policy, low corruption, low inequality, productivity trends, and so on.
Extending the theory, the monetary and fiscal policies of a country have a vital role to play in the economy's success. Similarly, the monetary and fiscal policies of a blockchain project plays a role in wide-spread adoption and success.
Monetary Policy
Monetary policy is a set of tools that a nation's central bank uses to control the overall supply of money to the nation's banks, its consumers, and its businesses. Changes in the money supply can affect the actual production of goods and services. Therefore, monetary policy is a meaningful tool for achieving both inflation and growth objectives.
In crypto projects, the monetary policy refers to the supply and release of the tokens. We can deploy various mechanism to increase or decrease the token supply – for example inflation, deflation, and burning.
Fiscal Policy
Fiscal policy is the use of government spending and taxation to influence the economy. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty. Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced.
In crypto projects, the fiscal policy defines the benefits for the token holders, users, and investors. The simplest benefit is the gain from price appreciation and utilisation. Beyond the appreciation, policies to promote holding & staking tokens, discounts & waivers, paybacks and more will go a long way in influencing the growing of the micro-economy.
What are the branches of Tokenomics?
Economics into divided into two categories:
- Microeconomics: Microeconomics is the study of individuals and business decisions. Aspects like individual income, savings fall into microeconomics.
- Macroeconomics: Macroeconomics looks at the decisions of countries and governments. Aspects like GDP, interest rates, inflation, GDP fall into macroeconomics.
Similarly, tokenomics has two branches: micro tokenomics and macro tokenomics.
Micro Tokenomics
Micro tokenomics focuses on the individuals and the micro properties of the crypto project or blockchain network. For example, micro tokenomics would address questions related to economic incentives to participants, penalties (or disincentives) for an individual's negative behaviour, or the profit to be shared.
Macro Tokenomics
Macro tokenomics focuses on the entire system, i.e., an aggregate of the individuals and the collective properties. For example, macro tokenomics would address big picture questions like token distribution, how much liquidity is required, factors to influence the token valuation, level of governance, etc.
What are the benefits of Tokenomics?
Remember the famous fable of the donkey, carrot, and the stick?
Incentives and disincentives are fundamental to economic behaviour. In fact, incentives drive everything. Though not guarantees of behavioural changes, incentives & disincentives induce changes by choice rather than by force.
As you know by now, you are creating a new mini economy with your crypto project. Tokens are at the core of the incentive and disincentive programs. Tokenomics help create new economic models and designs, on top of the possibilities offered by blockchain networks.
Tokenomics is an agent to open limitless possibilities for your mini new world.
What are the drawbacks of Tokenomics?
First, both blockchain and tokenomics are emerging fields. Unlike established economies and traditional stock markets, there aren’t hundreds of years of data available for us to reflect upon. One drawback is that you will work with a lot of assumptions. It’s therefore advisable to build a tokenomics framework which can withstand the vagaries of time and market.
Second, smart contracts are used to implement the designs out of tokenomics models. Smart contracts are extremely difficult to change – any error in implementation can be expensive and time-consuming. You need to be cautious of what parameter gets written on-chain and off-chain.
What factors are included in Crypto Tokenomics?
Tokenomics is a multi-disciplinary field encompassing technology, economics, mathematics, statistics, cryptography, IT, game theory etc. Contrary to popular opinion, the boundaries of tokenomics extend far beyond fund raising. The token economics of every single asset cover the token design and inception, token sales, and operations to token decay. This includes supply, inflation, rewards, fines, and governance.
Token Design
The design of the token is a critical factor in the tokenomics and the project. As a starting point for the token lifecycle, you must align the designing of the token with your project goals. There is no one-size-fits-all approach available. The design needs to be optimised for stakeholders’ incentives and the long-term sustainability of the ecosystem. At a minimum, the following factors need to be considered during this phase:
- Token purpose
- Token classification
- Token utility
- Token durability
- Token rights
- Token model
- Business & financial plan
Token Distribution
Once the design is in shape, the next element to consider is how the tokens are created and distributed. The right distribution can have a significant impact on the overall functioning of the network. Wrong distribution may even impact the network negatively. For example, in many projects, the tokens sold end up concentrated in the hands of a few individuals. This may lead to pump and dump schemes, from which many projects never recover. The key aspects to consider are:
- Token supply
- Token allocation and vesting
- Token value & token fair price
- Token sale / fund raising
- Discounts & bonus during sale
- Distribution mechanisms beyond sale
Token Operations
As you launch the platform and distribute the tokens, the real token engineering starts. You will need to constantly monitor the token models for performance and iterate through. Some factors to watch and track during this stage are:
- Token flows
- Token conversion
- Token velocity
- Staking/ Yields
- Price stability
- Consensus & Governance
Token Burn/Decay
Some projects burn their tokens. Token burning is the process of permanently removing tokens (“burning”) from circulation. The primary aim behind the burning is to reduce the overall supply and create scarcity of the tokens. The burns can happen as a pre-programmed or an ad hoc event. The factors influencing token burns are:
- Token buy backs
- Token burns/decay
- Burn/Mint equilibrium
What are the various Token Models?
In economics, the economic model is a simplified, often mathematical, framework designed to illustrate complex processes. The models are a simplified version of reality. Using models, we can make certain observations, understanding, and predictions about economic behaviour. We construct the models using a set of variables and a set of logical and/or quantitative relationships between them.
Similarly, in tokenomics, the token model exercise involves simulating situations about how participants in the economy behave or how the token-based economy works. Many variables are chosen and the interactions amongst them designed to visualise how the economy will look like, under certain conditions. Some of the key variables or dimensions used for the token models are:
- Token Type: Fungible, Non-Fungible
- Token Purpose: Fund raise token, payment token, utility token, access token, collateral, benefit, or other
- Token Scope: Single token, dual token, fungible + non-fungible tokens
- Token Value: Asset-backed, network-backed, stablecoin, hybrid
- Token Supply: Inflationary, deflationary, variable
- Token Governance: Centralised, Decentralised, Mixed
What are the Key Metrics for Tokenomics?
A solid tokenomics will help the cryptocurrency project to develop into a strong and long-term rewarding ecosystem. As we have seen above, the focus on tokenomics should be for the entire lifecycle, not just on the design and fund-raising stage.
Whether you are the project owner, user, or investor, a view on tokenomics will help understand the project and the ecosystem better. The key metrics to watch for are:
- Hard Cap: The maximum fund raised via the token sale.
- Soft Cap: The minimum funding required for the project viability.
- Token Allocation: The allotment of tokens for various purposes. The tokens are purchased or earned. For instance, a certain % of the tokens are set aside for sale (purchased) and for team (earned).
- Total Token Supply: The maximum number of tokens the project will ever issue.
- Circulating Token Supply: The total tokens issued to date and are currently available on the market and public hands.
- Token Emission Schedule: A view of the design of the token supply into the market. For example, the emission schedule would give an insight into token vesting and algorithmically pre-set release schedule.
- Token Model: Whether the token is inflationary, deflationary, or hybrid.
- Token Listing Price: The price of the token when the project is launched, and the tokens are listed on an exchange.
- Token Price: The current price of one token.
- Market Cap: MCap is “Token Price x Circulating Token Supply”. Market cap is a useful metric for comparing the total value of one cryptocurrency with another.
- Fully Diluted Market Cap: FDMCap is “Token Price x Total Token Supply” - a theoretical market cap if the entire token supply was in circulation.
What are the Tokenomics Terminologies?
As the world of crypto and tokenomics are moving rapidly, new terminologies are being added constantly. In this section, let us get a grip on the commonly used jargons and terminologies.
- Fair launch: Fair launch is a way to promote decentralisation. Instead of a small group of people holding a significant chunk of tokens and receiving early access, fair launches aim to provide for fair and transparent initial distribution of tokens.
- HODL: A misspelling for “hold”. HODL became a famous acronym for “Hold on for Dear Life”. HODLers are the believers of the project and hold on the tokens instead of selling in the short run.
- Layer 1 Coins & Layer 2 Tokens: Layer 1 typically refers to coins which are native to the blockchain network (e.g., ETH for Ethereum network). Layer 2 refers to the tokens created on Layer 1 blockchain networks (e.g., USDT token created on Ethereum network). Not to be confused with Layer 1 & Layer 2 networks which refer to the scalability solutions.
- Liquidity pool: Liquidity pools, a popular concept in DeFi, are crypto assets locked in a smart contract. Your crypto project might create a liquidity pool of its own to enable trading and swapping between other crypto tokens and your project token.
- Minting: Minting is generating new coins.The Government or the Central Bank mints the Fiat currencies in our countries. In crypto, minting doesn’t involve the central authority, but enables a person to generate new coins or tokens in a decentralised way. We can mint coins or tokens in two ways:
- Mining: Mining is a process to issue new coins and to reward participation in the network (e.g., Bitcoin mining via Proof of Work).
- Staking: Staking is a process where users stake their pre-existing cryptocurrency to perform certain validations in the network. On successful completion of their work, the stakers get new coins as rewards and fee (e.g., Ethereum’s Proof of Staking).
- Minting vs Staking: In popular parlance staking is commonly referred to as Minting; even though staking is one method of minting.
- Mined vs Pre-Mined: Bitcoin is distributed as it is mined. Contrarily, pre-mined coins are mined (and possibly distributed) before a coin has been made launched and made public (e.g., Cardano’s ADA coin).
- Pump and Dump Schemes: A pump-and-dump is a scam to inflate the price. Initially, scamsters buy a large amount of a coin to increase its value. This creates a "hype" leading to others' buying. Eventually, the scammers dump their assets by offloading their coins at a high price. This may lead to a price crash, while the scamster made a profit.
- Rug pulls: A scam pulled off by the project owners. This occurs when the project creators abandon the project and vanish with the assets they amassed.
- Supply and Demand: In a free market, supply and demand are equated through the price of goods and services sold. If demand is more than supply, the price goes up. If the demand is lower than the supply, the price goes down. The key is to find the balance between the supply and demand, known as market equilibrium.
- Time to Total: TTT is the time when all the tokens will be released in the market, i.e., the time when “Total Token Supply = Circulating Token Supply”.
- Whale: An individual or an institution having a large holding of cryptocurrency. Whales can dump their coins on the market in an instant, causing a major price impact of the cryptocurrency.
Disclaimer: This is not an investment advice. DYOR (Do Your Own Research) and understand the risks before investing.