Glossary

What is Tokenomics in Blockchain and How Does it Work?

what is tokenomics

Do you believe that economics is the backbone of any financial system? A group of smart folks in RBI or Federal Bank pulls some levers, and the entire economy of the country follows suit. Ignore the basic principles of economy, and you might become the next Zimbabwe, Argentine, Turkey, or Sri Lanka. 

If economics plays such an important role in the physical world, why should the virtual world be any different? Your cryptocurrency tokens are also governed by the basic laws laid by economists. And hence the evolution of the word: Tokenomics. While it’s not hard to guess that it comprises of two words: token and economics, the real question is, what is tokenomics?

What Is Tokenomics: The Demand and Supply of Cryptocurrencies

Tokenomics is the study of economics governing a project. Just like any other asset, the long-term value of cryptos is generated purely based on their fundamentals. However, in the short term, the price movement of cryptocurrencies is determined by the basic rules of demand and supply. 

This demand and supply heavily depend on the factors like the total number of tokens available in the market, how these tokens are distributed amongst founders and the general public, is there a possibility of adding new tokens to the system? etc. And guess where you’d get all this information from? Tokenomics! Most white papers (a document that entails all the project information) have a dedicated section for tokenomics. 

Let us take this up with the help of an example. Bitcoin, the world’s first cryptocurrency, is so valuable because it cannot be created out of thin air. Its tokenomics is designed such that its max supply is capped at 21M. Apart from that, the decision of rewarding a fixed number of tokens (which keeps on getting halved every four years) to the miners is also defined. This ensures that Bitcoin continues to accrue value over a period. 

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The Fiat Parlance

Let us look at it from a different lens now. Something much closer to home. The fiat currency. USD, INR, EUR etc. 

During the onset of the pandemic, the entire economy came to a standstill. People stopped moving out of homes (hence spending close to nothing other than bare essentials). As a result, manufacturing units had to slow down their production and hence cut their employees’ wages (which means they would spend less too). This created a vicious cycle of economic downturn. 

As a solution to this problem, governments across the globe decided to put money in the hands of the people. The idea was very simple. More money equates to more spending, more production, higher wages, and the entire cycle returns to life. 

Now the way they did it is by creating more money. How? By printing more of it. This boosted the supply of money and helped the economy’s revival. However, it brought another problem along with it. 

Now, since there was more money, its value kept on decreasing. Why? Because the rate of production remained constant more or less. So there was more money demanding the same set of goods. As a result, we saw the highest inflation in 40 years in the US. At one point the inflation numbers also touched 9.1%

So now you know how a simple game of supply and demand (economics) can make or break the economies. 

How Does Tokenomics Work in Blockchain?

Well, we just saw how the fed printed more dollars to pump the economy. Did Powell (or equivalent in your nation) run a vote before taking that decision? No right? They relied on the collective wisdom of a group of people before taking a call for the entire nation. While this should not be a problem as they have way more experience and context than an average joe, it would have been nice if you could somehow foresee this turn of events. 

That is where blockchains come into the picture. Blockchain offers features that make crypto assets more powerful than their fiat counterpart. Let us discuss the same:

A. Immutability

If Blockchain is a city, then code is the law. Its associated cryptos have clearly defined tokenomics that cannot be altered at will. Any change needs to be factored in through community voting. Therefore no single individual (even the founder) has the power to change anything that was decided upon in the beginning. 

Compare that with fiat money. US dollar was pegged against gold before 1972. This means that the US could not print more money than the total value of its gold reserves. However, one fine day, to boost the economy, Nixon, then president of the US, decided to do away with the gold peg. Ever since money has been artificially inflated or deflated through federal policy. 

B. Transparency

Public blockchains offer unmatched transparency for all transactions. That is one feature of distributed ledger that makes it possible for everyone to participate in the game. Imagine if you could monitor all the whale activity and take preventive measures to safeguard your interests. If at all there is some manipulation going on, it is anybody’s chance to anticipate it. 

Recently feds hiked the interest rates by 1%, the highest ever single time increase in history. This resulted in a massive crash in stock and crypto markets. This often happens because when interest rates go up, it becomes difficult to borrow money. This is perceived as negative news for the industries, and people try to keep their savings in liquid and safer investments. If somehow an average retail investor could predict this move (or have a say in it), they could have avoided wealth destruction by reallocating their funds. 

The basic types of tokenomics in the blockchain realm can take the following shapes:

A. Deflationary Vs Inflationary

A deflationary token is one whose total supply keeps on decreasing over a period of time. For example, Fiat is inflationary as the total supply continues to increase. On the other side of the spectrum, BNB continues to decrease in supply and hence it is deflationary. A specific amount of BNB is burnt every quarter depending on the profits generated by the Binance exchange. 

B. Mint and burn

Some tokens are minted all at once and then burnt periodically. This event is spread across various milestones. E.g., Shiba Inu, a meme coin, was minted all at once, and half of its supply was burnt post-launch. 

C. Periodic releases

Some projects release the tokens in the ecosystem periodically. This is common with the tokens having usability within the platform. For example, most chains that run on proof of stake consensus algorithms reward their validators in the native tokens for helping them maintain the network. 

What Are the Factors That Go into Crypto Tokenomics?

Now that we realize the importance of tokenomics, it is time to understand what all factors are a part of it. Tokens are cryptocurrencies the project owners create on top of a blockchain. Therefore, it is very important to understand that the founders of these projects can pick whatever model suits them best for generating these tokens. 

However, a prudent investor must evaluate these models and get into the nitty-gritty of tokenomics to make a wise decision. Let us explore these factors in detail:

A. Distribution of tokens and their allocation

Web3 projects are fundamentally different from web2 projects in terms of funding. While web2 projects deal in equity or a percentage share of the business to raise money, web3 projects often rely on tokens. This money is raised using ICO (Initial Coin Offering) or IEO (Initial Exchange Offering). ICO or IEO is a new-age method of raising money. Projects launch their tokens and offer them at a discount in ICO/IEO sessions. Hence, attracting enthusiastic investors. This is very similar to IPO in traditional finance.

Since the entire funding is done through these tokens, the tokens are reserved for various aspects of the project. Token distribution describes the proportions in which different groups of users and investors own project tokens. 

B.  Supply of tokens

The maximum supply of a token plays an important role in its price movement. For example, Shiba Inu has a total supply of 1 quadrillion. A lot of people believe that it might hit $0.01 someday. The rationale behind this thinking is the fact that they bought millions of tokens at a dirt cheap price. Now they believe they would be instant millionaires if it ever hits 1 cent in price. However, if that ever happens, it would reach a market cap (calculated by multiplying the current price and total supply) of $10 trillion. This is more than the market cap of the entire crypto industry right now. 

C. A model for token

While exploring the tokenomics of a project, always think about the problem it is trying to solve along with the use of tokens. For example, would ETH be so valuable if it was not required for every transaction happening on Ethereum? Therefore, the more the utility, the higher the chances of boosting demand and hence the possibility of the token’s value going up. 

Similarly, keep an eye on whether the token is inflationary or deflationary. Often, deflationary tokens can act as a store of value. 

D. Capitalization of the market

While evaluating a token, it is important to understand the dominance it asserts on the entire cryptocurrency market. For example, Bitcoin dominance, a ratio of BTC’s market cap to the total market cap of the industry stands at roughly 50%. This ensures that fluctuations in Bitcoin are enough to change the course of the market. 

Similarly, the project you are evaluating must not be extremely insignificant when it comes to market capitalization. This is exactly like like a penny stock in the stock market. It is not necessarily good if it’s cheap. 

What Are the Advantages and Disadvantages of Tokenomics?

Tokenomics has unfolded a new era of economics. From centrally driven policies to individuals experimenting with different models that work, tokenomics provides a great deal of flexibility. Let us explore some of its advantages and disadvantages:

Benefits of tokenomics

Tokenomics is a relatively new field, and a lot is left to be explored. But in the early days of its advent, there are a few pretty evident benefits:

A. Alignment of stakeholders

All of us use multiple internet-based products out there. With so many options, you side with one of them and exhibit your loyalty. But have you ever been rewarded due to the massive growth of the product? Even the shareholders just get indirect benefits in the form of dividends, and that is it. 

However, tokenomics aligns the incentives for producers and consumers alike. If the token value appreciates, both ends of the equation are benefitted. Essentially, we just replaced Venture Capitalists with a common retail investor using tokenomics. 

B. Flexibility

Do you have a better idea for running an economic model? Go ahead and give it a shot. Now anyone can try to run an entire economic system powered by tokens. For example, the Terra ecosystem failed, but at its heart, they tried to innovate the entire stablecoin universe. 

C. SALM

Smart asset life cycle management or SALM is a feature offered by blockchains. This allows the creator to manage all the aspects of an asset (token) automatically like issuance, burning, escrowing etc. 

Currently, if you want to buy an asset remotely, you might have to pay in time and fees to facilitate the intermediaries. With blockchains and tokenomics, you may not need that infrastructure at all. 

Disadvantages of tokenomics

Another perspective to look at the ‘newness’ of tokenomics is that it may not be as established as other models. For example, Axie Infinity, a play-to-earn game, tried to bring a brand new model to the gaming industry where people earned real money while playing the game. However, it has not been doing well after an initial bout of success. 

Let us discuss some other disadvantages of tokenomics. 

A. Legality

Governments across the globe are sitting on the fence when it comes to regulating cryptocurrencies. This means that the future of a lot of tokenomics-powered projects lies in the hands of government agencies. While decentralized forces cannot be banned completely, a healthy legal infrastructure is a must for retail adoption. However, the sentiments look largely positive globally.

B. Infancy

Despite all the euphoria, none of the models has stood against the test of time. For example, Axie Infinity is struggling, the Terra ecosystem has failed completely, and many other projects are pivoting as we speak. This might be a cause of concern for a retail investor who plans to experiment with tokenomics-powered projects. 

However, this is all a learning curve.

Conclusion

No matter how the problem is approached, in essence, tokenomics tries to democratize wealth and power amongst the users. The entire idea of having skin in the game is definitely enticing for the end users. We’ll have to wait and watch what the future holds for us in this domain. 

FAQs

What is another name for tokenomics?

Tokenomics stands for token economics or crypto-economics. It is a study of the economic model governing a cryptocurrency like Bitcoin, Ethereum, or BAT. 

Does Bitcoin have tokenomics?

Yes. Bitcoin has a clearly defined supply of 21M. Apart from that, every block results in the formation of new Bitcoins. This means a miner is rewarded with a certain number of Bitcoins every time they successfully mine a transaction. This number also gets halved every 2,10,000 blocks or four years. Currently, it stands at 6.25BTC per block. The next halving is due in 2024, post which it will come down to 3.125BTC.

Why is it important to look at tokenomics before investing?

Tokenomics is the backbone of fundamental analysis. How are you supposed to gauge the future prices if you do not understand how much of something exists in the market? Also, tokenomics can help you find out if a single entity holds a large chunk of tokens. This creates doubt in the minds of investors. 

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