Tokenomics 101: How Founders and Economics Experts Build Value into Crypto Projects
Being the savvy investor that you are, odds are you’ve probably heard of the term ‘tokenomics’. Do you know what that word means and what creating sound tokenomics entails?
Even investors who know the definition of the word may not understand the latter. That’s why in this post, you’re going to go deeper into the topic.
Studying the tokenomics of a project is a form of fundamental analysis that can help you find undervalued cryptocurrencies. If you can sink your teeth into a thorough understanding of economic design principles related to cryptocurrencies, you can couple that knowledge with both on-chain analysis and technical analysis to truly get an overall picture of whether or not it’s worth investing in a particular crypto project.
This post isn’t going to give you any hints as to which projects have sound tokenomics, but it will give you the basic principles and make you a better crypto investor.
Get ready for a crash course in the economic principles that define most cryptocurrencies.
What Is Tokenomics?
Tokenomics is of course a merging of two words: token and economics. It defines the incentives that investors receive in exchange for holding onto a given token. The reality is, all of the desire behind why humans do what they do relates to some sort of incentive. You go to work because you want to get a paycheck, you eat right because you want to live a long life, you travel because you want adventure, you have children because you want to pass on your genes, and you start a business because you want autonomy and the opportunity to leave a legacy.
They say money makes the world go-round, but money itself is just a representation of value. The opportunity to receive value is an incentive. So, for the sake of this post, let’s both agree that incentives make the world go ‘round.
Token Versus Cryptocurrency: What’s the Difference?
Both fiat money, cryptocurrencies, and tokens are all ways of expressing value, but they don’t all offer utility.
The difference between the three is that government-backed money and cryptocurrencies like Bitcoin are only forms of payment and nothing else. You can’t use either one to vote, and neither one gives you ownership of anything outside of acting as a unit of financial measurement.
The Four Basic Types of Tokens
Here are the four basic types of tokens.
Security tokens represent investment contracts. These are tokens that are capable of passing The Howey Test, which is a test used by regulators to define a given vehicle as an investment.
Utility tokens finance the operation of a blockchain network. The Basic Attention Token was used to build BAT and create the Brave web browser, a browser that lets users get paid for giving their web search data to BAT. The token itself helps founders of the project find advertisers and grow the browser’s user base.
All Ethereum tokens are created equal. They all have the same financial value. Trading one Ethereum token for another is like trading a grain of rice for another. When one version of an asset is the same as any other, this means you have a highly fungible token.
In contrast to fungible tokens, non-fungible tokens (NFTs) possess unique characteristics that make their inherent value different from others. NFTs act as proof of ownership, or a digital certificate of authenticity. They also represent access, social status, rarity, and varying degrees of value that are not directly comparable to one another.
Five Ways to Put Tokens to Work
Now that you understand incentives are what drive people to take action within a given ecosystem, you need to take a look at the other side of the fence and understand how a token benefits the mission and vision of a given crypto project. A good tokenomics model strives to adequately account for the objectives below.
1. Token Distribution
Token distribution refers to any means of distributing tokens to users. That could be an initial coin offering, mining rewards, airdrops, or any other method of rewarding users.
2. Price Stability
Cryptocurrency prices are far from stable unless we’re talking about a stablecoin. That said, founders who put critical thought into their token supply and how they’re going to release tokens over time to manage that supply and the corresponding price fluctuations that come with it can add to stability.
3. Business Goals and Dividends
A crypto project may or may not be governed by a central authority. Even if it’s decentralized, the ultimate goal is to increase the value of the token and reward token holders through dividends or other means. Without accomplishing a clearly defined goal and rewarding those that support the mission and vision of a project, there is no reason for a token to exist.
Governance tokens allow users to have a voice in the decision-making processes related to a given project. UniSwap, Yearn.Finance and many other tokens that also have financial value give their users a say in the development of a project.
5. Adapting to the Future
Developers and investors both need to understand that whatever is working for a token right now may not necessarily work in the future. Sustaining all of the above factors within a proper tokenomics model and using a forward-thinking approach to tackling challenges that aren’t yet totally clear is by far the most important reason for the existence of tokenomics.
The Three Pillars of Any Good Tokenomics Model
Now that you understand how project founders, developers, and investors can put tokens to work to achieve the goals of that project and ultimately reward people for coming along on the journey, it’s important to leave you with the three pillars of any good tokenomics model. Remember to consider these factors as part of your due diligence before you make an investing decision.
Anytime a token is used to facilitate exchanges between users, it means you’re essentially creating a marketplace. A good tokenomics model triggers an adequate level of thickness. Thickness in economics refers to the idea that you need a critical mass of people participating in a marketplace for that market to survive, otherwise the token has little or no value.
The catch with this in the blockchain world is that most 1.0 and 2.0 blockchains are still trying to solve for scalability and transaction speed. You need to get to this critical mass in designing your market, but you have to make sure that this critical mass of people doesn’t get turned off by transaction congestion, high transaction fees, or an inability to participate.
You also have to make sure that your blockchain is safe. Building on an existing blockchain that is proven to be safe like Ethereum is the best way to combat this last part.
Mechanism design refers to things like governance, non-financial incentives, and the process of verifying information and value. Is a token using oracles to update information? Are users rewarded for validating information? A properly designed mechanism motivates users fairly and transparently.
What are the interest rates attached to a token? How much of the supply will be released initially? When will it be released? Which users get access first? Answering these questions is the token economy’s equivalent to developing a monetary policy.
A token’s design has a big impact on its value. Ultimately, the goal of token design is to adequately meet some or all of the objectives defined by the five ways to put a token to work.
Financial incentives you can offer within this design include not just interest, but also lower prices on the cost of tokens for bringing new users, mining rewards for validating transactions, or contributing to the profitability of a business associated with the token. These are just some examples. There are many more.
Why There Is No Such Thing As a Perfect Tokenomics Model
Tokenomics models, and all economic models in general, try to account for all of the desires and choices a person can make when it comes to how they create, HODL, and exchange value. The basic principles of a solid model are outlined throughout this post, but at the end of the day, there is no perfect model.
Creating a good tokenomics model is a challenging task. Creating a bad tokenomics model on the other hand pretty much guarantees that a project is going to fail in the long run. A bad model makes market participants want to walk away from the project, may cause them to lose their value or have it stolen, and ultimately causes a project to lose all of its steam.
In a fast-paced world like cryptocurrency, building momentum is much more difficult than losing it. At least you now know the basics of a good model.
Buying Cryptocurrencies with Sound Tokenomics
Ethereum is the first token in the history of cryptocurrency to develop a tokenomics model attractive enough to lure in a mass group of people. This not only increased Ethereum’s market capitalization over time and made the second most valuable cryptocurrency in the world, it’s also helping the project achieve its broader goal of becoming the world’s biggest, most advanced decentralized global computer.
Other cryptocurrencies offered at Netcoins, like Bitcoin and Litecoin aren’t considered tokens because they don’t offer utility. They are traditional cryptocurrencies.
But if you want a real-life case study for how a good model can help a project rise to the top, study the early beginnings of Ethereum 1.0, and follow the projects move to a proof-of-stake consensus algorithm by staying on top of Ethereum 2.0 updates.
If you think owning some ETH tokens will inspire you to learn more about tokenomics and how to take advantage of the built-in incentives that crypto projects offer to you, sign up for a free account with Netcoins.
You don’t have to pay any buying fees on your purchases and it’s the most trusted cryptocurrency exchange in Canada.
Hopefully this post is enough of an incentive to keep learning about tokenomics. Consider what you’ve learned as the pay off for reading this right to the very end!
Writer, content marketing at Netcoins.