What is tokenomics? 

Put simply, tokenomics, or ‘token economics’, is the basics of evaluating a crypto. It covers everything about how tokens work, including their mechanics, distribution, the factors that influence long-term value and much more.

When looking at tokenomics, we’re looking to determine what makes a crypto valuable. We aren’t considering the protocol it belongs to, but rather the token in isolation. What does the token do within the ecosystem? How is it designed to act with supply and demand dynamics (e.g. is it inflationary or deflationary? Does it have staking? etc.)

Tokenomics is extremely helpful in determining how valuable an asset is and how valuable it will be in the future. 

What is supply? 

It’s vital we consider how a crypto’s supply will change over time (emissions), as this is a determining factor as to whether the token will hold, increase or decrease in value over time.

Also, when the token’s price is affected by supply change, the perceived value of the project can also be affected. This is because when the price falls due to an increase in supply, investors can get spooked and sell out, perceiving the fall to be a risk. This can be very negative for a protocol, especially one that relies on public attention and hype. It can cause a domino effect, with more investors getting spooked and selling out, driving the price further down, in a self-reinforcing loop.

In terms of supply, with all else being equal, a token’s value will increase if, in the future, fewer tokens exist compared to now – this is known as deflation. On the other hand, if more exist, a token’s value will decrease – this is known as inflation. We’ll look at inflation and deflation in more detail later. 

Circulating supply

The circulating supply is the number of tokens that have been issued so far (the number of tokens currently in the market).

Circulating supply is important because it determines the supply currently available to be sold on the market. When we compare the circulating supply with the maximum supply, it tells us how many more are going to be released, which is vital when considering the potential value of a protocol in the future. 

Maximum supply

Note that for some tokens, there is no set maximum supply.

When considering the potential future value of a crypto, it’s important to look at the maximum supply, rather than the current circulating supply. If you are considering holding a token for the long term, the maximum supply will likely be reached whilst you hold it. 

If the circulating supply is low, but the maximum supply is high, that’s a potential red flag, as it could cause the value of your tokens to be diluted. Short-term holders don’t need to worry as much regarding the maximum supply, as it’s likely they won’t be around for all token unlocks. However, they do need to be aware of any large unlocks, as they could get badly stung.

Bitcoin, for example, has a maximum supply of 21,000,000. This scarcity is central to its value proposition. It explains why many see it as a store of value and refer to it as ‘digital gold.’ 

There are also some cases where the number of tokens will reduce. Some projects, either at random or following some pre-set rules, burn a certain percentage of tokens (meaning that they can’t be recovered and are gone from the supply forever). Burning can relate to fees, so the more a particular asset is used, the faster its tokens are burned. 

Ethereum, for example, doesn’t have a maximum supply. However, Ethereum’s EIP1559 update introduced a burning mechanism for a portion of the gas fees. This means that if the Ethereum network is used heavily, it becomes deflationary. And, after The Merge, inflation has been reduced further from 5,500,000 ETH issued per year to only 600,000 ETH. 

Total supply

A crypto’s total supply is the number of tokens that have already been created or mined. In other words, the number of tokens that currently exist rather than the maximum number of tokens that will ever exist. 

The total supply = the on-chain supply - burned tokens (if there is a burn mechanism).

What is market capitalisation (market cap)?

The market capitalisation (or market cap, or m’cap)  of a crypto is far more important than the token’s $ price, as the price doesn’t actually tell you what a project is valued at. 

A crypto’s price is decided by the number of tokens in supply, which is often a completely random and arbitrary number. Therefore, price is entirely useless when valuing a project, unless you are multiplying it by the circulating supply (which gives you the market cap), or maximum supply (which gives you the fully diluted value - more on this later).

Market cap is the total dollar value of all coins in circulation. A crypto’s market cap is calculated by multiplying the circulating supply by the token’s price. 

Market cap offers an indication of how valuable a crypto is, as well as its growth potential (as if you know it is valuable, but it has a small market cap, there could be high growth potential). It’s much easier to get massive returns from small market cap coins, as there is significantly more room to grow. However, a crypto with a smaller market cap is a riskier investment, as it’s much more likely to go to 0 than one with a larger market cap. 

Some cryptos have a huge supply, like Dogecoin, for example, which is why it’s one of the biggest by market cap even though the $ value of each coin is very low. Hence why it’s important to look at a crypto’s market cap and not just $ price. 

If crypto X has a circulating supply of 600,000 tokens and each token is valued at $1, its market cap is $600,000. If crypto Y has 100,000 tokens in circulation and each is valued at $3, its market cap is $300,000. So, while the individual $ price of crypto Y is higher, crypto X has a market cap that is twice as valuable. 

Fully Diluted Value (FDV)

The fully diluted value (FDV) is the theoretical market cap of the crypto if all tokens were in circulation. This is calculated by multiplying the crypto’s current price by the maximum supply of tokens. 

If there is a significant difference between a token’s market cap and fully diluted value, it means there is still a large number of tokens waiting to be released into the market, which could be a red flag. So, it’s important also to check how and when these tokens will enter the market - something we’ll look at later. 

There’s a big difference between a token whose supply is growing by 5X in 5 months, rather than 5X in 5 years. So, it’s also necessary to look at the time period over which these tokens will be released. 

Token Distribution 

Another thing to consider is the allocation or token distribution - what tokens will go where? Scarcity breeds value. The rate of the release of a token, as well as where and to whom it is distributed, affects its value and reputation. 

If a few investors, or team members, hold a large amount of the tokens, it adds a high potential risk. They could have excessive swing over governance, or control the price by pumping and dumping to suit them. Even without anything dodgy, they could simply have made a lot of money already, and dump their tokens to cash out, resulting in the price falling.

A good distribution design is when no individual or group holds a significant amount of the token. Instead, it should be distributed among many, with a fair allocation focus to the community. 

Fair launch: A fair launch is when the community collectively mines the coin or token e.g. Bitcoin, or Litecoin. There’s no token allocation for fair launch cryptos. Note that a fair launch is the best, but it’s very rare, as it requires the creators of the crypto to get no allocation (which most aren’t happy to do). Fun fact, Vitalik wanted Ethereum to be a fair launch, but pressures from other team members prevented this.

Pre-mine: Most altcoins have a pre-mine, which is the process of allocating a fixed amount of tokens prior to public launch (to insiders and early investors). In the case of a pre-mine, some or all tokens are minted before opening up the network to the public. Note, that it is a risk if an excessive amount of tokens have been allocated to the project’s team and investors. 

Private sale: A private sale is an early-stage fundraising round, where investors can buy into the project at a cheaper rate. Note when private investors' tokens are unlocked, that often causes a lot of selling pressure. For example, if a large amount is unlocked at the same time or near to each other, the investors would likely have got in early and at a low price and will want to take profits. Tokens allocated to angel investors/venture capitalists (from private sales) will often be the first to be sold, as they will have bought in at very low prices, and are likely to want to cash in profits. 

Public sale: A public sale is when a project makes its token available to the public. This is done in a variety of ways. In recent years, ICOs (Initial Coin Offerings) have become less popular due to scams. Since then, alternative token offering methods have emerged (they function broadly in the same way, but without the negative connotations of ICOs). These are IEOs and IDOs.

IEO: An IEO or Initial Exchange Offering is a type of funding method in which a centralised crypto exchange oversees the sale of the tokens. This means that the project and its whitepaper go through a vetting process, reducing the risk of scams and increasing investor confidence. IEOs can also help generate publicity for projects and help them raise money quickly. 

IDO: An IDO or Initial DEX Offering is the same as an IEO. However, it is run on a Decentralised Exchange (DEX). As they are decentralised, IDOs remove the need for third-party influence, protecting against biases and human errors. They are generally considered a fair way to launch a new crypto project. Often, IDOs have anti-whale and anti-bot measures, to ensure no single investor can purchase a massive amount of tokens, and to prevent other bad actors (although these don’t always work). Note that while projects are vetted by the DEX, there is less regulation than an IEO on a large, regulated exchange, so be wary and ensure to DYOR before taking part in an IDO!

Vesting & emissions schedules 

Tokens may be locked up for a specific period of time, during which they cannot be transacted or traded. The vesting schedule (also referred to as the token lockup period) is the timeline of how the team and investor tokens will be released. 

A good vesting schedule helps to increase the confidence of token holders, as it means the market won’t be overwhelmed by a mass release of tokens allocated to the team or private investors. 

Usually, vesting schedules take place over many years, often with a ‘cliff’, which refers to a period before they start unlocking, often 1 year (but decided by the team and can be any period). This prevents unlocking too many tokens at once or in a short period of time, which can sink the price of a token and have potentially fatal consequences.

Emissions refer to how quickly new crypto tokens are created and released by the protocol. For example, a new Bitcoin block is added to its blockchain every 10 minutes. Miners are rewarded with BTC for every block that is validated. Right now, the reward is 6.25 BTC, at the next Bitcoin halving event in 2024, this will be reduced to 3.125 BTC. 

Emissions refer to mining/farming/platform rewards, so if you stake and get tokens back that are not from revenue (i.e. it is added to the circulating supply), those are emissions. 

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Inflation & deflation

A crypto is either inflationary or deflationary. If 5,000 tokens out of 10,000 have already been created, the supply will inflate by 100%. Inflation can reduce the value of tokens over time, but, if done right, can add huge value by attracting initial interest and liquidity, turbocharging growth.

Deflation can increase the value of tokens over time. As there are fewer tokens, each one is worth more. This is why deflationary tokens can be so valuable. However, we must consider how those tokens are being burnt. For example, some protocols charge a high tax on sales (50%, for example), of which 60% goes to the protocol, and 40% is burned. This doesn’t add value to the protocol at all and is a red flag. 

Often you can stake your tokens to avoid dilution through inflation. If you do so,  you’re receiving tokens in line with the rate of inflation (not including private sales, team unlocks, or incentives outside of staking).

Inflation is used by many projects to incentivise participation. However, the sort of aggressive inflation used to pay liquidity providers in many DeFi protocols can overwhelm your investment and erode value drastically. An example of this is LOOKS (LooksRare’s token), where 50% of tokens were distributed in the first 90 days. If you had bought in at launch, this inflation would have drastically eroded the value of your tokens, with the amount of tokens doubling from launch in only 90 days.

Bitcoin, for example, has a maximum supply of 21 million bitcoins, and according to its rules, the block reward received by miners is cut by 50% every 4 years. So, it’s likely that we won’t see any significant inflationary pressure that could decrease the value of Bitcoin as it’s fixed and inflation decreases every 4 years through halving. This means there won’t be any surprises. 

What is utility?

Even if a token has great supply tokenomics, it doesn’t necessarily mean it’s valuable. The token still needs a good purpose to exist and for people to want to hold it. 

Utility is often also referred to as the use-case of the token. When looking at utility, consider the question: Why would you hold this token? The answer may be revenue sharing, staking, governance etc. For something to have value, people need to believe it to be valuable and that it will continue to be valuable in the future. 

Token utility vs utility tokens

Note that the term ‘utility tokens’ is not the same as the term ‘token utility’. Simply put, token utility is the umbrella term for what a token does. A utility token is one of those use cases, which refers to a token that doesn’t fit into the other categories (such as governance, revenue sharing etc.). Often, utility tokens are, in fact, tokens without much utility and are not inherently good investments!

Some crypto exchanges use a utility token for their internal payment system. These tokens are sold before the protocol launches, raising funds to build the platform. It’s expected that those token holders will then use the tokens to pay for fees on that exchange.

This utility token model works for exchanges. However, the only thing that gives the token value is the users’ willingness to pay fees on the exchange. The main argument against this model is that users could just use a different exchange on which they could use Ether or another asset they already hold to pay fees. So, why would they bother buying the exchange token? Well, they probably wouldn’t, so they wouldn’t use the exchange. This bad token use case actually drives people away from such protocols. 

Here are some examples of utility:

Bitcoin is a store of value like gold (accessible to anyone), and there’s a lot of demand for an easily accessible store of value. 

Ethereum users can pay fees on applications built on it (Dapps) with ETH. There’s a lot of demand for ETH to pay gas fees. And, since the Ethereum Merge, people staking ETH get a share of revenue from gas fees. 

For DeFi tokens, utility may come in the form of votes in the governance system for their protocol, revenue sharing with token holders, or many other use cases.

Utility: Revenue & Rewards

In this context, we’re talking about revenue and rewards in terms of how much income the asset can generate for you by holding it. Rewards may be earned through staking, mining, revenue-sharing, and yield farming. Such rewards can help further the demand for the token. 

Cryptocurrencies that utilise the proof of stake consensus method allow holders to “stake” their tokens to support the security of the network in return for rewards. Staking is a way of earning a passive income, simply by holding and staking a token. Staking in this form is very beneficial, as the staked tokens are productive (as they secure the network). This is opposed to staking where the rewards are paid out purely from token inflation (which is unproductive and seen in many cryptos).

If a token has built-in rewards and revenue sharing through staking or other forms, it’s easier to justify investing in it. 

Note that staking may have restrictive effects on supply. When you stake a crypto, those tokens are often locked up for a period of time. Staking acts as a way to reduce the supply of tokens on exchanges. It restricts the number of tokens in circulation, which could encourage positive price action.

Not all proof of stake tokens have a lock-up period, so in these cases, tokens could be moved to an exchange at a moment's notice and push a downward move as people take profits. Also, sometimes, lock-up periods don’t align incentives but are designed simply to get people to lock up for long periods of time, meaning they can’t sell, which may be negative if a large number of tokens eventually unlock and hit the market.

Also note if a token offers staking without using the proof of stake consensus mechanism to secure the network (or another use case meaning the tokens are actually productive whilst they are staked), the project is essentially just incentivising you for locking up your token. The project isn’t getting anything out of it, and your tokens aren’t doing anything productive. This can be an issue, and while it is seen a lot, it’s a bad thing). 

Utility: Governance

Owning governance tokens gives holders a say in decisions. Choosing the direction the protocol takes, as well as controlling things like token emissions (and much more!).

Governance tokens represent ownership in a decentralised project. They give holders the right to influence the project’s direction. This may include deciding which new features or products to develop, which partnerships to pursue, or how to spend funds (including deciding whether to share the revenues with the community). 

While the exact process differs depending on the protocol, governance token holders can typically propose changes through a set proposal submission process. Then, if specified criteria are met, the proposal will go to a vote. Holders can then use their tokens to vote on the proposal. 

In decentralised protocols where there is no centralised governing body, governance tokens are essential for decision-making (taking the role of the centralised body, and putting it on all token holders). They enable the distribution of power across an entire community. Token holders are not just users, but owners of the protocol. 

Note that governance tokens don’t make sense for every protocol. 

What is veTokenomics? 

‘ve’ stands for ‘vote escrowed.’ It is a method of locking up tokens, removing them from the circulating supply and making sure holders can’t sell them. It can be a ponzinomic method of locking supply, but there are real use cases in which it can be productive and positive. 

It is specifically used amongst governance tokens, and the longer you lock your tokens, the more weight your tokens have when it comes to voting on governance.

Curve introduced the ve (vote-escrowed) staking model, requiring holders to lock their CRV tokens which are then converted into veCRV, allowing holders to take part in voting. The lock period isn’t fixed, but holders can lock up their CRV for a maximum of 4 years, with more voting power awarded to people who lock their token for longer periods. 

Also, once the holder has decided to lock their CRV for a certain period of time, there’s no option to unstake them early. The aim behind token-locking is to build a longer-term value proposition for the token holders. Locking tokens also creates an incentive for all holders to act in the protocol’s best interest. 

veTokenomics solves a potential problem with whale manipulation. In non-ve models, large whales can purchase lots of tokens for short-term governance and rewards. (Whales in crypto are people or organisations who own large amounts of crypto). 

Potentially, a whale could purchase millions of tokens to manipulate governance proposals of a competing protocol, and then simply dump the coins. 

In the ve model, this kind of manipulation isn’t as effective, if possible at all, as they have to lock tokens, and if they do it for a short period planning to dump after, they will carry much less weight.

Diving into the economics behind tokens is crucial for making informed investment decisions. Understanding how tokens operate within their ecosystems, their supply and demand dynamics, and their utility and governance structures is foundational to grasping their potential value and impact.