Intro to Tokenomics
3/5: Distribution & Incentives
Token distribution describes how tokens are allocated to the original team and its public and private investors. This can happen through various methods, including initial coin offerings (ICOs), pre-mines, public sales, airdrops, mining, rewards, and more.
In the case of the USD, the Federal Reserve is in charge of ‘token distribution’; they acquit themselves of this task by purchasing securities on the open market, or lending money to banks. For more on this, feel free to research the Cantillon Effect.)
Token distributions often happen in stages. The most common practice is allocating a specific number to the original team as an incentive for participation. To prevent team members from selling all of the tokens simultaneously, these tokens are often locked for a set period and released gradually. Then, the project may seek private or venture capital investor funding over several rounds before releasing the tokens on the public market. It behooves a smart digital asset investor to research and understand these details. They matter!
Most reputable projects have normalized the public release of their distribution practices and vesting schedules. However, if you're considering purchasing a currency that hasn’t made its token allocation public, you should tread carefully to avoid a pump and dump scheme. Likewise, if most of the tokens are held by the founders or their first few investors, these are red flags.
Historically, the strongest investments have been distributed in a way that minimized its impact on the circulating supply and maintained relative price stability.
Some cryptocurrencies have built-in burn protocols intended to prevent inflation. Burning a token permanently removes it from circulation. This concept is based on the laws of supply and demand. Theoretically, reducing a token’s supply should support its price by enforcing scarcity. In other words, the fewer tokens there are, the higher the price should be if the demand remains the same. Ethereum started burning a portion of the tokens sent as transaction fees previously used to reward miners. Since Ethereum is an inflationary token with no fixed supply, the token burn was implemented to reduce the overall supply and hopefully have a positive effect on the token’s value over time.
But as is the case with any of these tokenomic factors–they work together in symbiosis, and– won’t always make up for a glaring lack in another area of the project’s tokenomics, such as low utility. A crypto project can burn all the tokens it wants, but if for example, developers are flocking to work on other projects and there is diminishing utility for the token… Then a token burn is nice but not very useful. That’s up to you to research and use your common sense!
An incentive is anything that influences users to behave desirably. It changes the cost-benefit analysis that users perform when evaluating their choices. When it comes to cryptocurrency, there are a few common incentive mechanisms designed to encourage participation and investment.
The most common incentive mechanisms are mining and staking rewards. For Proof of Work blockchains like Bitcoin, miners must solve complex computational problems, “work,” to win the race to mint the next block of transactions. The miners receive BTC as a reward for this work, as it’s an energy-intensive process.
For Proof of Stake blockchains like Cardano, network participants stake their tokens to the network to increase their probability of gaining the right to mint the next block of transactions. The more tokens are staked, the greater the chance of success. Since staking contributes to the overall performance and security of the network, those who stake are given staking rewards for their service.
Other incentive mechanisms include liquidity pools, where participants are rewarded for contributing their tokens to provide liquidity for decentralized finance (DeFi) protocols, and governance mechanisms, where token holders are granted the right to vote on proposals that govern the network… But beware! As we have recently seen with LUNA and UST–some incentive mechanisms can turn out to be fatally flawed. Hence DYOR : )
Disclaimer: This article is not intended to provide investment, legal, accounting, tax or any other advice and should not be relied on in that or any other regard. The information contained herein is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of cryptocurrencies or otherwise.