What Is Tokenomics and Why Is It Important?

Until the invention of Bitcoin, fewer investors asked questions about how many units of a certain currency were in circulation, how many more could be issued in a given calendar year, or even, for example, how geopolitical risk could affect these factors. In equity investing, of course, this is much more common: Investors look at a company’s market cap, debt, shares outstanding, floats, moats, product demand, etc…

With the arrival of Bitcoin, investors have been invited to examine many of these questions more closely–but as pertain to Money, Currencies, and Digital Assets (be they commodities or securities–as never before. This study is called Tokenomics.

Tokenomics is a portmanteau of “token” and “economics.” It describes all of the factors that determine how a token functions and how it may be valued. It can also be viewed as the study of any particular currency’s monetary policy. When Ethereum implemented EIP-1559 for example, it changed its monetary policy to become deflationary by implementing a token/gas-burn policy.

It follows that tokenomics uses many of the same terms as mainstream economic analysis, such as supply and demand, market cap, and volume. For anyone who has taken Economics 101, many of these concepts may be familiar. But tokenomics also includes terms more specific to cryptocurrency, such as “burn schedule,” “mining,” or “staking.”

Suppose you want to determine the value of a currency unit–whether crypto or FIAT–to determine whether it might work well for you as a store of value over the next 5, 10, or 25 years. You wouldn't simply go on instinct, or look at how many hashtags a project has on social media… You’d also want to examine the project’s core metrics such as issuance, exchange volume, holder distribution, liquid supply, demand, utility, adoption, and further; core characteristics, such as its on-chain analytics (which is a new area of study born of bitcoin).

For example, it used to be simple to tell the amount of US Dollars in circulation: It was published regularly by the Fed as the M2 Supply at https://fred.stlouisfed.org/series/M2. As the world reserve currency, and given that most commodities (like oil) are priced in dollars; demand for the USD was relatively stable and made its demand relatively easy to quantify and predict… But then came the global pandemic. And as countries began shuttering their economies to halt the spread of Covid 19, demand for oil (priced in dollars) plummeted, and the Federal Reserve injected trillions of dollars into the economy by purchasing treasuries and mortgage-backed securities to keep our societal wheels turning–and, well greased at that!

And then there is the issue of eurodollars. Fractional reserve means that European banks have also been creating dollars on European ledgers–separate from the federal reserve!–since the 1960s. There is quite simply no longer a single source for how many dollars there are in circulation throughout the world… So that the St. Louis Fed famously stopped publishing US Dollar M2 money supply data (shortly after it began to hockey-stick up following the pandemic lockdowns) is no surprise. Tokenomics applies to FIAT, too.

To value any project–whether Amazon, US Treasuries, bitcoin, or ether–we need to understand how they work. When it comes to crypto or FIAT; tokenomics is that study.

While some are forked or copy-pasted, most cryptocurrency projects are quite unique. For instance, how is its blockchain secured? Does it use Proof of Work, Proof of Stake, or another consensus mechanism? And what's its utility? Does it function as a store of value, or does it have a practical purpose like privacy, speed, paying for file storage or wifi, or buying goods in a particular metaverse? As most cryptocurrencies and their tokenomics are unique, so are the characteristics that affect the way a particular cryptocurrency behaves in the market. Getting a firm grasp of a project’s tokenomics is essential to evaluate its potential as an investment: Tokenomics studies the factors behind a token’s supply and demand with the ultimate goal of determining its value today and over time. So, before aping-in to the shiny new project, here are some resources to help you learn to DYOR (do your own research).

We’re researching a complex web of interconnected processes that all contribute to a cryptocurrency’s value and future outlook. Just like life, it’s messy and chaotic. It won’t work the same way every time, and more often than not, people and markets are unpredictable.

However, there are general patterns that emerge based on macro and micro trends both within the crypto ecosystem and in the global political economy.

These are the most critical factors that are instrumental to most currency tokenomics.

There are two primary metrics to keep in mind when looking at token supply. The first is the maximum supply. This tells you the total amount of tokens that will exist in a cryptocurrency's lifetime. For example, Bitcoin has a maximum supply of 21,000,000 BTC. Once all 21 million BTC are mined, no new coins will ever enter circulation. The USD for example does not have a maximum supply, as we have seen: Had the dollar still been backed by gold, this might be a different story as gold is scarce and has an inflation rate of around 2%/year… But that ship sailed in 1971, so determining the total supply of dollars in the world is now almost impossible. (Stay tuned for our next series; The History of Money.)

The second metric is the total circulating supply. This tells you how many tokens currently exist in the market and can be bought, sold, or held. Circulating supply can be thought of as a company's available shares on the market.

Bitcoin has a current circulating supply of over 19.1 million BTC (at the time of writing), roughly 91% of its maximum supply. While this may sound like Bitcoin is running out quickly, it has other characteristics influencing its supply levels that will be discussed later.

Some cryptocurrencies don’t have a capped supply, like Ethereum. Instead, these cryptocurrencies rely on limited minting rates and burn mechanisms to keep the circulating supply in check.

In broad terms, if a currency’s supply remains the same or decreases while demand increases, its value will also increase. For example, gold’s yearly supply is well known and increases marginally each year, it may also theoretically retain strong purchasing power for its holder. This is known as scarcity. If on the other hand, however, demand decreases or its supply increases at a greater rate than demand, its value will likely decrease.

Utility tells us what a currency is used for. If it fulfills a highly sought-after purpose and proves beneficial for a wide variety of people or companies, its value is likely to increase. For example, since it is used to settle most international trade, one of the currencies with the greatest utility in the world today is the US Dollar. Utility for Gold is a store of value, electronics, or jewelry/art.

As another example, Chainlink (LINK) is a utility token that helps the Chainlink network incentivize data accuracy and secure transactions between information oracles. Since there is a growing use case for reliable data transfer between users, companies, and exchanges, Chainlink’s value has consistently remained among the top-ranking cryptocurrencies.

However, if a utility token becomes outdated or is only required by a small group of users for niche operations, it may be less likely to grow in value. And to make matters murkier, as Web3 continues to develop and the industry expands, new forms of crypto utility are emerging all the time. Here are some of the most common use cases on the market today:

• Store of value (BTC, USDC, USD, Gold, Real-Estate, Art, Stock, etc)
• Smart contracts (ETH, SOL, AVAX, ADA)
• Payments (XRP, LTC, XLM, USD)
• Governance (DAO, MKR)
• Exchange tokens (BNB, UNI)
• DeFi (COMP, AAVE)
• NFTs and gaming (AXIE, CHZ, APE)
• Utility tokens (LINK, GRT, FIL, VET, MANA)
• And Memes (DOGE, SHIB)

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 their 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.

A cryptocurrency’s network is made up of its founders, developers, team members, and its community of supporters and investors. These are the people who believe in the cryptocurrency’s potential and dedicate their resources, whether time and effort or financial support, to help the project succeed.

These stakeholders work together to ensure a token's long-term viability. Without a talented and dedicated founding team, the project is unlikely to attract enough support from investors to maintain an upward trajectory. Likewise, without the backing of a large community, the cryptocurrency is unlikely to sustain enough engagement to keep moving forward.

Of course, these two do not always go hand in hand: The relationship between a cryptocurrency’s network and its success in the market is notoriously hard to predict. Just because a token has a strong community doesn’t mean it has solid fundamentals. Investors should beware of projects that look too good to be true, as well as the scams and false promises that–have and continue to–plague the crypto industry at large.

On the other hand, a lack of utility doesn't always mean failure. For example, Dogecoin (DOGE) and Shiba Inu (SHIB) are two cryptocurrencies best categorized as "meme tokens." Without any particular utility, they operate primarily on the momentum of their social community. These tokens have exploded in popularity and value but have also experienced dramatic corrections.

Before purchasing any cryptocurrency, it’s always wise to investigate its tokenomics. This is the best way to evaluate the fundamentals of the project and whether it has any long-term profitability.

To recap, here’s a DYOR Checklist of some of the essential questions to ask regarding a cryptocurrency’s tokenomics:

• How many coins currently exist, and how many more will be issued in the future?
• Is the token supply increasing (inflationary) or decreasing (deflationary)?
• What is the currency’s utility, and does this connect to tangible real-world use cases?
• How are new tokens issued? Can they be mined by anyone? Are they difficult to produce? Or is a  single individual relied upon to manage the whole process, such as is the case with the Federal Reserve?
• What does ownership distribution look like–is it heavily concentrated in the hands of a few investors (like Wall Street, DogeCoin, or Silicon Valley), or is it more evenly spread out across a wide range of wallets (like Bitcoin)?
• What are the incentive mechanisms for owning this cryptocurrency?
• Who is behind the project? Do they have the necessary experience to pull it off? (For example, the bulk of Fed Chair Jerome Powell’s training and experience is as an attorney and a politician, not as an economist. Would you put your currency project in such an individual’s hands without any checks or balances? More importantly, would you invest in such a project?
• What is the technology backing the project? Is it tried and tested, or does it have a history of spectacular failures? Does it rely on legacy infrastructure from the 1970s?
• Does it have growth potential? Why? How?
• Is the team transparent with their updates and progress? (If you keep most of your wealth in Dollars, do you watch the Fed’s FOMC meetings? You’ll be pleased to know that Fed Chair Jerome Powell is “Just beginning to understand how little they understand about inflation.” His words.)
• Does the project have an active community of supporters and developers working on the project? Or do they rely on powerful institutions to enforce their use?

Now that you have a better grasp of the fundamentals of evaluating a cryptocurrency, you can go through these questions on your own. Use them as a springboard for the due-diligence deep dive into any potential investments… before putting any hard-earned money into the project. As always, DYOR, and never invest more than you can afford to lose!

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.