What is Tokenomics?
Tokenomics is a composite of "token" and "economics" and is a collective term for the elements that make a given cryptocurrency valuable and interesting for investors. This includes everything from what a token is offered and how it is issued to things like the utility it has.
Tokenomics is an important concept to consider when making an investment decision, as a project with smart and well-designed incentives to buy and hold tokens is likely to fare better in the long run than a project that has not built an ecosystem around its token. A well-built platform often leads to higher demand over time as new investors flock to the project, which in turn drives prices higher.
Likewise, when launching a project, the founding members and developers must carefully consider the tokenomics of their own cryptocurrency if their project is to attract investment and be successful.
Key features of tokenomics
The structure of a cryptocurrency's economy determines the incentives that attract investors to buy and hold a particular coin or token. Just as fiat currencies are all different, each cryptocurrency has its own monetary policy.
Tokenomics determine two things about a cryptocurrency – the incentives, which set how the token is distributed, and the token's utility, which affects its demand. Supply and demand have a huge impact on price, and projects with the right incentives can increase in value.
Here are the top variables developers are changing that affect tokenomics:
Mining and staking: On foundational blockchains like Ethereum 1.0 and Bitcoin, mining is the main incentive for a decentralized network of computers to validate transactions. Here, new tokens are awarded to those who use their computing power to discover new blocks, populate them with data, and add them to the blockchain.
Staking: Rewards those who perform a similar task but instead lock away a number of coins in a smart contract — that's how blockchains like Tezos work , and it's the model Ethereum is moving towards with its 2.0 upgrade.
Yields: Decentralized finance platforms (DeFi) offer high yields to incentivize the purchase and use of tokens. Tokens are deployed in liquidity pools — huge pools of cryptocurrencies that power things like decentralized exchanges and lending platforms. These returns are paid out in the form of new tokens.
Token burns: Some blockchains or protocols "burn" tokens, ie permanently retire them, to reduce the supply of coins in circulation. According to the laws of supply and demand, reducing the supply of a token should support its price as the remaining tokens in circulation become scarcer. You can compare this to stock buyback programs in the stock market. In August 2021, Ethereum started burning some of the tokens as transaction fees instead of sending them to miners.
Limited vs. unlimited supply: Tokenomics determines the maximum supply of a token. For example, Bitcoin's tokenomics dictate that no more than 21 million coins can ever be mined, with the last coin expected to circulate around the year 2140. With Ethereum, on the other hand, there is no upper limit, but the annual issuance of coins is limited. NFT (non-fungible token) projects are taking the shortage to the extreme: for some collections, only a single NFT may be minted for an artwork.
Token allocations and lock-up periods: Some crypto projects provide for a detailed allocation of tokens. A certain number of tokens are often reserved for venture capitalists or developers, who can only sell these tokens after a certain period of time. This, of course, has implications for the coin’s circulating supply over time. Ideally, a project's team will have implemented a system where tokens are distributed in a way that minimizes the impact on a token's circulating supply and price.
Who decides about tokenomics?
All of these decisions are made at the protocol level, and most tokenomics are embedded into the computer code of a given cryptocurrency by the founding developers.
Before a cryptocurrency is released, its tokenomics is often described in a dedicated whitepaper , a detailed document that explains what the proposed cryptocurrency will do and how it and the underlying technology will work.
Crazy Tokenomics - Game Theory in Action
The above list forms the basis for tokenomics, but that's just the beginning. Cryptocurrencies are basically a free pass to adopt any type of game theory the creators desire.
Many tokens are so-called utility tokens , meaning they have a specific purpose within a specific ecosystem — AMP, for example, is used for a decentralized escrow system, and Index Coop’s DeFi Pulse Index Token powers a decentralized index fund for top DeFi tokens.
Game theory is an economic concept that assumes that traders are rational actors and, given certain incentives, will ultimately make the optimal choice (e.g. staking ETH for high returns, mining Bitcoin, etc.). For example, compare two vastly different tokenomic timelines: that of Olympus DAO, the controversial decentralized reserve currency project, and that of Loot, the NFT character arc game by entrepreneur and programmer Dom Hofmann, who co-founded the video hosting service Vine.
In recent years, token holders have been able to vote on rules that define a cryptocurrency's economy by using tokens to vote on Decentralized Autonomous Organizations (DAOs). For example, a DAO can vote to change the number of tokens issued to stakers — those who pledge tokens to validate transactions.
The Olympus DAO, for example, ran a sort of giant decentralized money market fund, where those looking to create a reliable reserve currency benefited from additional funds joining the pool. Following the project's game-theoretic model (which was popularized by the meme (3,3)), investing OHM in the protocol's auto-replenishment protocol was the most rational decision.
This was due to the tokenomics of the protocol; using OHM would strengthen the decentralized reserve currency and allow people to buy more bonds. If everyone sold OHM, it would affect the price of the protocol and all holders would be affected. So you see how the protocol's tokenomics drove people to buy and stake the token.
Tokenomics don't always go according to plan. Ultimately, many people sold OHM after investors who were using an OHM liquidity pool on a third-party platform were liquidated. This led to a dramatic price drop that scared other investors away from the token.
Loot, on the other hand, is an NFT project developed by Hofmann. Thanks to tokenomics, anyone could buy loot immediately after launch; the 10,000 character sheets, which listed items the characters would use in a yet-to-be-developed game, sold out almost immediately. The tokenomics of Hofmann's game revolved around scarcity; since there were only 10,000 character sheets and they were hyped on Twitter, they became immensely valuable.
Token governance and decentralized coordination
Governance plays a big role in tokenomics these days. Many tokens act as what are known as governance tokens, meaning holders are given voting rights to influence a project’s future rules and decisions. This is all done in the name of decentralization: instead of a centralized group of developers calling the shots, token holders can vote on how the platform should be run.
Think of the governance tokens like shares in a public company, albeit without a CEO. DeFi platforms work via DAOs – this is what a governance system based on token governance is called. Owners can vote on anything.
Tokenomics crucial for project success
Tokenomics are critical to the success of a project; just as a reckless CEO can bankrupt a company, poor governance decisions can derail top DAF projects. If all else fails, it's always possible to force a new tokenomic timeline into existence by hard forking a cryptocurrency — a process that involves copying a blockchain's codebase, making a few non-backwards compatible changes, and old cryptocurrencies and validators are migrated to the new network.
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