What is Tokenomics?

Tokenomics

Introduction

The term “tokenomics” is formed by pairing up two words: “token” and “economy”. Tokenomics is the field that studies the design of economic systems based on blockchain technology.

The goal is to study the economic aspects of tokens, starting from their creation through their distribution, and the design of the incentive mechanisms for token holders.  

The objectives

What are the aspects tokenomics examines? Given a network and its native token, through the design of tokenomics we intend to answer the following questions:

  1. Nature of the token – What is the main function of the token? (Governance, Security, Utility)

The token type setting depends on the main goal the token has for the network. For example, a governance token is used to distribute decision-making power to its holders and make the protocol decentralized.

2. Usability – What are the token use cases and the reward mechanisms for the participants?

The design of the incentives system and token use cases is maybe the most tricky phase. At this stage, we need to map the network stakeholders and set-up the mechanisms that incentive the token adoption for the users. For example, the first exchange in the world – Binance – introduced many use cases and benefits for BNB holders, who are incentivized to hold the token. Among the benefits: cashback for the debit card, participation in launchpool & launchpad, discounts on trading fees.

3. Monetary policy – How does the token is distributed  over time?

The choice of the initial token allocation and the release schedule to stakeholders shouldn’t be underestimated, as they are very important aspects from investors perspective. For example, a token with unlimited supply and high daily emission is a not-scarce resource, inflationary, and consequently risks not to be interesting for potential future price appreciation.

4. Governance – Who has decision-making power in the network?

The governance setting has to do with the protocol decentralization degree. For example, at the highest degree of decentralization anyone who wants to participate in the network decisions can do so, by voting with a weight proportionally to the number of tokens held. Alternatively, for a more centralized set-up, it is possible to choose the specific nodes that will have the right to vote and modify the protocol.

The Metrics

In order to create a winning tokenomics it is necessary to study the metrics that affect the value of the token and create a set of rules and use cases, an economy, which uses these metrics correctly.

Among the best known metrics, there are:

  • Max Supply: The total number of tokens that can be issued. The simplest example is Bitcoin which has a maximum supply of 21 million.
  • Circulating Supply: The amount of tokens that are circulating in the market and are in public hands. In the case of Bitcoin, the circulating supply is equal to 18.7 million BTC.
  • Price: price of a single token in the different sales rounds (seed, private, IDO etc ..).
  • Market capitalization: The token price multiplied by the circulating supply.
  • Fully diluted market capitalization: The market cap if the max supply was in circulation. It is a better metric than the simple market capitalization for evaluating a project.
Source: Coinmarketcap

These metrics must be defined consistently with the 4 objectives explained above. For example, a Utility token with different use cases and with high daily trading network volumes will probably need to set-up a large or unlimited supply. On the contrary, a token that aims to be a scarce resource, like a commodity, will have a limited and lower supply.

The importance of Tokenomics

A token will be successful and will appreciated over time only if it has a good tokenomics. Designing a correct tokenomics is essential to create a token that reflects the growth in value and protocol utilization. The most important thing is to understand how the token will be used. Is there a clear link between the service adoption and the token? If so, there is a strong possibility that to a growing protocol utilization will correspond an increase in token price.

Moreover, it is important to point out that market capitalization may not be the best metric to evaluate a cryptocurrency. In fact, there is a fundamental difference between the market capitalization for stocks and for the cryptocurrencies. In the case of stocks, the total number of shares available is a much more accurate figure and truly defines the company ownership distribution. On the contrary, in cryptocurrencies, by just knowing the market capitalization we cannot make an accurate evaluation of the project. Indeed, we don’t know how many tokens are deposited in dormant or lost wallets, and what is the real token velocity. In absence of this information, market cap isn’t really the best way to estimate the value of a cryptocurrency.

Also for this reason, the study of tokenomics for an investor helps to evaluate the merits and potential of a project regardless its market capitalization.

Risks

It is useful to underline that the Token Economy is not a software product, no one has complete control of the entire environment, it is not a deterministic economy with expected results. A Token Economy is a complex system in which it is possible to defined just some rules, but the evolution over time depends on exogenous factors that cannot be controlled.

Usually only a few tools are available to guide its evolution, which otherwise is mostly determined by the interactions between unpredictable components, such as the network participants and the stakeholders.

Conclusion

The tokenomics design consist in defining the rules of the economy of a blockchain-based system according to the token objectives. To do this, it is necessary to define metrics, use cases and incentive systems that justify the token existence.

It is important to understand that tokenomics is not a deterministic and predictable environment, there are a series of uncontrollable variables that influence the evolution of the protocol. What matters it is to create consistency between the token’s goals and its fundamental metrics.


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