A beginners guide to tokenomics

Where is the real value? Oh, you sweet summer child.

One of the first things to learn in the crypto space is tokenomics. There are a few fundamental things you must have a basic understanding and this is one. With understanding comes competence, with competence comes conviction. You’ll need that. So, lets get down to the basics and get started.

So, What actually is a crypto token?

A crypto token signifies a denomination of value on a given blockchain or platform. They can often be swapped or exchanged and usually come with incentives to encourage participation.

What are tokenomics?

In it’s basic form the tokenomics represents the economics of a crypto token. All it’s features, mechanics, functionality, utility, policies, ect,. The tokenomics for each token are often unique (unless forked, think “copy and paste”), details are often found in the whitepaper or litepaper of the relevant project.

Why are tokenomics so important?

Each project, platform and blockchain has their own micro-economic ecosystem, constantly changing and evolving. To know how that ecosystem works and if it is likely to succeed you need to have a grasp of their tokenomics. The goal is to seek out the model’s and designs that can achieve their aims/objectives and become stable and functional. No small feat.

Where’s the value in tokenomics?

Essentially all economics are driven by incentives, one way or another. Let’s take the dentist anology. People adhere to their dentists’s recommendations (or so i’m told, I dunno. I’m British innit) to maintain dental hygiene and lower the risk of problems, they pay for this incentive. In economics the incentives are commodities, equities, currency, and now crypto.

Cryptocurrency was never intended to be free, that isn’t a bad thing. Value is essential and often propels different tokens for different reasons. Often in cycles. Value however, does not need to be tangible, and in the case of crypto it isn’t.

Tokens are most commonly used to facilitate decentralization, capital efficiency and flow of liquidity.

Are there different types of tokens?

Yes, and it’s important you know them. Although they seem to be constantly changing there are some prevailing types. These are:

Layer 1 Tokens: Native to a blockchain they are often used as uphold the relevant network. Most famous layer 1 tokens could be BTC or ETH.

Layer 2 Tokens: These tokens are most commonly linked to specific protocols. Layer 2 protocols operate on top of Layer 1’s. For example, Polygon’s token MATIC.

Security Tokens: These are linked to investment smart contracts. Due to some of the similarities they share with securities that’s what they have been dubbed. They often derive their value from trade-able and external sources, as a result they are one of the tokens under most regulatory pressure. For example, Uniswap’s token UNI, Uniswap is a decentralized exchange operating on the Ethereum network.

Utility Tokens: Often used in Initial Coin Offerings (ICOs), these tokens are often used to finance a network. For example, stablecoins like FRAX or USDC.

There are also different classifications of tokens.

We can divide these simply into two:

Fungible Tokens: These feature the same value and a replication facility. ETH on the Ethereum network is a perfect example, the tokens value is the same and so they can be used interchangeably. Many systems and mechanics can be layered onto fungible tokens and they often are, Ethereums EIP-1559 is a perfect example.

Non-fungible Tokens (NFTs): NFTs do not share the same value, each NFT is unique and digitally verifiable on the relevant blockchain. We have only scratched the surface of NFT potential, so far they’ve been used for real estate, artwork, pictures, collectibles, tickets, music, exclusive memberships. This is only the beginning.

What are some of the important factors you should pay attention to when looking at a token. Reading through the smart contract excluded.

Token allocation and distribution: Tokens may be generated differently, often featuring a “fair” launch or a pre-mine. A fair launch is when tokens are mined, earned, owned and regulated by the community. There are no early access distributions or private allocations, BTC is a perfect example. Pre-mining however means that tokens are generated and distributed to a select group (VCs, developers, ect,.) before they go to market.

Many tokens come pre-mined so it’s not ground to dismiss them, however do take it into account if you see an unfair distribution and a small amount of wallets holding a considerable percentage of the total circulating supply (whales). When and if those wallets dump, things will be bloody. But, if the project is credible with a competent team and community, you will likely increase you chances of entering into a successful project.

Token Supply: Token supply is intrinsically linked to tokenomics. The three things to note are, total supply, circulating supply and max supply. Total supply is the amount of tokens currently in existence but excludes any burned (destroyed and never to return), circulating supply refers to the amount that has been issued so far and are in circulation and max supply is the total amount that may ever be created (projects that have this are referred to having a “hardcap” on their max supply).

Be aware, a gradual increase can be beneficial. It can increase token liquidity (low token liquidity could be considered a “liquidity trap”) and utility among other things, however too many being released over a too short period of time will lead to high inflation rates and dilution.

Token Models: Is the token you are looking at inflationary or deflationary? Does it have a max supply or no cap at all? If so or not, why? A deflationary models are capped, take BTC for example, it is capped at 21 million. While ETH is inflationary, consider why. ETH uses it’s token emissions to pay delegators and validators(they uphold the network) but as long as fees outpace emissions, with EIP-1559 it has deflationary characteristics. What happens when all BTC has been emitted?

Some protocols may feature a duel token, one being a security and another for utility. For example, MakerDAO. It has MKR (security token) and DAI (utility token).

Market Capitalization: This is a simple metric used to measure the relative value of a token. It’s calculated by multiplying market price of that token with the total number in circulation. It helps to give a quick snapshot of the size of a protocol. Do not mistake this for value in the market or value captured by the token.

Total Value Locked (TVL): TVL indicates simply how much value is locked at any one time in the protocol. For example, Curve.fi has over $20 billion worth locked at this moment in time.

I have mentioned only a few factors to consider when gauging the potential of risk/reward of a token. There are many, many more. I hope this gives you an idea and wets your appetite to learn more.

This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains. You also affirm that the sole purpose of reading this article is for expanding your educational awareness and nothing more.

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Ouija

Ouija

I am a researcher focused on philosophy, heuristics, decentralisation, DAOs and DeFi. Believe in the sovereignty of the individual for all.