Tokenomics of Cryptocurrencies and Its Importance

The cryptocurrency market experienced exponential growth during 2021 when the prices of crypto assets rose in some cases by thousands of percent. With the growing popularity and adoption of cryptocurrencies, the number of cryptoassets on the market has also steadily increased. The same was true during the last year, accompanied by declines, during which their number still increased by several thousand.

According to data from the web portal Coinmarketcap, there are currently more than 22,000 cryptoassets on the market. Therefore it is very complicated for an ordinary investor to follow individual crypto projects and evaluate their technological and growth potential.

As the number of coins and tokens available in the market continues to grow, investors need to familiarise themselves with the tokenomics of any asset before investing. It is tokenomics that can reveal a lot to investors and often alert them to potentially fraudulent schemes or unfairly distributed models. That is also why Fumbi has prepared an article for you dealing with important aspects of the tokenomics of crypto projects, which are definitely worth following when investing.

What Is Tokenomics?

Tokenomics is a term that includes all aspects that determine the economic model of any token or coin. This term includes, for example, the redistribution of tokens, their total amount, the schedule of the issue or its usability in practice. A well-built tokenomics of a project combined with its utility often translates into higher demand in the long term.

Tokenomics of crypto projects is one of the most important aspects to consider when making investment decisions. Projects with rationally designed tokenomics, which have utility and motivate investors to buy and hold tokens in the long term, are very likely to have a higher chance of success than those whose utility and use in practice is zero.

The most common example of optimally set tokenomics is the cryptocurrency Bitcoin. Its total supply is pre-programmed to a maximum amount of 21 million coins. The reward Bitcoin miners collect for mining a block is halved every 210,000 blocks. Since 3 January 2009, when the first block was created on the Bitcoin network, the block reward has already been reduced three times, from the original 50 BTC to the current 6.25 BTC per block.

Source: Bankless

This monetary model ensures that Bitcoin is deflationary in the long run. Moreover, based on the rules embedded in the Bitcoin source code, it is very easy to predict how many Bitcoins will be mined in which year and when the very last Bitcoin will be mined. To avoid situations where the block mining rewards cannot cover the miners’ costs, Satoshi Nakamoto defined a rule in the protocol that defines that the block reward will include not only the newly mined bitcoins but also the transaction fees from the transactions included in the block.

From this point of view, we can say that the tokenomics of Bitcoin is simple and, at the same time, economically perfectly thought out. Everything is transparent and predictable, with the decreasing reward for mining a block increasing its rarity over time.

Factors Influencing Project Tokenomics

Circulating and Total Supply of Tokens

Before investing in any crypto project, it is a good practice to check the information regarding the circulating as well as the total supply of tokens.

Circulating supply represents the number of tokens or coins that are currently in circulation. The circulating supply of most projects tends to increase over time, whether through the emission of new tokens from mining or staking or through a periodic release, which is usually indicated in the tokenomics of individual projects.

The total supply represents the maximum amount of tokens or coins that will ever be circulated during the project’s lifetime. For example, Bitcoin has a maximum coin supply set at 21 million, Litecoin at 84 million, and Cardano has a total supply set at 45 billion ADA coins.

However, some cryptocurrencies do not have a set maximum supply. Therefore the supply of these cryptocurrencies increases every year. The best example of tokens with an unlimited supply is, for example, stablecoins. These tokens are usually issued depending on the reserves intended to cover them and theoretically can grow indefinitely, provided that the companies have sufficient cash reserves to cover them.

Checking the information related to the circulating and total supply of tokens or coins can give investors an insight into the inflation of given crypto projects and how many new tokens or coins are still going into circulation.

Token Distribution

Token distribution is an essential aspect, especially for new and developing projects. In practice, knowing what types of investors own a given token is useful because, in the market, retail investors usually behave differently than institutional investors.

The distribution of tokens among entities usually depends on how the tokens are marketed. Some crypto projects get into circulation through the initial sale of coins (the so-called IC), some through private sales and others through airdrops (rewards for users who, for example, tested the network in advance). A less frequent phenomenon today is the so-called Fair Launch, which is known, for example, from the days of Bitcoin or Dogecoin.

In the past, it has been shown that in some crypto projects, a significant amount of tokens got into the hands of a small group of people, venture capital funds or related persons ahead of time. They subsequently sold their assets during price growth and pushed their price down significantly because their purchase price in advance was significantly lower than the market price at the start of public trading. Such a method of launching tokens is not completely fair, but crypto projects often get funding in this way in their beginnings to finance their activities.

ICO, or pre-sale of tokens, is not a completely bad solution, but it has its pitfalls. In an ICO, tokens are usually sold only to a small percentage of entities from the total number of interested parties. Subsequently, when the tokens start to be publicly traded, their price tends to skyrocket at the beginning, allowing this narrow group of people who were lucky enough to sell their assets at a high profit.

The fairest approach in token distribution is the so-called “Fair Launch”. In this case, there is no option or early access to allow some group of investors to get token access before the token is issued and publicly tradable. An example of the fairest fair launch is Bitcoin itself – in the Bitcoin network, no one initially had any Bitcoins preloaded, and practically anyone could participate in mining from its launch.

Example of redistribution of NEAR protocol tokens

Source: Near Protocol

Token Utility

What properties the token has and whether it has any real use is another significant factor in its possible success.

If the token is to be successful, it is very important that it is used for some activities in the cryptocurrency sector that will create demand for it. For example, Ethereum has several different use cases – it is used to pay transaction fees in the network, to pay so-called gas fees when interacting with DeFi and NFTs, to create smart contracts and decentralised applications, and it is also used to maintain the overall security of the network through staking, which generates additional rewards in ETH to validators.

If the token has no real use, there probably won’t be enough purchasing power to keep its price going up in the long term.

Token Burning

Burning, or burning part of the supply, is a very interesting way to increase the attractiveness and demand for a particular token. Currently, many crypto projects regularly burn part of their supply, which means these tokens are permanently withdrawn from circulation.

One of the popular blockchains that introduced regular burning is BNB. BNB uses a system called Auto-Burn to reduce the total supply to 100 million BNB. This mechanism determines the amount of BNB to be burned based on the price of BNB and the number of blocks generated on the BNB Smart Chain (BSC) during the quarter.

Another project that introduced burning in 2021 is Ethereum. The implementation of the London Hard Fork introduced the burning of transaction fees on the Ethereum network, which aims to reduce the total circulating supply of ETH and turn it into a deflationary asset over time.

ETH burned so far

Source: Etherscan

Governance

With the decentralised nature of crypto projects and applications, governance plays a huge role in project tokenomics. Many tokens act as so-called governance tokens, meaning that holders are granted voting rights to influence future votes and decisions regarding the direction of projects.

A governance model is an important tool for the decentralisation of crypto projects, as it ensures that instead of a centralised group of developers, token owners can directly decide which direction the project should go.

Final Thoughts

An insight into the tokenomics of crypto projects can provide investors with an important fundamental concept that captures the main factors affecting a token’s value. Tokenomics is, however, only one of the many factors of fundamental analysis. Therefore, all other factors, such as technological potential, analysis of on-chain data or analysis of the competition and other market influences, must also be considered in the analysis.