Tokenomics is a popular catch-all phrase that refers to all elements that contribute to making a particular cryptocurrency valuable and interesting to investors.
The concept plays a pivotal role in determining the success of a crypto project.
It is important to consider tokenomics when it comes to making an investment decision in the crypto market.
A well-designed crypto platform often translates into higher demand as new investors flock to the project, which in turn boosts its price performance.
All this is achieved by maintaining good tokenomics.
This article is a comprehensive guide to the functioning of tokenomics, its features, and how it determines the health of a cryptocurrency.
You will learn why the concept is important and how to use tokenomics to determine the value of a token.
What is Tokenomics?
Tokenomics is a portmanteau of the two words “token” and “economics”. It refers to the supply and demand characteristics of a crypto project.
The concept takes into account the various economic aspects of a cryptocurrency, such as issuance, attributes, distribution, supply, and demand.
Just like how all cryptocurrencies are different, each crypto token has its monetary policy.
The economic structure of a cryptocurrency determines the incentives that encourage investors to buy and hold the asset.
Tokenomics mainly determines two elements of a crypto economy – the incentives that dictate how the particular token will be distributed and the utility it has that influences its demand.
Supply and demand greatly influence the price of a token and projects that get the incentives right can surge in value.
Cryptocurrency projects have pre-determined and algorithmically created issuance schedules for their tokens.
Looking at it, we can predict the number of coins in circulation at a given time.
Now, let us take a look at how all of this works in tandem.
How Does Tokenomics Work?
Tokenomics sets up the economy of a crypto project by creating incentives for the token’s holders and defining its utility, which ultimately determines its demand. Various variables at play influence a cryptocurrency’s tokenomics.
| Supply | Supply is a major criterion in the tokenomics of a cryptocurrency. Here, you will need to take into account the total number of tokens available as well as the supply that is in circulation. |
| Token Allocations and Vesting Period | It is normal for crypto projects to allocate a certain amount of tokens to stakeholders. Most projects in an attempt to establish credibility, now implement a vesting period on the tokens allocated to venture capitalists or developers. Tokens under the vesting period are locked for a certain period, thus saving investors from perpetrators of pump-and-dump schemes. |
| Mining and Staking | The Bitcoin Network issues tokens to incentive miners for validating transactions on its blockchain. The mechanism used here is called proof-of-work, where miners have to use their computing power to mine new blocks and add them to the blockchain. Whereas, proof-of-stake (PoS) blockchains such as Ethereum 2.0 or Solana have implemented a staking model for network validators, where they are rewarded for locking away a certain number of the tokens in a smart contract. |
| Yields | Yield farming is a mechanism used by decentralized finance (DeFI) platforms to incentivize their customers to buy and stake tokens. Here you can lend your tokens to anyone who needs loans by depositing them in liquidity pools that are managed by a smart contract. In return, the stakes earn interest and principal on the loan in the form of the token issued by the decentralized exchange (DEX) managing the pool. |
| Token Burns | Some crypto projects permanently remove their tokens from supply through a process called “token burn”. This is done to prevent inflation. According to the laws of supply and demand, reducing a token’s supply would help support its price as the remaining supply in circulation becomes more scarce. |
Who Decides the Tokenomics of a Cryptocurrency?
The supply and demand of cryptocurrencies are major determinants of their price.
In this section, we will examine how the tokenomics of a cryptocurrency is determined.
| Supply | At its base, tokenomics is all about understanding the supply and demand of a cryptocurrency. This gives an insight into how desirable a given token is. To factor in the supply of a token, we need to determine whether its value will increase in real-time or if it will inflate away. |
| Demand | It is the demand side that determines whether a token is valuable. Certain cryptocurrencies have a limited supply, but a fixed supply doesn’t automatically translate into value. To convince investors, the asset needs to have value now and also carry it into the future. To determine whether a token will be in demand, you need to examine its return on investment (ROI), game theory, and community engagement. |
| ROI | Return on Investment (ROI) refers to the cash flow a particular cryptocurrency is expected to generate for someone holding it. If a token has inherent ROI, investors won’t be interested in holding it. If you truly believe that a token can hold value in the long run, you will be willing to invest in it. |
| Game Theory | Game theory is the fundamental mechanism beneath any technology. It is a systematic study of how and why people make decisions. When applied in the crypto domain, it helps developers gauge the stakeholders’ decision-making in an interactive environment. |
| Community Engagement | The enthusiasm of a crypto community provides insight into the beliefs of the people who have staked their funds in a token. For this, get into their groups on Discord, Twitter, and other social media platforms and try to know how long people have been active in the community. |
Conclusion
Properly understanding tokenomics provides you with the fundamental skills to evaluate a cryptocurrency project.
By reading a white paper, you can gain insight into the tokens’ supply and demand.
You will also be able to figure out how the community is driving demand for the token and rationally analyze its prospects.
Tokenomics is a key factor in determining how a token will perform against the US dollar, Bitcoin, and other altcoins.
Analysis can help you conclude whether developers behind a crypto token have instilled innovative ideas or continue to hold on to prevailing concepts.
It also helps you pick projects with good tokenomics, which ultimately enhances the value of your investment portfolio.
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