A Beginner’s Guide: What Is Tokenomics?
Before investing in a cryptocurrency, it’s recommended you make an analysis of it in order to manage the risk of your investment. Such analysis requires scrutiny of that cryptocurrency’s main aspects. However, investors are not limited to investing only in cryptocurrency coins but also in tokens. These tokens have value, too. When you conduct an analysis into whether or not you should invest in a token, that’s Tokenomics.
Tokenomics elides the words “token” and “economics.” It means analyzing why a token has value, and why it’s reached the price that it has. By looking at various factors which define the world of cryptocurrencies, tokenomics provides an answer to the economizing problems of tokens and their functionality in blockchain technology. But before diving into the world of tokenomics, let’s briefly explain tokens.
What Is a Token?
Tokens are units that are used for a specific purpose and have a value based on their characteristics. Tokens are usually considered as valuable assets that serve more than just a currency. For instance, football tickets can be considered as tokens, because they can either be used to go watch a football match, or traded for something else.
In the same sense, tokens can be found in cryptocurrencies as well. These tokens can have various functions within a network besides being used only as trading assets. The concept of tokens in cryptocurrencies grew larger with the creation of Ethereum. The Ethereum network was the first blockchain technology that offered more decentralized services to people, rather than just transactions. Just as transactions require money in order to be completed, these decentralized services in the Ethereum network require tokens. In the Ethereum network, these are known as ERC-20 tokens.
Tokens can be categorized into two main types: Layer 1 and Layer 2.
Layer 1 tokens are native to a particular blockchain, and can be used for fueling every service within it. Two examples of Layer 1 token in cryptocurrencies would be Ether (ETH) on the Ethereum network and BNB in the Binance chain.
Layer 2 tokens are used for decentralized applications within a network. For instance, OMG tokens are Layer 2 because they’re used for OmiseGO, which is a decentralized project within the Ethereum network.
Another way of classifying tokens is based on their usage. There are two types of tokens: security and utility tokens
Security tokens are considered investment contracts. To be considered as investment contracts, these tokens need to entail a money investment, profitability and common enterprise — and to come from the computational efforts of others. This process of contract verification is known as the Howey Test. Hence, tokens that pass the Howey Test are considered security tokens. An example of a security token would be the way Siafunds (SF) work on the Sia network.
Utility tokens are those tokens that ensure the financing of a network. Usually, utility tokens are given out through an initial coin offering (ICO) in order to fund development of the project. For instance, the Basic Attention Token (BAT) is a utility token that was initially distributed through an ICO. It can now be used in decentralized advertising on the Brave browser, running on the Ethereum network.
Tokens can also be categorized as fungible or non-fungible.
Fungible tokens have the same value, and can be replicated. Since fungible tokens are the same for everyone, you can replace one ETH with another because they have the same value.
However, non-fungible tokens (NFTs) do not have the same value because each NFT is unique. NFTs are usually tokenized assets such as pictures, artworks, collectibles and real estate, etc. Since NFTs are unique they cannot be replicated. This can make their value higher than that of fungible tokens.
Coins vs. Tokens
So, what are the similarities and differences between coins and tokens in the world of cryptocurrencies?
- Coins and tokens both work in blockchain technology in a decentralized manner. This means that using tokens or coins in cryptocurrencies does not require third parties or central authorities who would normally regulate these services.
- Coins and tokens may both have a value. While the price factors might differ for coins and tokens, they may both be purchased or sold at the amount required.
- Coins can be used with an independent blockchain. This operability is what gives coins an advantage.
- Change in value
- There are many external factors that determine the price of a coin. However, the change in the value of a token is heavily tied to variation in the value of the cryptocurrency on which the token is based.
- Coins, as the name suggests, are designed for the purpose of representing a monetary value. Tokens, on the other hand, can be created for the purpose of running other services within the blockchain.
What Is Tokenomics?
Tokenomics is the study of tokens, how they work, what purpose(s) they have and what factors need to be considered before investing in cryptocurrencies. This is where it derives its name.
More generally, tokenomics is anything that can influence the value of a token — including the token itself.
Which Tokenomics Factors to Consider When Investing
There are many factors which can determine the price of a token and a cryptocurrency. However, several of these factors are quite important to keep in mind if you want to invest.
Total Supply and Market Cap
When looking at a cryptocurrency, it’s important to look at the total supply of coins. Usually, cryptocurrencies that have a limited total supply may have an increasing value in the future. This happens because scarcity causes a shortage in the market. Shortage requires an increase in price in order to reach an equilibrium.
On the other hand, if the supply is unlimited, the future price may not increase as much as it could if the supply were limited.
The supply of a cryptocurrency has a strong correlation to market capitalization. Market cap is the total amount of the circulating supply times the current price of one token. The fully diluted market cap is a hypothetical estimate of the market capitalization if the total supply of a cryptocurrency is in circulation.
Even if one cryptocurrency has a larger supply than another, it doesn’t mean that the market supply is necessarily bigger. The same can be said about the price of a cryptocurrency. A higher price doesn’t necessarily mean that the market cap of a cryptocurrency is larger than that of other ones.
Market cap is an important factor to consider before you invest. A lower market cap might mean that the cryptocurrency has more potential to grow. This is the case with small-cap cryptocurrencies (less than $1 billion worth of market cap). Large-cap cryptocurrencies (more than $10 billion worth of market cap) might be a safer investment, but their growth potential tends to be smaller.
Allocation and Distribution
Before a cryptocurrency is launched, the allocation of the tokens can be done by either fair launch or premining.
Fair launch is the allocation of a cryptocurrency in an organized way after it is released. The tokens are allocated through mining, and the amount of mining usually depends on the computational power of the nodes in the blockchain.
Premining, on the other hand, is the allocation of a cryptocurrency before it is launched. This is done through an ICO, which secures funding for the development of the cryptocurrency.
These two models have a huge impact on how tokens are distributed.
If a cryptocurrency is fair-launched, then the distribution is more focused on nodes with higher computational powers, since they can mine more tokens. It is considered “fair” because in this way, those who invest more in mining are rewarded more than those who invest less.
If a cryptocurrency is premined, the tokens sold through ICO are usually sold to institutional investors and the team behind the cryptocurrency, rather than retail investors. Hence, token distribution is not well-balanced when institutional investors own a larger share of the total supply. Therefore, such investors can drastically change the price of a cryptocurrency by selling the tokens at once.
Vesting and Inflation
When a cryptocurrency is premined, people running the cryptocurrency can decide to lock up the circulating supply and release the tokens gradually over time. This assures retail investors that institutional investors won’t get a hold of all their tokens at once, and cause an unbalanced market. However, it is important that the release of tokens is logical, meaning that the distribution is done at low amounts throughout the years.
Inflation refers to the change in the value of the existing tokens after the release of many tokens at one time. If many tokens would be in supply, there would be a surplus. And whenever there’s a surplus, a decrease in price follows. Deflation, on the other hand, is the opposite of inflation, where the possibility that the existing supply may decrease causes an increase in the price of the tokens in circulation.
Staking and Utility
Staking is the process of locking tokens for a specific period of time (depending on the cryptocurrency) in order to receive a passive income or reward from the network. The problem with staking is that the staked tokens cannot be moved until the staking period is finished. If a large number of tokens are staked, then the supply will be more limited during the staking period. This can have an effect on a cryptocurrency’s price. There are some cryptocurrencies that have a lower staking time, or no staking time at all. Because of this, big price increases or reductions might not occur because the tokens can easily be bought or sold by the users.
Utility refers to the usage of the tokens. In simple terms, the utility of a token is what makes people buy more tokens and, as a result, increase the price of a cryptocurrency.
The Team and the Community
The team behind a cryptocurrency is another factor worth considering. For instance, one of the reasons why BAT (Basic Attention Token) has been a success is the team that runs it. Academically credible people — such as Brendan Eich and Brian Bondy — induced trust in the BAT project before it was even released.
The team behind BAT. Source: Basic Attention Token
The community is also an important factor. At the end of the day, without the people that are going to buy tokens, a cryptocurrency is worth nothing. So the team behind the cryptocurrency needs to make sure that they establish a good relationship with the community, as well as try and expand that community.
Bitcoin vs. ETH Tokenomics
Bitcoin and Ethereum are the two biggest cryptocurrencies, based on their market capitalization. Let’s look at the Tokenomics of these two and see their differences.
- Total supply
- Bitcoin has a limited supply of 21 million BTC, while Ethereum has an unlimited supply.
- Market Cap
- Bitcoin has a market cap of around $940 billion as of April 2021, while Ethereum has a market cap of $260 billion. Both are large-cap cryptocurrencies, meaning that their potential to grow is not what it was when their market caps were below $1 billion.
BTC market cap, fully diluted market cap, circulating supply. Source: CoinMarketCap
ETH market cap, fully diluted market cap, circulating supply. Source: CoinMarketCap
- Both BTC and ETH were fair launched, although a large number of ETH was also premined.
- The top 100 BTC owners own 32% of the total BTC supply. The top 376 ETH owners own 33% of the total ETH supply.
- Since Bitcoin was fair launched, it does not need vesting. Some Ethereum tokens, though, are in the process of vesting.
- Since Bitcoin has a limited supply, it is inflation-free and its price can rise as it becomes scarcer. Ethereum, however, is likely to inflate because of its unlimited supply.
- Staking can occur in Proof-of-Stake (PoS) blockchains. Since Bitcoin has a Proof-of-Work (PoW) blockchain, it cannot be staked. Ethereum tokens can be staked. Some people stake their ERC-20 tokens for developing Ethereum 2.0.
- Bitcoin utility serves as the “gold” of cryptocurrencies. Ethereum tokens vary in terms of utility. As a network, Ethereum’s utility allows people to run decentralized services by requiring gas fees. More services, more gas fees. More gas fees, bigger market cap.
- An intriguing factor behind Bitcoin’s success was its unknown founder with the pseudonym of Satoshi Nakamoto. As for Ethereum, Vitalik Buterin’s insights and charisma were the stepping-stone to establishing credibility.
- Both Bitcoin and Ethereum have enormous communities, as they are the two biggest cryptocurrencies in the world.
The Bottom Line
To conclude, Tokenomics is everything related to a token in cryptocurrencies. Each Tokenomics factor should be carefully analyzed before investing in cryptocurrencies.
Tokenomics is a relatively new field of study, but it can become one of the future’s biggest economic subfields.
So, with the new found knowledge in crypto, why not sign up to Bybit?