Required Course for Crypto Projects: Token Economics

What are token economics?

Combining the two words "token" and "economics", tokenomics is a crucial concept in the crypto space, however, it has been lacking a consensus. However, the two words "token" and "economics" are a perfect entry point for us.

Economics is a social science that analyzes how individuals, organizations, governments, and nations allocate their resources, primarily through the production, distribution, and consumption of products and services. On the other hand, tokens refer to non-native digital assets based on existing blockchains (e.g., ETH is Ethereum’s native cryptocurrency, a digital asset). Combining these two definitions, we can conclude that token economics is the fundamental science that explores the potential of tokens, including key factors such as their utility, supply, price stability, distribution, and governance.

Why are token economics important in cryptocurrency?

Just like central banks utilize monetary policy in relation to their respective fiat currencies, properly designed, managed, and executed token economics allow project teams to create an efficient economic environment around their products, fostering growth in the ecosystem and token prices.

From an investor’s perspective, token economics is a critical factor to consider as it has a significant impact on the future price of a digital asset and whether the project will be able to achieve the goals set out in its roadmap.

Simply put, regardless of the team’s expertise and dedication, the concept’s potential, and the amount of funding collected from early investors and venture capitalists, poor token economics will most likely lead to a cryptocurrency project’s ultimate failure.

Token Economics: 6 Key Factors to Consider

1. Practicality

Utility is perhaps one of the most important elements of a cryptocurrency project’s token economics.

Even if a token is deflationary, has a perfect price stabilization mechanism, a stress response mechanism, and a decentralized and efficient on-chain governance process, it will be difficult for it to have greater value if it cannot ultimately be implemented.

The same applies to fiat currency, as it only has value if the country’s citizens use it, for example, for daily payments, investments, and other transactions. This is also why some central banks have cracked down on digital assets in the past.

To avoid the situations detailed above, cryptocurrency project teams must empower their digital assets with multiple use cases that benefit the ecosystem and its participants.

Examples of this could include enabling holders to gain profit opportunities through activities such as staking, liquidity mining, and revenue sharing.

In addition, tokens can also be a medium of exchange in a platform or the entire ecosystem, collateral for other assets in the ecosystem (such as stablecoins). For example, the main utility of ETH is to pay transaction fees and deploy DApps and smart contracts, and even a value storage tool to some extent. Bitcoin is used as both a value storage and a medium of exchange.

Generally speaking, the utility of a token is responsible for creating demand, which drives the value of the digital asset up if the supply remains the same or decreases.

2. Supply and price stabilization mechanism

Another key factor in cryptocurrency token economics is supply and price. Cryptocurrency projects must also carefully manage the supply of their tokens as it also has a direct impact on its price in the following ways.

If the supply of a token increases while demand remains the same, it will cause its price to fall.

The price of a token will increase as supply decreases (while demand remains the same).

So, if a cryptocurrency project simply wants to create value for early holders, it can design the token as a deflationary asset, and over time, a considerable portion of the tokens will be removed from the overall liquidity, but remember that tokens without practical value will not generate higher value even with deflation.

An alternative solution is to create an inflationary asset and gradually reduce its inflation rate. Bitcoin is a good example, which halves the number of new coins that can be mined per block roughly every four years until it reaches a maximum supply of 21 million BTC in 2140.

However, in some cases, due to the nature of the cryptocurrency project’s solution, inflation or lack of a maximum supply is necessary for the token to perform its core function. For example, while ETH’s supply has no hard cap, the project mines new coins to incentivize validators to maintain the ecosystem.

Generally speaking, there are two main ways that cryptocurrency projects can control their token supply:

By limiting (or not limiting) the number of tokens that can be issued (maximum supply)

The token is introduced to increase overall liquidity by implementing price stabilization mechanisms (e.g., burns and buybacks, and BTC’s halving mechanism).

In general, before investing in a coin, it is imperative to analyze the dynamics and mechanisms of the asset that directly influence its supply.

While some coins can maintain long-term growth during deflation with little increase in demand, others will experience price collapse due to inflation even after new capital and buyers.

3. Asset Distribution

Issuance is not only a key factor in token economics, but also a vital step in the entire token cycle. If a project cannot distribute tokens to its users in some way, no one will be able to use its network because the community will not be able to obtain the platform's native assets.

There are many ways to bring their tokens to market. Some are more about rewarding team members and early investors, while others, including fair launches, are designed to benefit the community.

For example, in the following cryptocurrency projects, tokens are issued in the following ways:

• Ethereum started with a crowdsale, with early contributors contributing 31,000 BTC. For this, crowdsale contributors received 60 million (83%) of the initial 72 million ETH, with the remaining 12 million ETH (17%) being split between early contributors and the Ethereum Foundation. After this, the new ETH supply has been sent to miners as a reward for securing the ecosystem.
  

• For Bitcoin, it doesn’t matter whether the creator Satoshi Nakamoto pre-mined the first few coins or whether he obtained them as a regular miner. Because the cryptocurrency has a fair launch model in terms of initial distribution. Regardless of whether he participated in mining in the early stage, Satoshi’s approximately 1.1 million BTC has never been touched, and none of the coins are circulating in the market. In other words, the remaining Bitcoins have been distributed among Bitcoin miners (just like ETH).

• The Ethereum-based Uniswap distribution model is very different, somewhere between a fair sale and a 2017-style ICO model (in the latter, project teams, investors, and advisors are the biggest beneficiaries). After the September 2020 launch, the 1 billion UNI supply will be distributed as follows: 15% for community airdrops, 2% for liquidity mining, 43% for the governance treasury, 21.51% for the team, 17.8% for investors, and 0.69% for advisors (all tokens except those allocated for airdrops and liquidity mining have a 4-year lockup period).

The token distribution model is not only related to the lifeblood of a cryptocurrency project, it also has a huge impact on how the public views the project.

On the one hand, a completely fair launch model is conducive to building trust between users and the project. On the other hand, if most of the tokens are distributed to team members and private investors, the community will question the project.

The latter, on the other hand, ensures that developers and ecosystem participants have access to the necessary resources to make their visions a reality.

For the crypto community, decentralization and transparency are two highly valued qualities, and the community generally supports projects with a fair launch model.

In addition, distributing tokens fairly among (tens of thousands of) users rather than among a bunch of whales or large early investors is also relatively safe for the project itself, as it greatly reduces risks such as control, malicious attacks, or governance centralization.

4. Governance

In token economics, there is another topic that cannot be avoided, and that is governance.

While it has only a loosely indirect impact on the future success of a cryptocurrency project and the price of its native token, it is just as important as other factors, especially for tokens whose primary function is to be used for governance.

Just like the impact of a government on a country's economy, it is a very important thing in itself for a project's core development team or community members to plan for the future of a cryptocurrency through governance committees and institutions selected through decentralized governance.

In addition, the process of allowing the team or community to govern the project is also important. In terms of governance model, there are still many problems:

• The degree of centralization (ultimate power held by the core team versus a fully decentralized community governance process)

• Whether governance occurs on-chain or off-chain (although, off-chain governance can still be decentralized).

• How accessible the governance process is to the average user (e.g., how easy is it to create a proposal and vote on it).

• The minimum share of votes required to approve a proposal.

• If the core team is heavily involved in the governance of the project, consider their background, skills, and experience.

In general, although decentralization is highly valued in the crypto field, it does not mean that all decentralized projects are necessarily better than fully or partially centralized projects.

Transparency, integrity, collaboration through effective procedures, and a professional team (whether they are core developers or elected community members) are more important things for the project.