All About Tokenomics
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Two words we’re all familiar with, but when you put them together, you get a whole new meaning. Economics is the science of production, distribution, and consumption of goods, and how human behavior and interaction play into it. Tokenomics takes that idea and applies it to cryptocurrency.
Tokenomics refers to the mechanics of a token system, as well as the psychological or behavioral factors that can affect it. The tokenomics of a project are perhaps one of the most important things to examine before making an investment decision. A well-designed token model can lead to the long-term success of a project, and a poor one can doom it to failure.
Understanding tokenomics is essential for both token developers and investors. Let’s take a deep dive into tokenomics, what it is and how to assess a project’s strategies.
What is Tokenomics?
A portmanteau of “token” and “economics”, tokenomics is a general term to describe the supply and demand characteristics of a crypto token. Unlike government-issued currency, tokens do not have a mutually agreed upon worth. Value must be created for them. This includes how and how much of the token is mined or created, how it is issued, how it can be used, and more. These elements determine the future prospects of a token and if it will have sustainable long-term development.
For long-term development, developers aim to bake in some sort of incentive mechanism in order to encourage participation. This incentive mechanism can range from mining to staking to liquidity rewards and more. Whichever incentive mechanism is used, it is usually meant to work with the protocol to keep participants actively engaging with it, as well as acting honestly. For example, mining incentivizes miners to secure the network by offering rewards.
Developers also pre-determine token supply, which can have a huge effect on token price as well. When a token is created, the project usually doesn’t release all tokens at once onto the market - a market flooded with a bunch of tokens would negatively impact the price. So developers come up with a plan of how many tokens there will be in total, and how they will come into circulation. For example, bitcoin has a total supply of 21 million coins, but they are slowly released into circulation over time via mining.
The History of Tokenomics
Tokenomics started with the release of the first crypto, bitcoin. Satoshi Nakamoto’s Bitcoin Whitepaper paved the way for many future projects with its simple, transparent, and predictable model. Bitcoin, a digital asset, has a pre-programmed supply of 21 million coins that are created and released into circulation via mining. Miners use computing power to respond to quite hard challenges that come in the form of mathematical puzzles.
Miners generate millions of hashes, which are mathematical functions that convert an input of arbitrary length into an encrypted output of fixed length, per second in order to find the winning hash. As a result of finding the winning hash and securing the network, the miner who discovered it receives a reward of new bitcoins. The reward started at 50 BTC and is currently 6.25 BTC because every 210,000 blocks, it is decreased by half until all bitcoins are in circulation, which is set to be around 2140.
Miners also receive the transaction fees of the newly validated block, which increase as transaction size and network congestion rise. The maximum supply of bitcoin is fixed, and the circulating supply increases on a predictable schedule, at a predictable rate, which ensures no harsh increases in supply. The fixed nature of the maximum supply drives demand, which is why bitcoin has been called “digital gold”. Mining created an incentive to validate transactions which, in turn, releases more coins into existence.
This model would serve for the first generation of blockchains, including Ethereum. Ethereum adopted the same consensus mechanism as bitcoin, proof of work, which used mining as the incentive mechanism. But while this model is simple and decentralized, problems arose.
Network congestion was frequent, with sudden spikes in transaction fees. Ethereum in particular suffered from this, limiting the scalability of the blockchain. It prevented Ethereum from being used by the masses as an easy, cheap, and quick payment method. Criticisms of its environmental impact were also widespread.
Eventually, staking was developed to help with the scalability of the blockchain while still remaining decentralized. The Merge was an upgrade to Ethereum that just recently took place on September 15. It joined the Proof-of-Work Ethereum mainnet (the execution layer) with the Proof-of-Stake Beacon Chain (consensus layer). After the Merge, Ethereum started implementing staking as the main incentive mechanism.
Key Components of Tokenomics
Tokenomics encompasses several important factors that influence a token’s value both at launch and over time. Developers must think about all of these elements to ensure a successful launch, durable value, and utility for the community. Come along as we examine some of the key components that influence tokenomics.
A simple supply and demand curve is one of the most important aspects of tokenomics. Part of the reason the demand for bitcoin is so high is because there is a finite amount of bitcoin. Bitcoin has a total supply of 21 million coins, which is why it’s been called “digital gold.” Its finite supply creates scarcity which theoretically drives demand.
Both the maximum supply and circulating supply of a token can be controlled. Bitcoin has a maximum supply, but Ethereum does not. Due to token burns though, Ethereum maintains a stable circulating supply to avoid inflation. Token burning is the process of removing a token or tokens from circulation by sending them to an unusable wallet address. Burning tokens reduces the supply, which can increase the price because now the token is more scarce. This is all pre-determined by the creators and is executed with the code.
Circulating supply is the number of tokens in circulation. There are some tokens that can be minted and burned, or locked up. The ability to fluctuate the circulating supply has an effect on token demand and price. Many projects choose to lock up tokens and release them at scheduled dates or intervals in order to avoid flooding the market with their token, which can drive demand down. Burning tokens is used as a way to decrease demand by restricting supply.
Minting NFTs or NFT collections are another example. There are some collections with thousands of tokens, but sometimes only one is ever minted for a single art piece. How scarce the NFT is coupled with how desirable it is determines the demand.
Once you have a token in your possession, how can you use it? The answer to this question can determine if your token becomes a mainstay token or if it loses value quickly. The ability to design a token that has solid use cases determines if there will bedemand. Let’s examine some of the ways in which tokens can be used.
Mining and Staking
Bitcoin, followed by Ethereum, both originally used mining as their incentive mechanism. This means that miners solve mathematical puzzles to validate blocks of transactions and receive tokens in reward. This is how new tokens enter into circulation.
Many new blockchains are built on the proof-of-stake mechanism, which uses staking as the main incentive mechanism. Ethereum transitioned to this consensus mechanism with the Merge. This model rewards block validators who have staked a certain number of tokens in a smart contract with tokens in order for securing the network.
Staking is considered less decentralized than mining, but the system is meant to incentivize good behavior and discourage malicious behavior. Validators must stake their own tokens, so if they do a poor job or attempt malicious activity, the smart contract is liquidated and they lose their own personal tokens. The more tokens they stake, the higher the chance they’ll validate a block, giving them the chance to earn more.
Governance refers to how decisions are made within the project. A unique aspect of crypto and web3 projects is that communities, including users, are empowered with decision-making power. This gives the community that supports the project an active say in where they want the project to go and how it happens. Community members vote on proposals by allocating their tokens to a proposal, making governance an important use case.
Non-fungible tokens are unique tokens that cannot be copied, substituted, or subdivided. Only one wallet can have ownership of a token at a time. NFT smart contracts can secure digital files like images, videos, digital collectibles, or even represent physical items like real estate. NFTs are seen as a store of value, as well as some are even being implemented in blockchain games. Due to the fact that NFTs are one-of-a-kind tokens, that is where the demand for them can increase. But the issue with NFTs is that there is not necessarily a built-in incentive to hold one.
NFTs are speculative assets. You could buy an NFT from your favorite digital artist for $50, and if they become popular, the price could shoot up to $50,000 and you could make a lot of money off of your purchase. But the opposite can happen as well, and has. Online influencer Logan Paul paid $623,000 for an NFT that is now worth almost nothing.
The incentive for owning an NFT currently is simply speculative. But some projects have thought of ways to add extra utility to NFTs such as making them special items or artifacts in online games. Sweet victory is enough to incentivize many to spend money on an NFT to power up their gameplay.
Yield Farming/Liquidity Providing
Yield farming is a process that allows crypto users to lock up their tokens by either lending out their crypto or staking it to maximize returns. There are a few ways to do this, but the most popular form is liquidity providing. People buy tokens that they then stake in liquidity pools, which power many decentralized exchanges and lending protocols. In turn for providing liquidity, providers are rewarded with tokens. If you’d like to learn about more yield farming options, check out our extensive article on the subject.
Token Distribution and Vesting Periods
When a token is launched, its creators must determine how it will be distributed. It is common practice that the developers are given an allocation of tokens, but too high of a percentage can make the public wary of a pump and dump scheme. Many tokens are also allocated for venture capitalists and other investors. Often, for both venture capitalists as well as developers, vesting periods are put on the tokens, meaning they are locked for a certain amount of time in order to avoid a sell-off. The goal is to avoid a large number of tokens suddenly becoming available all at once, which tanks the price.
Other distribution methods for tokens include airdrops which allow crypto users to receive free tokens in exchange for either promotional work or completing tasks. Uniswap decentralized exchange famously air dropped their UNI governance token in 2020. Staking/yield rewards distribute tokens to those who have staked their tokens in a protocol. Public and private sales are a good way to distribute tokens to investors. Private sale rounds are held for big private investors like venture capital funds who have been invited to invest in a token, and public sale rounds are open to the public.
For tokens without a cap on total supply, token burns are utilized to help prevent inflation. Token burns remove tokens from circulation, and can be scheduled or perpetual. Binance burns their BNB token quarterly, but Ethereum burns a portion of the tokens sent as transaction fees. Token burns bring down the circulating supply, hopefully maintaining demand and preserving token value.
As with regular economics, supply and demand are the two main forces at work when it comes to determining price. A solid understanding of how the developers designed the flow of supply and demand for their token can help determine if it will be worth investment.
The Supply Side
Understanding the supply side of tokenomics is relatively easy because you only need to focus on one thing: token supply. Based on the supply, how will the price be affected? From a simple supply and demand curve, we can see that the less of a token there is, the higher the price. But as with many tokens, the supply fluctuates, and so does the price.
Inflation and Deflation
That is where inflation and deflation come into play. As more tokens come into circulation, each individual token decreases in value. This is known as inflation. When you take more tokens out of circulation, the value increases. This is known as deflation. When looking at a token, you want to analyze what kind of inflation/deflation you might see with the token. This means paying attention to total supply, circulating supply, and how often the circulating supply changes.
Bitcoin has a total supply of 21 million bitcoin, of which most have already been released into circulation. We’re not likely to see a lot of inflation in bitcoin in the coming years seeing as the last bitcoin is estimated to be mined over 100 years from now. Ethereum, on the other hand, has no total supply, but thanks to EIP-1559, token burns were instituted. Now the circulating supply of Ethereum remains relatively stable, and could even become deflationary.
The Demand Side
If you hold a $20 bill in your hand, you know that whether you spend it today or tomorrow, it will be worth $20. You, and everyone else, knows that that piece of paper has value, and will still have it tomorrow. Now imagine I drew 20 of my own $20 bills with the picture of a doge on them, and I tell you that I will never make more of these $20 doge bills. Everyone would go crazy for one, right?
Not really, but that’s to be expected. What value does my $20 doge bill hold? And if you did pay money for it, there’s no telling if anyone else would want it in the future, so there’s no way for you to ensure that someone will want it, and will want to pay $20 or more for it.
This applies to cryptocurrencies as well. Currently, there may not be high demand for the token, but there may be in the future, and tokenomics help determine if there will be. In order to understand whether a token will have demand and value in the future, there are 3 components to examine.
ROI is the amount of cash flow that a token is expected to generate for someone who is just holding the token. There are several ways a token can generate a passive income for holders. One way is to stake a token to validate transactions for the network for those that run on the Proof-of-Stake consensus mechanism. Another way is yield farming or providing liquidity to DEXs. You can provide liquidity to the pool and receive a portion of the fees in return.
But if there is no return-on-investment for your token, there is no incentive to hold it. People will not hold the token if they won’t make any money. However, a strong community is one way to prevent this.
If you want to understand if a project has promise, there’s no better place to look than the community that the project has built around it. A healthy, active, and engaged community drives demand for the token. You can evaluate a token’s community by checking out its Discord, Twitter, Telegram, as well as other social media. Look for active social media accounts, where the community and the developers engage with each other. Simply being part of a thriving community can be incentive enough to hold a token and drive demand.
Sometimes, at the first sign of trouble for a token, people are ready to drop it. These sell-offs can crater the token price and spell doom for the entire project. This can be avoided by taking a look at the underlying game theory of the token. Simply put, game theory is the study of how and why people make decisions using mathematical models that can be used to predict the behavior of decision makers.
In the crypto world, this translates to understanding how token holders will act in certain situations. For example, locking or staking your token provides the incentive of rewards for token holders. You get a share of the revenue for locking your tokens in the protocol. The longer you stake, the more you earn, giving stakers a reason not to withdraw their tokens. If you can incentivise those in the community in the right way, your token will have utility and demand in the future.
The Tokenomics of APTOS
Aptos mainnet was just launched on October 12, 2022, marking the official release of the APT token, so let’s take a look at the tokenomics of its native token, APT. At launch, the total supply was 1 billion tokens. Out of the initial token distribution, 51.02% is allocated to the community, 19% to core contributors, 16.5% to the Aptos Foundation, and 13.48% to investors. For the community, 125,000,000 APT will be available initially to support ecosystem projects, grants, and other community growth initiatives. 5,000,000 APT will be available initially to support the Aptos Foundation initiatives. 1/120 of the remaining tokens for both the community and the Foundation are anticipated to unlock each month for the next 10 years.
There is a 4-year lock-up schedule for all investors and current core contributors, excluding staking rewards. The schedule goes as follows: no APT available for the first 12 months; 3/48ths of the tokens unlocking on the 13th month after mainnet launch (November 2023) and continuing each month until the 18th month (April 2024); 1/48th of the tokens unlock each month beginning on the 19th month (May 2024); all tokens are unlocked by the four-year anniversary of the mainnet launch (October 2026).
Both unlocked and locked tokens can be staked. Currently more than 82% of the tokens on the network are staked across all categories with the majority being locked per the distribution schedule.
Token holders who stake tokens to validate and secure the network receive staking rewards, and there are no distribution restrictions on the rewards that are split between validator operators and stakers. The current maximum reward rate is 7% annually, and is evaluated at every epoch. It’s meant to decline 1.5% each year until it reaches a 3.25% annual rate, which is expected to take place over 50 years. Staking rewards increase the total supply of the Aptos network and depend on the amount staked and validator performance. Transaction fees are currently burned, but all rewards and reward mechanisms can be changed via on-chain governance in the future.
Is Pontem Going to Have a Token?
As of right now, Pontem does not have a token. But it is definitely something the team is heavily looking into. The main goal is to take our time to determine if a token is even necessary, and then take even more time to develop it properly so that it lasts. We are currently looking into token models and determining how it might be best to proceed . Keep an eye out for future announcements.
Learning how to evaluate tokenomics on your own is a great way to make sure that whatever tokens you hold align with your own values. Understanding tokenomics makes it much easier to read through projects’ documents and white papers to determine how the token works and what its future prospects are.