Since 2020, the increasing popularity of cryptocurrencies has been very prominent. With a lot of investors being interested in cryptocurrency, a short overview on tokenomics can benefit a lot of people. So here’s tokenomics 101 for all the new investors just getting into the realms of cryptocurrency.
What is tokenomics?
The word ‘tokenomics’ is a portmanteau, made up of two words: token and economics. So, tokenomics is basically token economics or crypto economics. It is the study of the economics of a crypto token – from its qualities to its distribution and production, and much more.
What is a token?
In tokenomics, crypto tokens (or simply tokens) are units of value that blockchain-based projects build on top of an existing blockchain. Crypto tokens, like cryptocurrency, can be exchanged and hold a certain value but they are a completely different digital asset class.
In order to know more about tokenomics, it is important to know about the various types of tokens. One of the classifications divides tokens into two types: Layer 1 and Layer 2.
- Layer 1 tokens
Layer 1 tokens represent a specific blockchain and are used for other services like investment, storage, purchase etc. They settle every transaction on their network.
- Layer 2 tokens
Layer 2 tokens are designed to help scale decentralized applications in a network.
Apart from this, there is also another popular classification amongst crypto-enthusiasts.
- Fungible tokens
Fungibility is the property of assets to be interchangeable for another of the same kind. Hence, fungible tokens are the ones that have the same value and can be replaced with each other. Gold can be a great example of a fungible asset because its valuation remains the same across countries.
- Non-Fungible Tokens
Non-Fungible Tokens or NFTs, on the other hand, are unique and don’t have the same value. With the tokenization of assets such as artwork, furniture and real estate, NFTs are basically physical times held digitally. This new revolution of digital ownership has made NFTs really popular in recent years, with some being auctioned for millions of dollars.
The last possible classification is based on their usage.
- Security tokens
Security tokens are digital investment contracts which represent ownership for fractions of an asset.
- Utility tokens
Utility tokens are more well-known. They are issued through an ICO and are useful in capitalizing a network.
Factors affecting crypto tokens
For every beginner just getting into the realms of cryptocurrency, it is important to know the factors that might even remotely affect the value of a crypto token.
Distribution and allocation of tokens
One of the primary factors that decide a crypto token’s worth is how the token is being distributed. There are two ways of generating crypto tokens – either by pre-mining or by a fair launch. By the phrase “fair launch”, we mean that a cryptocurrency is mined, earned, owned and governed by the community from the outset. It is a decentralized network and no concept of private allocation exists here. However, with pre-mining, a portion of the coins is created (mined) and distributed before it is launched publicly. A portion of the coins are sold to prospective buyers in an initial coin offering (ICO). This is a way to reward founders, miners and early investors with newly minted coins.
So, if you want to make sure that the project you’re investing in is legitimate and ambitious, make sure that it distributes their tokens out to prospective users.
Supply of token
A very important parameter required to study a crypto’s tokenomics is the supply of a token. There are three kinds of supply for crypto tokens — circulating supply, total supply and max supply. Circulating supply refers to the number of cryptocurrency tokens that are issued publicly and are in circulation. Total supply, meanwhile, is the number of tokens that exist currently, minus all the tokens that were burned. It is calculated as the sum total of tokens currently in circulation and the tokens that are locked somehow. Lastly, total supply cannot be confused with max supply, which quantifies the maximum number of tokens that will ever be generated.
Noticing the supply of a token can be a good indicator of its future. The circulating supply of a token is increased by developers by active mining. If the circulating supply keeps increasing, then investors can expect the value of the token to go up. On the contrary, if too many tokens are released, the value might drop as well.
Market Capitalization of a token
In the context of cryptocurrencies, the market capitalization or market cap is a metric used to determine the popularity of the token. It is calculated by multiplying the current market price of a token with the circulating supply. The market cap is a good indicator of the value of the token, even in the long run. Small-cap cryptocurrencies are therefore riskier. While large-cap cryptocurrencies often potentially guarantee better returns and safety.
Every crypto token has a model which ultimately determines its value. Some tokens are inflationary, which is why they don’t have a max supply and can keep mining as time goes on. Quite the opposite are deflationary tokens where the token supply is capped at max supply. Deflationary tokens are useful to avoid circulating unsold coins and are usually not affected by market volatility. Inflationary tokens, on the other hand, does a good job at incentivizing miners, delegators and validators in the network.
Tokenomics also points out how important it is to study the implications of price stability. Cryptocurrencies are known for their volatility, which might not always work out in favour of the investor. Fluctuations can often lead to dwindling interest among investors. Furthermore, fluctuations can even lead to networks being restricted.
Investors should make sure that the project is doing everything to combat such fluctuations. The challenge could be dealt with by ensuring there are adequate tokens to match the supply levels. This would stabilize the price and thereby, investors can use the tokens for their intended purpose. Tokenomics can also help developers to stabilize the prices by creating equilibrium.