Tokenomics, Understanding the Economics of Cryptocurrencies

3 Nov 2023 by Harry Newman 5 min read

Tokenomics refers to the economics underlying a particular cryptocurrency, covering various factors that govern a token's creation, distribution, supply, demand and overall function within a blockchain.

Tokenomics helps to define how a particular digital token operates within a blockchain, a well-structured tokenomics model can contribute to the success and adoption of a cryptocurrency, whilst a poorly designed one can lead to problematic issues and inefficiencies.

Key Components of Tokenomics

Several components collectively shape the dynamics of a cryptocurrency.

The structure of the cryptocurrency economy determines how the token will be distributed and the utility of that token.

This helps to encourage investors to buy and hold a token, each cryptocurrency is different in its monetary policy so getting the incentives right can help surge the token in value based on supply and demand.

Token Supply

Token supply refers to the total quantity of that cryptocurrency that can ever exist. This includes maximum supply, token release schedules or inflation rates. Bitcoin, for example, has a capped supply of 21 million coins, this helps to create scarcity and therefore create value.

Use Case/ Utility

The utility of a cryptocurrency plays a role in its adoption and the value it brings to the blockchain.

The purpose of a token within a blockchain can function in various ways, such as facilitating transactions, granting access to specific features or services and participating in governance decisions, as well as features such as burning tokens as a way to regulate the coin's value in the marketplace.

Token Distribution

Token distribution refers to how the tokens are initially distributed, and how the new tokens will enter circulation, this can include various methods, such as mining, staking, ICOs or even airdrops.

This also includes how many tokens the team will keep, and how many are left for the community, marketing or other areas.

Governance

Governance tokens can be incorporated into tokens on the blockchain networks to allow holders to participate in decisions for the community.

Holders of the tokens can propose and vote on changes and improvements to the network, this helps to engage the community and promote decentralisation, users have to stake their tokens, and in most cases, users with the most tokens can have more say or votes for making decisions.

Comparing Different Tokenomics in Crypto

Understanding different tokenomics models is crucial to evaluating the strengths and weaknesses of different cryptocurrencies, we will compare Bitcoin and Ethereum below.

Bitcoin

Token supply

Capped at 21 million coins, this helps to create scarcity and contributes to the store of value Bitcoin is known for. The inflation rate of Bitcoin decreases over time in a process called a halving, which reduces the rate at which new Bitcoins are created by half, roughly every 4 years.

Token distribution

New Bitcoins are created through Proof-of-Work, a mining process. Miners compete to solve complex mathematical puzzles, the first one to solve it gets to add a new block to the blockchain and is rewarded with newly created Bitcoins.

Use case/Utility

Bitcoins' primary utility is peer-to-peer transactions, with it being a store of value and a hedge against inflation.

Governance

The governance of Bitcoin is highly decentralised. Bitcoin relies on miners and nodes to validate transactions and implement software upgrades. Decisions are made through consensus among stakeholders.

Ethereum

Token supply

Ethereum does not have a capped supply. New Ethereum is rewarded to validators in Proof-of-Stake, there has been discussion within the Ethereum community to implement a max supply cap but at the moment there is a total supply of 120,269,393 ETH.

Token distribution

Ethereum initially started as a Proof-of-Work system where Ethereum (ETH) was mined, but they have now shifted to a Proof of Stake system. Validators lock up a certain amount of ETH as collateral to participate in blockchain validation.

Use case/Utility

Ethereum can be used for peer-to-peer transactions, Ethereum is also used as a gas payment on the Ethereum network. ETH can become deflationary due to the amount of Ethereum being burnt, with the new deflation mechanism where a portion of transaction fees on the network are burned, eliminating them from circulation, outpacing the amount that is being minted.

Ethereum is a multi-use token.

Governance

Validators play a significant role in the decision-making. Core developers help to contribute to network upgrades.

The differences in tokenomics highlight the different goals and characteristics of Bitcoin and Ethereum within crypto.

Bitcoin focuses more on being a peer-to-peer transaction system that is a store of value and scarce digital asset.

Whilst Ethereum offers a versatile platform for decentralised applications and smart contracts.

Common Challenges with Tokenomics

Tokenomics are important to the potential success of a cryptocurrency, being transparent with users about the tokenomics of a project creates trust, a lack of this can harm that trust as users want to know what they are investing in.

Many tokenomics involve a large distribution to team members which can result in a large amount of tokens in a small number of wallets, giving them control over network nodes and governance decisions.

Despite a project having great tokenomics, lack of real-world adoption hinders a project, with widespread use a struggle to reach.

A project can as a result be very limited in its capabilities.

Some tokens can have very limited utility or use cases, their value is simply driven by speculation rather than genuine use, these can often take the shape of meme coins, but there are also meme coin projects that do have utility and use cases.

There is no one-size-fits-all approach when it comes to tokens. There is a diverse range of use cases and implementations enabled by the blockchain. To become a self-sustaining decentralised project you need to find out how tokens should work within the ecosystem.

Final Thoughts

Tokenomics provides a framework for creating a sustainable ecosystem with an engaging community that is helping to redefine the crypto ecosystem.

Understanding how they work is essential to making informed decisions.

The design and execution of tokenomics models can have a significant impact on how a cryptocurrency operates, getting them right is a challenging but essential part of creating a successful project.

Cryptocurrencies have vastly diversified tokenomics, there are many different varieties, each one with a different approach.

Finding the right balance between transparency, fairness and use cases/utilities is crucial.

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