An introduction to token economics (tokenomics)
Tokenomics, a combination of the words token and economics, refers to the economic properties that a token possesses. This could include qualities such as supply, issuance schedule, burn functions, and many more. A token’s qualities are factors that can be used to determine the quality and value of a token, presently or in the future.
With Bitcoin, as with many cryptocurrencies, its value proposition is highly correlated to its tokenomics. Its supply is capped at 21 million with a predictable supply schedule that decreases over time, reducing inflation. Its monetary policy is comparable to being set in stone and has remained relatively unchanged and stable since its inception 12 years ago. These features of Bitcoin are seen by some to be of high quality and result in giving it attractive tokenomics for potential investors.
The supply that a token is given is going to directly impact how scarce it is and how its scarcity is viewed by individuals in relation to its value. By default, when a token is given a low supply it is automatically deemed as scarce, and valuable, and when a token has a high supply it is deemed as low in scarcity, and low in value, however, this doesn’t paint the whole picture. While scarcity is one factor of the supply, the other is supply and demand.
An item isn’t automatically valuable because it is very scarce. If I take a picture it may be scarce because there is only one of that picture, but that doesn’t automatically make it valuable. It is the demand for that picture that will decide how valuable it is or will be in the future. It could be the best picture with the most amazing colors, but if nobody sees value in the picture and nobody wants to purchase it then ultimately its value is low. This also applies to cryptocurrencies.
First, you have the circulating supply of the token. This measures how many tokens are currently in circulation which are available for people to trade, use or hold. For Bitcoin, its circulating supply is over 18 million coins because that is the amount that has been mined, brought into circulation. The max supply is the maximum number of coins that will ever be created, which Bitcoin is infamous for with its max supply of 21 million. The total supply is the max supply minus coins that have been removed from the supply, through burning or other methods that have been tracked. You’ll see that Bitcoin’s total supply and circulating supply are the same and this is because no coins have been purposely removed from circulation by the network. Although coins may be lost, destroyed, or seized, since this was not done by the network it is not factored into the total supply.
Circulating supply and the price of the coin are what determine its market cap. This is why two coins, one with a small price and one with a large price, can have similar market caps. Below you can see that Chainlink is over $40 while USD Coin is only $1 but because USD Coin has a much larger circulating supply, over 14 Billion compared to only 400 Million for Chainlink, they have very similar market caps, at $17 Billion and $14 Billion respectively. This is important to understand because the price of a coin doesn’t make it “cheap”. A token can be overvalued even when it has a price of $3. This is why the market cap should be used first as an indicator before price when determining the value of a token.
Since the circulating supply is what is linked to the price and market cap, events that increase or decrease this could have a positive or negative effect on the price of a token. For example, if there is an option to stake a token for yields as a validator for a Proof of stake blockchain, then those tokens are essentially “locked up” and removed from the circulating supply. Since price is determined by supply and demand, if demand stays the same but supply decreases then the price will naturally increase. Conversely, if a large amount of those staked tokens are unstaked and suddenly introduced into circulation, then this could negatively affect the price. When supply increases but demand stays the same then price will naturally decrease.
This same principle can also be applied to the max and total supply. If there is an event that removes tokens from the max supply it may have a positive effect on the price, both short term and long term. Remember how supply and demand are the key factors that influence price? This is how tokens that have no max supply can still be seen as valuable, and continue to have their price increase. Ethereum is a great example of this because its lack of a max supply is seen as a controversial issue among some. The reason Ethereum can continue to rise in price, despite this, is because of high demand. This comes from not only investors wanting to buy ETH as an investment, but also the high demand from individuals using applications that require ETH to operate. Since this demand to buy ETH is higher than the number of people selling, and the amount of new ETH being added into the circulation, this is what allows its price to increase.
Token burning is a method that is used to permanently remove tokens from the circulating supply, which is a way that teams can use to push up the price of their token. The idea behind token burning is simple, reduce the supply so that the price can increase. Two common methods include regularly scheduled burns and fee burns. Regularly scheduled burns can work to push the price up by introducing a supply shock, depending on how many tokens are burned. Binance has a quarterly burn for their BNB token which has seen its most recent burn, on April 15, 2021, of 1.09 Million BNB or $595 Million at the time. While this may do good for BNBs price short-term, this can be seen as a short-term approach because there is no long-term sustainability to it.
The fee burn approach removes tokens from the supply by burning a portion of every transaction fee. This can be seen as a more sustainable approach as it reduces the number of tokens based on the usage of the network. It could be used to reduce the inflation rate, the number of new tokens being created, or if it outpaces the inflation rate it could even make the token deflationary. Ethereum is scheduled to implement a fee burn mechanism, with EIP 1559, to its blockchain so this will put the fee burn approach to the test on a much larger scale.
Similar to fiat currencies, like the dollar, cryptocurrencies also have monetary policies that dictate certain aspects of the token like its supply schedule, inflation, and more. This can be used as a mechanism to increase, decrease or stabilize the price.
The token supply schedule refers to the number of new tokens that are issued/created over a period of time, think of this as the inflation rate. If the supply schedule of a token is issuing too many tokens then this could harm the price if there isn’t enough demand. Conversely, a supply schedule that doesn’t issue enough tokens can have a positive effect on the price if there is more demand than is available. This supply schedule can also be fixed or variable. Bitcoin is an example of a crypto that has a fixed supply schedule, and by extension a fixed monetary policy, that is designed to remain unchanged. Currently, there are 6.25 new bitcoins mined per block and this will continue with the block rewards being halved every 4 years until the max supply of Bitcoin has been reached — see the graph below. By decreasing the number of bitcoins being created every 4 years, by half, it continually reduces its inflation rate until it becomes potentially deflationary once the max supply is reached. It can become deflationary because no new coins are being created, so that means any coins that are lost or destroyed are effectively removed from the circulating supply and make the remaining coins more valuable.
Ethereum is an example of a token where its monetary policy is variable, which means it’s open to being changed. Ethereum’s block rewards started with 5 ETH per block and has experienced two changes so far. This has brought the block rewards down to currently 2 ETH and creates a similar supply schedule to Bitcoin, where the block rewards have decreased over time, effectively decreasing its inflation rate — see the graph below.
Although Ethereum doesn’t have a max supply like Bitcoin, it has an interesting characteristic where its large ecosystem of Dapps is seeing an increasing use and lock up of ETH. This increased use increases demand because ETH is the native token that is used to power its Dapps, and by locking up ETH in these Dapps they are effectively removed from the circulating supply. This substantial amount of demand is what allows Ethereum’s price to continue increasing despite the lack of a supply cap.
Ethereum has multiple future changes to implement to the network that can have the potential to both increase demand and decrease supply. The variable nature of its monetary policy it what allows Ethereum to test and understand how to better improve ETH and the overall network. While a fixed monetary policy can have its benefits, there are advantages to having a variable monetary policy that allows the token to test and implement better monetary solutions, which can ultimately enhance a token’s tokenomics.
When a team is deciding how to launch a token they have two options; a fair launch, and pre-mine. A fair launch is the launch of a token where the opportunity to acquire it is fair for everyone. A pre-mine is the launch of a token where the supply of a token is either partially or fully created. It is then initially distributed to a mix of founders, private investors, development treasury, or others with access before launching for sale to the public.
Bitcoin is an example of a fair launch because anybody that wanted to gain Bitcoin had to go through the same steps to do so. In Bitcoin’s case, anybody who wanted to acquire Bitcoin had to mine for it. There was no initial sale of bitcoins to investors, or the creator, and all the miners had to go through the same steps to mine Bitcoin.
In contrast, a pre-mine can give unfair opportunities to certain individuals over others. A pre-mine isn’t inherently bad, however, it is the way tokens are initially distributed that can influence the integrity of the project — this is called token distribution.
For example, when developing a token and the ecosystem around it, there are expenses that need to be paid, like labor and other development overhead. Here it is fair to argue that the development team will need access to funds to finance future development. This can be easily achieved by distributing a percentage of the total supply to the team, this is common practice. It is how much of that supply is distributed is where controversy can emerge. If a team were to distribute 5% of the total supply to themselves to fund development, that may not have been seen as a problem. Although, if that distribution to the team was 50%, then it can be argued that the team may be giving themselves too many tokens, which might’ve otherwise gone to the public. Since a team needs to sell tokens to fund development, if a team holds a large portion of the total supply it could negatively affect the price if they were to sell large amounts of tokens.
There are many different ways that teams can use to distribute tokens to the general public. Over time, they have changed and evolved, as you can see below. These methods have different benefits and limitations as to how they go about distributing tokens to the public and the different incentives they provide.
In 2017, an ICO was the most popular method for teams to raise funds by allocating a percentage of the total supply to be put up for sale to the general public. A price per coin would be set initially and once the sale was open to the public, buying would stop once the team raised the necessary amount of funds they were after. In 2014, Ethereum held its ICO to raise $16 Million at a price of $0.31 per ETH.
Since then, projects have begun using different methods to distribute tokens to the public like airdrops or through rewards to platform users. Uniswap is a Decentralized Exchange that launched a token to provide rewards to their users and for governance, among other things. Below you can see a graph showing Uniswap’s token allocation.
60% of UNI is allocated to the public and 40% to the team and private investors with 4-year vesting. Vesting means that their allocated amount of UNI will be given throughout a period, in this case it is over 4 years. This is more beneficial for the tokenomics, and price of UNI, as it means investors can’t immediately dump their entire position because they won’t receive it in full until the 4 years is over.
Below you can see the release schedule for UNI over the 4 years, with each allocation marked with its specific color, pink being the largest for the public allocation.
Upon launch of UNI, September 2020, 15% of the UNI supply was immediately available for claiming by anyone using the platform, trading, or providing liquidity. 4.9% of the total UNI was given to liquidity providers, 49,000 of them, where the rewards were favored for liquidity providers who participated earlier on the platform when liquidity was low. 10% of total UNI was split evenly among all the historical user addresses, 251,500, where an airdrop of 400 UNI was available to claim.
43% of UNI is held in the governance treasury where it will be released into the community over time through programs like grants, community initiatives, liquidity mining, and others. After 4 years, 2% of UNI per year will be used to continue participation and contribution of the platform. Essentially, they will put funds towards programs that will incentivize user growth. This can be powerful for a platform that implements this because if done correctly it can lead to sustained long-term growth which is important for the tokenomics.
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