Tokenomics: What you need to know to make better investment decisions

Just as traditional economics explores the production, distribution, and consumption of goods and services, tokenomics delves into how digital tokens are created, managed, and circulated within the blockchain ecosystem.

Understanding tokenomics is crucial for anyone involved or interested in the crypto world, as it directly influences the value, utility, and potential of a digital asset. Dive in to grasp the foundational concepts and discover why tokenomics is pivotal to the future of decentralized finance.

What is Tokenomics?

Tokenomics is the study of the economic models behind a cryptocurrency token or crypto asset. It encompasses various factors, including total supply and future dilution, initial distribution, vesting periods, utility, burn mechanisms and economic stability. 

The relationship between the value of a token and its tokenomics behaves in this manner: if a token has strong utility, limited supply, and high demand due to its role within a thriving ecosystem, its value is likely to be positively impacted. 

Conversely, if a token has weak utility, an oversaturated supply, and no distinct role or demand within its platform, its value might be negatively affected.

For instance, a token with a capped supply and regular burn mechanisms might see its value increase as the circulating supply decreases (assuming demand remains constant or increases). Alternatively, a token that rewards holders with additional tokens might create selling pressure if many holders regularly liquidate their rewards.

In essence, tokenomics serve as a foundational blueprint that can guide the potential value trajectory of a token, but it's only one piece of the puzzle. Market sentiment, broader adoption trends, regulatory changes, and technological advancements can also play significant roles in determining token value.

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What is a Token?

A (crypto) token is a type of digital asset issued and managed on a blockchain. While often used interchangeably with the term "cryptocurrency," there's a nuanced difference between token, coin and cryptocurrency. Here's a breakdown:

Coin 

Coins have their blockchains. Examples include Bitcoin (BTC), which operates on the Bitcoin blockchain, and Ether (ETH), which operates on the Ethereum blockchain. 

Coins mainly serve as a medium of exchange, store of value, and unit of account. They are generally used in the same way as physical money—to buy, sell, or store value.

Token

Tokens are created using the smart contract functionality of another blockchain, often Ethereum. 

They do not have their own separate blockchains. 

Tokens can have varied functionalities beyond simple monetary value. They can represent assets (like FIAT currency, real estate or art), stake in a project, voting rights, access to certain functionalities of a project (like premium features), or anything the issuer decides. 

Examples include USD Coin (USDC), Wrapped Bitcoin (WBTC) or Uniswap (UNI).

In summary, while all coins and tokens are cryptocurrencies, not all cryptocurrencies are coins. 

The distinction lies mainly in their creation, functionality, and use-cases. 

Tokens, given their versatile nature, have given rise to various innovative applications in the crypto space, including Decentralized Finance (DeFi) projects and Non-Fungible Tokens (NFTs).

Read on: Cryptocurrencies with the most potential in 2024

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Why Does Tokenomics Matter?

While new token and project release numbers have definitely declined in the recent bear market, it is never a bad time to educate yourself to make better investment decisions. 

We are currently seeing increasing Bitcoin dominance, but once a new hype cycle kicks in, it is expected that a lot of capital will seek investments with a higher risk and return profile, often found in so-called Altcoins. 

Bitcoins function as a peer-to-peer value transfer protocol is simple and almost unchallenged, while Altcoins try to convince investors with new disruptive ideas involving their own coin or token. These assets vary greatly, so it is important to understand what’s behind it and how an investment could play out.

Tokenomics, a fusion of 'token' and 'economics,' refers to the design and framework governing the distribution and functionality of tokens within a blockchain ecosystem. For crypto investors, understanding tokenomics is crucial for several reasons. 

Firstly, it provides insight into a token's utility, demand, and value proposition, helping investors gauge its potential long-term worth and the relationship of the token per se to the product developed. 

Sadly, there are cases where the token is a pure fundraising instrument but does not find use or value later on.

Secondly, tokenomics can influence the scarcity or abundance of a token, which can impact its price and adoption rate. 

The distribution of token to various entities like the team, early investors, advisors or even a reserve treasury can have massive influence on how the token price can be influenced by certain stakeholders.

Additionally, lockup periods and token issuances can give indications on likely price movements in the market.

Furthermore, a well-structured token economy can foster network security, incentivize user behavior, and ensure the sustainability of a project. 

Conversely, flawed tokenomics can result in imbalances, potential manipulations, and ultimately, the failure of a crypto project. 

Hence, a solid grasp of tokenomics is essential for making informed investment decisions in the rapidly evolving world of cryptocurrencies.

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Key Components of Tokenomics

Token Supply

The token supply of a cryptocurrency is influenced by a combination of predefined rules set in its protocol and various external factors. 

In general it is important to distinguish between maximum and circulating supply and if the amount of tokens within an ecosystem is fixed or inflationary.

• Maximum Supply: This number represents the entirety of tokens which will ever exist. For new projects it is common that the largest portion of the supply is initially locked up and will become accessible over time.
• Circulating Supply: The portion of tokens who are currently liquid, meaning that they can theoretically be sold or bought at the market. 
• Fixed Supply: Some projects pre-mine all tokens before launching, meaning they generate a predetermined number of tokens before the public can access them. A portion of those tokens is often used for fundraising, developer rewards and marketing campaigns while the rest will be distributed to participants in the ecosystem over time. While some tokens might be locked up there is still certainty on how many tokens will ever exist. Fixed supply makes it easier to calculate economic models, as only the demand side needs to be evaluated. 
• Inflationary Supply: As known from proof-of-work (PoW) and proof-of-stake (PoS) systems, miners or validators are rewarded with new tokens for validating and adding new blocks to the blockchain. Same principles can be programmed into a token smart contract. Depending on frequency and conditions of these rewards it can become difficult to foresee the supply at a certain point in the future.

When evaluating a project and the respective token price, it is essential to take the maximum supply into account. Just looking at the circulating supply and its market capitalization might be misleading in reflecting the valuation of a project at this point in time.

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Token Distribution

The use of cryptographic tokens as a unit of account is revolutionizing the fundraising process for Startups and DAOs. Issuing a token can provide early liquidity and utility to investors, while bringing transparency for all stakeholders to the table. 

Well known terms include Initial Coin Offerings (ICOs), Security Token Offerings (STOs), and Initial Exchange Offerings (IEOs), describing the nature of the asset and the channel of distribution.

It is paramount that such an issuance process is well-structured and lays a sustainable foundation of a project, rewarding early believers while continuing to incentivize new ecosystem participants. 

To guarantee long term success and avoid extreme volatility, there are certain instruments to be used when structuring healthy tokenomics.

• Vesting: For a project's initial financing, investors seek a significant upside since they're backing an unproven idea. To prevent early sell-offs and stabilize token prices, vesting schedules with lockup periods are introduced, allowing gradual access to tokens over time.
• Staking: When tokens are staked, they're removed from circulation, increasing scarcity and possibly affecting price. Staked tokens can also grant voting rights in some systems, giving committed stakeholders more influence over the project's direction.
• Airdrops & other rewards: Token incentives boost a project's visibility and can prevent token concentration, reducing centralization risks, especially when tokens relate to governance rights. Some projects prefer airdrops over traditional sales to distribute tokens more naturally and avoid potential regulatory issues.

Token Utility

Token utility refers to the specific use or purpose a token serves within its ecosystem. Good token utility aligns with the project's goals, adds genuine value, and encourages user participation. 

In contrast, bad token utility might seem forced, unnecessary, or purely speculative without a clear function. Here are some examples of both:

Good Token Utility:

• Access Rights: Tokens can grant holders access to certain services or features within a platform. For instance, the Basic Attention Token (BAT) allows advertisers to pay for ad space and user attention within the Brave browser ecosystem.
• Governance: Some tokens provide voting rights, allowing holders to participate in the decision-making processes of the platform. MakerDAO's MKR token, for example, lets holders vote on various proposals that determine the future and policies of the platform.
• Staking & Network Security: In proof-of-stake systems, tokens can be staked to validate transactions or create new blocks, strengthening the network's security. Examples include Ethereum's transition to Ethereum 2.0 and Cardano's ADA token.
• Collateral & Borrowing: In decentralized finance (DeFi) platforms, users can lock up tokens as collateral to borrow other assets or mint stablecoins. 
• Fee Reduction: Some exchanges offer tokens that can be used to pay for trading fees at a reduced rate, like Binance's BNB.

Bad Token Utility:

• Forced Adoption: Projects that require token usage for services that don't inherently need a token can be seen as forced. For example, a platform that could easily use Stablecoins, Bitcoin or even FIAT but instead insists on users buying and using their proprietary token without clear added value.
• Redundant Utility: A token whose utility overlaps entirely with another token within the same ecosystem, without a distinct purpose, can confuse users and diffuse value.
• Overcomplicated Utility: If a token's use case is too convoluted or requires users to jump through multiple hoops, it can deter adoption and usage. Simplicity and user-friendliness should be prioritized.

Token Demand

In retrospect many outcomes can be traced back to the basic market law of demand and supply. It should be in the interest of all project stakeholders to drive demand for the product and ultimately token usage while minimizing the increase in supply.

Increasing the demand for a token involves a combination of strategic, technical, and marketing efforts. Here are some key drivers:

• Clear Utility & Use Case: Whether it's used for governance, access rights, staking, or any other function, value of a token should be evident to potential users.
• Robust Technology & Security: The underlying technology of a project should be strong, scalable, and secure. Regular audits, especially by reputable firms, can help in gaining user trust.
• Partnerships & Collaborations: Partner with established players in the crypto space or related industries. Partnerships can open up new use cases for a token and give access to a whole new user base.
• Community Engagement: A dedicated and enthusiastic community can be a project's most significant advocate. Word of mouth continues to be the most efficient marketing tool.
• Liquidity: If a token is easily tradable by being listed on multiple exchanges, especially reputable ones, access barriers are removed. Additionally, consider creating liquidity pools on decentralized exchanges or using liquidity incentives to encourage trading.
• Integration & Ecosystem Development: Encouraging third-party developers to build on or integrate with the platform broadens the ecosystem and increases the potential demand for a token.

While these factors can stimulate demand, the long-term success of a token is largely determined by the genuine value it provides and the problem the projects it aims to solve. 

Token Security

Security audits play a pivotal role in reinforcing the integrity of a cryptocurrency token and its associated platform. By subjecting a token's underlying code and infrastructure to rigorous examination, security audits identify vulnerabilities, weaknesses, and potential attack vectors - from both technical and economical nature.

In an industry where trust and security are paramount, regular and transparent security audits establish a token's credibility, enhance its reputation, and contribute to its long-term success in the market.

The Case for Tokenomics

Understanding tokenomics can serve as a protective shield for investors against pump and dump schemes or even projects with good intentions but bad designs. At its core, tokenomics outlines the intrinsic value and utility of a token within its ecosystem. By dissecting this, an investor can determine if a sudden price increase aligns with the token's genuine worth or if it's merely a result of market manipulation.

• Supply Dynamics: Pump and dump schemes often take advantage of tokens with low liquidity and concentrated supply. Understanding the token's issuance, distribution, and vesting schedules can help identify potential red flags.
• Transparency & Governance: Proper tokenomics often emphasizes transparency and may include governance structures. A project that's transparent about its token allocations, partnerships, and development can be less susceptible to manipulative schemes. Conversely, opaque operations might be a warning sign.
• Utility & Demand: A key component of tokenomics is the token's utility and its organic demand drivers. If a token is designed to mirror a project's success in the demand for it, this should also reflect in the token price.
• Community & Communication: Projects with strong tokenomics often maintain open communication with their community. A community that actively discusses the project's fundamentals, rather than just its price, is a positive sign. On the other hand, if there's a lot of hype with little substantive discussion, caution is advised.

While this is more of a general trading principle, combined with tokenomics, observing trading volumes and market depth can offer clues. Also understanding who's behind the project and their track record can give insights. A reputable team with a history of genuine contributions to the crypto space can be less likely to engage in manipulative practices.

Evaluating Tokenomics: A Step-by-Step Guide

Evaluating tokenomics is a comprehensive process that requires thorough due diligence. Here's a step-by-step guide to help you navigate this:

Begin with the Whitepaper & Official Documentation

• ‍Purpose & Vision: What problem does the project aim to solve? Why does it require a token?‍
• Technical Details: Does the project detail its technological infrastructure and explain how the token fits within this framework?‍
• Economic Model: How is the token used within the ecosystem? What's its role in driving demand, ensuring security, or providing utility?

Check Vesting Schedule for Team Tokens

• Check the allocation for the team and advisors. Is it reasonable? Typically, 10-20% is a standard ballpark, but it can vary.
• Determine the vesting period. Longer vesting periods (e.g., 2-4 years) indicate the team's commitment to the project's long-term vision. Look for potential cliffs (periods after which a significant portion unlocks).

‍Private or Seed Sales Investigation

• Find out if there were any private or seed sales. What was the token price compared to public sale or current market price?
• Were there any special conditions for these early investors, such as extended vesting or bonus tokens?
• This information can provide insights into potential future selling pressures.

Token Utility in Real-World Applications

• Analyze the token's utility. Does it serve as a governance token, provide access to services, act as a medium of exchange, or offer staking benefits?
• Look for existing partnerships, integrations, or real-world use cases that validate this utility.
• Evaluate if the token's utility is genuine or if it seems forced.

‍Examine the Project's Monetary Policy

• Burns: Does the project have a token burn mechanism? If so, how does it work? Token burns can introduce scarcity by reducing the total supply, potentially driving up demand.
• Buy-backs: Some projects use profits to buy back tokens from the open market and then burn or redistribute them. This can also create demand and reduce supply.
• Staking & Rewards: Does the project offer staking? What are the rewards, and how might they impact tokenomics? Consider inflationary pressures from reward issuance.
• Treasury & Funding: How does the project fund its operations? Is there a treasury system? How are tokens allocated for future developments and expansions?

Community & Governance

• Does the token provide governance rights? If so, how decentralized is the decision-making process?
• Analyze community engagement. Active and informed communities can be a good sign of a project's health and credibility.

Transparency & Security

• Does the team provide regular updates about developments, partnerships, and changes in tokenomics?
• Consider checking if the project undergoes periodic security audits and shares results transparently.

Economic Barriers & Entry Costs

• Assess if there are high barriers to entry or prohibitive costs associated with utilizing the token, which might deter adoption.

Market Analysis (if already listed)

• Examine the token's trading volume, liquidity, and exchange listings. High liquidity and presence on reputable exchanges can indicate trust and demand.
• Be wary of tokens with minimal trading activity or concentrated on lesser-known exchanges, as these can be more susceptible to manipulation.

Competitive Analysis

• How does the project stand in comparison to competitors in the same space? Does it offer a unique value proposition or better tokenomics?

By systematically going through these steps and critically assessing each aspect, investors can gain a comprehensive understanding of a project's tokenomics. This not only informs potential investment decisions but also aids in discerning genuine value propositions from highly speculative or poorly-structured ventures.

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Common Pitfalls and Red Flags in Tokenomics

Sometimes extensive research efforts can be cut short if a red flag emerges in clear sight. Here are some common pitfalls investors need to watch out for:

• Excessive Reserves for Early Investors, Founders, and Team: If a significant portion of the token's total supply is reserved for early investors, founders, or the team, it can raise concerns about centralization and the potential for market manipulation. These large holdings can lead to disproportionate control and might result in massive dumps, adversely affecting the token's price and stability.
• Unrealistic or Uncapped Hard Cap: If a project aims to raise an unrealistically high amount of funds without a clear justification of its use or if there's no cap on the fundraising, it may be a sign of greed or poor financial planning.
• Promises of Guaranteed Profits: Any project that promises guaranteed returns is a major red flag, as it can indicate a Ponzi scheme or other fraudulent activities.
• Absence of a Clear Roadmap: Projects should provide a clear roadmap indicating how funds will be used, development milestones, and future plans. A vague or absent roadmap can indicate a lack of planning or intent to follow through.
• Inconsistent Token Metrics: If the project frequently changes its token metrics, allocations, or other fundamental aspects without clear justification, it can indicate instability or a lack of clear vision.
• Lack of Clarity or Overly Complex Distribution Mechanisms: A token's distribution mechanism should be transparent and straightforward. If the distribution process is shrouded in mystery or seems unnecessarily convoluted, it could indicate a lack of transparency or an attempt to obscure unfavorable terms.
• No Clear Utility or Purpose for the Token: One of the most significant red flags is a token without a clear utility or purpose. If a project fails to justify why it requires a token or how the token adds value to its ecosystem, it might merely be a means to raise funds without offering genuine value.

Real-world Examples of Good vs. Bad Tokenomics

Addressing the utility token with the largest market capitalization: Binance Coin (BNB) has been at the forefront of the crypto space, in part due to its strong tokenomics which include:

Clear Utility

• Trading Fee Discounts: Initially, Binance offered discounts on trading fees for users who paid with BNB. This encouraged users to hold and use BNB for their transactions on the Binance platform.
• Launchpad Participation: BNB can be used to participate in new project token sales on Binance Launchpad.
• Cashback: Users who hold BNB gain up to 8% cashback on Binance debit card purchases.

Token Burns

• Binance has committed to using 20% of its profits each quarter to buy back and burn BNB until 50% of the total supply (100 million BNB) is destroyed. This deflationary mechanism can potentially increase scarcity and value over time.

Expanding Ecosystem

• Binance Smart Chain (BSC): Binance launched its own blockchain, where BNB is used for transaction fees and as a base asset. This expanded the utility of BNB beyond just the Binance exchange.
• DeFi and dApps: BSC has attracted a growing number of decentralized applications, further increasing demand for BNB.

Staking and Farming

• On Binance and BSC-based platforms, users can stake or farm BNB to earn rewards, increasing its utility and locking up supply.

Transparent Distribution

• Binance held an Initial Coin Offering (ICO) for BNB, allowing for a transparent initial distribution to a wide audience.

Continuous Innovations

• Binance is known for its rapid development and launch of new products and services, many of which incorporate BNB in some way, ensuring the token remains relevant and in demand.

Real-world Use Cases

• Beyond the crypto sphere, BNB has been integrated into various real-world applications, including payments and merchant services.

It's worth noting that while BNB showcases strong tokenomics, the broader Binance ecosystem and the regulatory environment can influence its performance.

On the other side of the spectrum Bitconnect is one of the most infamous projects in the crypto space, largely remembered for its unsustainable business model and allegations of being a Ponzi scheme. Here's how its tokenomics and overall structure contributed to its downfall:

• Guaranteed Profits:
• Bitconnect promised its users guaranteed high returns, claiming up to 40% per month. This is a major red flag, as no legitimate investment can guarantee returns, especially of such magnitude.
• Lack of Transparency:
• The Bitconnect platform lacked transparency regarding its operations, strategies, and technology behind its "trading bot," which was purportedly responsible for generating the promised returns.
• Forced Reinvestment:
• Users were encouraged to reinvest their earnings back into the platform, which would lock up their funds for longer periods, thereby sustaining the scheme for a while.
• Multi-Level Referral System:
• Bitconnect employed a multi-tiered referral system, a common feature in pyramid schemes. This system incentivized users to recruit more participants to inject fresh funds into the platform.
• Centralized Control:
• The majority of BCC tokens were held by the Bitconnect platform and a few early investors, leading to centralized control and significant potential for price manipulation.

Bitconnect abruptly shut down its lending and exchange platform in January 2018, citing regulatory issues and continuous bad press. This resulted in a sharp decline in BCC's value to zero, and many users lost significant amounts of money. 

In the aftermath, Bitconnect has been labeled one of the largest scams in the cryptocurrency world. This serves as a cautionary tale about the importance of proper tokenomics, transparency, and sustainable business models. Investors should always be wary of projects that promise guaranteed or unrealistically high returns.