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What is tokenomics and why should we study it?

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PDAX

July 13, 2022

9 min read

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TL;DR

Tokenomics is the study of the supply and demand patterns and market characteristics of a cryptocurrency. Serious crypto investors study tokenomics to understand the factors that impact the value of a specific token in order to develop an effective investment strategy around it. 

What is tokenomics?

The term “tokenomics” is a mashup of “token” and “economics”. In a nutshell, tokenomics is a deep dive into the market behavior surrounding a particular cryptocurrency.

Much of tokenomics concerns itself with the study of supply and demand as these are the main variables that have a direct effect on market value. Basically, the higher the demand for a particular token, the less supply there will be available for buyers–which in turn translates to a higher market value. 

On the other hand, as more supply becomes available, demand naturally goes down as the needs of buyers are met, causing prices to go down as well. 

These general principles of supply and demand are the same whether it be with fiat currencies, the stock market or the commodities market. However, cryptocurrency is not like fiat money wherein the government can choose to print more money should they choose to do so. Nor is it like stocks and commodities wherein supply is determined by the rate of production or the availability of raw materials.   With cryptocurrencies, the supply for a particular token is usually predetermined as set by their developers. The supply is also usually issued or “vested” in predetermined amounts following a schedule or is triggered by algorithms when certain conditions are met. 

For example, Ripple (XRP) has a total supply of 100 billion tokens, but the whole supply is not issued all at once so as not to flood the market and lower the value of the token. Instead, XRP is issued at a rate of only 1 billion tokens per month, with an escrow system in place which also removes unused tokens from circulation at the end of each month to keep the supply manageable and predictable. 

Bitcoin (BTC) on the other hand, only has a maximum supply of 21 million tokens, of which 19 million so far have been released in circulation through a process called “mining”. Bitcoin’s mining mechanism is set up in such a way that it gets harder and harder to mine new coins as time goes by, restricting supply and causing demand to rise. Mining Bitcoin nowadays is so difficult and competitive, requiring top-of-the-line high performance hardware, which is primarily a reason why Bitcoin has grown so much in value through the years. 

As each token has different protocols, mechanisms and use cases that affect its supply,  studying their tokenomics thus becomes a very important tool in the speculation of the potential growth of these digital assets both in the short and long term. 

Breaking down tokenomics

It can be quite a lot of effort to study the supply mechanisms of every coin and token in the market to evaluate which one might be profitable. However, there a few general key metrics that one needs to pay attention to in order to get the broad picture of the tokenomics for a particular cryptocurrency:  

  • Circulating supply - This refers to the amount of tokens that are currently in circulation. Generally, the fewer tokens there are in circulation, the higher the value of each individual token will be. 
  • Maximum supply - This refers to the maximum amount of tokens that can be expected to be in circulation in the future. Cryptocurrencies whose circulating supply is still quite a long away from reaching their maximum supply may mean that the project still has a lot of room for growth. On the other hand, cryptocurrencies whose maximum supply is already in circulation means that the supply has already been exhausted, and demand may be on the rise. 
  • Market capitalization - Market capitalization or "market cap" is basically the current valuation of a token derived from multiplying its current market value with its current circulating supply. A lower market cap generally means that a token is more volatile as the project may still be new or may not yet be widely known. This of course means that there is a higher potential for profit in case of an uptrend–but also a higher potential for losses in case of a downtrend.
  • Issuance rate - Different tokens are issued at different rates depending on their design and utility. Some tokens are released incrementally over a period of two years or more depending on the token’s development plan. Meanwhile some token’s supplies are issued depending on usage, such as rewards for mining, staking, or for other utilities such as rewards for play-to-earn games.  
  • Allocation - This refers to the shares of ownership of the coins in circulation. A big factor that can impact this is the percentage allocated for private and public token sales upon launch. If a considerable amount goes into private wallets, this means that the project may have sufficient funding to pursue its goals, but it also means that the initial supply is concentrated in the hands of a few. Thus, any  movement (such as sudden sell-off) can have a significant impact on the value of the coin.
  • Burning mechanism - “Burning” tokens simply means removing tokens from circulation to reduce the overall supply. Some tokens have burning mechanisms whenever users transact with the token, while others have burning mechanisms that are pre-scheduled. 

Deflationary or inflationary?

An inflationary cryptocurrency is one wherein the supply in circulation increases over time. For example, Dogecoin (DOGE) abolished its hard cap of 100 billion DOGE back in 2014, which means that the supply of DOGE is now unlimited.

A deflationary model is one wherein the supply of coins decreases over time to trigger a natural rise in the token’s value. For example, Ethereum (ETH) “burns” part of the gas fees for processing transactions to reduce the overall supply of ETH. During times when there is a rise in network activity, the burning rate also accelerates, making the coin deflationary.

Both models actually have their pros and cons. Though people generally think that deflationary models are guaranteed to increase in value over time, it sometimes leads to users hoarding their tokens instead of using them, causing demand to drop. On the other hand, the supply of inflationary tokens might outpace their demand, but a well-balanced inflationary model can encourage their users to spend their tokens instead of hoarding them, resulting in real world utility and value–and hence, rising demand. 

Utility and other factors 

There are, of course, other factors to consider when looking at the investment value of a certain cryptocurrency. Sometimes it’s not just about the rise and fall of market prices. Some tokens might be inherently valuable to users because they offer value through their utility. 

Some tokens used for decentralized applications (dApps) can rise in value as the dApp itself proves useful or profitable for people. Some tokens might be used for payments, transactions fee, discounts, or governance relative to the app. 

There are also other tokens used in decentralized finance (DeFi) that can serve as viable investment vehicles because of their yield farming or staking features. This makes them an appealing source of passive income generation for investors and traders.

The underlying technology of course, plays a part too. For many dApp tokens, it is important to consider the Layer-1 blockchain where the project is built on, as the price movements for these major networks also has an effect on the dApp tokens that are built on them. 

All in all, understanding tokenomics means developing a good sense of judgment on how to weigh all these factors together, which can be attained through diligent research and experience. 

How to research tokenomics

To evaluate a token, here are a few best practices when it comes to researching a token’s background and tokenomics and keeping yourself informed:

  • Study a project’s whitepaper - A whitepaper is an official document published by a project’s developers that highlights the features of their technology and the purpose of the cryptocurrency project. It contains detailed plans, statistics, economic formulas, and roadmap schedules that you can study to determine whether a certain project is on track to meet its goals or not. Through the whitepaper, you can also do a background check on the development team, and assess their repute through their experience, past projects and partner organizations.
  • Join online communities and forums - There are plenty of online communities and forums which can connect you with other traders and investors so that you can get a broader perspective of global market demand as well insights on ongoing issues that may be happening. Official social media groups and pages can even connect you directly with the developers so you can get firsthand updates. 
  • Participate in token governance - Many tokens have community governance mechanisms that allow their token holders to vote on the token’s future directions such as network updates and even changes to the supply and burning mechanisms. Participating in token governance will get users in contact with even more intricacies that factor into a token’s functionality and design. 

Conclusion

When making an investment decision, it’s always important to study tokenomics as a form of due diligence and financial protection. Tokenomics help investors understand the nuances of a token’s behavior on the market and it could potentially protect them from falling for false hype and making poor investment choices. 

Though tokenomics might sound like an advanced field, understanding the basics can already cover a lot of ground in enriching one’s knowledge not just about a specific token, but with the broader world of digital assets.

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DISCLAIMER: The statements in this article do not constitute financial advice. PDAX does not guarantee the technical and financial integrity of the digital asset and its ecosystem. Any and all trading involving the digital asset is subject to the user’s risk and discretion and must be done after adequate and in-depth research and analysis.

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