What is Tokenomics and how do it works?

Each cryptocurrency that exists has a foundational base, a specific functioning, a purpose, specific ways of distributing potential benefits or giving rewards to its users… All these mechanisms that shape and define the cryptocurrency itself are its tokenomics.

Tokenomics, which are generally detailed in the white papers of each project, are implemented, in whole or in part, through smart contracts. Thanks to smart contracts, greater transparency and security are achieved. In addition, smart contracts make it possible to automate and reduce the cost of certain processes such as interest payments, token distributions…

Decentralized finance (DeFi), as the name implies, is articulated through smart contracts without the need for a trusted third party. This means that common human errors are generally absent from the token economy mechanisms.

The universe surrounding tokenomics

As can be intuited, tokenomics have the task of making the mechanisms by which investors’ money “works”. In that sense, they are no different with respect to the mechanisms used by other services to accomplish similar tasks. The big difference is that the latter operate human teams and the former operate algorithms, as we will detail later. The topics to be studied in this article are listed below:

It is worth noting that this new concept is set to fundamentally change the world of investments and many facets of the economy. In other words, the universe of cryptocurrencies, decentralized finance and all its derivatives are firmly established thanks to tokenomics.

Although this is a process that is in its infancy, the impact it is already having is considerable. For example, sports clubs, the real estate market and many other businesses are venturing into the world of tokenization and thereby offering various opportunities and methods to take advantage of these proposals. The latter is what is known as internal tokenomics.

What is tokenomics?

Tokenomics are all the mechanisms, agreements and functionalities that define a cryptocurrency and allow it to function as expected. As a whole, tokenomics, seek the establishment of a new type of economy. It is based on the revolutionary blockchain and its sustainability depends on the movement of tokens. In such a way, tokens are the backbone on which all business processes coupled to this technology revolve.

“Tokenization of the real estate market is one of the most promising for the financial world.”

Users interact with the tokens through some kind of interface. At the same time, those tokens can be linked to real assets, which represent the wealth of the project and investors. A simple example can be found with mobile car racing game applications. The user can participate in racing tournaments and according to the score is assigned tokens, nothing new.

However, in most of those games the tokens have no market value. This is where the revolutionary aspect of tokenomics comes into play. These, when linked to the blockchain, give the ability to add real financial value to those tokens. With this, games go from being hobby apps to become apps that combine hobby with revenue generation or GameFi. Among the most popular games are Axie Infinity, Defi Kingdom and others.

It should not be lost sight of the fact that the concept of tokenomics applies to virtually anything tokenized. As already mentioned, tokenization of the real estate market is one of the most promising for the financial world. Along with this, there are lending, staking, etc. options.

Below we will look at some of the most crucial aspects that make up the tokenomics of any project:

Allocation and planned distribution of tokens

When a new token is launched, one of the characteristics relates to its distribution among project participants. This is about the percentages of the coin that each party will get, i.e. the developers, the community and the large equity investors, and is a very important part of tokenomics. How these factors are designed could determine the price stability of a token.

It is worth noting that when a venture capital fund, angel investor or other heavyweight investor places large sums, they reserve large sums of tokens. This can lead to a big problem, as these can take profits and lead to the plummeting price of a coin. If the project behind does not have a well-structured plan, the risk of loss for investors increases.

A successful project tends to plan a thorough distribution that avoids that a massive sale affects as little as possible.

Dynamics of tokens

As will be seen below, the nature of tokens is varied as are their types. Different dynamics in the creation and distribution of tokens determine their typology and are a major aspect of their tokenomics:

Supply

It is the unit quantity that the token will have in circulation. It is a key parameter of tokenomics and is generally included in the white paper of the cryptocurrency. There are two types of token supply: limited and unlimited. It should be noted that these two categories determine whether a token is inflationary or deflationary, which is reviewed below.

Future issuance or burning

For an investor, it is vitally important to understand how the supply of a given token is handled. Generally, project developers map out the mechanics of future emissions (in quantity and frequency) and flaring. To prevent supply from getting out of hand there is the burning process where excess quantities are sent to an unrecoverable wallet. The latter should also be detailed in the tokenomics, as well as the quantity and frequency of such processes. For example, 5% of issued tokens are burned on a quarterly basis.

Market capitalization

This is one of the crucial aspects in determining the health of a project. It represents precisely the value of the supply of tokens that are in circulation. This value is usually represented in fiat currency. It should be noted that market capitalization is not measured in isolation, but in relation to the amount of supply. For example, when a token has a high market capitalization and its issuance is limited, it can be read as an indication of appreciation.

Market capitalization is obtained by multiplying the number of circulating tokens by the unit price.

Community Rewards

According to the strength of the community surrounding a project, its success can be measured. To achieve a strong community, the tokenomics model must offer significant benefits to the participants. The way the token is issued depends on how the community obtains rewards (mining, staking, yield farming). If there is feedback between a community that strengthens the fundamentals of the token and the project, trust increases.

Game theory

Game theory consists of an element that is not exclusive to cryptocurrencies, but encompasses virtually all technologies. It is the constant study and knowledge of people’s behavior when investing or making related decisions. For token projects, knowing the momentum people need is crucial.

Some elements make the mechanisms attractive to drive investors. Such is the case of blockchains (for staking, farming or others). In exchange for leaving their tokens locked, a respectable reward is offered that makes people unwilling to unfreeze their money.

Forms of token issuance

It was already said that tokens count on a supply (limited or unlimited). That is followed by the question how are these coins or tokens issued? The most important ways of generating new coins is through the process called mining, staking and yield farming.

Mining: it works with the Proof-of-Work (PoW) protocol and is a complex process that is performed by adding computing power to a blockchain to process transactions. For doing so, miners receive a reward from the network. Depending on the token algorithm, the token is mined with CPUs, GPUs or complex ASICs.

Staking: the purpose and function is the same as mining, but this time it is not done with computing power, but with a proof of participation. Hence the protocol is called Proof-of-Stake (PoS). Users stake or block for a certain time their coins in a smart contract to validate the transaction blocks. For doing so, they receive a reward of new coins.

Farming: some coins work with the Proof-of-Space and Proof-of-Time protocol. Unlike mining or staking, the user makes his hard disk storage capacity available. The network rewards you for your contribution of space and time with newly issued coins.

Yield farming: Yield farming is another way of obtaining part of the issuance of a given token. To do so, the user locks his funds into a liquidity pool, which provides funds to decentralized exchanges (DEX) or other protocols. For making that liquidity contribution, the user takes part of the token issuances. In other cases, the rewards come from commissions per trade.

Vesting calendar: a must for the investor

When a project releases large amounts of tokens at a certain time it is very common to see a sharp drop in the price of the cryptocurrency. Most projects have the investment of large funds, to which a blocking period (called vesting) is applied with periodic deliveries of tokens to prevent them from selling suddenly and sinking the price of the cryptocurrency. In that sense, it is important to know the tokenomics of a project, which generally include the detailed map of the vesting period. In this way, we can anticipate price drops or find opportune moments to buy.

In that vesting period, funds in tokens are locked up so that venture capitalists will be unable to sell them at the first opportunity when they see a high price. With this, investors’ money is safe from a fall that could be lapidary for their funds and for the project in question.

Why is tokenomics important?

The key aspect that determines the importance of tokenomics is that it was born as an alternative to the centralized system. Consequently, one of the core tasks is to preserve wealth in the face of inflation. The control of traditional currencies such as the USD or EUR is tightly monopolized by central banks.

The latter have the ability to issue money at will, which generates inflation, which is one of the most damaging phenomena for people’s economy. At this stage, the importance of tokenization comes to life as an alternative to the inflationary phenomenon of centralized entities. Tokenomics are as varied as the number of applications with tokenized services or options. In general, DeFi applications have a White Paper.

In this document, the mechanisms of the token economy of a given project or financial application are explained in detail. This ranges from issuance and distribution to exchange rates and rewards. All these elements make it possible to enter the services of a decentralized application, for which one must proceed to acquire its native tokens. In the end these will set in motion all the internal mechanisms established by its developers. Hence, it is crucial to know the whole process of the movement of these tokens in all its facets in their respective white papers

For example, in the Decentraland metaverse, people can buy lots of land, build houses or clubs. With any construction they will get profitability if they do well. But to go from A to Z on that platform you have to enter with the MANA token. With the tokens, the whole complex universe of tokenomics of that platform starts to roll.

The varied nature of tokens

The basis of the token economy is, and could be none other than the token. To have a clear context, it should be said that the token is for the tokenomic what the commodity is for the classical political economy, that is, the nucleus from which a whole big bang and its universes explode. But tokens are not a single entity; rather, an important variety of models can be distinguished. The following are the most outstanding ones:

Although at first glance these concepts may seem complex, the reality is quite different. In that sense, anyone who has used cryptocurrencies, even at a basic level, will quickly understand what these different natures of tokens are all about.

Within the crypto market world there are all these models and usability depends on users’ tastes. Some people prefer to bet on tokens that are deflationary for short and long term profitability. Although these tokens usually offer large amounts in a short time, their volatility makes them high-risk assets.

Other more conservative users opt for backed tokens, which offer moderate and steady returns. If these two cases sound familiar with those who opt for Bitcoin, on the one hand, and those who prefer to invest in stable coins like USDT on the other, that’s what it’s all about.

1. Inflationary token model

These are tokens that have no printing limits, i.e., developers will release as much coin as they deem necessary. In that aspect, they are similar to fiat currencies such as the USD or the EUR. It should be noted that minting is carried out in most cases in accordance with the White Paper or, in other words, with an established plan.

Some currencies have fixed inflation rates. In any case, inflationary tokens have control mechanisms such as the so-called burning. Burning is the sending of “excess” tokens to a wallet whose keys are not owned by anyone, so they are lost in a limbo of the blockchain.

There are many inflationary coins or tokens. Among the most popular are Ether from the Ethereum network, which has no issuance limit. This quality is shared by coins that work with the Proof-of-Stake (PoS) mechanism. Similarly, coins working with Proof-of-Work (PoW) are generally deflationary.

It should not be lost sight of the fact that this is not a rule, since there are PoW coins that are inflationary at the same time, such as XMR or Monero. What is important in this case is that inflationary currencies can play with issuance and burning to maintain a certain stability in price. In the case of Ether, part of the transaction fees are sent to a burn wallet.

2. Double-token Model

Also known as dual tokens, as these are two tokens that perform functions in parallel on the same blockchain. The reason for this modality, is that one of them functions as a kind of funding option. Meanwhile, the second one fulfills the function of a utility. This model emerged as a novel outcome to respond to the risks of the 2017 wave of ICOs.

Thus, the second of the tokens (the utility token) is intended to drive transactions on the blockchain. The other serves the function of lending crowdfunding to the project. Although in most cases the dual token model is applied during initial coin offerings (ICOs) its existence is not limited to ICOs. In fact, some DeFi projects such as MakerDAO apply this model despite never having launched an ICO.

Around the two tokens of that chain (MKR and DAI) the tokenomics of the protocol are developed. The emergence of this model complies with the request of the U.S. Securities and Exchange Commission (SEC). This requested that the tokens offered in ICOs be considered as bonds so that they could fit into the laws of that country. This is a model that is becoming increasingly popular, since it avoids violating US laws with initial offerings, as was done during 2017.

Consequently, when an investor buys the tokens, treated as bonds, he acquires rights to a stake. Expressed in simpler words, it is like buying shares and from there it goes without saying that the purchaser of the token has rights to the profits and dividends that the particular blockchain eventually has.

3. Deflationary token model

Deflationary tokens rely on a mechanism to generate scarcity. Generally, one thinks of coins with quantitative limitation such as Bitcoin, which has a cap of 21 million tokens. However, the boundary between deflationary and inflationary tokens is much fuzzier than one might imagine.

In that sense, a token with infinite issuance is certainly inflationary. However, it can become deflationary if it applies mechanisms such as repurchase and burning, discussed above. Thus, if the issuance of a token is fixed, for example, up to 4% and the repurchase and burn together exceed 4%, it can be said that there is a deflationary token. This implies that the amount of tokens being disposed of is greater than the amount of new coins minted.

The advantages of such coins are that they provide great benefits to long-term savers or hodlers. In the case of Bitcoin, being a fixed number of 21 million tokens, even if its price and demand increase rapidly, its quantity will always be the same.

On the other hand, even taking for granted the theory that mining is an inflationary process (because it keeps adding new tokens to the market), this issuance is also decreasing. This is due to the mechanism called Halving. This automatic movement that occurs every 210,000 mined blocks, approximately every 4 years, cuts the reward for each mined block in half.

The most recent of these cuts occurred in May 2020. At that time the reward per block mined dropped from 12.5 to 6.25 BTC. In 2024 there will be the next cut in half and so on until mining generates a few fractions, which would be of great value in the medium and distant future.

4. Backed token model

The last of the token models, is the one known as backed. The most popular of these is the so-called Tether or USDT backed 1 to 1 with the US dollar. The variety of these currencies is abundant and range from fiat currency backing to natural resources, gold, commodities, companies and a long list.

It should be noted that these tokens do not have a value of their own, but rather their price rests on and depends on an underlying value. This way of backing some cryptocurrencies provides greater stability and security for investors, especially for those who are less risk tolerant. Thus, the volatility typical of these markets is nullified. Projects based on these tokens have the most predictable tokenomics for investors.

It should not go unmentioned that some of these tokens are very controversial and with the Terra case it was demonstrated that they are not absolutely safe. That blockchain had a USD-covered token (UST). However, it was not really backed by that currency, but by a complex algorithm that played with the burning of another token (LUNA).

A mysterious withdrawal shock caused a spiral that led to UST losing its equivalence to the USD. The result was the loss of tens of billions of user dollars.

As mentioned above, there are also tokens backed in gold, silver and even oil. Of all backed tokens, the most dangerous are the algorithmic ones, since their underlying value is not material.

Other token classifications

Apart from those mentioned, there are also other classifications of tokens. Two of them are fungible and non-fungible tokens.

Fungible tokens are those that possess the property of exchange equivalence with others of the same type. In other words, fungible tokens have the same value and can be exchanged with each other. Among traditional assets, fungibility is abundant. For example, one ounce of gold is equivalent to another ounce of gold and holds the same value in any country.

Among cryptocurrencies, there are also abundant examples of fungible tokens. Such is the case of Bitcoin. 1 BTC in one wallet is a completely identical equivalent to another BTC in another wallet.

Non-fungible tokens, on the other hand, are the opposite. They are unique assets and each has its own value compared to another. They can be described as physical time brought into the digital world. Examples of the latter include tokenization in the art world, the real estate market, scientific articles in the emerging DesCi or decentralized sciences, and others.

The emergence of tokenization in the world of content creation became a digital revolution. The NFT market has become a multi-billion dollar market in a short period of time.

The emergence of DAOs and their tokenomics

Governance is one of the newest players in the investment arena in the digital currencies and DeFi market. Many projects create governance tokens to successfully roll internal tokenomics. An example of this is the already named case of the double-token model.

As such, much of the protocols are turning to the decentralized model of DAOs (Decentralized Autonomous Organization). This is a system based on governance tokens. The hodlers of these tokens become part of the decision-making in the projects through voting. The holders of these tokens occupy a position similar to the holders of shares in a company, with the difference that the company does not have a CEO or a central board of directors.

The place of the board is taken by the functionality programmed into a smart contract. Simply put, a DAO is a computer program that works automatically. At the same time, it needs participation to operate, since it does not perform all its tasks by itself. Such user participation is realized by means of governance tokens.

As already noted, there are projects that work with a dual token model, one to raise funds and the other to keep the protocol operational.

Why investors should know about tokenomics?

As explained in this article, knowing the token economy of a certain cryptocurrency is of fundamental importance for investors. Taking for granted that supply and demand conditions are determinant for the present and future value of any asset, from stocks to cryptocurrencies, it becomes vital to know the mechanisms of token-based financial service offerings.

“White paper is the main target to aim for. By handling this, you will know in depth what will be the approximate value in the future that certain tokenomics will yield.”

By this is meant that before placing capital in a project, the investor should check what the smart contract will do with its tokens and how. On this depends on a large extent the fluctuation of the currency in the market and, ultimately, its price and the outcome of his investment.

In that sense, the investor must have a thorough understanding of the mechanism of fund movements within the project. To do so, he must have access to information that allows him to know the number of current tokens and those that will be created or burned in the future. He must also know to whom the project belongs in order to avoid the danger of a rug-pull.

On the other hand, the investor must be clear whether there is a guarantee that the burned coins are really unusable. For this, the White Paper is the main target to be aimed at. By handling this, it will be known in depth what will be the approximate future value that certain tokenomics will yield.

The future of tokenization

Although the world of tokenization that currently exists has the appearance of being deep and developed, the reality is very different from that. It is a process that is just taking its first steps, which brings with it major problems and flaws that could be negative for its development.

It should be borne in mind that not all tokenomics work ideally and many of them lead investors directly into the pit. There are coins whose minting and burning turn out contrary to what was promised in their White Papers. Nevertheless, it can be said with some degree of certainty that “natural selection” will act on the flawed projects.

Many businesses are approaching the application of the token economy. Some of them belong to large companies that are serious about projects linked to video games and are projecting into future developments such as the metaverse.

In any case, it is a movement that points to the future and its advance is accompanied by the movement of the economy and finance to the digital world. Technological development could turn tokenization into something as indispensable for business in a few years as digital marketing through social media platforms is now.