Tokenomics is the science behind the cryptocurrency economy - it dictates some of the supply and demand factors that affect this nascent ecosystem. Think of it as the monetary policy of crypto tokens, where various stakeholders play the role of central banks amongst other functions.
In traditional finance, issuing money rests upon central authorities such as central banks and the federal reserve. They are dubbed as ‘monetary authorities’ given that their core functions revolve around the issuance and removal of money from circulation. Central banks have long used monetary policy to keep economies and currencies checked through various tools, including reserve requirements and open market operations (buying and selling of securities by central banks).
These monetary policy tools are used interchangeably depending on the economic situation and how fast a central authority wants to change the trajectory. For instance, the U.S federal reserve can decide to raise reserve requirements, which means that banks will have to deposit more cash with this central authority. In doing so, the federal reserve reduces the amount of money in circulation as banks will have less capital to lend out - such action reduces inflation as there will be less money to chase the existing goods.
Unlike traditional finance, cryptocurrencies operate within decentralized environments and have no central authority to keep inflation in check. This is where tokenomics comes in - it plays the role of monetary authorities in crypto. Stakeholders in this market can create their micro-economies guided by various tokenomics models. In most cases, each crypto token has a distinguished tokenomics model that guides its monetary functions, such as the number of tokens in supply at any point.
The concept of tokenomics dates back to 1972 when Harvard psychologist B.F Skinner first introduced it. Skinner propounded that ‘Giving some unit of recognizable value would incentivize positive actions and vice versa’.
In cryptocurrency, tokenomics covers the aspects involved in a token’s creation, management and life cycle within a network. We will highlight some of the token fundamentals that rely on sound tokenomics to function effectively and efficiently.
Crypto tokens need to be distributed to prospective users for any decentralized network to exist. Projects have taken different approaches to distributing their tokens as part of the overall tokenomics model. Some of the most common distribution methods include selling the tokens through an Initial Coin Offering (ICO), rewarding miners and network validators. Other avenues such as airdrops have also gained popularity following the rise of Decentralized Finance (DeFi) innovations.
Sound tokenomics is necessary for token distribution, especially with the volatility in crypto markets. This is one of the areas that savvy investors analyze before jumping into a particular crypto project. The fine print of such analysis can feature distribution methods and who are the beneficiaries - does the founding team or developers end up with the bulk of the tokens, or the community benefits equally as well? This is among the factors you ought to pay attention to when investing in the token economy.
For example, the Bitcoin tokenomics model caps the total number of coins at 21 million. So far, over 18 million coins have already been mined and are currently in circulation. The token distribution model for Bitcoin follows an incentive mechanism, where miners solve algorithmic problems and are rewarded with coins once they have solved a new block. Notably, the reward amount for each solved block reduces by half after every four years - popularly known as the Bitcoin halving. This provision introduces the concept of ‘scarcity which means that Bitcoin is likely to become more valuable after each halving.
Just like fiat money, the value of crypto tokens needs to be kept in check to avoid a situation where the tokens become less valuable or what would have otherwise been deemed as inflation in traditional finance. Innovators in the crypto niche have come up with various models to ensure that the value of their tokens is not eroded over time.
In this case, the tokenomics models primarily focus on balancing the demand and supply of underlying tokens. Methods such as burning crypto tokens are now widely used by both centralized and decentralized crypto projects. Burning involves the process of sending tokens to a wallet that cannot be recovered - hence removing them from circulation.
The Binance exchange coin ‘BNB’ is one of the tokens that follow a burn model to ensure price and value sustainability. In 2017, Binance committed to burning half of the total BNB token supply, translating to 100 million BNB tokens during its ICO. As of December 2020, the project had already burned around 13% of the target amount. The exchange further announced it would speed up the burning process to take 5-8 years instead of the initial 27 years. BNB is now the 3rd coin in market capitalization, gaining over 2,900% within the past year.
Tokenomics also guides how tokens are governed over their existence period - the core team may devise rules that inform token creation, distribution and removal from the network. It is quite noteworthy that different crypto projects will assume varied governance models for their tokens. Quite similar to how various jurisdictions adopt different monetary policies and tools to suit their specific needs.
Some of the popular token governance approaches feature a mining or pre-mined distribution model. Bitcoin falls in the former category as coins are mined over time, whereas a token like Ripple’s XRP is pre-mined. This means that XRP coins were mined before being made public in the Initial Coin Offering (ICO) - a good number of these pre-mined tokens are still held in reserve for the future growth of Ripple’s ecosystem.
Cryptocurrency projects are designed with mainstream adoption in mind - this makes adaptation a crucial aspect of the tokenomics model. Some innovations are based on flexible tokenomics that allow stakeholders to alter fundamentals such as distribution and token governance. This is particularly the case for Decentralized Finance (DeFi) projects where governance tokens can be used to change existing tokenomics.
Governance tokens are built as an incentive to attract users to a DeFi protocol. Ideally, they enable an environment where the holders of a given coin can vote on token distribution, rewards, and new features. Famous examples of governance tokens include Compound (COMP), Uniswap (Uni) and Yearn Finance (YFI).
Tokenomics is a founding pillar of the cryptocurrency economy - this form of ‘monetary policy’ could lead to a sustainable digital ecosystem. With the suitable tokenomics model, blockchain innovations are likely to be more productive and support more use cases. However, the philosophies and principles are still in an experimental phase - plenty of the existing tokenomic models will not work, while those that survive may need to be revised.