What is tokenomics ?
The term “tokenomic” is a contraction of the words “token” and “economic”. This expression can be translated into “the economy of tokens”.
In concrete terms, tokenomics represents the control and management systems of cryptocurrency projects.
Naturally, the price of an asset is the result of the relationship between supply and demand at a given time in a market. If demand is greater than supply, the price rises. If not, the price decreases.
Since the crypto-currency market is extremely volatile, the challenge is to avoid too great an imbalance between supply and demand.
The tokenomic pursues precisely this objective by governing the ecosystem of a crypto-currency project and the blockchain on which it is based by determining the conditions under which the tokens will be offered, and the use cases they allow.
As a result, investors can be able to estimate the potential of the token they are about to acquire.
What are the components of tokenomics?
The circulating supply represents the share of tokens circulating on the market at a given time. Tokens that are stalled or blocked are not considered as circulating. Schematically, the circulating supply corresponds to :
Tokens created at time T – (Stored Tokens + Blocked Tokens) = Circulating supply
The total supply represents the share of all tokens created at time T, reduced by the number of burned tokens. The total supply is then calculated as follows:
Tokens created at time T – Tokens burned = Total supply
Good to know: burning tokens consists in destroying tokens. This practice is generally used to regulate the market, especially when there are too many tokens in circulation or when a user has made a mistake. The burn can be planned in advance, by conditioning its execution to the satisfaction of certain criteria. The burn can also be planned in the context of the purchase of a product by a user thanks to his tokens (a fraction of the price is burned after the purchase). Finally, the burn can be decided a posteriori, on the decision of the issuer.
The max supply corresponds to the maximum number of tokens that will be issued when the protocol provides for a limited number of units.
The market cap et the Fully Diluted Market Cap
Market cap refers to the market capitalization of a cryptocurrency. In other words, it is the quantity of cryptocurrency that can be used in an ecosystem at a given time. The market cap is obtained by the product of the circulating supply and the price of the token, which is the following formula
Circulating supply x Token price = Market cap
The Fully Diluted Market Cap corresponds to the total capitalization of a cryptocurrency. It is obtained by multiplying the Max supply by the price of the token, that is to say :
Max supply x Token price = Fully Diluted Market Cap
What are the effects of tokenomics on crypto assets?
Tokenomics help to combat inflation of a cryptocurrency. Inflation is a loss of purchasing power of a currency that results in a sustained and general increase in prices. In other words, it is the phenomenon by which a currency loses its value.
One of the main causes of inflation is the excessive creation of money. As too much money circulates, its value is reduced and prices rise to compensate for the depreciation of the asset.
Controlling the inflation of a crypto-currency therefore allows to stabilize its price and make it keep its purchasing power, which strengthens the confidence of investors.
To do this, it is necessary to control the quantity of tokens to be issued. Several models exist to achieve this goal.
What are the tokenomics models?
The Disinflationary Model of Limited-Quantity Issuance
When a cryptocurrency is issued in limited quantities, it is issued gradually until the maximum supply is reached, that is, the total number of tokens expected.
However, over time, the issuance of tokens is less to avoid inflation, which is why it is called a disinflationary model. This model is used by very popular crypto-currencies such as bitcoin or SOL (native currency of the Solana blockchain).
Good to know: deflation and disinflation should not be confused. The former expresses the idea of a sustained and widespread decline in prices (or token price) and the latter expresses the idea of a decrease in the rate of inflation (i.e. a slowdown in the rate of inflation).
The controlled inflation model
This model is used by blockchains whose quantity of issued tokens is not limited (Ethereum for example).
Through network updates, the quantity of tokens issued can be regulated. These updates can include :
- Change the annual rate of token issuance. Changing from Proof of Work to Proof of Stake can reduce this rate.
- Implement a “burn” system. This mechanism is notably used by Binance for its BNB cryptocurrency. The transaction fees supposed to be paid to the validators are destroyed. Thus, the purpose of the burn is really to limit the fall of the price of the token by reducing the number of tokens present in the pool of liquidity.
Tokens acquired early such as those obtained by investors in cryptocurrency fundraisers are commonly subject to a lock-in period: this is known as vesting.
This is intended to prevent those investors who have acquired a token before its valuation from deciding to immediately sell the assets en masse once listed on the exchange platforms in order to realize a significant capital gain. Such a practice would cause the price of the token to collapse. At the risk of repeating itself, it is with the aim of avoiding this situation that vesting is set up.
A vesting schedule is therefore usually put in place to control the arrival of these tokens on the market.
Cryptocurrency fundraisers (carrying out an ICO, IDO, IEO, etc.) will therefore have to pay particular attention to their tokenomic in order to determine the appropriate strategy for valuing their token.
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Published on: February 9, 2023
Editor : Elias BOURRAN, Attorney at Law (Paris Bar, France) and PhD in Law.