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What is Tokenomics and Why is It Important? a Guide for Beginners

Written by

Emmanuel O.

Reviewed by

Andrew Strassmore

Fact checked by

Artem Goryushin

May 6, 2023

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Money has important uses in almost every sector and for every person. You purchase products and services for everyday use with money, while international corporations use it for business transactions. However, the advent of cryptocurrency and tokenomics has completely changed the global perception of financial systems.

Recently tokenomics has become a suitable alternative for the application of monetary policy to blockchain networks. The term definitely sounds new, and it has significantly changed conventional economic norms based on cryptocurrency.

The Importance of Value in the Token Economy

The first thing you should notice is that the world we see around us is based on incentives. The incentive structure is present in every business, institution, etc. Cryptocurrencies were not meant to avoid the incentive structure, so the tokenomics model emerged. Cryptocurrencies are essentially strings of numbers and a set of mathematical rules for transferring value along with running computer code. 

So, what is the most important factor behind tokenomics?

Value is the answer. While crypto-assets have fascinated the world with new economic opportunities, they lack tangibility. You can touch and see the U.S. dollar, whereas that doesn’t apply to cryptocurrencies like bitcoin.

How Do Cryptocurrencies Enjoy Their Value?

The decision to invest in cryptocurrency is not an easy one, especially when you question the value. Thus, a detailed analysis of cryptocurrency is important to ensure effective risk management when investing. Therefore, you may need to thoroughly research all the important aspects of cryptocurrency. On the other hand, investors in the crypto space are not limited to investing options with cryptocurrency tokens only.

You can now invest in cryptocurrency tokens, which also have value. This is why analyzing factors and context before investing in a token is called tokenomics. Based on the combination of “token” and “economics,” it basically deals with the science of token economics. It can explain all aspects of a token’s life cycle, such as its creation, management and removal. Token economics points to a system that dictates incentive behavior.

Tokenomics And Stimulus Theory

The decision to invest in cryptocurrency is not an easy one, especially when you question the value. Thus, a detailed analysis of cryptocurrency is important to ensure effective risk management when investing. Therefore, you may need to thoroughly research all the important aspects of cryptocurrency. On the other hand, investors in the crypto space are not limited to investing options with cryptocurrency tokens only.

You can now invest in cryptocurrency tokens, which also have value. This is why analyzing factors and context before investing in a token is called tokenomics. Based on the combination of “token” and “economics,” it basically deals with the science of token economics. It can explain all aspects of a token’s life cycle, such as its creation, management and removal. Token economics points to a system that dictates incentive behavior.

Tokenomics and Stimulus Theory

Tokenomics uses incentive behavior to reinforce and develop necessary behavior in the blockchain ecosystem. Incentive theory is a theory of human behavior. This means that human behavior depends primarily on the desire to reinforce incentives or the ability to receive incentives. Incentives play a crucial role in the token economy, motivating users to participate in the value exchange offered by blockchain networks.

Incentives are also important requirements for motivating users to provide better blockchain security and transaction validation. As a result, incentives are very important for performing unique functions in the relevant blockchain network. Participants who comply with the rules of a particular network are rewarded in the form of cryptocurrencies.

The transaction model in tokenomics must be set up so that participants can earn more tokens by contributing positively. In this case, tokenomics ensures that the incentives for tokens are financial because of their financial value and contribution to the overall market capitalization of the project.

To understand the value of tokenomics and the way it works, it’s important to understand what tokens are about. Tokens are basically units that serve a specific purpose along with holding value based on various characteristics. Tokens are recognized as valuable assets that can perform more than just the role of currency. 

The tokenomics model relies heavily on tokens represented as cryptocurrencies. Tokens can perform different functions in the network, not just the role of trading assets. The emergence of Ethereum gave a significant boost to the concept of cryptocurrency tokens.

The Ethereum network proved to be the first blockchain platform to offer participants a wide range of decentralized services, not just providing transactions. The importance of tokens is evident in the capabilities of these decentralized services on the Ethereum network. They are like the money needed to make transactions. You can find tokens in Ethereum as ERC-20 tokens.

The Meaning of Tokens

If you want to understand tokenomics, it is important to understand different types of tokens and their meaning. The structure of tokens can primarily be divided into two different types: Level 1 and Level 2 tokens.

Level 1 tokens

Level 1 tokens are native to a particular blockchain, and are also used to run all services in the blockchain. One example of a Level 1 token in cryptocurrencies is BNB in Binance Chain. Ether or ETH on the Ethereum network is also an example of a Level 1 token in cryptocurrencies.

Level 2 tokens

This type of token has a unique idea of “what is tokenomics”. They are used in the case of decentralized applications on a particular network. For example, OMG tokens are classified as Level 2 tokens because they are implemented for OmniseGO, a decentralized project on the Ethereum network.

In addition to these two notable classifications, token economics also emphasizes the division of tokens into categories based on usage. Two well-known types of tokens in terms of use include security token offerings and utility tokens.

Security Token Offerings (STO)

Security token offerings are called investment contracts, and they must correspond to many conditions. STO must include a cash investment, common enterprise, and profitability with the computational efforts of different participants. STOs include a comprehensive contract verification process, also known as the Howey test. Tokens that can pass the Howey test receive the STO credentials. One prime example of STO is evident in the way Siafunds or SF works on the Sia network.

Utilitarian Tokens

Utilitarian tokens, or service tokens, are also another important classification of tokens that you may encounter in tokenomics. Utility tokens are mainly useful for funding a network, and they are issued through an ICO (initial coin offering). An ICO is important for funding the development of a project. For example, the BAT or Basic Attention Token is a utility token originally delivered through an ICO. BAT can now be useful for decentralized advertising in the Brave browser, which runs on the Ethereum network.

It is also important to note that tokens also fall into two categories: fungible and non-fungible.

Fungible Tokens

Fungible tokens are usually known for having the same value along with the ability to replicate. An example of a fungible token is obvious in the case of ether (ETH) on Ethereum. The value of ETH tokens is the same, and they can be exchanged for each other.

Non-fungible Tokens

Non-fungible tokens (NFTs) do not have the same value, indicating that they are unique. NFTs have attracted a lot of attention lately, generating interest in tokenomics, especially through high-profile NFT auctions. The tokenization of assets such as images, collectibles, real estate and artwork through NFT has not only sparked a new wave of the digital ownership revolution, but has also demonstrated the potential of tokens. Without any replication capability, NFT options bring higher value to non-fungible tokens compared to fungible tokens.

The most important factor in understanding the economics of a token is how it works. The possibilities of tokenomics in 2023 are the result of years of improvisation. Over the years, token economics has evolved into a broad discipline focused on the study of the economic institutions and policies involved in the creation and distribution of tokenized goods and services. As mentioned, tokenomics helps us study tokens, how they work, and the important goals they achieve.

Key Elements of Tokenomics

The term “tokenomics” covers a wide range of factors that affect the value of a cryptocurrency. The factors listed below are worth being taken into account when considering cryptocurrency tokenomics. 

Supply of Tokens

Demand and supply are the main factors affecting the price of goods, services or cryptocurrency. There are several critical indicators that measure the supply of tokens. 

The first is the maximum supply. This metric indicates the maximum possible number of tokens for a particular cryptocurrency. For example, the maximum supply of bitcoins is 21 million coins. Litecoin is 84 million coins and BNB is 200 million.

However, not all tokens have a maximum supply. For example, the supply of tokens on the Ethereum network increases every year. And stackable tokens such as USDT, USD Coin (USDC) and Binance USD (BUSD) do not have maximum supply because these coins are issued based on reserves that support the coins. Theoretically, their number could grow indefinitely. 

The second measure of supply is the amount in circulation, which means the number of tokens currently available. Tokens are constantly being created, burned or blocked in some way, which directly affects the price of a token.

The current number of tokens in circulation allows you to calculate how many tokens will eventually be issued.

Using a Token

The options for using a token are provided in advance in the code of each project. 

Tokens can also be used in other ways. For example, management tokens allow the owner to vote for changes to the token’s protocol. Stablecoins are used as currency. And securities tokens are used as financial assets. For example, a company may issue tokenized shares in an initial coin offering (ICO), which vests the owner with ownership and provides dividends.

Keep these factors in mind when analyzing options for the use and development of the token economy.

Allocation of Tokens

In addition to supply and demand, it is also important to consider the distribution of tokens. Large companies and individual investors act differently. If you know which entities own a token, you can guess how they plan to dispose of their assets and how that will affect their value. 

There are generally two ways to launch and distribute tokens: a fair launch and a launch with pre-mining. A fair launch involves no early access and private distributions bypassing the general public. BTC and Dogecoin were launched by fair launch. 

Pre-mining allows some of the cryptocurrency to be distributed to a select group of users before it appears in the public domain. This is how Ethereum and BNB were launched. 

Note whether the token is evenly distributed. If one large company owns a large share of the supply, the situation is risky. If the tokens are mostly held by investors and founders, however, their actions will be aimed at long-term success. 

We also advise studying the timeline for blockchain and token issuance. The issuance of a large number of tokens can affect its value, which is important to consider when planning an investment strategy. 

Token Burning

Many cryptoprojects regularly burn tokens by removing them from circulation.  A reduction in token supply is called deflation, while an increase is called inflation.

Incentive Mechanisms

An incentive mechanism is a key element of tokenomics because it motivates users to take certain actions and ensures long-term stability of the project. Block rewards and transaction fees on the Bitcoin network are examples of a successful model.

The proof-of-ownership mechanism is another block verification method that is actively gaining popularity. It invites participants to block their tokens, become validators, and engage in transaction validation. Generally, the more tokens are blocked, the higher is the chance of being selected as a validator and start earning transaction validation rewards. If validators attempt to harm the network, however, they will lose their assets in stacking. This encourages participants to act with integrity and maintain the reliability of the protocol.

Understanding the Basics of Tokenomics

Clearly, the token economy relies on a system of incentives to encourage desirable behavior in the ecosystem. Desired behavior in users’ intent to use a particular token can help determine the value of the token. Incentives play a crucial role in the token economy, motivating users to work for the benefit of the platform. 

The blockchain developer uses certain protocols to control the rate at which new units are created and therefore the total amount of currency in the system to check the availability of tokens. The restrictions imposed by the blockchain creator help preserve the value of cryptocurrency by giving users a sense of scarcity. In this way, you can clearly see how tokenomics depends a lot on the value of tokens.

The Most Common Use of Tokens in Tokenomics

The discussion of token economics so far has emphasized the importance of value in the crypto landscape, the types of tokens, and the incentive behavior encouraged by token economics. Now the next step in understanding the token economy involves an overview of how tokens work. In fact, you can learn how the token economy works if you know how tokens work.

1. Allocation of Tokens

One of the most important aspects of working with tokens will obviously relate to ICO (initial coin offering) issuance. Projects must have the ability to distribute coins to potential users. If a project fails to distribute coins to interested users, it will simply exist and no one will be able to use them. 

Networks can choose to reward miners or users who validate transactions with newly mined cryptocurrencies. On the other hand, some networks choose to sell some tokens to interested users through an ICO or initial coin offering. It is also important to note that some tokens follow a distribution approach based on certain actions and behaviors. The best example of such a token is Augur, which provides users with rewards for fact-checking on its betting network.

2. Price Stability

Tokenomics also points to the need to study the implications of price stability. Cryptocurrencies in particular are known for their volatility, though not in a positive sense. The volatility of cryptocurrencies is one of the main reasons for fluctuations, which can reduce the potential for investor interest. In addition, volatility can also open the way for speculators to impede proper functioning by buying and selling tokens.

Token projects can solve this problem by providing adequate coin storage to match supply levels. As a result, the price of a coin can be stabilized, thereby encouraging people to use tokens for certain purposes. The token economy helps companies stabilize token prices by creating equilibrium. In addition, token economics can also support token prices by increasing demand.

3. Business Scope

Another important aspect you can find in the tokenomics model concerns the business scope of tokens. The underlying utility of a token depends on the utility of the token in exchange for the products and services it serves. 

In addition, companies also provide profit sharing in the form of dividends, as well as other financial benefits for users. As a result, companies can easily increase user loyalty. At the same time, the projects can provide a robust network characterized by a constant circulation of tokens.

4. Management

Token management is undoubtedly an important aspect of tokenomics. The core team working on each project is responsible for creating the rules governing the creation or mining of tokens. In addition, tokenomics also emphasizes the specification of approaches for putting tokens into the network and withdrawing them. Thus, it is clear that different projects will follow unique management approaches.

In the case of some projects, redundant tokens may be included in the ecosystem at a later stage. The main purpose of the initiative is to stimulate growth or provide payments for maintaining the system. One of the most common examples of this type of token management is Ripple.

Some of the other token projects in tokenomics take an intentional non-interference approach to their network. A prime example of this approach is evident in the work of Augur. Developers at Augur have no influence over the network and only care about maintaining the infrastructure.

It is also important to draw your attention to Proof of Stake (PoS) systems, which depend on validators putting their own coins on the line. Consequently, applying token economics to management can also help ensure fair and equitable behavior for participants.

5. Preparedness for the Future

Tokenomics also relies heavily on understanding how a token project can address the challenges of the future. Therefore, developers need to understand that the thing working for their token projects now may not be appropriate in the future. The growth and maturity of the network may mean the need to change approaches to token management.

Examples of the Use of Token Economics

Examining the various uses of the token economy can provide detailed insights into how it can shape the future of cryptography and blockchain technology. Here are some of the most prominent uses of the token economy.

  1. Stacking

Stacking is one of the important topics you might encounter in a tokenomics guide. The network stores value in the wallet when stacking, and validators with more value in their wallets may have a better chance of getting a huge reward for checking transactions. The Delegated Proof of Stake model is an excellent example of using token economics in stacking. The main difference between this model and the PoS model is random delegation and selection. As a result, it can be difficult for participants with the highest stakes to consistently receive validation rewards. Thus, it offers a robust approach to wealth sharing.

2. Value Exchange

The most common example of using tokenomics also refers to its use for value exchange. Bitcoin is a perfect example of using the token economy in exchange for value. Ethereum has successfully proven that token projects can use tokenomics for both exchange and value creation. It can use the token economy to encourage fundraising activities as well as to launch decentralized applications.

3. Contributing to a Project

Among the many uses of tokenomics in 2021, contributions to project development are evident. The example of Steemit clearly demonstrates the potential option of using tokenomics to reward contributions to the project. Steemit rewards users with tokens for their contributions as content creators, moderators, and commenters.

In addition, the platform also encourages users to direct traffic to content that is interesting from their perspective. 

4. The value of Tokenomics

The last point in the tokenomics will obviously refer to the value it brings. Tokenomics can help reflect economic as well as social costs when accounting for token projects. This is a huge requirement at a time when we can expect tokens to represent almost any real asset, such as precious metals, real estate, art and collectibles. Most importantly, tokenomics is able to offer value to community-based solutions aligned with consumer values.

Tokenomics Design

The right token model can help avoid many critical problems, and also requires significant effort and resources. A robust token model usually depends on a team of programmers, economists and mathematicians with academic and industry experience. Their input into the creation and development of the token model can play a huge role in ensuring its effectiveness. While the process may seem very complex, it usually involves a consensus mechanism.

Choosing a Consensus Algorithm

Although many people consider token model design to be a complex process, it is based on a consensus algorithm. The consensus algorithm plays a crucial role in tokenomics, encouraging users on the network to reach consensus during transaction validation. You can find the Proof of Work (PoW) model as the consensus algorithm for Bitcoin and Etherium.

According to the PoW algorithm, miners verify transactions to protect the network by solving cryptographic problems in blocks. The growth of the network gradually leads to a decrease in the number of coins issued to miners. Consequently, the equations you need to solve to verify transactions on the network become more complex. You have nothing to worry about, since this mechanism not only helps to avoid inflation, but also to create scarcity.

The design of the tokenomics model also relies heavily on another well-known type of consensus algorithm, the Proof of Stake (PoS) model. Ethereum plans to switch to the PoS model from the PoW consensus algorithm. Other well-known cryptoprojects, such as Tezos and DASH, currently use the PoS model to achieve consensus. The Proof of Stake consensus algorithm helps currency holders place their value in a wallet.

At the same time, it allows wallets to serve as security deposits in a validator, which then works to check blocks. Users with more tokens are likely to be rewarded for solving the next block. Consequently, the PoS model definitely improves the efficiency of consensus approaches. The PoS model is advantageous in tokenomics because it does not cause competition between network participants. On the other hand, it can cause certain users to accumulate significant token value in order to better control the network.

Effectiveness of the Token Economy Model

The right consensus algorithm can help you design an effective token economy model. Both PoS and PoW models for consensus reinforce incentives to encourage network participants. Consensus algorithms can increase network participation while improving security.

At the same time, they can also guarantee genuine transaction validation while preserving the integrity of the network. All of these actions are an important aspect of tokenomics because they lead to inflation in the value of currency. Bitcoin uses its consensus mechanism to reduce the number of bitcoins that can be mined by half in four to five year intervals.

Tokenomics – Now and in the Future

In conclusion, it is quite clear that tokenomics is more than just the two words “token” and “economy.” Tokens are gradually becoming the new digital representations for real assets. At the same time, the representation of cryptocurrencies as tokens also emphasizes the need to study token economics. Nevertheless, the token economy path is still in the very early stages of maturity.

While tokenomics can change the global economy, it requires serious analysis and review. Because tokenomics deals with potentially disruptive technologies and trends, it is important to focus on all influencing factors. The growing interest in careers in blockchain and crypto-space definitely creates an opportunity to study the token economy.

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