Tokenomics 101

Definition

The methods used by a crypto project to distribute and manage their token supply.

All you need to know

Tokenomics is a mash-up of the words, “token” and “economics.” The term refers to how a project distributes its locked token supplies and how many tokens will eventually be released into circulation. A project should also explain what the tokens represent in their ecosystem. Does owning the tokens offer shares in the company? Revenue share? Governance? Access to special features? When a project releases its tokenomics, they might also include how they intend to manage the token supply through burns and emissions. Let’s navigate these topics by discussing the main points you’ll read about in a project’s tokenomics.

Supply and Market Cap

Supply is the quantity of tokens available. Market cap is the total value of a project, calculated by multiplying the supply by the token price. For many projects, there is a difference between the circulating supply and the total supply.
  • The circulating supply refers to how many tokens are currently available to be traded or locked into staking contracts. The current market cap can be calculated by multiplying the circulating supply by the price of the token. For example, if a token costs $0.02 and has a 100 million circulating supply, the market cap is $2 million.
  • The total supply refers to the sum of the circulating supply and locked tokens. Projects will often release a limited supply at first. Then, they will release more tokens into the circulating supply. You can estimate the fully diluted market cap by multiplying the current price by the total supply. The tokenomics for a project will cover the reasoning behind the release of tokens into the circulating supply.

Token Distributions

Some crypto projects are community-driven and others are supported by private investors. This plays an important role in how the tokens are initially distributed. If a project is community-driven, the team will rely on the public to purchase and support their project. The team can sell tokens on public exchanges to raise money to build their project. A community-driven project might also rely on airdrops to raise awareness of their token. Airdrops use on-chain data to collect a list of wallets that have been active in an ecosystem that is deserving of receiving a free allocation of a token.
If a community is supported by private investors, they may sell tokens to venture capitalist (VC) funds and other investors for a set price before the token is available to the public. The project can use these funds to begin building their project, and then release the token to the public later on. The tokenomics of a project should cover the supply of tokens distributed to the public, private investors, the team, and the project ecosystem. The tokenomics should also cover when the private investors and team are permitted to sell their “unlocked” tokens.
Let’s dive a bit deeper into this and evaluate how two simplified projects distribute their tokens:
  1. 1.
    Project A is a community-driven project on the Binance Smart Chain. They have 10 million tokens total. The team sets up a liquidity pool on Pancake Swap to allow users to swap BNB for Token A. Their tokenomics state that 60% of their token supply is reserved for the public, 10% is for the team, and the remaining 30% will be used for the project ecosystem (such as distributing staking rewards and marketing). Because this project did not accept private investor money, early adapters got into the project at a very low price/market-cap. However, a disadvantage to this method of token distribution is that the team will face challenges raising cash to continue developing without negatively impacting the price. With so many projects out there, community-driven projects have a low rate of success. Nonetheless, when a strong community rallies around a great team, there can be exceptional opportunities.
  2. 2.
    Project B has a Solana token with a total supply of 10 million tokens. They received 5 million dollars in funding before their project launched to the public. To raise these funds, Project B distributed 2 million of its tokens to private investors and venture capitalists. Their tokenomics state that 20% of their tokens are for private investors, 20% is for their team, and 10% is for a public sale at a higher price. The remaining 50% is for the ecosystem and will be released over 5 years to stakers and community members. To protect their token price as much as possible, the team and private investors agreed to keep their tokens locked for the first six months with scheduled unlocks every 3 months afterward for 2 years. Project B is benefitted by the connections and funding of the private investors. However, retail investors do not have the same opportunities of being “early adopters” compared to a community-driven project.
You can see that whether a project is community-driven or supported by private investors offers a distinct set of advantages and disadvantages. While you cannot simply say that one of these strategies is better than the other, the way the tokens are distributed is certainly something to keep in mind when evaluating whether a project fits into your portfolio.

Supply Management

A project is responsible for how its tokens are distributed and managed. Emissions are token releases from a project’s locked token reserves. Many projects afford themselves the flexibility to offer rewards for participating in their ecosystem. They do this by distributing tokens from their locked supplies or marketing wallets. By nature, this dilutes the circulating supply, so projects need to be careful with how many tokens they release for these incentives. It is important to understand that emissions can raise a project’s market cap without a change in price because they add tokens directly to the circulating supply. Therefore, the emissions need to be worth it to attract new users and bigger investments, and the project needs to deliver while the token supply is being diluted to keep up with the short-term inflationary pressure. Here are some examples where a project might use emissions to benefit their ecosystem and reward their community:
  • Airdrops, community rewards: The project may incentive active members of the community through giveaways and promotional events. This creates a network of token holders and spreads initially liquidity throughout the ecosystem. Always exercise caution when hunting for airdrops - thoroughly research any project offering airdrops, especially if they require connecting your wallet.
  • Single-sided staking: Projects reward users who lock their tokens in a liquidity pool. This is a method of incentivizing investors to be holders and not traders.
  • LP staking: Tokens require liquidity to be traded on decentralized exchanges. A project can establish a liquidity pool for its token, but they will eventually require more liquidity to prevent extreme volatility. The project can incentivize users to join their liquidity pool by offering LP staking. This is where a user stakes their LP tokens (their proof of contributing to the liquidity pool) for additional rewards.
  • Gaming mechanics: Play-to-Earn games require emissions to get the in-game economy up and running. A project can carefully allocate rewards to players based on their in-game performance. Over time, other mechanics (like costs for upgrades in the game) can take the place of emissions, as long as the game turns out to be attractive enough to players.
Although these rewards are most frequently generated through emissions, this does not mean that all rewards distributed from a project to its community are inflationary. When a project succeeds and generates revenue streams, rewards from emissions can be replaced with distributions of profits. Therefore, projects typically have schedules to reduce emissions over time as the project and user base grow.
On the other hand, you have burns. Burns are events that permanently remove tokens from the total supply. To initiate a burn, the project will designate a wallet as a burn address. A burn address can accept tokens but is not permitted to send tokens. Effectively, any token sent to a burn address becomes worthless, or burned. A project might consider burns to increase the scarcity of their token. When tokens are burned from the circulating supply, the market cap can decrease without a change in price. This creates deflationary pressure, which may be perceived as a bonus to investors. Burns can be a part of transactions, game mechanics, or promotional events.

Overview

If you are researching a project and any of these details are missing, it would be wise to consult the team before investing in the project. Tokenomics give fundamental insight into the supply of the token, which is critical for the price. Therefore, you cannot set reasonable expectations for the performance of a token without an understanding of the tokenomics.
Remember, good tokenomics do not imply a good project AND vice versa. A project might attempt to incentivize early investors with token burning, limited circulating supply, and community driven distributions, but there are many other variables you should use to measure the viability of the project. Always do your own research and take your time evaluating a project before becoming an investor.