How to ‘DYOR’: Tokenomics Edition
Learn how to analyze a cryptocurrency’s economics and determine if it is worth investing in
In the world of cryptocurrency investing, everyone seems to think that they are financial advisors and believe they can get away with not having the credentials by saying “this is not financial advice, do your own research (DYOR)”.
Of course, only about 10% of people in this space actually know what they are doing and the rest only pretend. So to prevent yourself from falling prey to the plethora of fake crypto finance gurus on TikTok and youtube, the best weapon you can arm yourself with is the ability to actually know how to ‘do your own research. The first place to start is with understanding the economics of crypto tokens, better known as “Tokenomics”. Thus, this article will describe everything you need to know about tokenomics so that you can join the minority of people that actually know what they are doing in this space.
Tokenomics Background Information
To understand tokenomics, one must first understand what a cryptocurrency token is and how they work. Simply put, a cryptocurrency is a digital currency built on decentralized computer networks where transactions are recorded on a distributed ledger known as the blockchain. This digital currency functions differently from fiat currencies, like the US Dollar, which is a form of currency minted by governments for citizens in their country to use as a medium of exchanging value. The value of fiat currencies are affected by three main things:
- Supply and demand factors
- Sentiment and market psychology
- Technical factors (GDP Data, News, big events)
Cryptocurrencies on the other hand, fundamentally derive value from the issuance, distribution, and burning of tokens on the blockchain. However, like fiat currencies, factors such as market psychology or ‘hype’, utility, and technical factors also play a big role in the perceived value of any given cryptocurrency.
It is also important to note that there are different categories of tokens, each with a different purpose, that exist in this space. The first kind is called ‘Layer 1 Tokens’. These are used for scaling transaction processing speeds and are the main blockchain protocols on which other tokens can be built. Some examples include Bitcoin, Ethereum, Avalanche, Cardano, and Solana.
The second kind of token is known as ‘Layer 2 Tokens’. These are created with the purpose of solving transaction speed and scaling issues with existing layer 1 blockchains. An example would be the Polygon Network, built on the Ethereum Blockchain. Polygon enables faster transaction speeds as well as lower transaction fees and solves a lot of the issues with Ethereum. These are all examples of fungible tokens, meaning they can be exchanged with one another. However, tokenomics also applies to non-fungible tokens, which cannot be exchanged as each unit is unique.
Elements of Tokenomics
Now that you have some background information on tokenomics, Let’s look at what aspects actually comprise the token economics of a cryptocurrency.
Allocation and Distribution of Tokens
Most cryptocurrencies are generated through either a fair launch or are pre-mined. Fair launched tokens are earned, owned and governed by the community from the start, meaning everyone can participate equally. There is no early access, pre-mine or allocation of tokens. Examples include Bitcoin, Yearn Finance, and Dogecoin. Most projects however, are pre-mined meaning a select group of people such as developers, early investors and team members are allocated a percentage of the tokens before their initial coin offering (ICO).
Why it’s important: Pre-mining remains a taboo practice for many in this industry, as it generates distrust among users. Many developers would pre-mine and set aside a large number of coins before the ICO, without releasing this information to the public. Then, when the cryptocurrency is launched and prices are inflated due to lower circulating supply, these developers then can take their pre-mined coins back into the market, causing a nose-dive in their price and damaging outsiders.
The Token Supply
When it comes to the supply element of tokenomics, the three main types of supply to know are the total supply, circulating supply, and the max supply. The total supply refers to the total number of tokens that are in existence presently, not including previously burned tokens. The circulating supply on the other hand, refers to the total amount of issued tokens that are actively available for trade and are being used in the market and in general public. Lastly, the max supply is the maximum amount of coins that will ever exist in the lifetime of the cryptocurrency. Once the maximum supply is reached, no new coins or tokens will be produced or mined. Not all cryptocurrencies have a maximum supply, meaning more can be minted into existence at any point, which leads to inflation. Ethereum is one such cryptocurrency that has no max supply, making it an inflationary currency. Bitcoin however, is a deflationary currency which is why its max supply is capped at 21 Million tokens.
Why it’s important: Inflationary currencies have no limit to how many units are in circulation, while deflationary currencies have a max supply. Other factors remaining the same, the buying power of inflationary currencies reduces as more units are printed.
Volume
The volume of a cryptocurrency is a metric of how much the coin has been traded over a set period of time, usually over 24 hours. A greater volume indicates fair prices and healthy liquidity in the project whereas a low volume signals inefficient or low trades. Low trades occur when the asking prices of sellers fail to meet the price potential buyers are willing to pay.
Why it’s important: Volume can show the demand, direction and volatility of a cryptocurrency and is often used as a predictor for future prices. It is one of the main indicators of future profitability because a project with very high trading volumes indicates that the price will increase due to the laws of supply and demand. If there are more people who are interested in buying than there are sellers, people will be willing to pay a higher price.
Fully Diluted/Market Capitalization
A cryptocurrency’s market cap is the total value of all the coins that have been mined. It’s calculated by multiplying the number of coins in circulation by the current market price of a single coin.
The fully diluted market cap differs from the market cap in that it measures the hypothetical market cap if the max supply were in circulation. It can be calculated by taking the sum of the maximum supply of the coin multiplied by the current price of the coin.
Why it’s important: Market cap can be used as a rough gauge for how stable a coin is likely to be. The higher the market cap the less volatile it tends to be, similar to how a heavy ship can handle harsher weather conditions than a tiny kayak.
Consensus Algorithm
Currently there are two main consensus algorithms that cryptocurrencies can use: Proof-of-work (PoW) and proof-of-stake (PoS).
The PoW consensus requires miners to verify transactions for securing the network through a solution of cryptographic puzzles in the blocks, in exchange for rewards in the native currency. As the network grows larger, the rewards get smaller which creates scarcity and prevents inflation. Examples include Bitcoin and Ethereum.
The PoS consensus on the other hand, employ a network of “validators” who contribute — or “stake” — their own crypto in exchange for a chance of getting to validate new transaction, update the blockchain, and earn a reward. It is worth noting that to be selected to be a validator you will usually need a significant amount of the native cryptocurrency to be staked in the protocol. Examples of coins with a PoS consensus are Cardano and Tezos, and soon Ethereum 2.0.
Why it’s important: Staking a cryptocurrency is a great way to incentivise users to hold their coins and preserve the stability of the token, especially if they participate in locked staking, in which their coins are locked in a staking pool for a fixed period of time. Since not every cryptocurrency offers staking, it is important to know the consensus mechanisms for each one you invest in.
To better illustrate this idea of tokenomics, let’s look at Bitcoin and how its tokenomics explain how its price rose from $0 to 40,000 USD over the course of 13 years.
The Tokenomics of Bitcoin
Now that you have a solid grasp of tokenomics, let’s apply your newfound knowledge to the world’s largest cryptocurrency.
Bitcoin is often compared to gold, and for good reason. Similar to gold, the total supply of Bitcoin is finite and has to be ‘mined’ in order for it to be added to the circulating supply. The max supply of Bitcoin is 21 million, this was preprogrammed by its developers so that it would be a deflationary currency that goes up in value over time, unlike fiat currencies, where you can always print more.
Further, A Bitcoin block is mined about every 10 minutes, rewarding the miner 6.25 BTC. For context, when Bitcoin initially launched, it was rewarding 50 BTC per block, then it halved to 25, 12.5, and now it is at 6.25. This is known as the Bitcoin Halving Cycle which occurs after every 210K blocks that get mined. It takes about 10 minutes to mine 1 block, so if you do the math, each halving takes place every 4 years. Without changes to the protocol, the final Bitcoin will be mined around the year 2140.
Bitcoin’s inflation rate is cut in half every 4 years and to date, we can see that this has caused a price surge in anticipation of reduced supply. In fact, during the first halving, the price of Bitcoin went from $12.5 to $1237.6, which is a price increase of 9,881 percent!
Today, after 3 halving cycles, the price sits at over $40,000. It is important to note that the price of any cryptocurrency is determined by two main factors, the circulating supply, and the market capitalization. Moreover, to derive the exact price of a coin, simply divide the total market cap by the total circulating supply.
The tokenomics of Bitcoin thus demonstrate how over time, as rewards get more scarce, and the total circulating supply approaches the total supply, the perceived value of Bitcoin will continue to go up, which drives more demand. This idea alone encapsulates the essence of tokenomics.
Conclusion
Admittedly, the economics of tokens is not the sexiest of topics to learn about, but it certainly can be helpful when doing your research on a potential investment. Simply looking at degen discord chats about the latest ‘sh*tcoin’ and memes will only get you so far. But if you are trying to become a serious investor in this space, understanding how to analyze the tokenomics of any given cryptocurrency is a great place to start.
Connect with Us
Follow us here, and on Twitter to get news, and look out for our Discord for deeper connections with the community of futurists, artists, collectors, and creators we have brought together.
- Anas: twitter.com/ananasbrb
- Danosch: twitter.com/thecryptosheikh
- Rahim: twitter.com/rahim_mahtab
- Zayaan: twitter.com/thenftpenguin
- Sam Z: twitter.com/zuckerswag
- Kristel: twitter.com/atelier_kristel
Thank You
Thank you for getting involved early in the Arts DAO journey. We are dedicating every moment we have to building and being part of the evolution of blockchain technology, the NFT space, and art more generally. We look forward to meeting with you either in one of our real-life events or elsewhere in the metaverse!
