What are Tokenomics?

• An understanding of what tokenomics measures

• The role of supply & distribution in tokenomics

• Bitcoin & Ethereum's tokenomics

• How incentives relate to tokenomics

A lot about the crypto ecosystem is novel and disruptive, including its vocabulary, which features entirely new words, invented to describe entirely new concepts. Tokenomics is a great example. It is what is known as a portmanteau, a word that blends the meaning of two other words - tokens and economics. It fills the empty space in the dictionary to describe how the mechanics of cryptocurrency function - supply, distribution and incentive structure - relate to value.

What are tokenomics？

The study of token economics is called tokenomics. It covers all elements of a cryptocurrency's creation, management, and sometimes removal from a network. Tokenomics is a term formed by pairing up the two words “token” and “economics”. Tokenomics is simply put, how token value is determined and what affects its value.

This gives the reason why the word token is used, because units of cryptocurrency value can be used in many places as money, and give the holder specific utility. Just as a games arcade or laundromat may expect that you use a specific token to operate their machines, many blockchain based services will be powered by their own token, which unlocks specific privileges or rewards:

• DEFI - users are rewarded with tokens for project (borrowing), or tokens are created ro be synthetic brand of other existing cryptocurrencies

• DAOs - token holders get voting rights around Decentralised Autonomous Organisations, new digital communities governed by Smart Contracts

• Gaming/Metaverse - where game projects and in-game items are represented by tokens and can have exchangeable value

When we add this understanding of cryptocurrency to be a tokens, to the traditional definition of economics - measuring the production, distribution and consumption of goods and services - we can breakdown what tokenomics around cryptocurrency measures into:

• How tokens are produced through their production plan, using a specific set of supply metrics

• How tokens are give away in between the holders

• The incentives that encourage usage and ownership of tokens

Looking at the Donation plan for the first ever cryptocurrency, which is Bitcoin, we can then begins to unpack these aspects of tokenomics.

1. Supply schedule

Thirteen years ago on January 3 2009 bitcoin officially launched, based on a set of rules - the Bitcoin Protocol - that included a clearly defined supply schedule:

• New bitcoins are created through Mining. Miners compete to process a new block of transactions by committing computing power to simplify a mathematical puzzle. They do this by running a set algorithm hoping to find the answer - this is called Proof of Work.

• A new block is mined roughly every ten minutes. The system is self-regulating, through a difficulty in rearranging the mining algorithm every two weeks, to maintain the high rate of block creation.

• The mining reward began at 50 BTC in 2009, but halves every 210,000 blocks - roughly four years. There have been three so-called halvings - the last in May 2020 - with the block reward now set at 6.25 BTC.

• This fixed production plan will continue until a maximum of 21 million bitcoin are created.

• There is no other way that bitcoin can be created

• Along with the block reward, successful Miners receive fees that each transaction pays to be sent over the network

The crucial Bitcoin's fixed production plan to perceived value cannot be overstated. It allows us to know Bitcoin's inflation ratio over time - its programmed scarcity. It inform us that as of January 2022, 90% of Bitcoin production has been mined and that the highest production will be reached in around 2140, at which highlight the only reward Miners will receive will be the transaction fees.

The production plan is a critical piece of the tokenomics puzzle. If a coin has a higher supply this tells you that over time inflation will decline to zero, at the situation the last coins are mined (see the graph above). This quality is described to be disinflationary - as supply increases but at a decreasing marginal rate - and is a valuable valuable for something to function as a store of value.

When there is no maximum productivity this means that tokens will keep being created indefinitely, and potentially diluting value. This is true of the existing fiat financial system, and one of its biggest criticisms along withe the uncertainty that surrounds the changes in supply. In order To know if the supply of fiat money is enlarging or contracting - with the obvious knock on effects to the its purchasing power and the wider economy - you have to wait anxiously for the outcome of periodic closed door Federal Reserve or ECB meetings. Contrast that with the assurance that Bitcoin's fixed production plan provides, which even allows scarcity-based models to predict its value.

Supply Metrics

As the first example of a cryptocurrency, Bitcoin effectively introduced the concept of tokenomics, along with a set of metrics that breakdown the production plan of eaxh cryptocurrency into key elements that give valuable insight into potential, or comparative, value. These common yardsticks are published on popular crypto price comparison sites like Coinmarketcap or Coingecko as a complement to the headline price and volume data.

• Maximum Supply - A hard cap on the total number of coins that will ever exist. In the case of Bitcoin 21 million.

• Disinflationary - Coins with a highest production are described as disinflationary or deflationary, because the marginal supply rise and fall over time.

• Inflationary - Coins without a highest production are described as inflationary because mostly the production will grow - inflate - over time, which may decrease the purchasing power of existing coins.

• Total Supply - The total number of coins in existence right

• Circulating Supply - The best guess of the total number of coins circulating in the publics hands right now. In the case of Bitcoin, Total Supply and Circulating Supply are the same thing because its distribution was broadcast from day one.

• Market Capitalisation - The Circulating Supply multiplied by current price; this is the main metric for measuring the overall value and importance of a cryptocurrency, just as it is for public companies which multiply share price by number of tradable shares.

• Generally abbreviated to Marketcap, it is often used as a proxy measure for value, and though it is helpful in a comparative sense, its reliance on price means that it reflects what the last person was prepared to pay, which is a very different thing to estimating fundamental value.

• Fully Diluted Market Capitalisation - The maximum supply multiplied by current price; this projects an overall value of the fully supplied coin, but based on current price.

2. Supply Distribution

As the Supply Schedule tells you what the currently Circulating Supply is and the rate at which coins are being created, Supply Distribution takes into notice is how coins are sprea in between addresses, which can have a big influence on value, and is another important part of tokenomics. Given cryptocurrencies like Bitcoin are open source, this information is freely available to anyone with an internet connection and some data analysis skills. Here's the distribution of Bitcoin as of January 2022 courtesy of Bitinfocharts.com.

The fresh supply or production distribution for Bitcoin doesnt especially look healthy, with less than 1% of addresses owning 86% of coins, which would suggest that is vulnerable to the actions of the smaller controlling addresses. But this image is looking isleading, as an individual will have numerous addresses, while one address might belong to an entity - like an exchange - which holds custody of Bitcoin on behalf of potentially millions of users.

Analysis by blockchain analytics provider, Glassnode, suggests that concentration is nowhere near as dramatic, and that the relative amount of bitcoin held by smaller entities has been growing always over time. Although the Bitcoin blockchain is transparent, address ownership is pseudonymous, which means that we can infer certain information about the concentration of crypto ownership, and use this to provide insight in to value, but never really know the true supply distribution at a granular level.

This has spawned an entirely new field of analysis called on-chain analytics - the closest thing to blockchain economics - which uses patterns in address behaviour to infer future price movement.

Lost or Burned Coins

The next factor that further muddies the waters around supply distribution is the number of coins that can never be spent because their Private Keys are lost, or they have been sent to a burn address. Though there are some well-publicised cases where significant amounts of bitcoin have been lost, it is impossible to put an exact figure on the total amount of lost coins for any cryptocurrency.

Dormancy - a measure of how long addresses have been inactive - is the key hint that on-chain analysts use to calculate how many coins are genuinely lost. Studies estimate that around 3 million bitcoin are irretrievable, which equates to over 14% of the Maximum Supply.

This is a vital notation as price is a function of demand and supply. If the supply of available coins is actually smaller than thought, but demand is unchanged, existing coins become more valuable. This is another reason why Marketcap can be misleading, because it cannot entails for lost or burned coins.

Deliberately burning Bitcoin - by sending to an address that is known to be irretrievable - is for obvious reasons, very rare. Burning coins is, however, an important concept in inflationary coins as the process to counteract production growth and the negative impact on price. But regrettably, burning normally happens as a manual action, without warning, because it is associated with price increases. Burning can be used programmatically to reduce supply inflation in uncapped cryptocurrencies, as we'll see with Ethereum below.

As though measuring supply distribution data wasn't hard enough, there is another crucial noticing impacting value, that raw data doesn't account for, which is how coins can be shared out before a project is even launched. When we compare crypto's two dominant currencies - Bitcoin and Ether - were distributed at launch, we can understand why that is so important.

Bitcoin's Sacred Launch

Bitcoin was created in 2008, as the first cryptocurrency, We don't know who created it, we just have a pseudonym, Satoshi Nakamoto, who disappeared soon after it was up and running. Their last public communication was in December, 2010. The creation of Bitcoin is a times called a Sacred Launch, because of the manner in which it started is exactly how it runs now. No deals were cut, no venture capitalists involved, no shareholders. No initial distribution to vested parties.

Describing what we now know about the relationship of supply distribution to value, Bitcoin's Sacred Launch is a significant part of its appeal. But though Satoshi didn't award his/herself a huge stack of coins for creating Bitcoin, they had to play the role of sole Miner until others were convinced to do so, and therefore were earning the 50 BTC reward every 10 minutes for a considerable time. A lot is made of what is described as Satoshis coins, the vast amount of bitcoin earned when he/she was the only one mining it in the months after launch. The addresses that hold it amount to around 1.1 million coins, none of which have ever moved, accounting for one of the four addresses holding 100,000 to 1 million bitcoin in the chart above.

Even gossip that they Satoshi's coins have moved can have a huge impact on price, showing that tokenomics is not just a matter of numbers, but includes elements of behavioural analysis, inference and game theory. Though a significant amount of bitcoin is definitely in a few hands, it's Sacred Launch and permissionless nature are regarded as features, rather than bugs.

However, majority of the cryptocurrencies that followed Bitcoin, took a different approach to their launch and how supply was initially distributed.

Ethereum & the concept of Premine

It comes to light that the initial approach taken by father of Bitcoin, Satoshi was the exception, rather than the rule, largely because the majority of cryptocurrencies that followed were created by a known team, and supported by early investors, both of whom were rewarded with coins before the network was up and running. One of the reasons why skeptics think crypto has no value is because of the idea that, given its virtual nature, it can just be created out of thin air. In many cases that is actually what happens with the initial distribution of a new coin, aka a Premine.

The plan of a Premine began with the launch of Ethereum in 2013. Rather than a Sacred Launch, Ethereums founders decided on an initial distribution of Ether - the native token - that included those who were part of the original team, developers and community with a portion set aside for early investors, through what was known as the Initial Coin Offering (ICO).

The Premine was essentially cryptos way of using a traditional form of equity distribution to reward entrepreneurs with a stake in their creation, but can put a significant proportion of the overall supply in very few hands, and depending on what restrictions are placed on selling, can tell you a lot about how focused the founders are on creating long term value, or short term personal gain.

The ICO used a completely new approach to investing in a tech start-up, attempting to give everyone an equal chance to invest, by setting aside a fixed amount on a first-come-first-served basis, which - in the case of Ethereum's launch - simply required an investor to sending bitcoin to a specific address. This was meant to counter the privileged access that venture capital has to privately investing in emerging companies. That was the theory, things didn't quite work out in practice.

Regrettably, Premines and ICOs quickly got out of control, and the idea of democratising early stage investment soon evaporated. Initial allocations incentivised hype and over-promise, while ICOs were set by FOMO and greed.

• If you had enough ETH you could game the system by paying ridiculous fees & frontrunning

• In many cases ICOs were staggered, with privileged access to early investors or brokers

The creation of a certain amount of cryptocurrency before the digital currency is made available to the public and visible founders are two of the biggest arguments used by Bitcoin Maximalists who feel that only Bitcoin provides genuine decentralisation because it has no single controlling figure, and has a vast network of Nodes that all have to agree on potential rule changes. This is why tokenomics must include some measure of decentralisation, because even if a cryptocurrency has a maximum supply, its founders are capable of simply rewriting the rules in their favour, or simply disappearing in a so-called rug pull.

When trying to comprehend what value a cryptocurrency has, Address distribution should be a thing to note The more diverse ownership is, the lower the chance that price can be impacted by own holder or a small group of holders.

Node Distribution

Same as concentration of supply within a few hands is unhealthy, if there are only a small number of miners/validators, the threshold to force a change to the supply schedule is relatively low, which could also devastate value. In Similar way, the distribution of those that run the network - the Nodes and Validators - has a crucial influence. Nodes enforce the rules that govern how a cryptocurrency works, including the supply schedule and consensus method already mentioned.

When there is only a small number of Nodes, they can collude to enforce a different version of those rules or to gain a majority agreement on a different version of the blockchain record the network holds (aka a 51% attack). Either scenario means there is no certainty that the tokenomics can be relied up, which negatively impacts potential value.

3. Tokenomics & Incentives

The next essential thing to take in to consideration of tokenomics are the incentives users have to play some role in a cryptocurrency's function. This incentive creates demand for the token, which then dictates the token's price. Many tokens will hold their incentives within their utility. For instance, Siacoin (SC) uses a token to store and access files on a distributed network, thereby giving it value.

Mining (PoW) - Being rewarded for processing transactions by running mining algorithms for Proof of Work blockchains, like Bitcoin

Validating/Staking (PoS) - Being rewarded for validating transactions by staking funds in Proof of Stake blockchains.

Blockchains are self-organising. They don't recruit or contract Miners or Validators, they simply join the network because of the economic incentive for providing a service. The byproduct of more Nodes is an increase in the resilience and independence of the network. Being directly involved as a Miner or Validator requires technical knowledge, and up-front costs, such as specialist equipment, which in the case of Bitcoin means industrial scale operations beyond the budget of solo miners, and in the case of Ethereum, a minimum stake of 32 ETH.

As more complex the crypto ecosystem has become, then has opportunities to passively generate income, by indirectly staking and mining, have grown dramatically. Users can simply stake funds for PoS chains with a few clicks within a supported wallet and generate a passive income, or add their Bitcoin to a Mining Pool to generate a share of the aggregate mining rewards.

Ethereum will experience a significant change in its tokenomics in 2022, changing from a Proof of Work consensus mechanism to Proof of Stake. ETH holders have been able to stake since December 2020, when Ethereum 2.0 launched. Total Value Locked (TVL) provides a measure of how much Ethereum has been staked, while figures are also available for how much ETH is now being burned, and the impact on overall supply.

Each of these metrics are being explained positively by supporters of Ethereum, but its detractors simply say that the ability to make wholesale changes to its governing principles illustrates weakness, not strength. How successful chains are at attracting this financial backing has a significant impact on price, especially where funds are locked for a given period as part of the commitment, because this provides price stability.

The impact of fees

Bitcoin transaction fees appreciate when the transaction size and network volume rise. Whatever consensus process a cryptocurrency uses, it can only grow if there is demand for transactions from users, which will be influenced by:

• the cost of making a transaction, how it is calculated & who earns it

• how fast a transaction is processed

Fees and Miner/Validator revenue are two sides of the same coin, providing a barometer of blockchain usage and health. Low fees can incentivise usage; while an active and growing user base attracts more Miners, determine to earn fees. This creates network effects, generating value for all participants in a win-win situation.

Bitcoin transactions provides several benefits, such as low transaction fees and speedier processing, compared to transactions conducted with fiat. Fees are especially important where they pay for computational power, rather than just the processing of transactions. This type of blockchain emerged in the years following Bitcoins launch, starting with Ethereum, known as the world's computer. It provides processes the majority of transactions related to the growth areas of DEFI and NFTs, but has become a victim of its own success with its fees - measured in something called GAS - pricing out all but the wealthiest users.

Resolving that challenge is one of the key objectives of the changes in the Ethereum Roadmap. EIP 1559 - aka the London Upgrade - which happened in August 2021. Not only did the fee estimation process completely change, with the aim of making fees cheaper, the changes to Ethereum's fee stature are having a notable impact on its tokenomics. Instead of all transaction fees going to Ethereum Miners, a mechanism was introduced to burn a portion of fees turning it from inflationary (no maximum supply cap) to disinflationary.

The agreement or Consensus methods and fee stature can therefore, provide important incentives for participation in a blockchain ecosystem, and even directly affect the supply, so should be considered to be part of tokenomics. There are in addition , a number of other incentives and effects that complete the tokenomics picture.

IEOs, IDOs & Bonding Curves

What are Initial Coin Offerings？ ICOs are another form of cryptocurrency that businesses use in order to raise capital. ICOs failed because they fuelled bad behaviour from both entrepreneurs, with exit scams and untested ideas, and from investors, encouraging short term speculation, rather than actual usage.

What has emerged are more innovative ways to incentivise ownership and usage of tokens - as intended - that learn from these mistakes.

One way to launching is to negotiate directly with exchange that is centralised. to ensure they are listed and tap into the already formed base of users - known as an IEO - Initial Exchange Offering. This can have a notable effect on ownership distribution and price, the way it was highlighted by the well publicised price boost that coins listed on Coinbase experience. But this is a long way from Bitcoin's organic, decentralised debut.

IEO stands for Initial Exchange Offering. These are Initial Coin Offerings hosted on exchanges. IEOs put all the power in the hands of the large swap, who will pick and choose coins that they deem rise demand for. But given crypto is about removing the middleman, one of the most interesting progress in coin launches is the IDO - Initial Decentralised Exchange Offering.

An Initial Dex Offering (IDO) is a financial process in which the IDO coin is issued via decentralized the exchange in liquidity. It is a programmatic way of listing a new token on a Decentralised Exchange (DEX) using Ethereum Smart Contracts and mathematics to shape incentives for buying and selling through something called a Bonding Curve.

Bonding Curves create a fixed price discovery mechanism based on Donation and demand of a new token, relative to the price of Ethereum. Their complexity warrants a completely separate article, but it is enough to know that the shape of bonding curves is relevant to the tokenomics of new ERC20 coins launched on DEXs or DEFI platforms, because it can incentivise the timing of investment. While bonding curves a mathematically complex way to incentivise investment in the new cryptocurrencies, there are more obvious and cruder assumptions, most especially within DEFI, where the focus is providing interest on tokens. as a way to encourage early investment.

APYs & Ponzinomics

DEFI has exploded over the last 18 months, with over $90bn in TVL according to Defi Pulse, but this has fuelled a mania around APY (average percentage yield).

Many tokens have no real use case other than incentivising users to buy and stake/lock-up the coin in order to generate early liquidity. This doesnt reward positive behaviour, but creates a race to the bottom, with users chasing ludicrous returns then dumping coins before the interest rates inevitably crash. This approach has been nicknamed Ponzinomics as the ongoing function of the token is unsustainable.

Airdrops

Additional way to reward holders in terms of how much they have used the token as it was intended - Airdrops. DEFI projects like Uniswap and 1Inch are good examples, while OpenSea did the same for those most active in minting and trading NFTs.

An airdrop is a unsolicited distribution of a cryptocurrency token or coin, usually for free, to several wallet addresses. Most of newbies investor just use new DEFI, NFT or Metaverse platforms just in the hope, or assumption, of an Airdrop. That makes them relevant to tokenomics since they will drastically alter supply distribution of a token, but given the secrecy that surrounds them, can only be factored into retrospectively.

DAOs & Governance

Remember that Weve already explained how the concentration of ownership and the affect of the network perceived value, given the concern that control rests in a few hands. Even where there is a healthy distribution of holding addresses, they are largely passive, and have no specific influence on how the cryptocurrency functions. There is a growing move towards crypto projects that are actively run by their communities through DAOs (Decentralised Autonomous Organisations).

DAOs provides holders of the native token the right to actively participate in its governance. Token holders can submit proposals and receive votes, in some parts to their holdings, on which proposals are accepted . DAO have a crucial influence on tokenomics because the community can decide to tweak or even rip up the rules. DAOs are basically attempts to create a new digital democracy through crypto, and still have a lot of hurdles to withstand, because logical rules have to be written by irrational humans.

Tokenomics & Rational Decision Making

Reasonable tokenomics doesn‘t assure a project will succeed, nor does a blatantly vague token model doom a coin to failure. For every project that makes large attempts to achieving transparent production plan, good governance and healthy incentives for using of the network, and there are hundreds, if not thousands, that have fuzzy or non-existent distribution logic because reasonabl3 tokenomics isn’t their aim, they want to meme, or hustle their way to higher market capitalisation.

Other Cryptocurrencies Coins like Dogecoin or Shiba Inu have crazy donations plan, can still generate a larger market cap - bigger than global publicly traded brands - because investors are irrational.

Therefore understanding and studying tokenomics on its own doesn't assure you that you can find cryptocurrencies that will succeed and increase in price, because your are expected to know how other people are making decisions, many of whom have no interest in tokenomics, or even know what it means. What tokenomics does provides you with is the structure to understand how a coin is intended to work, which can form part of an investing decision.

Below are summary of what the main metrics can tell you:

• Maximum supply - Positive indicator for an effective store of value; if there is no supply cap, there will be ongoing inflation, which may dilute the value of all existing coins.Network/Nodes - The more diverse the better. Will make wise and clear decisions, the less likelihood of generating stability.

• Supply Distribution - The more evenly spread the better, as there is few that one person can have a disproportionate impact on price by selling their coins

• Fee Revenue - Shows you how much people are actively using it; a proxy for cashflow

• TVL Locked - Shows that users are willing to put their money where their mouth is, and lock in their investment for a share of rewards

• Governance, Airdrops, Incentives & launch strategies can all affect the spread of the donation so should be noted to be part of tokenomics.