Money has prominent applications in almost every sector and for every individual. You purchase products and services for your daily use with money, while an international corporation uses them for business transactions. Even if money is such an influential element in the life of every individual on this planet, it has been subject to control by central institutions such as banks and governments. However, the arrival of cryptocurrency and tokenomics completely changed the world’s perception of financial systems.
This is where tokenomics emerged as the suitable alternative for applying monetary policy to blockchain networks. The term definitely sounds new and has recently made profound strides in changing the conventional norms of economics based on cryptocurrency. The following discussion provides a detailed tokenomics guide to help you understand what it is, how it works, and the different use cases it can serve.
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Table of Contents
- Significance of Value in Token Economics
- Incentive Theory in Token Economics
- Token Economics: How Does It Play Out?
- Working of Tokenomics
- Understand the Basics
- Most Common Use of Tokens in Tokenomics
- Design of Token Economics
- Token Economics Use Cases
- Tokenomics – Now and Beyond
Significance of Value in Token Economics
The first thing that you should notice is that the world we see around us runs on incentives. For example, a child goes to school because it will give them the opportunity to earn an education for their future. People follow the recommendations of their dentist for maintaining dental hygiene and reducing the risk of any dental problems. Even the rules you follow while crossing the traffic might be more about avoiding fines rather than safeguarding your life.
The incentive structure is present in every business, institution, and framework and pretty much everywhere you can look. Cryptocurrencies were not meant to escape the incentive structure, and thus the tokenomics model came into existence. Cryptocurrencies are basically strings of numbers and a collection of mathematical rules for transferring value alongside triggering computer code. At the same time, the underlying economic incentive structures have the capability of creating a completely new and expanding asset class.
So, what is the most important factor that can drive the foundation of tokenomics?
Value is the answer you are looking for. Although crypto assets have fascinated the whole world with a lot of promises in economic opportunity, they lack tangibility. You can touch and see a US dollar while the same is not applicable in the case of cryptocurrencies like Bitcoin.
How the US Dollar Enjoys Its Value?
The United States government offers the assurance of backing for the US dollar, thereby ensuring that people could believe in it and its value. Since the world trusts the United States and its economy as well as potential for long-term viability, the US Dollar is capable of maintaining relative stability in comparison to currencies of other countries such as Turkey or Venezuela. On the other hand, what would happen if the US government doesn’t recognize the dollar?
The US dollar is likely to lose its value in such a case because it is just a piece of paper. However, the dollar can serve in the role of a currency on the grounds of its functions for helping in trading goods and services. The same is applicable in the case of cryptocurrencies that derive value from the trust in blockchain networks rather than governments.
How the Cryptocurrencies Enjoy Its Value?
In addition, cryptocurrencies also showcase their value in utility, thereby ensuring that they are at par with fiat currencies worldwide. Now, you must be wondering about the reasons for discussing the value of cryptocurrencies in this discussion. As a matter of fact, it is quite a significant element for understanding ‘what is tokenomics’.
The decision to invest in the crypto space is not an easy one, especially when you are doubtful about value. So, it is important to implement a detailed analysis of a cryptocurrency for ensuring efficient risk management with the investment. Therefore, you might have to conduct in-depth scrutiny of all the significant aspects of a cryptocurrency. On the other hand, investors in the crypto space are not restricted to investment options only with cryptocurrency tokens.
Now, you could invest in tokens in the crypto space, which also have value. Therefore, the analysis of factors and context before investing in a token refers to as tokenomics. Based on the collaboration of ‘token’ and ‘economics,’ it basically deals with the science of token economy. It can explain all the aspects involved with a token’s lifecycle, such as its creation, management, and also removal. Token economy points out the system that dictates incentive behavior.
Incentive Theory in Token Economics
Now, many of you might be wondering about the incentive behavior and its role in the tokenomics model? Token economy uses the incentive behavior for reinforcing and developing required behavior in the blockchain ecosystem. The incentive theory is basically a human behavioral theory. It implies that human behavior primarily depends on the desire for reinforcing incentives or the ability to receive incentives. Incentives play a crucial role in token economics by motivating users for participating in exchanges of value offered by blockchain networks.
Incentives are also important requirements for motivating users to ensure better safeguards for the blockchain and validation for transactions. As a result, incentives are quite important for the execution of unique functionality in the concerned blockchain network. Participants following the rule of a specific network get rewards in the form of cryptocurrencies.
The model of operations in the token economy should be configured for enabling participants to earn more tokens by contributing positively. In this case, tokenomics ensures that token incentives are financial in nature owing to their financial value and contribution to an overall market capitalization of a project.
Did you know? According to the latest report by World Economic Forum, $867 Trillion markets opens to Blockchain.
Token Economics: How Does It Play Out?
In order to get an understanding of tokenomics price and its working, it is important to dive further into tokens. Tokens are basically units that serve particular objectives alongside holding value on the basis of different characteristics. Tokens are recognized as valuable assets capable of serving more than the role of currency. For example, football tickets could work as tokens because you can choose to watch a football match with the tickets or trade the tickets for something else in return.
The tokenomics model depends a lot on the tokens represented in form of cryptocurrencies. Tokens could serve different functions in a network other than serving the role for trading assets only. The arrival of Ethereum gave a substantial boost to the concept of tokens with cryptocurrencies.
The Ethereum network turned out to be the first blockchain platform offering a wide range of decentralized services to participants rather than just enabling transactions. The importance of tokens is evident in the facility of these decentralized services on the Ethereum network. It is just like the money required for completing transactions. You can find tokens in Ethereum as the ERC-20 tokens.
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Significance of Tokens
It is important to understand different types of tokens and their significance if you want to know about tokenomics. The structure of tokens could be primarily classified into two different types, such as Layer 1 and Layer 2 tokens.
Layer 1 Tokens
Layer 1 tokens are native for a specific blockchain while also used for powering all services in the blockchain. One of the notable examples of the Layer 1 token in cryptocurrencies is the BNB on Binance Chain. Ether or ETH on the Ethereum network is also a prominent example of the Layer 1 token in cryptocurrencies.
Layer 2 Tokens
This type of token has a unique representation in the meaning of ‘what is tokenomics’. They are used in the case of decentralized applications in a particular network. For example, OMG tokens are classified as Layer 2 tokens because they are implemented for OmniseGO, a decentralized project in the Ethereum network.
Apart from these two notable classifications, token economics also emphasizes dividing tokens into categories on the basis of usage. The two notable types of tokens on the grounds of their usage include security tokens and utility tokens.
The security tokens are referred to as investment contracts, and they have to fulfill many conditions for the same. Security tokens must include a money investment, common enterprise, and profitability with computation efforts from different contributors. Security tokens involve a comprehensive process for contract verification, also known as the Howey Test. Tokens that are capable of passing the Howey Test earn the credential of security tokens. One of the notable examples of security tokens is evident in the way of working of the Siafunds or SF on the Sia network.
The utility tokens are also another important classification of tokens you would encounter in tokenomics. Utility tokens are basically useful for financing a network, and they are issued through an ICO (Initial Coin Offering). The ICO is important for funding project development. For example, the BAT or Basic Attention Token showcases a utility token initially delivered through an ICO. Now, BAT could be helpful for decentralized advertising on the Brave browser, which runs on the Ethereum network.
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It is also important to note that tokens are also classified into the two categories of fungible and non-fungible tokens.
Fungible tokens are generally known for having the same value along with the facility for replication. The example of the fungible token is clearly evident in the case of Ether (ETH) on Ethereum. The value of ETH tokens is the same and could be replaced with each other as they have the same value.
Non-fungible tokens don’t share the same value, thereby depicting uniqueness. NFTs have gained prominent attention in recent times while driving interest in tokenomics, especially with high-profile NFT auctions. Tokenization of assets such as pictures, collectibles, real estate, and artworks with NFT has not only spurred a new wave of digital ownership revolution but also showcased the potential of tokens. Without any scope for replication, NFT use cases bring a higher value of non-fungible tokens than fungible tokens.
Also Read: Fungible vs Non-Fungible Tokens
Working of Tokenomics
The most critical factor in understanding token economics refers to its working. The scope for tokenomics in 2020 is the result of years of improvisation. In the year 1972, Harvard psychologist B.F. Skinner was the first person to put forward the idea of the token economy. According to his assumptions, the token economic model could help in controlling behavior. The token economy model basically concentrated on offering certain units of recognizable value for incentivizing actions and the reverse.
Over the years, token economics has evolved into a massive discipline focused on studying economic institutions and the policies associated with the creation and distribution of tokenized goods and services. As already discussed, tokenomics help us study tokens, their working, and the important objectives they achieve. However, the working of token economics depends on the use of tokens.
Understand the Basics
Before diving into the individual aspects in the working of token economics, let us get a basic impression of the same. It is quite clear that token economics relies on a system of incentives for encouraging desirable behavior in the ecosystem. The desirable behaviors in the intent of users for using a specific token can help in determining the token’s value. Incentives play a crucial role in token economics by motivating users to work for the advantage of a platform. Many cryptocurrency platforms offer incentives to users for carrying out governance decisions in the form of newly mined cryptocurrencies.
The developer of the blockchain employs certain protocols for controlling the rate of creation of new units and, subsequently, the total amount of currency in the system for keeping a check on the supply of tokens. The limits imposed by the blockchain creator help in retaining the value of a cryptocurrency through the creation of a sense of scarcity among the users. Therefore, you can clearly notice how tokenomics rely profoundly on the value of tokens.
Most Common Use of Tokens in Tokenomics
The discussion on token economics till now has emphasized the significance of value in the crypto landscape, types of tokens, and the incentive behavior encouraged by token economics. Now, the next step in understanding the token economy would involve an overview of the working of tokens. As a matter of fact, you can know how token economics work when you know how tokens work. Here are some of the notable facets that you should look out for in the working of tokens.
1. Token Distribution
One of the foremost aspects in the working of tokens would obviously refer to issuing ICO (Initial Coin Offerings). Projects should have the ability to distribute coins to potential users. If the project fails in distributing coins to interested users, then it would just exist without anyone capable of using them. Since the token distribution was a significant addition to tokenomics in 2020, there are many ways to achieve the same.
Networks could opt for rewarding miners or users who validate transactions with newly minted crypto coins. On the other hand, some networks opt for selling a portion of the token supply to interested users through an ICO or initial coin offering. It is also important to note that some tokens follow the distribution approach on the basis of specific actions and behaviors. The best example of such a token is Augur that provides rewards to users for verification of facts in its betting network.
2. Price Stability
Tokenomics also points out the necessity of studying the implications of price stability. Cryptocurrencies are specially recognized for their volatility, albeit not in a positive sense. The volatility of cryptocurrencies is one of the prominent reasons for fluctuations that can reduce the potential of investor interest. In addition, fluctuations could also open the path for speculators to restrict the network from proper functions through mass purchase and sales of tokens.
Token projects could deal with this challenge by ensuring an adequate repository of coins for matching the supply levels. As a result, the price of the coin could be stabilized, thereby encouraging people to use tokens for designated purposes. Token economics helps companies in stabilizing the token prices through creation of equilibrium. In addition, token economics could also support an increase in token prices through growth in demands.
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3. Business Scope
Another significant aspect that you can find in a tokenomics model refers to the business scope of tokens. The basic utility of a token depends on the utility of the token in return for the products and services that it serves. Many companies have created decentralized marketplaces which allow users to leverage tokens for trading in products and services offered on the marketplaces.
In addition, companies also ensure profit distribution in the form of dividends as well as other financial advantages to users. As a result, companies could easily achieve improved levels of user loyalty. At the same time, projects could ensure the availability of a robust network characterized by the constant circulation of tokens.
The governance of tokens is undoubtedly a critical aspect of tokenomics. The core team working for each project is responsible for creating rules to dictate the creation or minting of tokens. In addition, token economics also emphasizes the specification of approaches for injecting tokens into a network and taking them out. So, it is clearly evident that different projects would follow unique approaches for governance.
In the case of certain projects, tokens in reserve could be included in the ecosystem at a later stage. The primary objective of such an initiative refers to an avenue for promoting growth or ensuring payments for system maintenance. One of the most common examples of such a type of token governance is Ripple.
Some of the other token projects in tokenomics follow a deliberately hands-off approach in the working of their network. A noticeable example of such an approach is evident in the work of Augur. The developers in Augur don’t have any impact on the operations of the network and take care of infrastructure maintenance only.
Companies can also implement token economics in their governance models for allocating voting and decision-making rights to users. Tokenomics price governance, in this case, depends on users paying or staking tokens. Some networks offer incentives to people for ownership, holding, and use of tokens to prevent people from hoarding coins.
As a result, it can ensure that the tokens work as expected according to their design. It is also important to point your attention towards Proof-of-Stake (PoS) systems that depend on validators for putting their own coins at stake. Therefore, the application of token economics for governance can also help in ensuring honest and fair conduct by participants.
5. Future Readiness
Tokenomics also rely profoundly on understanding how a token project can tackle the challenges of the future. Many teams responsible for the development of a network in the crypto space do not end up as its rulers. Therefore, developers have to understand that the things which work presently for their token projects might not work in the future. The growth and maturity of the network could imply the need for modification in approaches for the governance of tokens.
Although some token projects have come up with measures for adapting to future changes, many others have to catch up. Successful token projects have employed effective consensus mechanisms for ensuring provisions to dictate the capacity of network users. The consensus mechanisms introduce effective modifications in approaches for token management in the ecosystem for users.
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Design of Token Economics
After a detailed overview of all important aspects of tokenomics, it is important to reflect on its design. It is important to ensure that a token economics model is highly secure and durable. Any sign of weakness in the infrastructure could lead to profound discrepancies. For example, malicious participants could find opportunities for exploiting the network to personal advantage. So, it is important to design a good model based on a comprehensive understanding of ‘what is tokenomics’.
The right token model could help in avoiding many critical issues and also requires considerable effort and resources. A reliable token model would generally depend on a team comprising of programmers, economics, and mathematicians with academic and industry expertise. Their inputs in creating the scope and developing a token model could play a formidable role in ensuring its effectiveness. Although the process might appear very complex, it usually rounds upon the consensus mechanism.
Selecting the Consensus Algorithm
While many people think of token model design as a complicated process, it primarily rests on the consensus algorithm. The consensus algorithm plays a crucial role in tokenomics by encouraging users on the network to achieve consensus during the validation of transactions. You can find the proof-of-work or PoW model as the consensus algorithm for Bitcoin and Ethereum.
According to the PoW algorithm, miners verify transactions for securing the network through a solution of cryptographic puzzles in the blocks. The growth of a network gradually leads to a reduction in the number of coins awarded to miners. Therefore, the equations that you have to solve for verifying transactions on the network become more challenging. You don’t have to worry as this mechanism helps in creating scarcity alongside avoiding inflation.
The design of a tokenomics model also depends considerably on another notable type of consensus algorithm, the proof-of-stake or PoS model. Ethereum is planning to shift to the PoS model from the PoW consensus algorithm. Other notable crypto projects such as Tezos and DASH are currently using the PoS model for consensus. The proof-of-stake consensus algorithm helps the holders of currency for staking their value in a wallet.
At the same time, it enables the wallets to serve as security deposits in a validator, which then works for validating blocks. Users with more tokens are likely to get a reward for solving the next block. Therefore, the PoS model definitely improves the efficiency of approaches to achieve consensus. The PoS model is favorable in tokenomics as it does not incite competition among participants in the network. On the other hand, it can lead to specific users accumulating substantial token value to exercise more control over the network.
Efficiency of a Token Economics Model
It is quite clear that a proper consensus algorithm could help you design an efficient token economics model. The design of a token model is more than just reflecting on the answer to ‘what is tokenomics.’ You have to think about the future and the objectives you want to achieve with the specific token project. Both the PoS and PoW models for consensus leverage incentives for encouraging network members. The consensus algorithms can increase participation in the network while improving security.
At the same time, they can also ensure an authentic confirmation for transactions while maintaining network integrity. All these actions serve as an important aspect in tokenomics as they result in inflation of the currency values. Well, you have the same demand while the number of coins on the market increases and inflation is clearly evident. Bitcoin leverages its consensus mechanism for reducing the number of Bitcoins that can be mined by half at an interval of every four to five years.
Also Check: PoW vs PoS Consensus Algorithms
Token Economics Use Cases
The study of token economics is quite an expansive domain, with new trends and principles gaining recognition every day. However, it is also important to notice that use cases also define the direction of tokenomics price evaluation. The study of different use cases of token economics could offer a detailed impression of how it can define the future of crypto and blockchain technologies. Here are some of the notable use cases of token economics.
Staking is one of the notable topics that you can come across in a tokenomics guide. The network stores value in a wallet in staking, and validators having more value in their wallets can have better chances of reaping massive rewards for verifying transactions. The Delegated Proof of Stake model is a perfect example of the use case of token economics in staking. The primary difference of this model from a PoS model is the random delegation and selection. As a result, participants with the highest stakes could find it difficult to get validation rewards constantly. So, it offers a credible approach for sharing the wealth.
2. Exchange of Value
The most common example of the use cases of tokenomics also refers to their use for exchanging value. Bitcoin is a formidable example of token economics use cases in exchange for value. Ethereum has been successful in proving that token projects can use token economics for exchanging value as well as creating value. It can leverage token economics for encouraging fundraising activities as well as for launching decentralized applications.
3. Project Contributions
Among the many use cases of tokenomics in 2020 was evident in the contributions for project development. The example of STEEMIT clearly showcases the potential use case of tokenomics for encouraging contributions to a project. STEEMIT rewards users with tokens for their contributions as content creators, moderators, and commentators.
Furthermore, the platform also incentivizes users to drive traffic to the content that is interesting according to their perspective. The rewards for content creators, moderators, and commentators can play a crucial role in expanding the STEEM platform. Users could cash out their token rewards in STEEMIT dollars for their work in developing a bigger and better STEEMIT platform.
4. Value of Tokenomics
The final addition in a tokenomics guide would obviously refer to the value it brings to the table. Token economics could help in reflecting on the economics as well as social costs in accounting for token projects. This is a huge requirement in a time when we can expect tokens to represent almost any real-world asset such as precious metals, real estate, artwork, and collectibles. Most important of all, tokenomics is essentially capable of offering the value of community-based solutions aligning with consumer’s values.
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Tokenomics – Now and Beyond
On a final note, it is quite clear that tokenomics is more than just about the two words – ‘token’ and ‘economics.’ Tokens are slowly emerging as the new digital representations for real-world assets. At the same time, the representation of cryptocurrencies as tokens also emphasizes the need to learn token economics. However, the journey of token economics is still in the earliest stages of maturity.
While it has the potential to transform the global economy, token economics requires a lot of introspection and review. Since token economics has to deal with potentially disruptive technology and trends, it is important to focus on all the influencing factors. The rising interest in careers in blockchain and crypto space definitely paints a favorable opportunity to learn about token economics. Get started now!
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Author: Diego Geroni