Tokenomics

Ahead of the curve

Disclaimer: tokenomics is a rapidly-changing field. Because of this, information in this post may go out of date. This blog post is not financial or legal advice of any sort.

As an investor, it’s easy to get lost in the FOMO and dive into a cryptocurrency project that fails to yield returns. Usually, this is because of:

• Poorly-designed incentives within the project.
• Incompetence and/or malice on part of the project’s developers — scams, hacks, etc.
• Users not fully understanding the system.

This post will cover:

• A recap of the supply and demand model.
• Analysis of project tokenomics using the supply and demand model.
• A glossary of common terms in tokenomics.

Tokenomics is a subfield of economics relating to cryptocurrency projects — the study of the structure and incentives designed into these systems, as well as the behaviors that emerge when they collide with the real world. The same economic concepts apply but in novel and often unintuitive ways.

What is Supply and Demand?

You are likely already familiar with the supply and demand economic model, in which functions mapping price to quantity supplied/demanded intersect at an equilibrium/market price. For typical goods and services, the supply function monotonically increases, and the demand function monotonically decreases.

Most cryptocurrency token projects can be effectively analyzed using this model. This is because their tokens are created from somewhere, are desired for some purpose, and are exchanged in competitive markets.

The intersection of the supply and demand functions is known as the “equilibrium point”. Image is CC BY-SA 3.0, source.

Let’s look at the Bitcoin network.

Bitcoins are created by mining. Every 10 minutes, on average, one miner will be rewarded 6.25 BTC (as of February 2022). At regular intervals, this reward is halved by the network — the last time was 2020–05–11, and the next is sometime in early 2024, when the reward will become 3.125 BTC.

If the quantity of BTC demanded is growing linearly over time by 6 BTC per 10 minutes, then the equilibrium price will slowly fall due to a surplus of 0.25 BTC per 10 minutes. However, in early 2024, the equilibrium price will suddenly start rising quickly due to a deficit of 2.875 BTC per 10 minutes.

Sounds simple, right? In practice, the equilibrium price swings wildly and unpredictably. Here are some events that had a major influence just in the latter half of 2021:

• Bitcoin banned in China (2021–09–24): due to increased barriers to entry for transacting with Bitcoins in China, as well as more subtle fears of regulatory action in the near future, the demand shifts downward, causing equilibrium price to fall.
• Bitcoin planned to become legal tender in El Salvador (2021–06–08): due to excitement over a potential real-world demonstration of Bitcoin used as a currency, as well as a wider audience of Bitcoin network users, the demand shifts upward, causing equilibrium price to rise.
• Rising case counts for the omicron variant of COVID19 (2021–12–29): due to fears of economic contraction, people moved away from risky assets toward safer assets. Bitcoin is considered a risky asset, so the demand shifts downward, causing the equilibrium price to fall.

Evaluating Supply and Demand

Predicting some of these changes is difficult-to-impossible. However, when evaluating any kind of token for investment, certain things that are always worth considering on the supply side:

• Token distribution: How are tokens distributed to the people who want them? Did certain classes of investors get preferential treatment? Are they airdropped? Are they launching on centralized exchanges? Are they launching on decentralized exchanges? Which ones? Is it available as spot, options, or futures?
• Liquidity capture (see glossary): What kind of vesting schedules are involved in distribution, if any? Are there staking programs and liquidity provider incentives to help capture free liquidity? Where are the liquidity onramps/offramps? What will the volume look like on these onramps/offramps?
• Supply over time: How many tokens will exist now and in the future? Will tokens continue to be created over time? Are tokens consumed for any common activities, and if so, at what rate? What actions/events cause tokens to be minted, burned, rebased, locked, or unlocked?
• Reserves: Is the project’s organization planning to reserve a treasury to fund project operations? Does the organization have an ecosystem fund, marketing budget, or grant program backed by their own tokens? How much of the token supply is under direct control of the organization, and how much by the community? How much influence will the organization be able to exert using these funds?

Supply is usually easy to gauge by looking at whitepapers, pitch decks, and developer documentation.

Demand is a little bit trickier, but certain things are always worth considering on the demand side:

• Mindshare: Who’s talking about the project? Who is the target audience of the project? Is that target audience actually interested in the project? For example, a decentralized market maker project would heavily rely on people with lots of money being interested in providing liquidity.
• Utility and complements: To whom is the project useful? Do those people using the project cause the project to become more successful? Does the utility form a positive feedback loop with the project itself or other projects in the same ecosystem?
• How to obtain the tokens: Just like on the supply side, how do you move liquidity into and out of the project? Are they doing airdrops? Are they listed on centralized exchanges, are they running liquidity pools on decentralized exchanges?
• Reputation: What reputation does the project’s organization have? What about their founding team, their lead developers, and their investors? What about the reputation of the community around the project? Reputation is still an important factor even when project team members are pseudonymous.

Glossary

Being a fast-moving space, some terms don’t have a consistent definition. Here are some tokenomics-adjacent terms as we define them.

• Term: Utility — how useful a token is; reasons to continue holding a token rather than just selling it.

What to look for: Tokens often fall into one or more of these categories: 1) utility tokens — tokens used as some sort of resource on a platform (e.g., LP tokens on Uniswap); 2) governance tokens — tokens used to control a platform or protocol (e.g., COMP for Compound); 3) security tokens — tokens that represent ownership over some sort of asset (e.g., tokenized stocks). The more useful a token is, the more likely the owner will be to keep the token in order to actually use it.

• Term: Market Capitalization — the product of the token price and the total number of tokens currently supplied.

What to look for: For example, if there are 1,000,000 tokens, and each token is worth $50, the market capitalization of this token would be $50,000,000. A very rough measure of how much the token is worth overall. Like with startup valuations, the magnitude of this number has very little to do with the amount of money actually moving, but comparing the market cap of a token with the market cap of other tokens can help set expectations with respect to current supply/demand, future growth potential, and others’ expectations for the same.

• Term: Fully Diluted Value (aka FDV) — the product of the token price and the total number of tokens that can ever be supplied.

What to look for: A very rough measure of how much the market cap will be in the future. Only defined for tokens with a fixed supply. This metric is controversial because it doesn’t take into account the probability that this future supply will actually materialize — it supposes a situation where all possible tokens are eventually circulating, within some reasonable timeframe. This is not always the case, as projects can change their token distribution plans, change their timelines, and use their treasuries in unpredictable ways. However, comparing it to the market cap gives an idea of how much of the supply is still unavailable to the market.

• Term: Liquidity — as an adjective, refers to how easily a market allows users to buy and sell a particular asset; as a noun, refers to assets that are easily bought and sold.

What to look for: The liquidity of a token’s market can be estimated by looking at market volume and spread. Highly illiquid token markets will by definition be difficult for you to buy into or sell out of without losing value to slippage. Projects building utility and security tokens should generally aim to have highly liquid token markets; a project that is not doing so is often failing to efficiently distribute tokens.

• Term: Liquidity Generation Event — an event in which tokens are distributed, often due to vesting, airdrops, or giveaways.

What to look for: Since the recipients are generally able to then sell the tokens on the open market, these events increase supply. In response, the market prices of the tokens typically drop.

• Term: Liquidity Capture Event — an event intended to cause token holders to make their tokens unavailable on the open market, usually to prevent the market price drop associated with a liquidity generation event.

What to look for: Big liquidity generation events almost always require a big liquidity capture event planned around the same time, in order to prevent all the token recipients from going directly to the open market and dumping the token. Look for staking, LP incentives, and other mechanisms designed to incentivize people to lock up their tokens temporarily or permanently.

Author(s): Paul Mcinnis and Anthony Zhang from the Hype Team