Yes, investing in crypto is risky, but you might be making it riskier than needed.
There’s rhyme and reason to what makes one coin pump and another drop until it’s worth almost nothing, and tokenomics is part of that equation.
Want to know if that new puppy coin or DeFi project your friend recommended has a chance of survival? Or whether it's more likely to get you rekt and leave you with empty bags?
Read on to learn more about tokenomics: what it is, why it matters, and what factors to take a look at when researching any crypto project 🔎
What is tokenomics?
Tokenomics stands for "token economics" and helps you understand why one BTC is worth over $20,000 while one DOGE is only worth a few cents.
Because every blockchain or project includes scarce resources—in the form of coins or tokens—this creates micro-economies. Tokenomics in crypto is the study of how these scarce resources are produced, distributed, and consumed, and the incentives this creates in a blockchain economy.
Tokenomics is like monetary policy applied to blockchain networks, where project teams play the role of the central bank. They shape incentives to participate in their blockchain economy by designing and distributing their cryptocurrency in various ways.
Knowing the methods they can use and how they shape the demand for a cryptocurrency will help you better understand the price potential of a project over the short and long term.
Why you should care about tokenomics
While understanding tokenomics won’t turn you into a fortune teller (unfortunately), studying it will help you understand at a deeper level what determines the price of a coin or token, and stop relying on mere hype when making your investment decisions.
For crypto projects, nailing their tokenomics is crucial to creating the incentives they need to get their project off the ground; getting validators to secure the network, developers to join, and VCs to invest. At the same time, the wrong incentives could lead to pump-and-dump schemes and crash the project as soon as it launches.
The 5 factors that determine a cryptocurrency’s tokenomics
Just like the plain ol’ dollar, a cryptocurrency’s value is influenced by its supply, distribution, and how you can use it. Let’s break it down:
One of the most important tokenomics factors is how you can use a coin or token. What value does it give you?
Having real utility is much better for the long-term price potential of a coin or token, especially during bear markets. On the other hand, if the coin or token has no real utility, then it becomes a purely speculative asset, with all the risks that come with it.
Many native currencies of smart contract platforms, like ETH and SCRT, are needed to use apps and tools on the platform, as well as make basic transactions. As long as people are using Secret DeFi apps, minting Secret NFTs, or using Secret Tokens, there will be demand for SCRT.
Bitcoin is used as a store of value because of its design (we’ll dive into that later). Its reputation as “the digital gold” says it all.
Coins and tokens often allow you to participate in governance by voting on proposals, and many tokens have unique use cases that are specific to the project that made them. For example, all users staking at least 10 SCRT with any validator automatically gain access to ALTER, a private messaging platform.
Supply refers to the number of coins or tokens currently in circulation—i.e., in someone’s hands or wallet—and the maximum number of coins or tokens that can be created.
A cryptocurrency’s supply can be designed in two ways:
Hard cap cryptocurrencies
Hard cap cryptocurrencies have a set limit to the number of coins that can be created as determined by their design. Bitcoin, for example, has a hard cap of 21 billion, meaning there will never be more than 21 billion BTC.
The benefit of a hard cap is that it makes the cryptocurrency automatically scarce as there’s only so much of it that’ll ever be created. Investors don’t have to be afraid of project teams “printing more money” and inflating the price of a coin or token. And because unfortunate investors lose private keys or send crypto to non-existent addresses (it happens), hard-capped cryptocurrencies naturally become deflationary once all coins/tokens are mined or minted.
The drawback of a hard cap is that it limits a cryptocurrency’s use cases, as the price is harder to adjust and the supply can’t be scaled to match increased adoption.
No cap cryptocurrencies
A soft cap cryptocurrency means there’s no limit to the number of coins or tokens that can be mined or minted. This makes a cryptocurrency more like the US dollar.
Are cryptocurrencies without a hard cap automatically less valuable than ones with a hard cap?
Not necessarily—it all depends on the cryptocurrency’s purpose. Having an infinite supply allows coins and tokens to scale and act more like digital money. This is important for platforms like Ethereum that are looking to power billions of dApps and users.
Stablecoins also need a soft cap, as else they’d have no way to adjust the price of their coins to make sure they’re pegged to their fiat currency of choice.
The drawback of a cryptocurrency without a hard cap is that there’s the risk of inflation when a team or community decides to turn on the proverbial money printer.
Distribution refers to who holds how many coins or tokens.
If a few wallets hold the majority of the total supply (so-called “whales”), they can dump its price by selling their share—often at the expense of retail investors.
If a coin or token is very widely distributed amongst lots of small retail investors, its price can become overly dependent upon market sentiment, hurting its long-term prospects.
That’s why you should look for a healthy balance in distribution between the founding team, reputable VCs, and the community.
Allocation methods describe how coins or tokens are allocated during the project creation and can be categorized into two groups:
A fair launch means everyone can start mining or minting a coin or token simultaneously. Projects with a fair launch include Bitcoin, Litecoin, and Dogecoin.
A fair launch gives everyone the chance to enter the market at the same price point and helps make the coin or token more evenly distributed. For the Yearn Finance protocol, it helped them gain a dedicated community that benefits them to this day.
However, a fair launch could leave the project team with insufficient funds to incentivize developers to join and VCs to invest, making it harder to get the project off the ground.
Fair launches also make projects more vulnerable to pump-and-dump schemes as they launch. Especially with DeFi tokens, a token can crash right out of the gate if investors start mining the token en masse to sell it—with no buyers left.
A pre-mine means that part of, or all, the coins or tokens are mined before a network opens up to the public. The team can distribute or sell these coins or tokens via an ICO, exclusive pre-sale, airdrops, or save them for future investments.
A pre-mine gives project creators more control over the price action of their coin or token. It enables them to create incentives for developers and users to join the network and attract investors with attractive ROIs.
However, with great power comes great responsibility. If a project team has malicious intentions or messes up their “monetary policy,” they could leave investors like you holding the bag.
A pre-mine could, for example, crush a project’s success if the team or investors start selling their bags during a bull run. And there are plenty of projects where teams pre-mine coins only to dump them all on the market once the public sale starts. You’re warned 👀
When there’s a pre-mine, it’s common for projects to lock up part of their coins or tokens. Vesting schedules describe how pre-mined tokens or coins are unlocked over time after a project has launched.
The main benefit of vesting is more price stability at the start of a project. By vesting, teams can protect their cryptocurrency from pumps & dumps. A lock-up period also buys them time to prove their project’s potential before investors can decide to jump ship.
However, if a team plans on unlocking a large chunk of the coin or token supply over a brief time, it can hurt the price in the short term. That’s why you’d be wise to check out a project’s vesting schedule before buying some crypto.
You can often find vesting schedules on a crypto project’s website, and a bit of googling will get you more answers.
#6 Inflation & deflation
This refers to mechanisms teams can use to influence the value of a coin or token by changing the supply. Inflationary mechanisms increase the supply and make the price go down in case of consistent demand. Deflationary mechanisms decrease the supply and increase the value of a cryptocurrency.
Inflationary mechanisms include:
- Rewarding miners or validators with new coins when they mint a block
- Rewarding liquidity providers and yield farmers on DeFi platforms with new tokens
Deflationary mechanisms include:
- Burning coins or tokens to reduce the supply—Binance coin (BNB) for example burns part of its supply each quarter to reduce it until the BNB supply hits 100 million BNB
- Unfortunate investors losing their private keys or sending their crypto to non-existent addresses, sending their crypto into… yeah, where’s that actually going?
Crypto projects can combine inflationary and deflationary mechanisms in smart ways to create the right incentives to make their cryptocurrency thrive. Ethereum’s new proof-of-stake blockchain is an excellent example of this.
Ethereum 2.0 will incentivize validators to secure its network by awarding them with ETH if they mint a new block. They will also implement a burning mechanism to burn parts of the ETH earned from gas fees, reducing the supply of circulating ETH. If the gas fees rise because many people use dApps on Ethereum, more ETH gets burned than minted. This increases the value of ETH and should bring down congestion until more ETH is minted than burned again.
Where to go from here
While this information might not give you straight-away answers to what to invest in to become a crypto billionaire, it will help you better understand a cryptocurrency's price potential.
So we hope you use your newfound crypto tokenomics knowledge to DYOR and make more of your portfolio in the process.
Researching tokenomics deserves an entire guide, so we won’t get into too much detail here. However, here are some pointers to get you started:
- Some blockchains and projects might explain their tokenomics in-depth on their website, and some googling will get you far
- Circulating supply, including if a cryptocurrency has a hard cap or not, can be easily looked up on Coinmarketcap or Coingecko
- You can check out the top wallets holding the most crypto for any blockchain project by checking its block explorer—note that many of the top accounts are often exchanges; these don’t represent “whales”