What is cryptocurrency tokenomics?

Tokenomics is short for “token economics” and refers to the economic structure of a cryptocurrency project. 

Every cryptocurrency available on the market today delivers a unique combination of different characteristics that distinguish it from others. Many of these factors determine how the asset operates, and ultimately affects its viability as a medium of exchange, a store of value or other intended utilities.

From the design and management of a cryptocurrency's tokens, to its distribution, supply, utility, and governance mechanisms, tokenomics plays an important role in determining the token's potential for value, adoption, and overall success

Well-designed tokenomics can create a thriving ecosystem where tokens have real-world utility, value and a sustainable future. Poor tokenomics, on the other hand, can lead to extreme volatility, low demand and adversely affect long-term viability.

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What are the components of tokenomics?

Some key components of tokenomics include:

  1. Token supply
  2. Token allocation and vesting period
  3. Token distribution (through mining or staking)
  4. Incentive structures and yields
  5. Token burns and buybacks
  6. Token utility and governance

Every cryptocurrency features a different set of characteristics in order to operate. 

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How does tokenomics work?

Tokenomics encompasses various factors which collectively shape how a cryptocurrency operates.

These various factors are what the market constantly evaluates when determining the value of a project's native token.

By making certain decisions about how much of a token exists, how it is distributed and what functionality it delivers, cryptocurrency project teams are able to shape the economic models that allow their assets to operate. 

Let's take a closer look at some of the most important factors to consider when understanding how tokenomics works. 

Token supply

In tokenomics, the maximum supply of a crypto asset is a crucially important feature. It refers to the maximum number of tokens that can ever exist in circulation. 

The world’s first cryptocurrency Bitcoin was created with a fixed maximum supply in direct response to governments around the world printing new money out of thin air. This scarcity and fixed supply has led many to see Bitcoin as a viable store of value and a potential hedge against inflation over the years. 

It also encouraged many subsequent cryptocurrency projects to set maximum supply limits, and has grown to become an important differentiator of this asset class.

A fixed supply limit has a significant impact on both inflation and the perceived value of a crypto token. With a limited supply of tokens, inflation can be controlled more effectively since new tokens cannot be created beyond the predetermined maximum supply. This scarcity can, in turn, increase the value of the token, as users know exactly how many units of the token can ever exist. 

Tokens with an unlimited supply can be problematic for holders, as the constant stream of new tokens entering the market can dilute the value of existing tokens in circulation.

Supply also impacts a token's market capitalization. Market capitalization is a key metric used to measure the relative value of a token in the cryptocurrency market. 

Market capitalization is calculated by multiplying the current market price of a token by its total number of tokens in circulation.

Want to learn more about the role market cap plays in determining the overall value of a cryptocurrency? Check out our Kraken Learn Center article, What is Market Cap?

It is important to note that market capitalization is not necessarily an absolute reflection of the real value of a cryptocurrency project, but one of many indicators traders can use to gauge the value of a project.

Token allocations and vesting periods

In the world of crypto projects, who tokens are given to and how long they remain with those individuals can play an important role in determining the tokenomics of a given asset.

Token allocations and vesting periods play a crucial role in ensuring fair distribution and long-term stability of cryptocurrencies. Token allocations refer to the distribution of tokens to various stakeholders, including venture capitalists and developers, to incentivize their involvement in the project.

These allocations should be carefully planned and outlined in the token project's whitepaper or tokenomics model.

Regarding distributing token allocations, different cryptocurrency projects may have varying methods.

Venture capitalists, for instance, typically receive a portion of pre-sale tokens in exchange for providing important seed capital.

Developers, on the other hand, may be allocated tokens as a reward for their continued contributions to the project's development.

To prevent immediate sell-offs and potential pump-and-dump schemes, many projects implement vesting periods.

A vesting period is a predetermined time frame during which allocated tokens are gradually released to the stakeholders. This ensures that tokens are not dumped onto the market all at once, which can cause significant price fluctuations and negatively affect token value.

Vesting periods serve several purposes: 

  1. They incentivize stakeholders to remain dedicated to the project for the long term. 
  2. By gradually releasing tokens over time, stakeholders are encouraged to actively contribute to the cryptocurrency project's growth and success. 
  3. Vesting periods promote token price stability by preventing large quantities of tokens from flooding the market, thereby protecting token holders’ interests.

Token distribution through mining and staking

Mining and staking are two key concepts that incentivize active and honest participation in a blockchain network.

While both processes operate in slightly different ways, both are used to distribute new tokens into circulation.

  • Mining is a process whereby transactions are verified and added to the blockchain. Known as proof-of-work (PoW), miners use powerful computers and compete in a trial-and-error game to earn the right to propose the next block of transactions. When successful, they are rewarded with newly minted tokens as well as transaction fees. This serves as an incentive for miners to contribute their computing power and energy to maintain the network's security and integrity. Check out our Kraken Learn Center article What is Bitcoin mining? to learn even more.
  • Staking is a different process than mining, but also helps to verify transactions as they are added to a blockchain. Staking is part of the proof-of-stake consensus mechanism and involves participants locking away, or "staking", a certain amount of tokens in a crypto wallet. These participants are known as validators. Validators play a crucial role in the staking process because they  determine the validity. By staking their tokens, validators are selected to validate and add new blocks to the blockchain. In return, they are rewarded with newly created tokens. Check out our Kraken Learn Center article What is crypto staking? to learn even more.

There are benefits and drawbacks to both approaches — which you can learn more about in our article proof-of-work vs. proof-of-stake

PoW is known for its higher energy consumption, but promotes a highly robust and secure network. PoS is generally seen as more energy-efficient and capable of greater scalability, but can create centralization issues with larger holders dominating the validation process.

When a project releases a new token, they must decide which consensus mechanism best serves their goals. Not to mention, certain token holders may prefer one system over another, particularly given the differences in technological requirements between PoW, PoS and other types of consensus mechanisms.

Incentive structures and yields

Yield farming is a popular token economic concept that allows crypto holders to generate additional tokens by providing liquidity to decentralized finance (DeFi) protocols. 

Yield farmers employ various borrowing and lending strategies to maximize returns on their cryptocurrency holdings.

Decentralized exchanges such as Uniswap rely on liquidity providers to function without the intervention of intermediaries.

Check out our Learn Center article What is yield farming? to learn more.

These sorts of additional use cases can make certain tokens far more attractive to potential buyers, since they can earn additional assets on the cryptocurrency they already own. They may also help to mitigate periods of volatility in the crypto market.

Token burns and buybacks

Token burns are a concept commonly used in the crypto space to reduce a token’s circulating supply. 

By removing tokens from circulation, projects aim to increase the scarcity of their native assets. According to the principles of economics, if supply decreases while demand increases or stays the same, prices may rise.

The purpose of token burns is to counteract inflationary forces and create a deflationary effect on the token supply. By reducing the total supply of a cryptocurrency, token burns can increase the value of the remaining tokens in circulation. This can be beneficial for both holders and the project itself.

The process of token burning can be done through various mechanisms, such as burning tokens from the project's treasury, redistributing transaction fees to burn tokens or implementing a buyback and burn program.

Token utility and governance

Another important aspect of tokenomics is the utility and governance of a token.

  • Utility: Token utility refers to the functionality and purpose of a cryptocurrency within a particular blockchain network or ecosystem. Tokens can be used for various purposes, such as making payments, participating in governance, staking for rewards, collateralizing assets or engaging in yield farming activities. Each use case adds value and utility to the token, attracting users and increasing demand.

  • Governance: Governance tokens are a prime example of tokens that enable individuals to participate in the governance process of a decentralized autonomous organization (DAO). Holders of governance tokens have the right to vote on protocol changes, submit suggestions and influence the direction of the project or platform. This democratic and inclusive nature of governance tokens empowers token holders to actively contribute to the decision-making process, guaranteeing the decentralized and fair operation of the network.

Why are cryptocurrency tokenomics important?

Tokenomics is an ever-evolving field that requires careful consideration and strategic decision-making when it comes to developing a successful crypto token model. 

Projects must carefully consider a token’s supply mechanics, provide meaningful utility, and offer a clear roadmap to ensure consistent demand for the token over time.

Overall, the way in which a cryptocurrencies' tokenomics were created not only influences how people can use the cryptocurrency, but also how the market values the asset.

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