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Tokenomics 101: A Guide to Analyzing Cryptocurrencies

Tuesday, March 01, 2022 04:01 PM | Neal Farmer
Tokenomics 101: A Guide to Analyzing Cryptocurrencies

The term “Tokenomics” simply refers to the underlying mathematical formulas as well as incentives that influence cryptocurrencies.

Tokenomics encompasses both the actual mechanics of how a coin or token works along with behavioral factors that can influence its value. Projects with strong tokenomics incentivize investors to buy-and-hold their asset and are far more likely to succeed and stand out from the crowd of nearly 10,000 cryptos.

Just like economics, tokenomics all starts with the foundational supply and demand relationship.

Supply

When looking at the supply side of crypto projects, investors should focus on inflationary pressures similar to fiat currencies. An asset will increase in value if fewer exist over time and decrease in value if too many are created too quickly. Many crypto projects are designed to be deflationary, with the number in circulation shrinking over time. How many coins or tokens exist, is there a maximum supply, and how many tokens are being generated make up the supply side of tokenomics.

Besides the total supply, there's also the circulating supply, which is how many of the coins have been issued to date and remain in circulation.

For example, Bitcoin (BTC) has a maximum supply of bitcoins of 21 million, just under 19 million bitcoins are already in circulation meaning that only 2 million more will ever be released. Additionally, the rate at which bitcoins are generated is halved roughly every four years so investors should expect to see very little inflationary pressures on the largest coin by market capitalization today.

Conversely, a coin such as Dogecoin (DOGE) has no supply max and is experiencing roughly a 5% annual increase in supply. With weaker tokenomic measures in the meme coin, traders can expect the value of Dogecoin to fall faster than most when just looking at the supply side metrics. However, the other side of the relationship may help Dogecoin keep its value as demand plays a necessary role in value.

Demand

A coin with a theoretical perfect relationship for its coin production and max circulation isn’t going to be worth anything if no one wants it. The U.S. dollar holds value because people accept it as a general form of currency to pay for goods and services. Bitcoin is worth so much right now because people want to own it and believe it has real-world applications or simply believe the price will continue to rise. Without demand, a coin or token is worthless.

Sentiment

Demand for a crypto project can come in many ways though as something like Dogecoin relies on its meme factor. The coin is worth something because people want to own it as a joke or believe the price will rise because the coin is becoming more popular.

Because there are no earnings or performance reports for cryptos due to them not having some underlying business, technical analysis and market sentiment dominate price movement with no fundamental or valuation analysis to be done. People buy a coin because they believe others will buy in the future as it gains steam and then will sell if sentiment is falling as new coins become more trendy.

Unique Value Proposition

Of course the other major reason tokens can appreciate in value through demand is a belief in the benefits it may have in real-world applications. A sizable portion of Bitcoin investors are holding simply because they believe its price will increase and are essentially gambling on future price movements. However, many invest into coins such as Bitcoin because they believe in the benefits the underlying technology brings to the economy.

A decentralized form of currency with no need for banks or a central bank that has strong security measures through blockchain technology is what some believe will be the primary form of payment in the future. For Bitcoin, some retailers have already begun accepting the coin as a means of payment and even the country of El Salvador has adopted it as legal tender. The more institutions that accept Bitcoin as payment, along with higher demand for Bitcoin, will push the value of the coin higher strictly from a demand perspective.

ROI

Lastly, the other major factor on the demand side of tokenomics is the potential return-on-investment (ROI) of the crypto. How much income an investor receives for simply holding and staking an investment varies between each crypto project. Demand will rise for a coin or token if it can offer a stable and significant ROI as investors will look to acquire the crypto to earn a consistent return.

Ethereum (ETH) for example will offer a roughly 5% annual percentage rate of interest (APR) for staking to help secure its network when Proof-of-Stake (PoS) finally launches. Meanwhile, investors can stake other coins such as Sushi (SUSHI) that offer more than a 10% APR. The ROI is crucial for many cryptos as a stable return for investors is an easy way to attract many new traders looking for periodic returns and ways to minimize risk in a very volatile crypto market. If a coin offers no intrinsic ROI, then investors will be far more likely to move off the token once sentiment starts to fall.

Wrapping Up

Tokenomics covers an extensive range of mathematical formulas and behavioral incentives that affect crypto prices but the basics boil down to the same supply and demand relationship applied to traditional economics, just in a new way. Coins with strong foundational tokenomics with a max supply and/or measures in place to alter production rates are far more likely to succeed in the long-run. Meanwhile, tokens that offer unique value propositions to other crypto projects and financial institutions will be in far more demand. Offering a strong APR as well will entice many new investors to a project while meme value and pure market sentiment are hard demand factors to rely on long-term.

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