Tokenomics 101

September 23, 2021

Tokenomics takes what central banks use as monetary policy and apply it in blockchain networks. Blockchain technology enables projects to create micro-economies. To become self-sustaining, they need to figure out how tokens should work within their ecosystem. Tokenomics is the science of the token economy. It covers all aspects including coins’ creation, management, and sometimes removal from a network. Projects need to be able to distribute coins out to prospective users. There are several ways distribution can be achieved. The networks reward validators, or miners, with newly minted coins; others sell a portion of the token supply to prospective users in an ICO. Other tokens distribute to users via certain actions and behaviors. Augur for example, rewards people for verifying facts on its betting network. Besides, to keep price stability, projects ensure there are enough coins to match the levels of supply. This helps to create a stable price for the coin, which encourages people to use the tokens for what they’re designed for. The example of this is Ethereum, they are continually distributed by block rewards. The project sold approximately 7m Ether during its ICO back in 2014 to help kick-start mainstream adoption. There is currently no hard cap on Ether, meaning that the token supply can continue to grow as the network expands. However, how Ethereum’s tokenomics model will change as the network transitions to a PoS consensus system.

Tokenomics define the role that the token plays in the ecosystem and how it accrues value. Tokenomics are necessary because public blockchains are open to everyone, including bad actors. Tokenomics align the behavior of each actor, strengthen the protocol and create trust ultimately. It does it with the help of crypto assets. Four different actors participate in all blockchain projects. They are the founders and the developers who build the project, the miners or validators that run the blockchain and provide security, the investors who provide the capital required to make the project and finally, the consumers as the ultimate users of the platform.  During initial allocation, any blockchain project needs time and resources to go live. To attract early investors, developers and other talents, tokens are often allocated in advance to this group. If the project goes live and the value of tokens increases, they get rewarded for their effort. The initial allocation of tokens among this group is an essential element for a project’s success. The percentage needs to be high enough to motivate the contributors but not too big to challenge the fundamental idea of decentralisation. Tokens allocated at an early stage are often subject to a vesting period. This is another incentive for early participants to continue supporting the projects in the initial years of its life until it creates a sustainable ecosystem of its own. 

The token distribution

As soon as the allocation is decided, the distribution of tokens will start. The projects normally have employed a wide variety of strategies to distribute tokens at network genesis. We differentiate this between two phases, the genesis block and the subsequent blocks. The genesis block is the first block of a blockchain and plays an important role. It makes the initial distribution of tokens and must make it so that the blockchain becomes operable. This means that all ecosystem participants have to get tokens to create an economy and start it. The participants are the miners, the validators that provide the security and the users.  These allocations are generally determined by actions taken prior to network launch. To take an analogy, the genesis block is when monopoly players receive their first allocation of notes to start the game. In the subsequent blocks, token inflation is going to start. While inflation sounds negative, it is a great way to reward active participants and distribute more tokens in the economy. The more valuable the tokens, the more incentivised are miners and validators, reinforcing the blockchain. As in the real economy, money inflation does not harm as long as it is corresponding to economic growth. As the economy grows with the number of participants and transactions, the tokens must follow suit to maintain a balance between circulating supply and demand.

The token inflation

Inflation is the rate of increase in prices over a given period of time. Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. But it can also be more narrowly calculated—for certain goods, such as food, drink and service. As for token, inflation sounds negative, but it is a way to reward active participants and distribute further tokens in the economy. As the economy grows with the number of transactions, the tokens have to follow suit to maintain a delicate balance between circulating supply and demand. There are a few different types of token economic models, Ethereum (ETH) which is Inflationary (model) token will lead to inflation between supply and demand. The inflationary model or an inflationary token will continuously be printed over time, with no limit of tokens that can ever be created. There are variations on the inflationary token model, with some tokens limiting token creation yearly, and others going based on a set schedule in perpetuity. This model most closely resembles fiat currencies, however, because code and a decentralized community dictate the token model and not a centralized entity, it is more efficient and transparent. Therefore, because of resemblance to fiat currency, there are less questions around the viability of this model since it has been shown to (mostly) work with fiat currencies.