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Why is it important to understand Tokenomics?

Outside the current financial system, cryptocurrencies make a serious case for being the only assets that exist. That is why everyone is excited about them. But one must fully understand how they work. The most important question is why are some cryptos more valuable than others? The reason behind this difference is Tokenomics.

Tokenomics is one of the most important things to evaluate when analyzing a cryptocurrency. Let’s discuss various Tokenomic factors which one needs to analyze before investing in cryptocurrency.

Coins vs Tokens

Coins are any cryptocurrency that has a self-governing independent blockchain. They are the assets native to their own blockchain. For example, BTC, ETH, XRP, etc. All the coins exist as data on a global database or blockchain. This blockchain keeps track of all the transactions, that are checked and verified by computers around the world. Coins are most often used as money; however, some coins do have other uses. These include being used as a stake to validate a transaction on a network, or being used to fuel applications, or being used to fuel smart contract and token transactions.

Tokens often get mistaken as coins. However, this isn’t correct. There is a major difference! Tokens are cryptocurrencies that do not have their own blockchain but are created on existing blockchains. Tokens benefit from the original blockchain’s technology. For instance, ERC-20 tokens are built on Etherium. However, there are others such as Waves, NEO, Lisk, and Stratis. They can also exist on multiple blockchains.

For example, if the token is being created on Ethereum, the creator will need to spend some native cryptocurrency (ETH) to get the network’s miners to validate the token transaction.

Once created, tokens are then used to activate features of the decentralized application (dApp) they were designed for. In some cases, they are used as voting rights. In other cases, they are used to reward the users with discounted fees (eg. Binance) or for transactions on the dApp (eg. Civic).

Time and resources are saved as the developers of a dApp and token don’t have to create their own blockchain. With their dApp, they can use the features of cryptocurrency while benefiting from the security of the native blockchain.

Cryptocurrency exchanges can be used to exchange coins with each other because they are built on different, non-standardized code protocols. Conversely, tokens on Ethereum (e.g., ERC-20) can be exchanged amongst each other with minimal friction because they are built on standardized code protocols. 

Crypto Ratings Council has evaluated the regulatory risks for most of the major cryptocurrency coins and tokens.

Supply and Market Capitalization

While looking at any cryptocurrency, always pay attention to the market cap of that crypto and not the dollar value. Also, think in percentage terminology instead of dollar terms. 

The Market cap of any cryptocurrency = Number of coins or tokens in circulation x Current price of that coin or token

Almost every crypto has coins or tokens that are not in circulation either because they are locked or still need to be mined. Coinmarketcap shows the ‘Circulating Supply’ bar against each crypto.

One can also see the ‘Fully Diluted Valuation’ of a cryptocurrency on coingecko, which is the theoretical market cap of that crypto if every coin or token is in circulation. These values are not always accurate and it’s better to check the websites or block explorers of particular crypto you are looking for.

Allocation and Distribution

Cryptocurrencies are launched in two ways:

  • Fair Launch
  • Pre-mine

Fair Launch is having a publicly announced launch without any form of pre-mine. Everyone can start mining the coin or tokens. There are no coin or token allocations for fair launch cryptos.

Whereas pre-mine is when the team behind the project mints some or all of the coins or tokens before opening the network to the public. Some portion of these coins or tokens is usually sold before the launch of the project to raise the funds needed to build it.

Most of the pre-mined tokens are allocated to the team and private investors. Only a small percentage is sold to the public in an Initial Coin Offering (ICO). This results in small circulating supplies for many cryptos. This can limit the growth of that crypto. One can see the crypto allocations by looking at their ICO details on Icodrops and Messari.

Once the allocation fundamentals are clear, one can look at particular crypto’s blockchain explorers to check their distribution. Too many tokens in few wallets mean that there’s a risk that these can crash the price on the market in minutes. 

Vesting and Inflation

Vesting applies to pre-mine cryptos and refers to the allocation of the coins or tokens in the future. Projects with pre-mine often lock up a certain portion of their tokens and gradually release them over time. Regular token holders gain confidence that the market won’t be flooded by tokens allocated to the team or private investors. Usually, this vesting is scheduled over several years.

Cryptocurrency can have inflation or deflation. Due to excess inflation, the value of coins or tokens already in circulation can reduce over time. Proof of Stake (PoS) cryptos often have some degree of inflation to incentivize the validators on their network. Many DeFi tokens also use inflation to reward the liquidity provider on their respective protocols. It’s better to earn the DeFi tokens as a liquidity provider than to buy them on an exchange. If the crypto has deflation, the reduction in supply increases the value of that crypto over time. 

Staking and Utility

When staking the crypto as a validator, the coins or tokens are usually locked up for some time. For instance, any ETH being staked in Ethereum 2.0 will be locked until 2022. All that ETH being staked will not be able to make it on any of the exchanges. This restricts the actual circulating supply of ETH which could otherwise enhance the value. This effect is much bigger for other PoS cryptos. Though, some PoS cryptos don’t have a locking period.

Staking is also a common utility for many coins and tokens. The utility includes anything that drives demand for crypto coins or tokens.

Many DeFi tokens have voting utility in the governance system. As the total value locked in a protocol increases, so does the demand for its governance tokens.  

Conclusion

Cryptocurrency coins and tokens have their positives and negatives. While crypto tokens may be more profitable investments but they are riskier because of the regulatory risks involved. Crypto coins often support a larger ecosystem. This gives coins a longer shelf life and results in a more gradual increase in value because of their growing ecosystem. 

Cryptos should be evaluated based on ‘Fully Diluted Valuation’. It is then easy to spot whether a crypto is undervalued or overvalued. Though, fair launch cryptos are hard to find these days.

Approaching the crypto market is a challenging task, but understanding the basic difference between the various types of cryptocurrencies can help manage risk and make better decisions in a volatile ecosystem. 

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