Introduction to Tokenomics

November 6, 2019

Blockchain use cases are being produced for most industries. At the extremes, some may be totally disruptive to an industry sector, and at the other end of the spectrum, they may add little to no value.


In this article, we’ll focus on one central part of the majority blockchain solutions: token economics (also called tokenomics). We’ll touch on a number of aspects to consider when you introduce a token to your project and ecosystem. In many areas, experts already refer to a „token economy“.


A token economy is a system of contingency management based on the systematic reinforcement of target behavior. The reinforcers are symbols or tokens that can be exchanged for other reinforcers.


A token can be used in different ways and may incentivize people to join, remain, and contribute to an ecosystem, and to use, hold or spend tokens regularly or from time to time. In this regard, tokenomics is the science behind allocating tokens to incentivize users to utilize the token which is essential for building a vibrant token community which drives adoption. When you create or analyze a token, you should find its purpose, functionality, utilization and distribution.


Utility token, hybrid token or security token?

In some cases it’s not easy to categorize a token because the classification criteria is not yet 100% clear - many tokens may qualify as security tokens and as utility tokens - however, an important distinction has to be made for legal reasons and to determine the value to holders and issuers.


Differentiation takes place through various indicators including: a token purchaser or holder only wants to gain financial rewards, there are other utilities involved such as access rights to a network, a reward or discount for using a token along with similar incentive mechanisms. 


Due to security tokens being governed by existing securities laws, it’s imperative to seek advice from lawyers and financial regulators such as the SEC in the US, the FCA in the UK or BAFIN in Germany to avoid severe fines. This is especially important when doing a compliant token sale.


Fungible or non-fungible token?

The choice of fungible or non-fungible is usually easy to make. On one side, fungible tokens are interchangeable and it doesn’t matter which token you possess – they all have the same value and properties (Example: Bitcoin or „General Festival tickets“). Alternatively, non-fungible tokens are not interchangeable, and can’t be divided into smaller token units (Example: Cryptokitties or „Opera tickets with a specific seat for each guest“). It depends on the use case which kind of token should be chosen. Note: Some fungible tokens (Example: Bitcoin) are, in real use, not 100% fungible since it is possible to track Bitcoin units (Satoshis) throughout the lifecycle (UTXO model) and depending on the protocol functionality you can add metadata or other information to tokens.

One or two tokens?

As a project, you’re free to decide how many tokens you want to issue, and how they should be used. The projects and their goals can give reason for the introduction of a simple token or dual token architecture, for example, with a stable coin and another utility coin that can appreciate (depreciate) in value. The one, two or multiple token structure must be suitable for the ecosystem. Additional tokens must be justified as they add complexity, though there are good reasons to introduce more than one token including; incentivization of long-term growth, or two very different incentivization mechanisms.

Token distribution

For a blockchain network the most important aspect is security throughout the lifecycle. In order to build a long-term sustainable ecosystem, it’s essential to have a well-distributed network and no power accumulation in one place at some point. Therefore, there must be incentives to join early-on and throughout the project’s existence – no matter whether you’re a miner, a user, or an investor. This is highly relevant for structuring a token sale where you can distribute the total token supply, but it’s just as important later-on to ensure tokens are held by users and developers and not just accumulated by a few crypto investors. 


There’s a variety of ways to distribute tokens through a token sale or airdrops, periodically, or by utilizing bonding curves. Whatever you choose, you should be aware that an ever-rising token price may be interesting in the short to mid-term, but may harm network growth in the long-term for some projects as it will become costly using the network if no price flexibility is introduced. Price flexibility can be introduced through voting mechanisms on or off-chain about transaction fees, and especially by monetary policy such as inflation or changing supply. Ryan Shea shared a good introductory article on this topic – check it out here.


Token properties, metrics and valuation

Ultimately, it’s important to define the correct role, purpose and features to your token in order to achieve the intended project outcome. William Mougayar presented the correlation of these three aspects very accurately in this article, and provided further insight into crypto token usage and its derived value.


Role, features and purpose define token usage and token value

 

A token model must fit the underlying business model. Besides architecting a good token sale structure for a token offering, long-term value should be captured and aimed for in your calculations. Important factors to consider when structuring your token sale include; the total token supply, and potential changes in supply being allowed or disallowed, divisibility, soft cap and hard cap, compliance, discounts and of course the initial price to ensure the tokens have reasons to be used long-term.


Following a token sale, further metrics such as circulating supply and token velocity will be important to determine the value of the tokens. As you can see, there are many things to consider, and we’ll dive deeper into token metrics, token valuation and allocation in following articles.

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