The importance of Tokenomics in the world of total digitalization

Tokenomics is a set of rules that determine the monetary policy of a crypto asset. It varies from the issue to the “destruction” of tokens, if any. They use game theory to create incentives to reward the good and punish the bad players. Tokenomics also defines the role that a token plays in the ecosystem and how it acquires value.

Tokenomics is necessary because public blockchains are open to everyone, including scammers. It evens out the behavior of individual participants, strengthens the protocol and, ultimately, creates trust. This is done with the help of cryptocurrencies. The growth of good behavior leads to an increase in the value of the crypto asset, which encourages participants to be good market participants.

Harvard psychologist B.F. Skinner first proposed the idea of tokenomics in 1972. He believes that the token economy model can be useful for matching behaviors. In a well-designed tokenomics model, all costs and benefits are internalized (there are no externalities), so there is no way to manipulate the ecosystem, which ultimately makes it reliable.

Four different participants participate in all blockchain projects. These are the founders and developers who create the project, miners or validators who manage the blockchain and provide security, investors who provide the capital necessary for the project, and, finally, consumers – real users of the platform. Tokenomics creates a set of rules that unites all players and strengthens the ecosystem.

General offer

The first important component of tokenomics is the supply of tokens, limited or unlimited, and the demand that complements this supply. According to Coinmarketrate.com It is known that the Bitcoin supply limit is 21 million coins, while the Ethereum supply does not have such a limit. It is interesting to note that the two most successful blockchains in terms of market capitalization have different monetary policies.

Both crypto projects are successful because they offer different services. These differences are also reflected in their token policy. Bitcoin is perceived as digital gold, a scarce resource whose spending schedule is known in advance. Since the demand for military-technical equipment is constantly growing, and the supply is limited, its price has increased significantly.

Ethereum has a different usage scenario. It is a general purpose blockchain designed to support numerous applications, such as the famous decentralized applications (dapps). The main role of Ether (ETH) is to pay a commission to the system for processing a transaction. In this sense, ETN is basically a medium of exchange (while Bitcoin is a store of value), and an unlimited amount of money is present thanks to the ever-growing applications and dapps built on Ethereum.

However, in both cases, the issue of coins is carried out according to strict and strict rules established by tokenomics. Whether limited or unlimited, the token policy disciplines, and is a source of trust.

Demand for tokens

On the other hand, it is necessary to take into account the demand for the token. The demand for tokens may be driven by the benefits they provide or the rights they give to the token holder. Some tokens are based on the benefits that arise in the ecosystem, for example LINK. For each request to Chainlink’s Oracle services, a LINK price is paid. UNI has no utility, but token holders have a say in the management of the protocol, including control over its billion-dollar treasury.

Token holders can also directly or indirectly participate in the protocol’s revenue. For example, the income of Yearn Finance is used to buy back YFI on the open market, indirectly benefiting token holders. SushiSwap delegates earn five basis points on all transactions when they delegate their SUSHI tokens to the platform.

Proof-of-work blockchains such as Bitcoin and Ethereum are also useful tokens because they are used to pay for transactions on networks. Proof-of-Stake tokens and Delegated Proof-of-Stake, such as Polkadot, Cardano and Decimal Chain, are both useful and control tokens. In addition to paying transaction fees, stake holders also vote on the future direction of the protocol.

The right balance between the demand for crypto assets and the supply of tokens encourages miners and validators to increase the security of the blockchain, as they receive attractive remuneration for their work. In addition, users find the currency attractive as an investment, and pay a fair price for the service used or the rights granted. All this enhances the attractiveness of the blockchain and the ecosystem.

Initial distribution

It takes time and resources to launch a blockchain project. In order to attract early investors, developers and other talented people, tokens are often distributed among this group in advance. As the project is implemented and the value of the tokens increases, they are rewarded for their efforts. The initial distribution of tokens among this group is an important element for the success of the project. The percentage should be large enough to motivate depositors, but not too large so as not to violate the basic idea of decentralization.

Early-stage tokens are often subject to a blocking period. This is an additional incentive for the first participants to continue supporting the projects in the first years of their existence until they create their own sustainable ecosystem. The blocking period primarily applies to cryptocurrencies issued before the start of the project.

Fully diluted market value and token issuance are important factors to keep in mind when you want to invest in a token. This is due to the fact that the mass issue of the token can lead to a dilution of the share. Although predefined token distribution is commonplace, there are also projects where there is no team distribution.

Fair Release

BTC is a symbol of the so-called honest issue. With a fair issue, tokens are distributed among the community from the first day, without reserving tokens for developers and seed investors. It ensures that everyone will be able to take an equal part in the distribution, and seeks to prevent the concentration of a large number of tokens from one particular person or organization during the launch. It is transparent because everyone gets access to tokens or coins based on criteria other than public sale.

The Yearn Finance (YFI) company also started honestly. All tokens were initially distributed among stakeholders, with no reserves for the founder or protocol. However, after the initial distribution, it was difficult to attract talented strategists and developers without their own funds, and as a result, new tokens had to be issued to stimulate the team of developers and strategists.

The fair issue worked successfully, making Bitcoin the most decentralized project and asset in history (at least at the very beginning). However, for a DApp like Yearn Finance, which is in constant development, some reserves are needed to ensure the correct alignment of incentives.

Distribution

And so, the distribution of tokens. Two episodes should be discussed: the Genesis block and subsequent blocks.

The genesis block is the first block of the blockchain and plays a special role. He carries out the first distribution of tokens, and must ensure the functioning of the blockchain. This means that all participants in the ecosystem must receive tokens in order to create an economy and establish it. The participants are miners, security validators, and users. To use an analogy, the creation block is when Monopoly players receive their first token allocation to start the game.

In subsequent blocks, inflation begins. Inflation sounds negative, of course, but it is a way to reward active participants and distribute more cryptocurrencies in the economy. As the economy grows along with the number of players and transactions, tokens must follow suit to maintain a delicate balance between circulating supply and demand.

Token Inflation

In first-tier cryptocurrencies, the increase in token supply, inflation, is distributed between miners and validators for each block offered: this is known as a block reward. In the case of Bitcoin, the block reward is currently 6.25 BTC, and is halved every four years.

By rewarding these important players, tokenomics creates incentives for fair trading, strengthens trust, and ultimately increases the value of the cryptocurrency. The more valuable the tokens are, the more incentives there are for miners and validators to strengthen the blockchain. As in the real economy, monetary inflation does no harm if it is proportional to economic growth.

While Bitcoin uses a proof-of-work (POW) algorithm, other blockchains such as Polkadot use a proof-of-stake (POS) algorithm. With PoS, token holders have an incentive to bet on their cryptocurrencies in order to earn income that usually exceeds the inflation rate. Thus, coin staking protects against erosion caused by inflation.

It also allows you to accumulate more coins over time, and creates security and trust in the system, which is a win-win situation for both the crypt and its owner. Initial inflation is often high, as the goal is to encourage early adopters to use the new blockchain. In the case of the BTC, the reward for the block started at 50 BTC.

Decentralized applications

Over the past two years, we have witnessed the creation of new services based on existing blockchains. For example, decentralized financial applications (DeFi) are mostly built on top of first-level solutions such as Ethereum.

Since the underlying network ensures the security of these applications, the issuance of DeFi tokens, for example, encourages other behavior. The first followers of the DeFi protocols ensure the liquidity of these financial applications and get rewarded for it. This is called liquidity mining.

Again, the earlier liquidity is provided, the higher the annual interest rate (APY).

Creating value

The last important component of tokenomics is the value that the token generates. Value creation occurs when the use of blockchain or dAapp adds a certain value to the token, and investors benefit. This relationship is not always direct, and the mechanism by which value is added plays a big role in how positively the market evaluates the token and its price.

In first-level PoW protocols, tokens are usually useful tokens that are used to pay transaction fees. Bitcoin gets a premium for being a store of value and a system for exchanging values without permissions. Bitcoin is the oldest and most decentralized blockchain with a reasonable monetary policy and proven resistance to censorship, and it has earned this reputation.

PoS protocols create value by securing the network and receiving validators’ fees and transaction fees in return. They also get the right to vote in determining the direction of the protocol. This control is very valuable, and its value increases as the protocol becomes known. As for dApps, it should be noted that smart contracts can usually function normally without tokens. Therefore, it is important to understand what role the token plays in the ecosystem.

Conclusion

Tokenomics plays a central role in the functioning of the blockchain or DApp. They use a set of hard-coded rules and a token to coordinate the behavior of all participants in a way that is beneficial to the protocol.

As we have seen, there is no one good tokenomics model. There are several recipes for good dishes with different ingredients that lead to different taste qualities. In every recipe, it all comes down to the right combination of ingredients. And just like this, tokenomics differs depending on the blockchain services offered.