What’s the best cryptocurrency to invest in? Will the value of this NFT go up? Is the DAO I’ve been thinking about worth joining? How much BTC should I buy? Is this stablecoin really stable? How much can I really earn from this Web 3 or metaverse “play to earn” game? After you get excited about a project, your next step should be a deep dive into its tokenomics – it’s the key to understanding the true value of any token-based investment.
What Are Tokens?
The world of decentralized finance (DeFi) is powered by two basic types of tokens: (1) Fungible tokens such as bitcoin (BTC), ether (ETH), matic (MATIC), and other cryptocurrencies; and (2) non-fungible tokens (NFTs) such as digital collectibles and other unique digital assets. These tokens can be traded manually. However, DeFi transactions can be executed via smart contracts (contracts that automatically execute when their terms and conditions are met). In every case, all DeFi transactions are recorded on a blockchain (distributed ledger).
What Is Tokenomics?
Tokenomics is the DeFi-specific study of choice under scarcity. The goal of tokenomic analysis is to understand the potential value of a DeFi project by considering all aspects of a token’s creation and management including its supply, allocation, and distribution. Because the law of supply and demand is immutable, tokenomics has a significant impact on the value of every cryptocurrency, NFT, and DAO and every other type of token-based project.
How Tokens Are Used
Ownership – a token can represent your ownership or be used to grant access. Said differently, a token can grant you the rights to do something such as voting in a DAO.
Value Exchange – tokens are used internally and externally to exchange the value created by a DeFi project.
Utility – DeFi projects have infrastructure. Utility tokens are used to remunerate miners or minters of tokens or for any other internal purpose. Ethereum gas fees (the price ETH miners charge) is a good example.
Benefits Distribution – Tokens are key to the equitable distribution of increased value. Basically, they are the key mechanism for allowing owners of a token to share in the upside.
Allocation and Distribution
Your tokenomic analysis starts with the allocation and distribution of tokens. Are they pre-mined, or is this a fair launch?
In a pre-mined token launch, investors, developers, and select individuals and institutions are granted tokens before the public offering. There’s nothing intrinsically bad about pre-mined projects. It is a very common practice, and many wonderful projects have had pre-mined launches. Regardless, you’ll want to make sure that there aren’t a bunch of whales (very large wallets) hoarding significant percentages of the tokens. Whales like to pump and dump.
In a fair launch, there is no early access to tokens and there are no private allocations prior to making the token publicly available. Very wide distribution to numerous participants is a good indicator that the project is on sound footing.
Remember, the law of supply and demand is immutable. When evaluating the potential value of a token, you must consider two key numbers:
Circulating Supply – the total number of tokens in existence less those that have been burned (lost or inaccessible tokens).
Maximum Available – the maximum number of tokens that can ever be created (mined or minted). For an NFT, each token is unique. For crypto, some tokens (such as bitcoin) have a maximum number. Others (such as ether) do not.
The market capitalization (market cap) is the sum of the funds invested. The fully diluted market cap (market cap if the maximum available number of tokens was in circulation) is a key indicator of token value. For example, a token with a high market cap and a low circulating supply may increase in value over time.
Inflationary vs. Deflationary Tokens
If there is an unlimited supply, a token is considered inflationary. ETH is inflationary because there is no maximum supply limit. On the other hand, BTC is considered a deflationary token because only 21 million BTC will ever be mined.
BTC is the most popular and highest market cap cryptocurrency. ETH is the second most popular and second highest market cap cryptocurrency. Clearly, the token model (inflationary or deflationary) must be considered along with other factors.
The Founding Principles
All DeFi projects have extensive documentation espousing their founding principles, goals, and governance. These documents are required reading before getting involved with any DeFi project. How centralized is the DeFi project you’re analyzing? That may seem like a strange question, but reading the documentation will reveal the governance structure, and you may be surprised to learn just how centralized some of the biggest DeFi projects truly are.
The documentation for a DeFi project will also reveal important information about the founders, their team, advisors, and other data points you will need to consider before investing your time or resources.
The Bottom Line
Humans tend to make emotional decisions. “I like that” or “This is a cool project” is a common refrain. Spending some quality time learning about the tokenomics of a project may help you make better choices. Importantly, this is not a sponsored post. I am the author of this article and it expresses my own opinions. I am not, nor is my company, receiving compensation for it. I am not a financial advisor. Nothing contained herein should be considered financial advice. If you are considering any type of investment, you should conduct your own research and, if necessary, seek the advice of a licensed financial advisor. Good luck.
Learn more about DAOs
If the form is not visible, click here.