Tokenomics 101
A guide to understand how token supply and demand can be evaluated, and a high level (and necessary) regulatory consideration.
The intricacies of blockchains and tokens are confusing. This article aims to outline and ease some of the confusion with token economics, or tokenomics, which refers to a variety of topics such as the fundamentals of supply of tokens for a network.
One of the complications of the cryptocurrency world are the regulatory concerns regarding digital assets, which was made quite clear in the Congress hearing Dec. 8th.
First, let’s classify a digital asset and differentiate between a token and coin.
“an ‘investment contract’ exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others”1
If there is evidence of the three parts being passed, the “investment contract” is considered a security per the Securities Act of 1933 and is subject to federal securities laws.
Under the same act, it is unlawful to offer or sell any security unless there is a registration in effect for that security or an exemption from registration. This is in place to:
Provide the investor with necessary information pertaining to the security
Prohibit fraudulent or misinformation
This type of information disclosure was lacking during the 2017-2018 ICO boom.
ICO: Initial Coin Offering. An ICO is a way for a company to raise funds to help create their token or cryptocurrency project. Think of it this way: a startup publishing a whitepaper asking for capital to kickstart the project. These can either be public or private ICOs: offered to the general public or a small, private community.
Wikipedia defines a whitepaper as
“an authoritative report or guide that informs readers concisely about a complex issue and presents the issuing body’s philosophy on the matter. It is meant to help readers understand an issue, solve a problem, or make a decision”.2
Yet many ICOs failed to outline specific matters necessary to help fully educate investors on the projects. Per a UNSW Law report, 82.69% of the ICO’s studied had no information regarding the regulatory status of the ICO3. While many investors at the time did not care about this lack of information, the SEC does.
From the same report, 67.1% of ICO whitepaper issuers did not disclose valid postal contact details. Obviously, this is a great concern to investor information given the use of pseudonyms and other identity concealing actions taken by those involved in the crypto markets.
Bottom line - the SEC makes an active effort to protect investors by limiting the potential of information asymmetries between management and investors4. The complications of digital assets have made it difficult for the SEC to impose this regulation and protect investors.
Quick Clarification:
Coins: Coins have the same characteristics of money - they are fungible, divisible, acceptable, and durable. This will be expounded on below.
Tokens: Tokens are what enable users to interact with a system or project. They grant the participant a right of some kind, and serve a purpose far beyond transacting on the blockchain. Many tokens would be considered securities by the SEC when following the framework above.
Essentially, coins can be used to purchase tokens. For example, you can use Ether (coin) to purchase Uniswap (token) on an exchange.
Native Coins
To give a high level overview of why this distinction matters, the true purpose of native coins needs to be ironed out.
Think of your coins like a metro pass. Without enough money on your pass, you won’t be able to hop on the train. Without enough coins in your wallet, you won’t be able to send a transaction to the blockchain to be verified.
The transaction verification comes from the miners or other validators of the block. As I have written about before, there are different consensus mechanisms for validating a transaction. The Bitcoin and Ethereum networks are both proof of work, in which the miners solve increasingly difficult computational problems to provide cryptographic proof to the transaction.
Proof of stake allows “stakers”, or people who lock up their native coins, to be the validators of the next block. The validators are randomly selected (those with a higher amount of coins locked up having a higher change of being selected), and confirm the transactions within a specific block so that block can then be added to the blockchain. Other consensus mechanisms which I will not dive into today are proof of history or Avalanche Consensus.
Regardless, it is apparent how the native coin on a blockchain network is critical to actually being able to utilize that network. Utilizing the network grants access to the community and products of that network.
Regarding what was mentioned above with the legal considerations of digital assets, the native coins for a blockchain are not currently classified as securities. Based on a announcement in 2018 by the SEC, neither BTC or ETH are considered to be securities. Both of these projects were created and sold in different ways, which leaves the interpretation of asset classification up for a debate unique to either coin.
Tokenomics
As mentioned above, tokenomics (at a high level) refer to supply and demand characteristics of a token. As with the topic of traditional economics, this is a very broad way of encapsulating many factors. When thinking of traditional economics, more specific concepts come to mind such as interest rates, firm/market structures, GDP, and substitutes/compliments.
The same type of specification applies to tokens. Some of the different concepts contained within the supply and demand of tokens are allocation, distribution, and utility.
Disclosure: I will be comparing cryptocurrencies (native asset, coins) and tokens in the rest of this article. This will not aim to provide a framework for evaluating the growth potential of coins and tokens as investments, but rather a breakdown of tokenomics to better understand one of the often overlooked concepts of the digital asset world.
Supply:
The easiest and potentially most critical factor to look at for a cryptocurrency is the supply. These metrics can vary greatly, which explains why there can often be such a discrepancy between the market cap and price of certain tokens. Taking a look at Dogecoin:
DOGE is ranked #11 by market cap on CoinMarketCap, even though the price is a fraction of other cryptos ranked in a similar spot. This is because the supply of DOGE is astronomical compared to others.
Additionally, the circulating supply is something easy and worthwhile to look at. There is a difference between circulating supply and the total supply, and that difference is due to:
a) coins that have yet to be mined
The mining schedule for a native coin can be found with a quick search. For example, BTC has a schedule that will have a max supply of 21 million, with a decreasing schedule of BTC mined per block.
The top part of the bottom axis shows the amount of BTC mined per block for that period, and the bottom part shows the cumulative amount of BTC blocks mined over time. If you want to read more about the Bitcoin halving, read here.
Even though the rate of supply is decreasing, the total supply is increasing across time. This is not the same for Ether, the cryptocurrency for the Ethereum blockchain. Due to a recent update that changes the way blocks are mined, Ether has been deflationary for certain time periods due to burning of ETH. Read about EIP-1559 here.
For other blockchains, you can look at the developer docs to see details of the mining schedule.
b) tokens that have not been unlocked
The unlock schedule of different tokens is accessible data as well, and has similar implications to that of mining supply. The difference being that these tokens are already generated/minted, where as the coins that are mined are not until the block is verified.
I will detail different unlock schedules below.
Allocation:
Pre-mine: This refers to the process of creating coins for an inside group before listing an ICO. Think of this as sweat equity for those early members of the company.
Allocation can be easily compared to the equity structure of a company. When a private company raises different rounds of funding from investors, there are certain allocations of company ownership based on investment size and dilution. Some of the shares are set aside for employee stock compensation, and a sizeable portion left to the founders.
Tokens have a similar structure, here is a look at the popular blockchain Solana’s initial token allocation:
And Uniswap for comparison:
The allocation of tokens can have big implications into how equitable a project will be. Following the ICO boom in 2017-2018, there were many projects which allocated the majority of tokens to the founding team and developers. This also raised concern in the eyes of the SEC, as many investors simply followed the herd to the next big project or were misguided to invest in the ICOs.
In the instance of Uniswap, the above graphic only provides insight into the initial allocation plan, not where tokens currently reside.
Distribution:
After understanding how the tokens were initially allocated, we can look at block explorers for up to date insights into how the tokens are currently distributed.
These types of charts will vary greatly from project to project. Shown below is the current distribution of Uniswap tokens. Notice that the four largest UNI accounts are smart contracts: UNI Timelock being a governance (described below) contract address, and three treasury vesting contract addresses. Looking at the numbers in Etherscan, the wallet with the highest amount of UNI tokens has less than 2.5% of total supply.
As mentioned, this will change over time, and is worthwhile to keep an eye on to better understand what changes may be taking place for the given protocol or blockchain.
The way that tokens can be distributed to members of the community can be through liquidity providing incentives, airdrops, or other project sponsored incentive programs.
Vesting Schedule
The schedule in which cryptocurrencies are released has major implications in the price action. For coins that have a pre-mine take place, the full supply could already be mined from day one, but that does not mean the full supply is in circulation.
There can be vesting schedules for liquidity providers on exchanges such as Uniswap and Sushiswap, and different schedules for the early investors of a project.
Taking another look at Solana, here is the liquid supply curve over time:
Yes, this looks strange. Essentially all of the current supply of tokens were unlocked at the start of 2021. Solana has gotten a lot of notoriety, and is absolutely an efficient blockchain, this is just to highlight the discrepancies that can be found from project to project regarding tokenomics.
Searching through a projects developer docs can be worthwhile to gain an understanding of how they plan to release tokens for early investors and future rewards for liquidity providers/yield farmers.
Utility
The utility for different tokens and coins depends entirely on what the development team sets out to accomplish. Bitcoin’s primary use is as a store of value, being more accessible than gold and holding it’s value over time better than fiat currency.
Proof of stake networks incentivize users to stake the cryptocurrency. These can come with a variety of lock up periods from no lockup to several months. If stakers are able to quickly withdraw their coins and sell on the market to capture recent gains, that could halt upward price movement with both the influx of circulating supply and sell pressure.
Another use case is governance, which allows users to take part in voting for updates to the protocols. Decentralized Autonomous Organizations, or DAO’s, have exploded in use recently. Members of the communities are able to vote on changes to the “self-governing” code based on their token amount.
Conclusion
Avoiding jargon in the crypto space difficult, but I hope this was able to provide a comprehensive basis for what tokenomics is and why it is critical to evaluate across different projects. If I incited any confusion throughout this article, leave a comment or send me an email!
Thanks so much for taking the time to read this. Please pass along to anyone you know if they would benefit from reading about tokenomics in a digestible form.
Have a killer rest of the week!
Interesting Note
This article discusses the liquidity of the available bitcoin as of Dec. 2020. The way that liquidity is defined is by simply taking a ratio of the outflows and inflows of bitcoin to a specific entity’s wallet address. There are bounds set for certain liquidity measures which you can read in more detail, but the conclusion is very interesting.
The large majority of bitcoin supply is illiquid. Whether these are lost bitcoins, or people simply hodling for the anticipation of price appreciation, looking at this subjectively is bullish in terms of BTC price. There is much more that needs to be considered before drawing conclusions, but I stumbled across this in my research and wanted to include for those who may be interested in diving deeper.
https://www.sec.gov/corpfin/framework-investment-contract-analysis-digital-assets
https://en.wikipedia.org/wiki/White_paper#:~:text=A%20white%20paper%20is%20a,problem%2C%20or%20make%20a%20decision.
https://www.researchgate.net/publication/321381542_The_ICO_Gold_Rush_It's_a_Scam_It's_a_Bubble_It's_a_Super_Challenge_for_Regulators
Where this becomes especially interesting is in the case of Decentralized Autonomous Organizations, or DAOs, in which the investors of the enterprise ARE the management.