You might have wondered sometime why some cryptocurrencies thrive as others fade away, like they never even existed. If you have, this question would be a good one, and the answer lies in a very interesting concept: Tokenomics.
Tokenomics is that aspect of a token’s supply that controls how it works in the financial markets. This concept is deeply involved in the token’s supply, value, and incentives, not to mention its use cases. Whether you’re simply curious or a seasoned investor, here’s how to see past the hype and understand why concepts like supply and inflation matter for every digital asset.
Estimated reading time: 8 minutes
Table of contents
Token Supply as the Foundation of Value
Let’s start with the basics. Think of a token’s supply as the number of units a cryptocurrency has, and how many might be created in the future. This supply can either be fixed or unlimited, with each of these models having its own implications.
Fixed Supply and Scarcity
Bitcoin is a classic example of a cryptocurrency with fixed supply tokenomics. Only 21 million BTC will ever exist, and this scarcity is one of the things that makes Bitcoin so valuable. Since no more tokens can be created, the increasing demand will inevitably push prices higher over time.
Will Bitcoin ever hit the $1 million mark? The fixed supply tokenomics make it highly likely. However, fixed supplies for cryptocurrencies come with their own set of problems. For example, as demand rises and block space declines, transaction fees will surge and make the network more expensive to use.
Uncapped/Unlimited Supply
Some cryptocurrencies like Ethereum and Dogecoin do not have a fixed or capped limit. This unfixed model allows the network to continuously create new tokens indefinitely to reward network contributors or manage transaction costs. However, the problem with this model is that the project must control its inflation rate as tightly as possible to avoid devaluing the asset and triggering hyperinflation.
Token Burns and Supply Reduction
Crypto is often touted as being “immune to inflation”. However, this isn’t always the case, as supply/demand dynamics play a huge role in whether or not a token becomes essentially worthless over time. Many projects with unfixed supplies set up events known as token burns in place to offset inflation.
Think of token burns as a way to permanently destroy a part of a token’s supply. This helps to reduce its supply and improve the chances of price rallies. Projects like Shiba Inu and Ethereum burn tokens at regular intervals, based on events like transaction fees, smart contract triggers, or milestone achievements.
According to the ShibBurn resource, Shiba Inu has burned as many as 410 trillion tokens from its total supply of 1 quintillion tokens. Projects with fixed supplies can also burn tokens for the same reason. The Binance Smart Chain, for example, is currently in the process of burning 100 million $BNB from its 200 million supply.
What About Token Buybacks?
Token buybacks are similar to burns, and yet so different. They are similar in that they achieve the same effect, but different in that when tokens are burned, they are effectively removed permanently from circulation.
On the other hand, token buybacks happen when the governing body of a crypto project (whether a DAO or a semi-centralized entity) uses a portion of the transaction fees collected on the network to “buy back” tokens on the open market. These tokens can then be burned or locked away in reserves to control or reduce the circulating supply. Burns and token buybacks serve the same purpose, and are especially implemented when demand is on the rise.
However, these mechanisms only work if there is reasonable demand for the underlying project. Burning the tokens of a dead project with no demand will do no more than attempting to catch a falling knife. However, when burns or buybacks are tied to strong project fundamentals, they become powerful tools for a project’s tokenomics.
The Problem of Inflation
Inflation isn’t just for fiat currencies, as established. Crypto is incredibly prone to inflation as well, even though most crypto inflation is usually programmed and transparent. Good examples of hyperinflation in crypto include the Terra $UST “death spiral” in 2022, where the incident caused a wipeout worth billions of dollars across the market.
Crypto ecosystems like Bitcoin and Litecoin, on the other hand, have what is known as halvings, where the amount of new tokens minted is reduced by 50% (or halved) every four years. This makes these cryptocurrencies more scarce over time, and therefore more valuable. To summarize things, inflation occurs when tokens start to flood the market as demand grows.
Prices will begin to plummet as more and more investors lose confidence. The relationship between inflation and supply runs even deeper than most realize. When a decreasing inflation rate is combined with a capped supply, it creates long-term scarcity, which is great for prices. However, an uncapped supply with high inflation needs to have strong demand to stay afloat. If demand falls, then prices will inevitably collapse.
Utility and Why the Token Matters
A token’s value isn’t just about scarcity or supply. It also depends on what the token does for investors. This is what utility means. Some interesting roles that tokens play in the world today include governance, staking, transaction fees, access, payments, and so on.
Governance tokens, for example, allow holders to vote on decisions like protocol upgrades or treasury allocations. This promotes decentralization and gives the community a say in an asset’s future. Staking tokens like Lido’s $LDO, on the other hand, are used in the staking process, where investors earn rewards for locking their tokens up and helping to secure the network.
Many networks like Ethereum and Solana also require users to pay fees in their native tokens. As network activity increases, demand does as well, and prices can skyrocket. Many other tokens are used either as access to services or as payments in peer-to-peer transactions.
Real-World Use Cases Drive Value
Utility is what separates serious projects from the hype-fueled ones. If a token plays a meaningful role for its investors by powering apps, governance, or unlocking services, it is more likely to remain in a long-term uptrend.
On the other hand, many tokens become worthless and forgotten if they only rely on speculation. A token’s use cases can also trigger changes on the network itself. The more people use the token, the more valuable it becomes. This encourages more use and reinforces a positive loop that can support the token’s value.
Overall, tokenomics isn’t just one concept. It is a blend of supply, inflation, and utility. A well-designed crypto project should carefully balance all three to stay afloat for the long term. For example, a token with a capped supply and strong use cases might benefit from growing demand and experience price increases. Meanwhile, a token with an uncapped supply and weak use cases will always struggle to hold on to its value (even if its inflation rate is low).
Adoption Is a Major Factor As Well
Scarcity, demand, and utility are some of the major factors that drive real-world value. However, real-world adoption acts as an external driver that amplifies this effect.
Think of adoption as the icing on the tokenomics cake. Put simply, tokenomics matter. However, what matters more is how many people (or institutions) want to use the cryptocurrency outside of speculative trading. When a massive number of people see value in a cryptocurrency and buy into it, the more legitimate it appears (and becomes). As such, it starts to behave less like a volatile asset and more like a functional form of money.
Think of Bitcoin in 2010, for example, when Laszlo Hanyecz, a man from Florida, spent a staggering 10,000 Bitcoins on two large pizzas. Back in the day, Bitcoin was worth only a few cents, and fewer than a few people were interested in its value.
However, 15 years down the line, Bitcoin has overshadowed major companies like Meta and Tesla in market cap, and is on track to go toe-to-toe with gold over the next decade or two. This is the power of adoption on any kind of digital asset, not just Bitcoin.
Tokenomics Is Your Crypto Compass
Before jumping into crypto investment, you should understand that tokenomics is a very important aspect of the investment process. Understanding this concept can make all the difference between a rewarding investment and one that is less so. It helps to move beyond mere marketing slogans and hype and focus on the concepts that truly matter.
As the crypto market matures, tokenomics will play more and more of a role in separating projects with real-world use cases from short-lived experiments. This said, remember that whether you’re investing, building, or just learning, understanding how a token works under the hood is very important. Your portfolio (and peace of mind) will be better for any scenario.
