What Is Tokenomics in Crypto?
Token economics refers to key data points like supply and inflation for cryptocurrencies. This data is so important that it gave rise to a new term: tokenomics. The concept is similar to measuring stock fundamentals in traditional investments, although with more focus on supply and demand than on metrics like earnings per share.
Crypto investors look at factors like circulating supply and maximum supply, as well as factors that can cause inflation or deflation in the supply of tokens. Another important factor is the utility of the coin or token because increased usefulness creates value and demand. In this guide, we’ll break down tokenomics’ meaning and its various features. We’ll also examine red flags pointing to potential issues with a coin or token that might negatively impact the future price.
What Does Tokenomics Mean?
So, what is tokenomics, and why does it matter? Tokenomics, a fusion of the terms token and economics, refers to the study of the numbers that drive the value of a token. These factors include supply, locked supply, distribution, utility, and inflationary or deflationary supply mechanics.
Imagine a token with infinite supply, such as DOGE. While DOGE has a capped inflation rate, the maximum supply is unlimited. Without ever-increasing demand, the token value will fall over time. Traditional fiat currencies work similarly. Today’s dollar won’t buy the same goods and services as 20 years ago. The supply continues to grow, so the purchasing power or value falls.
However, it’s also important to measure the utility of the coin. Dogecoins pay for transaction fees on the Dogecoin network, so as long as people use the network, there will be demand for the coins. Additionally, Dogecoin is a meme coin as much as a peer-to-peer cryptocurrency, which adds volatility to the chart below.
Tokenomics measures key aspects affecting supply and demand characteristics so investors can make an informed decision based on factors that may cause a token to increase or decrease in value over time.
Key Features of Tokenomics
Several key aspects of a token define its tokenomics, including supply data, token distribution, incentives that can drive demand, and utility that drives demand. From a wide view, tokenomics considers how many tokens are available, whether circulating supply will increase or decrease, and which factors affect demand. Let’s examine each of these in more detail.
Token Supply
You can think of the token supply as being similar to the number of shares in a company. Each token is a proportional claim on the total value of the protocol. If you own 100 tokens, that number doesn’t mean much without the context of total supply, circulating supply, and market cap. The market cap is, of course, affected by demand as well as inflation or deflation for the token. Owning 100 bitcoins makes you a millionaire. By contrast, 100 dogecoins are worth about $13.68 at press time.
Token Supply Definitions
- Maximum Token Supply: The maximum supply refers to the number of tokens that will ever exist. This often differs from the number of tokens available for trading. Some part of the token supply may not exist yet or may be locked until a certain date. For example, Bitcoin has a maximum supply of 21 million coins. To date, however, less than 20 million bitcoins have been mined.
- Total Supply: Total supply refers to the number of tokens available for trading, less the amount that has been burned (sent to an unrecoverable wallet address). However, the total supply also includes tokens that are locked or held in reserve.
- Circulating Supply: The circulating supply of a token refers to the amount of tokens that are available for trading. By definition, the metric excludes burned tokens and does not include tokens that are locked or not yet minted.
- Inflation and Deflation: Inflation refers to growth in supply, whereas deflation refers to shrinkage in token supply. These metrics pair closely with the demand for the token. Increased demand with inflationary supply could suggest flat prices. However, increased demand combined with a fixed supply or deflationary supply suggests prices will increase, perhaps dramatically.
Be aware that some tokens and protocols allow for future changes in supply. For example, if the project team or decentralized autonomous organization (DAO) decides to mint new tokens and the token has its minting function enabled, supply can increase dramatically. Without a corresponding increase in demand, prices for the token can be expected to fall.
The Radiant Capital chart above makes it easy to see where the price direction changed. In April 2024, the Radiant Capital DAO voted to “potentially” increase the supply of tokens by 50%. Unsurprisingly, the token sold off as there was not yet any meaningful incentive growth for holders. We’ll discuss token incentives in just a bit.
Token Distribution
As important as total supply, analyzing the token’s distribution is also essential. How much of the supply was reserved for the team or private investors, and when can they sell their tokens? A large overhanging supply can cause token prices to behave bearishly.
- Initial Distribution: The initial distribution refers to how much of the supply was allocated to the team, early investors, or perhaps even incentives. Some of the allocation may also go a treasury wallet for future use. Often, early investors buy below the expected market value. This early capital infusion allows the team to pay the bills while they build the project.
- Vesting Schedules: Many crypto tokens use a vesting schedule to “unlock” token supply for the team or early investors.
Incentives and Rewards
Incentives play a role in tokenomics because the opportunity to earn a crypto passive income drives demand for the token. For example, the Ethereum blockchain uses Ether (ETH) as fuel for the blockchain. Ether pays for transactions on the blockchain and unlocks the world of decentralized applications (dApps) on the Ethereum blockchain. However, the Ethereum blockchain uses proof of stake as its consensus mechanism to validate transactions. Proof of stake allows ETH holders to stake their ETH tokens to earn a yield, often upwards of 3%. This dependable yield creates additional upward price pressure for ETH in two ways.
- Increased demand for ETH to stake: According to blockchain data on Dune, 28% of the ETH supply is currently staked. Liquid staking, such as Lido, and restaking protocols, like Eigen Layer, add to this growing demand for ETH staking.
- Reduced supply for transactions: More tokens locked in staking contracts leaves fewer tokens available for transactions. Together, these two factors suggest upward price pressure for ETH.
Incentives may take the form of staking rewards or mining rewards, although staking rewards may extend to other types of smart contracts beyond proof-of-stake smart contracts.
Staking Rewards
In addition to proof-of-stake contracts, many tokens and protocols offer additional incentives for locking tokens. For example, the Aave protocol allows staking of the AAVE token to provide an insurance fund for the Aave lending and borrowing platform. Users who stake their Aave tokens earn a yield.
Mining Rewards
Proof-of-work blockchains such as Bitcoin or Dogecoin provide mining rewards. In the case of Bitcoin, the blockchain pays miners a block reward comprised of new bitcoins and transaction fees for transactions within the mined block. These mining rewards are a two-edged sword, however. Miners must sell some or all of their mining rewards to pay for operating costs. However, a vibrant mining ecosystem and the enhanced security it brings help drive demand for Bitcoin.
The chart below shows the correlation between the reduction in block rewards with each Bitcoin Halving, in which the amount of new bitcoins mined per block is reduced by half, and the value of the mining rewards per block. Generally, as the amount of new bitcoins entering circulation decreases, the price of Bitcoin increases.
Governance Mechanisms
The method by which each protocol governs supply plays an important role in tokenomics. Earlier, we discussed several scenarios, ranging from minting functions to mining and even hard caps on maximum supply. Let’s look at some examples of tokens and coins, some of which we discussed earlier, and how each governs supply.
- Ethereum: The Ethereum protocol brings new ETH into circulation though staking rewards. However, the protocol also burns the ETH used for base transaction costs. This push-pull dynamic results in a largely stable supply that has even been deflationary at times.
- Bitcoin: The Bitcoin protocol creates new bitcoins as mining rewards. However, the amount of new bitcoins produced as mining rewards is reduced by half every 210,000 blocks. Although the circulating supply is growing, the supply’s growth rate is slowing, and Bitcoin has a maximum supply of 21 million bitcoins.
- Aave: The Aave decentralized lending protocol mints new tokens to reward those who stake AAVE tokens on the Aave protocol’s safety module at a rate of 550 tokens per day. AAVE’s maximum supply is capped at 16 million tokens, about 15 million of which are in circulation.
- Dogecoin: Much like Bitcoin, Dogecoin creates new coins as mining rewards. However, unlike Bitcoin, Dogecoin has no maximum supply. Instead, the inflation rate is capped at five billion coins annually. While inflationary, Dogecoin sees a diminishing inflation rate because the protocol targets a fixed number of coins as new supply rather than a fixed percentage.
Utility of Tokens
The usefulness of the token plays a pivotal role in tokenomics. Bitcoin pays for transactions on the Bitcoin blockchain. Similarly, ETH pays for transactions on the Ethereum blockchain, as well as on several Layer-2 blockchains like Base, Arbitrum, and Optimism.
However, some tokens are simply governance tokens. Uniswap (UNI) and Arbitrum (ARB) provide examples of tokens used for voting on protocol proposals. In other cases, such as most meme coins, the tokens have no utility.
Tokens with limited utility may see reduced interest over time, possibly leading to reduced prices as well.
Why Is Tokenomics Important?
Tokenomics measures the supply of tokens relative to demand and the factors that drive demand. The price itself is only relevant in the context of how many tokens are available, how many more might be available, and the expected demand for the tokens.
A coin’s tokenomics can help you understand the future prospects for prices and fully diluted market capitalization, the total value for all coins once all supply is released.
For example, we discussed Radiant Capital earlier. The token had a maximum supply of one billion tokens. However, a still-available minting function allows the DAO to vote on an increase in supply (which it did). If token incentives for staking remain stable and supply increases, the price will fall, as seen in the earlier chart. However, some expect increased revenue for the protocol due to increased incentives. Investors must weigh all the variables and how long they plan to hold the tokens.
It’s important to view the big picture, including ways in which supply or demand can change. Additionally, it’s essential to consider unlocking schedules. Buying just before supply from early investors unlocks could prove disastrous absent a catalyst to offset the expected selling pressure.
Red Flags to Watch Out For in Tokenomics
Tokenomics centers on supply-demand dynamics and how they relate to prices for specific tokens. Some red flags to consider include inflationary supply, top-heavy distribution, and the security of the token and protocol itself. Let’s examine each of these in more detail.
1. Inflationary or Unlimited Supply
Inflation brings risk in two potential ways: high inflation or unlimited inflation. Tokens that are early in their distribution can expect a large increase in supply in coming years even if the supply is ultimately capped.
For instance, Chainlink (LINK) has a maximum supply of one billion tokens. However, the circulating supply is just 608 million tokens. Nearly 400 million new tokens will make their way to market in the coming years.
Dogecoin offers an example of a cryptocurrency with an unlimited supply of tokens. New dogecoins will be mined in perpetuity. However, Dogecoin employs a maximum annual issuance cap of five million coins. Prior to converting to proof of stake, Ethereum used a similar strategy, limiting new mining issuance to 18 million coins annually. Unlimited inflation for tokens creates price risk if demand doesn’t grow at the same rate as — or higher than — supply inflation.
2. Unfair Distribution
Although most cryptocurrencies claim to be decentralized, that isn’t always the case in regard to token distribution. Often, ownership is concentrated amongst top token holders, possibly including the team or early investors. Single wallets or clusters holding a large number of tokens present a risk to smaller buyers. If these whale wallets were to sell in large amounts or in close succession, market prices would fall dramatically.
3. Lack of a Security Audit
Both tokens and their protocols should be audited to uncover potential exploits or risks within the token itself. A bug discovered in Bitcoin’s code in 2018 would have allowed Bitcoin to exceed its 21 million bitcoin cap. Fortunately, the bug was not exploited, and it was later fixed. In another example, investors in the popular Normie meme coin on the Base network saw the token lose 99% of its value, falling from $42 million down to $200,000 following a token exploit that allowed minting additional tokens.
Flaws or functions of the token itself can create risk. Before investing, look for token audits from reputable crypto security firms.
Conclusion
Tokenomics examines a broad range of metrics ranging from circulating supply to maximum supply and even factors that can affect demand or change supply/demand dynamics. Before investing, research the token you’re considering carefully. Weigh the growth opportunities against the remaining supply, locked supply, and token distribution. A bullish chart can quickly turn bearish if the supply/demand dynamics change for the worse. However, tokenomics can work to your advantage if you do your research and find a gem with a fixed or stable supply and growing demand.
FAQs
How is tokenomics calculated?
Tokenomics measures several key factors, including the circulating supply, maximum supply, token incentives, and token distribution. Ideally, investors seek tokens with a growing demand and a fixed or stable supply.
Where can you learn tokenomics?
Several online courses teach the concepts of tokenomics and the importance of each metric. However, the free guide above provides a basic overview of tokenomics, complete with examples and red flags to consider.
Is tokenomics complicated to understand?
No. Tokenomics largely focuses on supply and demand dynamics. Coins or tokens with a limited supply and growing demand should perform well, absent outside influences such as government regulations.
What are Bitcoin’s tokenomics?
Bitcoin benefits from a maximum supply of 21 million coins which is enforced by a worldwide network of node operators who independently choose which version of Bitcoin Core software to run on their nodes. The protocol also halves the supply of new bitcoins awarded as mining rewards every 210,000 blocks. If Bitcoin’s demand continues to grow, the fixed maximum supply and decreasing new supply suggest much higher prices over time.
References
- RFP-33: Strengthening Foundations for Growth and Innovation (dao.radiant.capital)
- Ethereum ETH Staking (Lido, Coinbase, Kraken, Binance, RocketPool, Frax…) (dune.com)
- Ether Burn Rate Plunges to Seven Month Low (finance.yahoo.com)
- Aave Safety Module (aave.com)
- Dogecoin Inflation (dogecoin.com)
- Disclosure of CVE-2018-17144 (bitcoincore.org)
- Normie memecoin team mulls hacker demands after token falls 99% (cointelegraph.com)
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Anatol Antonovici 
Ines S. Tavares