What is utility tokenomics? Full guide
Tokenomics is a set of parameters that create the value of a digital asset. It takes into account a variety of factors, from the supply of a token to its utility. Tokenomics is the most crucial aspect to consider when deciding whether to issue one or another type of token. Learn what utility tokenomics consists of, and what companies should pay attention to before releasing their own digital asset in our tokenomics guide.
Main features of utility tokenomics
Each investor carefully studies the project’s tokenomics before buying a digital asset. Utility tokenomics determines the supply and demand for a digital asset and, accordingly, affects the price and future of a particular cryptocurrency or token.
Tokenomics includes a number of variables that need to be considered before issuing a digital asset.
The way you produce new coins or tokens
Mining is the main incentive for first-level blockchains, such as Bitcoin or Ethereum 1.0. Miners provide their computing power to verify transactions and are rewarded for this. Staking rewards those who verify transactions by “freezing” a certain amount of digital assets in their cryptocurrency wallet. For example, staking is relevant for cryptocurrencies such as Tezos. Also, Ethereum will switch to the staking model after implementing the Ethereum 2.0 update.
It’s one of the most critical parameters for any investor. Decentralized services try to provide maximum returns to encourage investors to invest. Tokens are placed in liquidity pools — large pools of digital assets supported by decentralized exchanges (DEXs) and cryptocurrency lending platforms. Profits are paid in the form of new cryptocurrencies or tokens.
Some projects, such as Binance Coin (BNB), periodically burn their tokens or cryptocurrencies. Digital assets are being withdrawn from circulation in order to maintain their price. According to the law of supply and demand, the lower the supply, the higher the price. They use a deflationary model, creating an artificial shortage in the market. In 2021, Ethereum also began to move to this model.
Presence or absence of emission restrictions
Emission limits are also an important factor in utility tokenomics. It has an impact from the same point of view as the “burning” of tokens. For example, Bitcoin has a strictly limited supply of 21 million coins. There can be no more bitcoins. At the same time, it is expected that the last Bitcoin will be mined in 2140. This is a deflationary model. Ethereum, on the other hand, does not have a limit on the total number of crypto coins; there are limits only on the number of coins issued per year.
Allocation of tokens
Some cryptocurrency projects present a detailed plan of distribution of digital assets. For example, a reserve may be created for venture capital funds or developers. In this case, additional conditions may arise – for example, restrictions on the timing of the sale of tokens that were in reserve. That is, a venture fund that bought such digital assets will be able to sell them no earlier than in a year. This approach affects the number of cryptocurrencies or tokens that are in circulation.
Many types of digital assets operate now on the model of governance tokens. This means that investors who have bought such digital assets get the right to vote. Accordingly, they can participate more actively in community life and vote “for” or “against” any changes. Such a decision is beneficial from the point of view of decentralization since it is the community that determines how this or that project will develop.
Governance tokens are like shares of a public company. The only difference is that such a crypto project does not have a CEO, and all digital asset holders make up a huge board of directors.
The two economic models
Above, we have already discussed digital asset deflationary and inflationary models. Now let’s analyze them in more detail.
Within the deflationary model, there is a limit on the number of digital assets released into circulation. The offer only decreases for one reason or another. Burning tokens has become an essential tool to influence the price of a digital asset. Projects can use one of two types of token burning:
- Buyout. The project purposefully buys digital assets from users and withdraws them from circulation.
- Burning a transaction. A mechanism specified in a smart contract that provides for the removal of a certain proportion of tokens.
Quite often, crypto projects make a choice in favor of the deflationary model because of the ease of development.
As part of the inflationary model, there may be no restrictions on emission, or they may be soft (for example, the emission of a strictly defined number of digital assets per year, like Ethereum). Successful inflation models follow certain rules:
- Issuance of tokens according to a schedule or according to a non-linear function. The “minting assets on demand” model is unpromising.
- Annual inflation should be no more than 200%.
- The optimal balance is more than 20% of the initial circulating supply but less than 150% of annual inflation.
These rules are essential because it is not easy to maintain the price in an inflationary model. The offer increases and affects the rate. Therefore, it is vital to control emissions.
Some projects use both deflationary and inflationary models. They do not have emission restrictions. At the same time, they periodically launch a mechanism for burning tokens to control the supply.
The best example of such a model is Solana. This crypto is inflationary. However, it has some instruments to reduce the rate of inflation. The starting inflation rate (at the time of launch) was 8% per year, but the project team is aiming for inflation of 1.5% per year. The system uses the model of burning tokens in transactions, which allows them to control inflation.
What are the best tokenomics models?
Tokenomics is individual for each digital asset. Each cryptocurrency or token is guided by its own principles. However, there are certain rules for successful utility token tokenomics. The main ones are the following:
- The token is useful in the ecosystem. Without it, the ecosystem would not be as efficient or would not be efficient at all.
- The digital asset has a well-thought-out emission system.
- The system is scalable; transactions are processed quickly.
- There is a real use of the token or crypto – people can pay for goods or services or get benefits on the project’s platform.
- There are motivational features – economic or governmental.
- And most importantly, the digital asset has clear rules; it is “understandable” for users.
Tokenomics is of paramount importance for the success of any crypto project. Wrong decisions in utility token tokenomics can create big problems for the project or destroy its prospects. Therefore, it is extremely important to think through every step of the platform’s existence and the digital asset associated with it. Whether a digital asset becomes interesting for investors or not depends on well-planned tokenomics. As part of our digital assets consulting service, we help our clients correctly draw up tokenomics so that their project becomes viable and interesting for investors. You can contact us right now to book your first free consultation.