What is tokenomics?

The word inflationary is used to describe coins or tokens that are created (minted) at a higher rate than are destroyed (burned). Conversely, deflationary cryptocurrencies have mechanisms for burning more tokens than are created.

The concept of economic inflation, whereby the prices of goods or services increases over time, and the measures that can be taken to affect inflation are also often mirrored in cryptocurrencies.

Tokenomics is the blockchain practice where developers and token issuers incorporate inflationary or deflationary strategies into the economic design of their assets.

Inflation and deflation in large-cap crypto-assets

The Bitcoin protocol mints new BTC with each block, thus acting as an inflationary mechanism. However, Bitcoin’s periodic halving decreases the amount of the block reward and slows the rate of inflation over time. A slowing rate of inflation is referred to as disinflation. (Note that disinflation differs from deflation. Deflation is defined as negative inflation, or prices of goods and services decreasing over time.)

Another key factor limiting Bitcoin’s inflationary potential is its hard cap – only 21 million BTC will ever be created. Once that point is reached, Bitcoin will no longer be inflationary.

Dogecoin is another example of an inflationary currency where miners receive new DOGE as rewards for mining blocks. However, DOGE does not place an upper limit on the total supply but limits the amount of new DOGE that can be minted each year to 5 billion. This mechanism means that although DOGE is always inflationary, the cap on issuance serves as a disinflationary measure each year since the ratio of new supply decreases relative to the total.

Deflationary cryptocurrencies aim to decrease the total supply over time by burning more tokens than are created. For example, in 2019, the Stellar Development Foundation burned 55 billion Stellar Lumens (XLM) tokens, which had an immediate deflationary effect, although since the burning was a one-time event, it did not create persistent deflation.

Some assets incorporate both inflationary and deflationary elements into their tokenomics. In 2021, Ethereum underwent an upgrade that introduced a burn mechanism to the network transaction fees paid by users. Following the upgrade to proof of stake in 2022, the issuance of new ETH has fallen significantly since the network no longer needs to compensate for the high costs of mining under proof of work.

Therefore, although ETH still has an inflationary aspect since new tokens are issued as staking rewards, if the burn rate outpaces the mint rate, it is a net deflationary currency.

Tokenomics

The word “tokenomics” is a portmanteau of “token” and “economics,” and here, the term token can mean either a native cryptocurrency or a token issued on a smart contract platform.

“Economics” refers to the design of the token, including any measures in place to help manage inflation, deflation, supply, and demand. Some of these methods, such as limiting token supply and controlling the rate at which new tokens are issue, are discussed above.

Token burning, as in Ethereum’s new fee model, is another method.

However, tokenomic design can also incorporate other elements to help to influence inflationary factors, many of which leverage the principles of game theory. Given the economic element, a project’s tokenomics has become an important part of an investor's asset research, or a trader’s strategy.

Many elements of tokenomic design aim to manage the supply and distribution of the token, including staking, using liquidity pools, and implementing rules around token allocations and vesting schedules.

Staking

Proof of stake (PoS) protocols may incentivize block validation by requiring validators to put down a minimum stake, although this may not always be the case. For instance, Ethereum validators must stake a minimum of 32 ETH, whereas Algorand doesn’t require a minimum stake. In return for validating transactions, validators are rewarded in the network’s cryptocurrency (in this case, ETH or ALGO) via transaction fees paid by users, by newly minted crypto, or a combination of both.

Minting new crypto rewards is inflationary; however, with an incentive to stake, there will also be a percentage of total supply locked in staking and thus out of circulation, which reduces marketable supply and acts as a deflationary force.

Liquidity pools

DeFi liquidity pools, which enable decentralized lending/borrowing and token swaps on decentralized exchanges like Uniswap, can also be used in combination with staking. In these protocols, users lock tokens in return for incentives such as loan interest payments or swap transaction fees and often receive tokens representing their contribution to the liquidity pool. Token issuers may offer supplemental rewards to users stake their liquidity pool tokens in yield farms as it helps reduce circulating supply.

Allocations and vesting schedules

Many projects allocate tokens to various groups, such as founders and advisers, or for community grants. Vesting periods, where tokens are locked for a fixed amount of time, prevent a sudden supply shock by allowing a small group of people to sell a proportionately large volume of tokens in one tranche. Vesting periods may also be applied in phases to unlock allocated tokens incrementally.

Token utility

Token utility is what ultimately governs demand. Some elements of tokenomics designed to constrain supply may also serve as a utility for a token. For example, staking and liquidity pools give a token utility, since the token can be staked for rewards. Native cryptocurrencies like BTC and ETH also have utility as transaction fees paid by users, which deter spam transactions and act as rewards for node operators who maintain and update the ledger. These cryptos may also be used as a form of currency – both as a store of value or a medium of exchange.

Token utility can refer to anything that drives the desirability or demand for the token. For instance, a significant driver of utility for Bored Ape Yacht Club NFTs is their use as profile pictures on social media, which has been made popular by celebrities. Another utility of BAYC NFTs is access to the wider BAYC community and ecosystem.

Of note, token utility shouldn’t be confused with utility tokens, which refer to a specific class of tokens used to access apps or services.

Tokenomics essentials

• Cryptocurrencies can be inflationary if they are minted in greater quantities than burned, or conversely, deflationary if the burn rate outstrips the mint rate.
• Tokenomics describes the economic design principles that affect the availability of a token.
• Along with mint and burn rates, tokenomics uses game theory to manage supply and demand and, thus, has an impact on a token’s price.