Tokenomic models - how the cryptocurrency is issued

For a crypto project, a token is an important component. With the system's tokens, users have the ability to participate in activities, keep the project running, and reap the benefits of their participation in the project. Therefore, it is important for a crypto project to be able to distribute tokens to potential users. Tokens are frequently of interest to various types of investors (holders, traders). In addition to studying the fundamentals of a particular project, a sophisticated investor asks himself several questions:

• How many coins or tokens currently exist?
• How many will there be in the future and when will they be created?
• How quickly are tokens released into circulation?
• Does the rate of release change over time?
• What is the distribution structure of the tokens?
• Is there any information to suggest that a large number of coins have been lost, burned, removed, or rendered unusable for some reason?
• Are there deflationary pressures such as token burning?
• Are there significant changes in technology that could affect the number of project tokens? For example, Ethereum plans to move from proof of work (PoW) to proof of share (PoS).
• You can get the answers to these questions by examining the tokenomics of the project. Tokenomics (the economics of tokens) is a set of policies and algorithms for creating and distributing project tokens.

Aspects of the token supply

• The way the first coins are issued and distributed.
• Initial Offering. Involves evaluating the initial coins issued, and the specifics of their distribution to stakeholders (investors, founders).
• The type of issuance outlines the monetary policy governing the issuance of new coins of a particular crypto asset.
• Supply cap - whether the issuance is strictly limited or permanent.

Tokens distribution 

Tokens can be distributed in a variety of ways. Networks reward validators or miners with newly minted coins, and sell some tokens to potential users as part of an initial coin offering (e.g., ICO). Tokens can be distributed to users through certain actions and behaviors. Augur, for example, rewards people for fact-checking on its betting network.

Price stability

Cryptocurrencies are known for their volatility. If there are enough coins in circulation to match supply levels, market participants can influence volatility to a lesser degree. This helps create a stable price for the coin, which encourages people to use the tokens for what they are intended for.

Managing

The core team behind each project develops the rules for how tokens are created, or "minted," as well as how they are brought in and out of the network. Different projects take different approaches.

Some projects may include tokens held in reserve that can be added to the ecosystem later as a way to incentivize growth or pay for system maintenance. This is the method implemented by XRP, for example.

At the same time, other projects take a deliberately non-interfering approach to the network. For example, the developers of Augur play no role in the operation of the network; they simply maintain the infrastructure.

Future adaptations

Most of the teams building the network will not be able to dictate the rules. That's not how decentralization works. Most developers know that what they create now will not necessarily work in the future as originally intended. As the network grows and evolves, it may be necessary to change the way tokens are managed. Some projects have developed provisions for how network users can effectively change the way tokens are managed in the ecosystem through consensus.

Examples of tokenomics in action

BITCOIN

There will always be only 21,000,000 bitcoins, and the supply will be halved every four years. Approximately 19,000,000 already exist, so only 2,000,000 more will be released in the next 120 years.

This means that 90% of the supply is already in circulation, and in 100 years there will only be 10.5% more bitcoins, so we should not expect any serious inflationary pressure to lower the value of the coin.

ETHEREUM

There are about 119,000,000 coins in circulation, and there is no limit to the amount of Ether. But Ethereum's issuance has recently been adjusted through a combustion mechanism so that it has reached a stable supply, or perhaps even been deflationary. Given that, we shouldn't expect much inflationary pressure on Ether either. It could even be deflationary.

DOGECOIN

Dogecoin also has no supply constraint, and inflation is currently around 4% per year. Thus, we can expect inflationary tokenism to undermine the value of Doge more than bitcoin or ether.

Why is tokenomic so important?

Blockchain technology allows projects to create a microeconomy. To become self-sustaining, they need to figure out how the tokens should work in their ecosystem.

When it comes to tokens, there can be no one-size-fits-all approach. Blockchain has enabled a wide range of use cases and implementations. Tokenomics allows teams to create a new model or adapt an existing one that works with what the project wants to achieve. If done right, this can create a highly functional and stable platform.

Types of token issuance 

Limited ONE-TIME

The most typical example is the NEM (XEM) currency. The entire volume of coins immediately goes into circulation, their further amount remains unchanged, and their capitalization is determined by the market rate.

An important advantage of limited one-time token issuance is that digital money that adopts this approach is virtually unaffected by inflation. This is because, because new coins are not mined, a drop in their prices due to an excess of supply over demand is almost eliminated. Cryptocurrencies using such an approach are popular among investors because, if you buy coins at the initial stage, you can get quite a high income due to the growth of their quotations. With all other favorable conditions (demanded product, strong team), the asset's price will grow.

Examples of such currencies are XRP, Cardano, NEM, and others. The creators of XRP initially "froze" 53.6 billion coins of the total (100 billion) and then gradually brought them to the market. This approach allowed the creation of an artificial shortage of crypto-assets, and the developers got a reserve of time to develop and popularize the project.

Limited GRADUAL (until the maximum coins are reached)

This type of token issuance also involves limiting the maximum number of coins in circulation. The key difference is that the issuance of coins is not done in a lump sum but rather gradually. At the same time, it should be noted that there is a specialized mechanism regulating the process of issuing new coins.

A typical example is Bitcoin (BTC) and its forks. Coins are constantly mined by mining, where the complexity of the task increases with each block but the reward gradually decreases (halving). It implies a smooth increase in the number of coins in circulation up to the upper limit and, theoretically, a steady increase in their market value. For bitcoin, there is a maximum limit on the number of coins in circulation, which is 21 million. After this amount of coins is mined, the mining of new digital money will stop.

The mining of new Bitcoin coins is regulated by constantly increasing the complexity of the mining process. It should be noted that the difficulty of mining new blocks is further adjusted depending on the total capacity of the equipment involved in the process.

Among the key features of this approach to coin production is the fact that at the initial stage, there is a probability of inflation, which gradually decreases. The more coins mined at the current point in time, the lower the likelihood of inflation. An important advantage of digital money using this approach to coin issuance is that its quotes can be predicted with a fairly high level of accuracy.

Most popular digital currencies (Bitcoin, Litecoin, Dash) operate on this principle.

Endless issuance

Unlimited issuance of tokens implies endless production of new coins without any serious restrictions. Assets such as Ethereum (ETH) and Smooth Love Potion (SLP) function using such a model. A rather serious disadvantage of this approach to issuing new coins is that unlimited token issuance, under negative circumstances, can cause quite serious inflation.

In the case of ETH, developers are purposefully looking for ways to solve the problem by introducing coin-burning algorithms (such as smart contract gas) as well as increasing the complexity of the system and improving the platform.

Even though coins using one-time token issuance are more attractive in the eyes of potential investors, most digital money developers prefer not to use such an approach.

This is because this approach to coin issuance gives digital money developers only one chance to raise the necessary amount of investment capital to bring their projects to fruition. In addition, this approach has virtually no feedback mechanism between investors who have purchased coins and project developers.

When working with such projects, there is a probability that after selling all the issued coins, the developers may lose the incentive to develop the project further. Thus, there can be a situation when, after the ICO, the developers stop working on the improvement of the created platform. As a result, due to the shortcomings of the platform, users may lose interest in it completely, resulting in a decrease in the value of coins, and investors will lose some of their invested capital. Ideally, developers should receive capital in part at certain intervals, regularly proving their expertise and the usefulness of the product.

The degree of attractiveness of a particular asset depends on its type. For example, tokens with a limited, controlled issuance have a predetermined total volume. Moreover, the system has several regulatory algorithms, that will not allow tokens to enter the market uncontrollably, which means there will be no sudden inflation. That's why tokens with limited issuance are the most predictable.

Coins with unlimited issuance have the opposite situation. They are initially released into the market in large quantities, forming a predominance of supply over demand. It is more difficult to predict what value a token will have on the market after a certain period.

As for coins with a single issue, the situation with them is even more complicated. On the one hand, the total volume is known, which allows at least some analysis. In addition, the example of XRP can be used to "freeze" some of the assets to regulate their withdrawal into circulation. On the other hand, such coins have centralized control, which is not to the liking of all crypto users. Increasing their popularity by attracting miners will not work because they are simply not needed. Even the success of the payment system does not guarantee a significant profit (take XRP, which is fourth in capitalization but not even in the top 20 at the price of one coin). Thus, it is unlikely to get rich on these cryptocurrencies (like those who bought bitcoins in 2013–2015), and this is not the most attractive prospect.

Tokenomics models

Inflationary tokenomics 

An inflationary token has no maximum supply and will be issued over time. There are many variations of inflation token models. Some limit the annual creation of tokens, while others are based on a set schedule for issuing new tokens. An example of an inflationary token is the CAKE token of the decentralized cryptocurrency exchange PancakeSwap. The CAKE token has an inflationary model and has no maximum circulation limit; new tokens are "printed" in each new block, some of which are subsequently burned. Separately, the developers explain the issue of new tokens by the need to encourage users to provide liquidity, which is reasonable because liquidity availability is critical to the performance of any exchange.

Deflationary tokenomics 

If the total number of tokens in circulation is limited to a predetermined number, that token is called a deflationary token. Some projects may choose a deflationary token model because it can help increase the value of each token (the fewer tokens, the more valuable each token becomes). This reduction in the supply of tokens can be achieved in a variety of ways, including redemption or token burning. The main advantage of these models is that they prevent the market from being flooded with too many tokens. Bitcoin sets the industry standard for a deflationary token model. In this model, a certain number of tokens will be created, and the limit will never increase. This creates a deflationary currency because even if demand increases, there will be no supply.

The principles of regulating the issuance of new tokens

The more money governments and central banks pour into a country's economy, the more inflation swings. But cryptocurrencies are issued according to a certain plan, which is regulated by pre-approved algorithms:

Token lock and gradually bringing them to market

The method is used in projects with a one-time issue. Developers create an artificial scarcity of the asset to attract new investors.

Increasing the complexity of mining

New crypto tokens in the network are created within a certain time interval. For Bitcoin, it is 10 minutes, and for Ethereum, it is 14.2 seconds. Regardless of the number of miners or attracted capacities, the time remains constant. The complexity of cryptocurrency mining gradually increases: in the Bitcoin network, every 2016 block (about once every 2 weeks), in Ethereum, every 1000 blocks.

Halving, or reducing the reward for mining

In the Bitcoin network, the payment for finding new blocks is halved every 4 years. At the same time, the issuance of new coins slows down, creating a moderate shortage of assets on the market. The same processes take place in other projects.

Burning mechanism

To fight inflation and increase the value of a token, some projects practice combustion. This method is used, for example, by the Binance exchange. The exchange sends part of its net profit to buy BNB tokens from the market, which inevitably raises the price. The act of burning occurs when the currency is sent to a crypto wallet whose address no one knows. All token-burning transactions are recorded on the blockchain as transactions. Therefore, anyone can verify that the coins were destroyed.

Burning can also have disadvantages over time. As a project scales up, new services are added, and users increase, the same tokens will no longer be enough to cover all services. On the contrary, it is necessary to issue them additionally, not to buy them off the market and burn them. Simply put, if the current level of tokens can serve 10,000 customers, then when there are 100,000 customers, the number of tokens will have to be increased 10-fold. Or the price will have to be reduced by a factor of 10. Few people think about that because the main goal of the ICO is to raise money. The success of bitcoin has demonstrated that projects with an unscalable internal currency are often not used as a means of payment, but accumulate in wallets as their value grows over time.

Tokens distribution analysis 

Several definitions need to be understood for further analysis:

Vesting refers to the process of locking and distributing purchased tokens within a specific time frame.

Cliff is the prolonged blocking of tokens before the vesting deadline. It is most often used for seed and private sale investors.

TGE (Token Generating Event) - in general, synonymous with an ICO. To put it another way, one of the stages of an ICO is the issuance and distribution of tokens (the token sale).

An example of using vesting: is for the team and advisors (project advisors), thereby stimulating the creation of a competitive product and also showing the community that there is no reason to get rid of tokens because they are kept even by those who created the project. In token vesting, it's important to get an even split of tokens. Vesting, including with a cliff of 1 year or more, can mitigate the early rounds.

Below is an example of the IEO (Initial Exchange Offering) unlock chart for the Harmony project on Binance Launchpad.

You can see that a quarter of the volume is on the market at one time, the remaining tokens are unlocked within three and a half years, and they are physically impossible to sell because they are frozen on the smart contract.

Usually, the developer of the project determines in advance what proportions of tokens will be distributed when their owners can use them. The main distribution categories are:

• Seed/Strategic sale 
• Private sale 
• Public sale
• Team & Advisors 
• Liquidity 
• Marketing & Treasury 

Project owners can allocate different shares to each category. Let's try to figure out how this can affect the project and what you need to pay attention to when studying project tokenomics.

Seed/Strategic sale 

This is the very first round of investment in the project. Most often, it is attended by the main venture capital funds, those that can give the project the bulk of the investment. Care must be taken to ensure that the tokens in this round have a long lead time (at least 1.5 years) and that the token price in this round is not very low in relation to the other rounds. A value of x2 about the public sale would be an acceptable value. If this value is higher, however, it could indicate the possibility of unloading this round's tokens to those who would buy them on the listing. The unloading of this round should not exceed 10% on TGE. A cliff is an option, but it is not required.

Private sale

This round is for large investors and influencers who can help develop the project. Development can mean marketing or community building. Hosting for this round averages 12 months. The price on this round should not be much higher than the seed/strategic sale. This round should be balanced. If too many tokens are allocated to it with too little vesting, liquidity may not be able to handle the payoff. If the split is very small, the project may not have enough of the same influencers, which implies a lack of media support and outreach. Coverage, in turn, is the size of the community, and the community is the buyback of tokens on public sale.

Public sale

This round mostly does not exceed 10-15% of the total supply. The reason is that the main participants in public sales are retail buyers. They are the ones who most often sell their allocations when a token is listed on the exchange, which can collapse the price of a token in a matter of hours, sometimes even minutes. If the share of tokens allocated to this stage is significantly higher than 10–15 percent, it may indicate either the project team's belief in their community or the incompetence of the person who developed the project's tokenomics.

The price in this round is the highest, but there is no token lock-in and the smallest allocations. If the price in this round is more than 2-2.5 times the seed/strategic sale, that's not a good sign either. The reason is the same: early investors (especially those with low ratings) may want to lock in profits, putting pressure on the token price.

Team & Advisors

Advisors do not pay for their tokens, they get them for helping the project. Therefore, if this part of the tokens has a very fast split, it may indicate the unscrupulousness of the adviser, who is pursuing his interests.

The acceptable cliff for the adviser is 4-5 months, and the team's cliff is from 1 year, with mandatory vesting. The percentage of the total offer for the team and the adviser should not be more than 25%. Otherwise, the freed tokens after unlocking can put a lot of pressure on the price.

Liquidity

Liquidity is a completely free token for the project. And the team can do whatever they want with them. Therefore, if the project's tokenomics do not specify a timeframe for unlocking, it is not necessarily indicative of a scam, but should be an object of increased attention for the investor.

Marketing & Treasury

These tokens for the project are also free. They must have a long enough vesting period. Tokens from this fund can be used to pay influencers, to use as an additional fund to reward the community, to distribute airdrops, and in general, to fund any marketing activities. Often, these tokens are never allowed to enter the market, except in the most extreme case, or initially if the project was meant to be a dump. The percentage of such tokens in the total supply should not exceed 10%.

An example of ICP tokenomics analysis

It is difficult to describe all possible scenarios; each project has its distribution quirks. To understand how individual everything can be, it will be interesting to consider the tokenomics of the famous project Internet Computer (ICP token), ranked #37 in the Coinmarketcap ranking. The project is highly respected, but the tokenomics are quite controversial.

• The seed investor's share in the project was initially 25%, with an entry price of $0.03. Westing is unknown, if at all.
• The strategic investor share is 7%, with an entry price of $0.63 and a three-year listing beginning in May 2021. Investors: Polychain Capital, Andreessen Horowitz, CoinFund, Multicoin Capital, and Greycroft Partners;
• Private-sale round share of 4.96% with an entry price of $4 and vesting for one year beginning May 2021. Investors Andreessen Horowitz, Polychain Capital, SV Angel, Aspect Ventures, Electric Capital, ZeroEx, Scalar Capital, and Multicoin Capital.

The listing price of the ICP token in May 2021 was $450 (15,000x for the seed round, 714x for the strategic round, and 112x for the private sale). Within a few months, the price dropped by 95%. ICP is now trading at $18 per token. Accordingly, in the first months, until the early investors partially left, it was not worth entering such a project with a long-term horizon, even though ICP has top investors, and the project itself is unique.

Conclusion

For a qualitative assessment of the investment attractiveness of a project, we need a comprehensive analysis. What problem does the project address? Who are the team members, what experience do they have, and who are the competitors? The answers to these and many other questions must be found by the investor.

Well, of course, the study of tokenomics, is an important component of the new project.

Studying the quality of token holders, the distribution of shares, and web listings will help to make a well-informed investment decision.