What Is Token Economics?

Cryptocurrency does more than just replace fiat currency. It also tokenizes assets, develops DApps, proves ownership, and motivates holders to participate more actively in decentralized networks.

The twenty-first century has brought many innovations in our usual lives, and blockchain technology is certainly one of them. We can see thousands of blockchain-related projects that claim to be the most effective game-changers of tomorrow.

As token economics is a relatively a new phenomenon in the global economy, it can be difficult to understand properly and to avoid making mistakes during implementation. At the same time, token economics can help you determine the real potential of each project, and choose the one that is the most solid and has the highest potential for investment.

Token economics can either improve or break your crypto project, so let’s consider its most essential features.

Crypto Economics vs. Token Economics

Logically, both concepts are related to the blockchain-based economy and aim to create economic incentives for stakeholders to participate in a particular process as it is needed. However, there are also differences between them that are worth considering and remembering.

In crypto economics, incentive structures create a transaction and ensure validation of the cryptocurrency via randomly selected nodes. In the Bitcoin sphere, the main purpose is to provide motivation for miners to validate transactions under consensus protocol and mine new Bitcoin. As a result, more and more miners started to participate in mining to get a reward. this, in turn, made the network more secure, allowing faster and cheaper transactions.

For this, they get a reward from transaction initiators, who pay a fee to process their transactions.

Crypto economics represents the structure of a whole cryptocurrency supply process; for example, Bitcoin. Since crypto economics can evaluate and predict user adoption, asset price, transaction volume, and services, it can help buyers, sellers, service providers, and other parties achieve better investment results by choosing the best currency system parameters in which to participate.

Crypto economics is tightly related to game theory, as it must incentivize nodes by achieving Nash equilibrium. In order to avoid fraud and ensure an efficient number of coins produced during mining, the voting mechanism of consensus and incentives also must be synchronized to ensure voting under the Arrow theorem. It is quite complicated stuff, with advanced math under the hood.

Token economics, in contrast, is much broader, and despite these aspects, provides the possibility of working with other kinds of tokens beyond just currency. This means that token economics exists to ensure tokens in whatever form their usage in the ecosystem is intended.

Despite the broader definition of token economics, it is ruled with simpler and less mathematically-based economic theories.

Token economics mostly focuses upon token application, token supply, and token validation. Token economics explains token usage and its behavior, not only while conducting a transaction but after its accomplishment.

We can divide token economics into two branches:

  1. Microtoken economics focuses on the parameters and the individual.
  2. Macrotoken economics represents the whole ecosystem of the DLT network and its functioning and depends upon third parties like an exchange or a regulator.

Micro and macrotokeneconomicsBasic Knowledge of Token Economics

Cryptocurrency is not only an effective method for fundraising, but also creates the construction of entirely new business and governance models — for example, token economics.

Token economics is a new branch of the economy that explains the structure of a particular ecosystem in the blockchain sphere. It describes the study, design, and implementation of economic systems built on blockchain technology. Each platform and blockchain application is developed under its own token-economics model.

The main features of a well-developed token are:

  • utility within the ecosystem
  • resistance to inflation
  • scalability of usage
  • high value
  • presence on exchanges
  • potential to increase in usage

A utility token is an asset that provides access to products and services on a particular platform.

A security token is a type of token that gets its value from an external, tangible asset and provides a variety of rights — for example, entitlement to a share of profits, ownership, or equity in a legal entity. The difference between them is very small.

Also, users are provided with the ability to create a token that will meet legal and technical expectations, depending upon returns from token holders and the duration of the token sale.

Token valueA token can be fungible or non-fungible in scale. Fungible tokens are interchangeable and can be divided into small units. Non-fungible tokens are non-interchangeable and cannot be divided, as each token is unique.

Token Utility

Remember that simply having a clear purpose for a token doesn’t mean it will succeed. Do your own research on the token ecosystem to gain an understanding of how to use the token for its direct purpose.

Token Supply and Demand

Any new product entering the market focuses on token supply and demand. If a company decides to design too many products, this will put off purchases, as supply will be over demand. And what will happen to them? Their value will decrease. However, many ICOs still do not pay enough attention to this essential point of token economics.

An appropriate approach for supply-and-demand estimation is described in the Vernon Smith experiments. This was the first initial token offering without blockchain behind it. His approach allows estimation of how tokens should be launched, the direction of their consolidation, and potential levels of demand. As a result, token supply and potential price fluctuations can be easily assessed.

Token Distribution

Token distribution is one of the key elements of token economics, as it has a great impact on the achievement of the objectives of your project. A huge mistake would be to make token distribution fixed, as it is issued at a single moment in time. Think forward about the following:

  • when to put the token into circulation and leave it
  • the amount to release in the first instance
  • the interaction between current and projected distribution, utilization, and value

Utilization of fundsToken distribution is critical, as with tokens price fluctuations, a project that earns only on its utility tokens always has limitations on its operations due to cash-flow gaps.

Token Value

Token value, like any other product value, is unpredictable and may change in the future. The market will determine the value of your asset by itself, so do not be surprised if it differs from your predictions.

Also, consider the moment when users want to exchange the token for a certain service. That means if the market price for your token falls, you will have to set a new, adjusted price.

One more detail about listing on exchanges: if a token is listed on several reputable exchanges, this will serve as a sign that this token is generally recognized, and has a high value on the market.

Token Purpose

A token should not just be a profitable addition to your project. It should also have a global purpose. Most ICOs offer tokens that have no value. They are just trying to benefit from blockchain technology offerings and speed up fundraising for their business. If this is true in your case but you really want to attract investors to participate in your project, not just buy it, you need to create a token with a purpose greater than just financing.

When reading about your token, people have to understand what the token value is. In the end, you’d like investors to actually want to use your token, not just buy into it for purely speculative reasons.

The Architecture of the Token Ecosystem

Creating a token ecosystem means planning for the future and designing drivers that will motivate users to come, stay, and interact with the platform. Many blockchain-based projects have badly-designed ecosystems. Tokens are allocated disproportionately. With a hard cap of issued tokens, this can cause failure of the ecosystem, as there won’t be enough available tokens.

There are two types of token ecosystem architecture: dual and simple. The choice depends on several factors:

  • the alignment of interest between users and investors
  • key stakeholders of token evaluation, estimation of demand, the pace of token flow, and price fluctuation assessment
    volatility-prevention mechanisms
  • reserve estimation and rules of reserve release
  • cost of development (for example, listing tokens on exchanges)
  • the real goal of the project and token

Build your project’s token ecosystem to meet all of these criteria. For some projects, a simple token structure will be the most suitable; for others, it is better to design a dual token structure.

It is vital to provide stabilization mechanisms in order to cope with threats and link them to a crowdsale bonus, as this can have a negative impact on token economics. The bonus system can be different. However, some projects offer high bonuses (up to 80%) to early-bird investors. But be careful with setting such high bonuses to investors, as this can create a decisive single-investor impact on coin-price stability. If one investor has the majority of project income, this will likely give him or her the wheel of the ‘car.’

Monetary Policy

Token economics is dependent on a predetermined monetary policy that includes special measures that provide stability for a certain currency. There are three commonly-accepted instruments to ensure the stability of the monetary policy:

change the credit policy according to other banks
buy or sell government bonds and foreign currencies to influence money supply
change the reserve ratio for banks

Adoption of the right monetary policy is a must-have point of every token ecosystem. If there is going to be stability in a non-profitable ecosystem, this will make a deflationary system more effective for a profitable ecosystem.

Models for the Token Economics

Models for token economics are built for launching new cryptocurrencies. To develop the most suitable model for the token economics of your project, define the role of its native token. This requires your detailed analysis, as any weakness will sooner or later influence the work of the entire network. That’s why the economic model must be really good.

First, choose a consensus model. There is also the option to create a cryptocurrency through several consensus algorithms. For example, Bitcoin and Ethereum use proof of work, which means miners protect the network and are responsible for verifying transactions.

Cryptocurrencies like Dash and NAV use the proof-of-stake algorithm, which means the holders of the cryptocurrency stake their holdings in a wallet to solve blocks. Solving blocks and gaining rewards depend directly on the number of your holdings.

In these consensus models, the motor without which any token ecosystem cannot exist, the central focus is the incentive – something that calls people to action.

Incentive theory and human behavioral theory state that incentives determine people’s behavior, and will therefore motivate them to contribute to the network and improve the blockchain ecosystem.

In token economics, tokens serve as incentives and encourage users to behave for the benefit of the platform. The network sets the rules to prompt people to contribute to the platform with personal incentives. Because tokens have financial value, incentives are mostly finance-oriented. People invest their money in the cryptocurrency, and the token value depends on their number of investments. All people want more, and when you pay them more, they will do more for you.

However, an increase in currency causes inflation. The supply increases, so token value decreases as a result, while the demand remains constant. Every consensus model sets its own rules for inflation. For example, for each Bitcoin block solved, the miner gets 12.5 Bitcoin.

According to predictions, the reward is expected to be 6.25 until all 21 million Bitcoins are mined in 2012.

To avoid the consequences of inflation, most cryptocurrencies set a finite supply. As a result, the supply of coins is limited, and there is no way to create more coins. This will help to control the token price. It also is advantageous in comparison to the current economy, in which supply of fiat currency is endless. This makes individual currencies worth less and less. The cryptocurrency market protects people from such a scenario.

Carrot and Stick

There is a great chance for users to get a reward from developers for their activity in any given project’s improvement process. On the other hand, if a participant breaks the platform’s rules, or his or her actions are not accepted by curators, they can be banned.

Fortunately, there are more carrots than sticks on the blockchain. Logically, token holders are more motivated to develop the project if they have their own tokens of the platform — in other words, if there is a personal financial stake. The greater the value of the platform, the greater the value of the token holder’s share. The network distributes tokens to the most influential contributors to increase their personal financial stake and encourage them to improve the platform.

Token holders have a lot of opportunities to share in the profits made by the platform. For example, they have the right to vote on the direction of the platform. They can suggest alterations to the network’s programming and upgrades. In this way, token holders are the part of the network’s governance process.

The PoS and Delegated PoS-based models allow token holders to stake their shares. When we say staking, we mean storing cryptocurrency in a private wallet related to the blockchain. With the process of staking, the network is more secure, and the price of the cryptocurrency is stabilized if token holders trade less than these tokens. Staking also has a reward system for token holders.

Users who participate in staking can validate their transactions based upon the amount of the token.

Nothing Is Free

Users have to pay a transaction fee to conclude a transaction. As a rule, this fee goes to the miners of the blockchain who proceed with the transaction, but the network can also get it. For example, if you want to send some cryptocurrency to another wallet, you will have to pay a percentage of this transaction to the network for the supply of assets.

Token Economics: the ICO Side

Many ICOs make the mistake of analyzing a project, thinking that the ICO will be the only one source of funding for it from end to end. Relying only on your hands is suitable only for small and medium-sized projects, but not for a long-period prospective business with broader purposes.

For this goal, blockchain technology is the best solution. Nowadays, crowdfunding is a very popular means of fundraising within the crypto community. One of its most common and profitable means of crowdfunding is an ICO launch, which is designed to engage capital to a project.

The number of crowdfunding projects is growing every day on the world market. Here is a comparison of the number of ICOs launched between June 2017 and June 2018:

Monthly ICO numberAre you aware of the percentage of ICOs that are successful? And how many of them fail, as a result?

Leading ICO countries in 2017 (based on funding volume)

Experience shows that more than 90 percent of ICOs collapse, and experts think this is absolutely normal. Also, both investors and project developers should remember that 90–95% of ICOs won’t have any value in 3 years, even if they seem to be promising right now.

By the way, do you know that improperly-developed token economics is one of the most common reasons for ICO failure?

So, dear developers, take care of your ICOs in order to allow them to be included on the list of the most successful. When building token economics, it is very important to consider the token not only from a business or technical perspective, but also from the perspective of your future investors, especially with regard to ICOs. Pay attention to ways to increase the value proposition for investors contributing to your ICO. You need to create all the right conditions to help your investors complete a successful ICO.

Let’s get deeper into token metrics, like pricing, caps, supply, token-sale allocation, lockup periods, and bonuses.

The Hard Cap

First, set your objectively-achieved hard cap – the amount of money required to launch your ICO. Obviously, raising $100 million in several days is not realistic for the average project. Mostly, investors choose projects that are setting their hard cap at $30 million or even less, as they think this amount of money is ideal for low-cap projects.

It is recommended to have a detailed business plan with clear data to explain your purposes and costs of implementation. Stay specific, and plan a budget assigned to each step in your roadmap that can be divided into itemized segments.

The Soft Cap

The soft cap is the amount of money that is required for the creation of an MVP (Minimum Viable Product) version of your solution.
Most projects set one soft cap amount for the crowd sale, which includes the pre-sale and the main token sale. As a rule, the soft cap is set in USD and ETH.

However, you have to be careful when determining the minimum cap. If it is too low, you may fail to achieve your goals. If it is too high, investors won’t risk, but will wait until after you hit the soft cap.

If you have your own money for project development or initial investment, you can allocate a part of this sum to the soft cap, to raise more money later.

Token Supply

If you set your max token supply too low, be ready to face the Bitcoin problem of always working in fractional transaction amounts.
If you have a professional, experienced team, and your ICO enters the list of the top 20 coins in terms of market cap (today, the cap is at least $1.5 billion), divide that sum by your proposed max token supply in circulation. This will give your token a higher price in USD. For example, if your max supply is 300 million tokens, allocate 50% to circulation.

However, practice shows that some ICO investors avoid participating in projects with a high total supply of tokens. Others believe this is unwise. Because of the way token economics works, the total supply of tokens doesn’t matter. The truth is that 7 out of the top 20 coins have caps larger than 1 billion.

Token Pricing

Token pricing can be easily calculated as a mathematical example.
You have to:

  • determine a theoretical hard cap in ETH (if ETH is the currency your project is working on) based on current market prices
  • create your bonus system
  • plan the token allocation for your pre-sale and main sale

Now, a bit of math:

Imagine you are running Project S, which releases its own token, M. Developers determine a hard cap of $50 million USD, while the max token supply is 2 billion.

The token sale allocation is 1 billion (50% of the max token supply).

Step 1: Let’s determine the theoretical ETH cap.

$50 million today is about 474,721 ETH (1 ETH is around $105,325 USD as of November 27, 2018). (Consider that the cryptocurrency rate is always changing).

Step 2: Bonus system for early contributors.

It is recommended to allocate 15% during the pre-sale period only.

Step 3: Pre-sale

As a rule, project developers allocate 20% of sale tokens to the pre-sale. That is 200,000,000 of M tokens.

The balance of 800 million tokens is achievable during the main token sale.

Step 4: Base token price

x = TS/EC

x = Base Token Price; TS = Token Sale Allocation; EC = ETH Cap.

This gives us a base token price of M tokens. That’s a pretty clean number to use, but if yours is not as pretty, just round it to the nearest number that is visually appealing. The next part of the calculation depends on you.

It is worth remembering that these statistics are more related to the era of the “wild ICO market” in which everyone proposes utility tokens without any assessment of token economics and its influence on the business model. Currently, the situation is shifting toward separation of utility tokens, which are critically required for products and should be distributed as a service, as well as tokenized securities that aim to collect funds for further development. Tokenized securities have nothing to do with token economics, as they are just a blockchain-based representation of common securities. Those tokens are highly dependent on project financial projection, P&L estimations, DCF models, and, if someone is experienced enough to address all features, multiple-based valuation.

Conclusion

Token economics provides insights on how a token will be used on a platform. If a cryptocurrency is only used as a method for involving more money in project development, the demand for the cryptocurrency will decrease.

A deep analysis of the token economics behind a cryptocurrency can help define the potential of that cryptocurrency. The more spectacular use cases a project has, the higher the chances that the demand for it will increase.

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