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Token Economics in Crypto Simply Explained

Token Economics are the incentive structure of a crypto token. With token economics, crypto projects try to influence the value of the underlying asset.

Token Economics Simply Explained

Token Economics is a field of research that focuses on how tokens influence the broader cryptocurrency ecosystem. By adjusting different parameters of the utility of a token we can influence the value accrual and the popularity of the underlying asset. Most crypto tokens have some kind of token economics structure.

To maximize utility for the underlying token, crypto projects have a tool box to define the token economics structure. DeFi tokens are usually at the forefront of maximizing utility. The most important features of any token economics structure are explained below:

Token Distribution

The token distribution is highly important to define any token economics structure. From the very beginning, projects should carefully consider the token allocation. It doesn’t matter whether the token is issued with a fair launch or in the process of an ICO.

The rule of thumb is: Never centralize token holding too much. Token issuers are faced with the trade-off between wanting a large percentage of the token supply and decentralizing the projects. This usually leads to users holding not enough tokens and investors/teams holding too few tokens.

Too many teams are focusing on raising money instead of actually building a healthy ecosystem. This is the difference between long-term and short-term thinking. In fact, builders should realize that the initial token distribution will incentivize users to continue using the protocol. If the community doesn’t have many incentives to contribute, they won’t do so in the long run!

These are only a few reasons why token distribution is one of the most important features of any token economics structure!

Governance

Governance tokens allow users to vote on key decisions of the underlying protocol. Each token represents voting power in the decision-making process. That’s why governance tokens are a crucial part of a project to remain decentralized.

In general, token holders influence crucial decisions of where the protocol is heading. That involves proposing new upgrades or deciding on existing proposals on the governance platform. In fact, they can even change the governance system itself.

Total Supply

Another crucial part of the token economics structure is the total supply of the token. Projects determine the token allocation before the distribution.

Most tokens have a capped supply, which ensures that only xx tokens will exist – similar to the supply cap of Bitcoin. However, there are also tokens that have consistent inflation. A good example is tokens that implement a liquidity mining program in their protocol.

SUHI is such a token that inflates on a regular basis. Liquidity providers earn the token for ensuring that the exchange is liquid. But even inflationary tokens like SUSHI can have a capped supply. In the case of SUSHI, when the supply case is reached, no more tokens will be issued. Governance token holders can change the rule though.

Earnings Distribution

The most common use case of a DeFi token is to give it a monetary value. By turning the token into a capital asset, holders directly profit from the protocol’s growth. The concept is very similar to the way stocks work.

In plain words, DeFi protocols generate revenue, which has to be allocated somewhere. There are two main ways for DeFi protocols to use their cash flow:

  • Token Burn: The protocol can use the cash flow to buy back and burn existing tokens. The concept is very similar to a share repurchase in the stock market.
  • Fee Issuance: Another way to turn the token into a capital asset is to issue cash flow to token holders. In general, this concept works like a dividend. Token holders are eligible to claim a share of the protocol’s revenue. However, the protocol doesn’t have to emit all earnings to token holders. In addition, we can issue it to liquidity providers or other ecosystem participants.

The protocol has do define how much of the cash flow it issues to:

  • Token holders
  • Liquidity providers

In addition, it has to decide how much of the revenue should burn the token. Cash flow is limited and money allocated to token holders cannot be used somewhere else.

In order to create the best tokenomics, protocol participants need to make trade-offs. For example, when deciding where to optimally allocate the revenue.

Utility Tokens

The third way to form the best tokenomics structure is to include utility for the token.. In plain words, a utility token is a token that people buy with the intention to use inside a platform/protocol in the future. Owning a utility token gives the holder a special status on the platform.

For example, an online game company could issue a utility token to its users. The token holders could then use the tokens for purchases inside the game. The token would have a special status because it would be the only way to purchase a specific item. That’s how the company ensures demand for the token.

Conclusion

Token economics are highly important to ensure demand for the underlying asset. If done correctly, token economics will 

There is no universal way to create the best token economics structure.. We see a diverse ecosystem of many different structures. So, the best token economics will greatly depend on the individual needs of the decentralized protocol.

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