Crypto economics is gradually shaping up to become a mature ecosystem where demand and supply factors affect not just the market prices, but pretty much everything. While speculation still plays a dominant role, some innovations within this emerging industry have stepped up to build sustainable economic models - at least up to now. Today, we have ‘Tokenomics’, which is the science behind the economy of crypto coins and tokens.
Tokenomics came to the limelight when Bitcoin was launched over a decade ago, although it was propounded as early as 1972 by Harvard psychologist B.F Skinner. The concept behind tokenomics was that ‘giving a unit of recognizable value would trigger some positive actions and vice versa’. It is now a fundamental pillar of the crypto economy, especially Decentralized Finance (DeFi) innovations - they rely on sound tokenomics to sustain distribution and value retention of their tokens.
So what are these tokenomic models, and how do they work? There are currently two major tokenomic models; inflationary and deflationary. We will discuss each type in the following sections of this article to better understand how they function and each model's upside and pitfalls. Given their technicality, you might also want to introduce yourself to the fundamentals of tokenomics before diving deeper.
To understand tokenomic models, let’s start with a brief explanation of the traditional monetary structure. Today’s economies are influenced by various stakeholders, including monetary authorities, financial institutions, and consumers. At the core of this ecosystem is fiat money - each jurisdiction has its currency recognized as legal tender. The supply of fiat money is primarily dictated by monetary authorities, who have the mandate to print and remove money from circulation. This is what keeps the value of a currency in check.
Things work a little bit different in the crypto ecosystem, although the end goal is similar to monetary policy functions. Cryptocurrencies operate on different blockchains, which can be thought of as micro-economies. These small ecosystems run on blockchain networks powered by crypto tokens - they enable in-house operations and act as incentive tools for building a community around a particular project. You can think of them as the fiat money of the cryptocurrency world.
Inflationary tokenomics is one of the leading models that innovations in the crypto niche seem to have adopted. This model functions similarly to traditional monetary policy as it gives the flexibility of adding more tokens (fiat) in circulation. Traditional Proof-of-Work (PoW) projects such as Bitcoin are among the crypto innovations that incentivize miners and validators through an inflationary tokenomics model.
This model allows tokens to be minted/printed over time - some are capped, which means they can become less inflationary once all the coins are mined or as rewards reduce progressively.
In effect capped coins even become deflationary after all are mined, due to lost private keys and hoarding, which is very likely if the value of the coin is expected to rise - like with Bitcoin, which many “HODL” for years exactly for that reason.
Let’s continue with the example of Bitcoin and review it’s tokenomics; the total number of tokens is capped at 21 million coins with over 18.6 million mined as of press date. The Bitcoin tokenomics model follows an inflationary design as mining began in 2009 and continues to date - more coins are added to the network when miners solve computational puzzles. This system is designed to incentivize miners and node operators by rewarding them with BTC.
Notably, Bitcoin’s mining difficulty increases by double after every four years when this leading digital asset undergoes ‘halving’. This means that the reward per block reduces by half - we are currently at 6.25 BTC per block following the 2020 halving. Consequently, the reward per block will decrease in 2024 to 3.125 BTC when the next halving occurs. Ideally, this will make Bitcoin more scarce while its demand is likely to go up - in this sense, BTC is also a deflationary asset.
Unlike Bitcoin, other inflationary crypto assets have no cap limit of the number of tokens that will be minted. One such project is Ethereum; this proprietary decentralized app blockchain is powered by Ether coins - over 115 million tokens are currently in circulation, with the limit being infinity. An issue that has raised questions about the long-term sustainability of Ether’s value.
The inflationary tokenomics model is one of the most researched and well understood as it closely resembles the traditional monetary policy structure. Furthermore, as the pioneer digital asset, Bitcoin has proven that this model can work as a suitable way to sustain value and incentivize network participation.
Inflationary tokenomics gives room for more coins to be injected into circulation - like how the money printer goes brrr! Crypto projects which use this model have the flexibility to print more tokens in perpetuity, apart from those with a capped supply like Bitcoin. This being the case, it could lead to excess inflation and eventual devaluation of a token.
Deflationary tokenomics works in contrast to the inflationary model - here, tokens are removed from the circulating supply. The process of eliminating coins from circulation is known as ‘burn’; there are two common execution strategies: buy-back and burn and the burn on transaction model.
The buy-back and burn deflationary model allows stakeholders, including an entity or team, to remove a portion of the circulating coins from the public market. Tokens removed from circulation through a buy-back process are transferred to a wallet that cannot be recovered - hence the term ‘burning’.
This deflationary tokenomics model preserves the value of a crypto token since the supply reduces when coins are removed. On the other hand, demand remains the same or increases. Some of the popular projects that use a buy-back and burn model include the Binance exchange coin ‘BNB’. This token undergoes a quarterly burn, with the latest one being in April 2021, where a total of 1,099,888 BNB coins were burned - worth over half a billion dollars at the time.
Unlike the buy-back and burn model, where the process is done manually, burn on transaction follows a more automatic approach. This model is mainly used by Decentralized Finance (DeFi) innovations where the team can integrate it into a smart contract. Practically, a burn on transaction deflationary model collects tax for each transaction that is done on-chain - part of this is burned. At the same time, some may be distributed to stakeholders, including the team and community. The rate at which tokens are removed in the burn on transaction model is dependent on trading volumes.
For example, VeThor Token (THOR), used to pay for transactions within the Vechain network, undergoes a burn on transaction for each transaction fee collected - 70% of these proceeds are burned while the rest goes to the authority node, which validated the transaction. This gradually reduces the supply of THOR tokens, a process that is automatically accelerated when the transactional volumes are high.
Limiting the supply of tokens by elimination ensures that value can be retained or increased as demand may remain the same or go up. In both scenarios, the underlying token’s value will likely increase. The deflationary model approach also eliminates the worry of inflation, as is the case with inflationary models.
There are questions on whether the deflationary model incentive structure will be the cause of its downfall. Having a limit on the number of tokens to be minted while removing some overtime is likely to incentivize users to hoard a particular crypto asset instead of using it. This may cause such a token to go out of circulation and eventually lose its deemed value.
Tokenomic models have proven to be a game-changer in the world of crypto assets - they are a foundation of the crypto economy ‘monetary policy’. Over time, more models are likely to emerge while some of the existing ones may prove unsustainable. Nonetheless, the crypto market needs sound tokenomic models to set a stage for the future of digital economies. That’s why innovators and other crypto stakeholders ought to pay attention to some of the possibilities that could strengthen the current tokenomic models.