Tokenomics made simple. Understanding the key concepts.
In this article, we look at tokenomics. We explain what its, how it works and why it is important. But before we get to the nitty-gritty of this we need to take a look at money. Only by fully understanding how money works can we begin to understand the importance and function of tokenomics.
So what is money and how does it work?
There is a famous old saying that goes, “Money makes the world go around.” If you think about it, pretty much everything you buy and sell is facilitated by money. By this, we mean that on one side of the transaction there’s a person who gives the money in exchange for a good or service.
Money is simply a means to conduct transactions. As such it is a medium of exchange. Before money existed people typically had to swap their products for other people’s products. This made trading difficult and slow. As you had to find a person with the product you wanted, who also wanted your product in exchange. The creation of money solved this, as it offered a standardised value as a token for trade.
The gold standard
Firstly, there were coins made of precious metals, which acted as a currency. The rarity of these metals and the fact they could be used as jewellery made it a practical substitute for the previous bartering system. This was because people had confidence in its value. And even until quite recently in our history the major currencies were backed by gold. Sterling moved away from gold in 1914 due to WW1 and the US offered to convert a dollar into gold at a fixed price up to 1971.
Today money is not backed by a physical commodity and is issued by a government. The government effectively backs the money/currency and this is what gives it value.
Importantly, as the supply of money is now controlled by governments, they can control the economy through its supply and demand. For example, if the government started printing more money it would create inflation and reduce the value of its currency against others.
The government can do other things with currency as well. It can raise or lower interest rates on its currency. Lowering interest rates makes the cost of borrowing cheaper and also discourages people from saving money. This can stimulate an economy and encourage trade in times of recession. On the flipside raising rates will slow down the flow of money and temper the economy when needed.
Money also operates through centralised exchanges. This means that the central bank is placed on top of the system and they work with banks that aid with trade between people and businesses. The banks and clearing agencies determine who has what money as records are kept by them.
- Money is a medium of exchange. It helps people to work and trade.
- The creation of money replaced the bartering system. This made trading far more efficient which allowed the business to grow.
- Money has worth, like gold and silver as people can believe in it.
- Fiat money is a government-issued currency that is not an asset backed by a physical commodity. It is merely backed by people’s confidence in the Government to honour its debts.
- A person’s money is determined by centralised records in the banking system.
- Above all money is a standardised unit that holds the same value no matter who holds it.
A new system
The arrival of cryptocurrency and tokenomics has transformed the world’s view of financial systems. Cryptocurrencies offer a decentralised exchange as many people are simultaneously recording the ledger of buy and sell transactions, so there is no need for a centralised exchange.
Cryptocurrencies operate through safety in numbers approach as people can’t tamper with the system as lots of people are recording the results. So if one record comes up different from the rest it is immediately flagged and not accepted.
This decentralisation takes away control from the central institution (the central bank appointed by the government) as they can’t control how a crypto functions. So if a central bank/institution can’t control or back an asset, then how can investors be confident in a cryptocurrency’s store of value? Well, this is where tokenomics comes in.
What is tokenomics?
Tokenomics has emerged as the primary alternative for applying monetary policy to blockchain networks. The term sounds new and is a fusion of the words token and economics. Tokenomics has made huge strides in changing the established norms of economics with respect to cryptocurrencies.
Tokenomics determines the rules that the crypto/token has to follow. These rules are set up by the token’s developers or creators. Any prospective investor can find the tokenomics of any crypto/token in its whitepaper.
In the ensuing sections, we take a look at tokenomics by giving a useful insight into how it works and why it is important.
Tokenomics and the incentive structure.
In basic economic theory, rational man operates according to incentive theory. Masterclass explains this. “In the most general terms, an incentive is anything that motivates a person to do something. When we’re talking about economics, the definition becomes a bit narrower: Economic incentives are financial motivations for people to take certain actions.”
An example of this is a person may take ongoing professional exams or work extra hours with the expectation of climbing the work ladder and earning more money in the longer term.
This incentive structure is present in every business, every institution and most situations. With Cryptocurrencies, they follow the same suit. There needs to be an incentive structure to motivate people to use it. And this is how the tokenomics model was formed.
In simple terms, cryptocurrencies are strings of numbers with a combination of mathematical rules for transferring value alongside triggering computer code. However, it is the underlying economic incentive structures that create a completely new and expanding asset class by giving people incentives to use it.
When dealing with currency or investment the incentive is always value. There is a promise of either keeping value or creating additional value in the form of profit.
How does Sterling keep its value?
The UK government backs Sterling. Though this is now independently managed by the Bank of England. Since the Bank of England guarantees to pay people who use it, Sterling maintains its value.
Whenever the government has borrowed money in past they have never defaulted. Furthermore, the government or Bank of England has always been careful about printing too many banknotes. This is because printing more money devalues the existing notes in circulation. A good example of this is Venezuela which has printed lots of money and its currency has deteriorated as a result. Consequently, people feel unsafe holding the Venezuelan Bolivia so opt to store their savings in other currencies like Sterling or the Dollar.
How do Cryptocurrencies keep their value?
Cryptocurrencies are completely intangible. Unlike a £10 note, you can’t touch it or smell it, or even know what it looks like. Unlike Sterling, it doesn’t have the UK government backing it up. Furthermore, cryptos are generally not so accepted as tender for buying goods from retailers. By this we mean you generally have to convert it into sterling to spend it. This results in transaction fees.
So an important question for potential holders is what incentives do I have for storing my wealth in it? This is where incentive theory comes in.
Incentive Theory in token economics
To incentivise a person to hold a token instead of a currency, a token needs to offer two things:
- Retain value. An investor needs to feel that the token will be a better store of value than Sterling or any other fiat currency, or he/she will continue to keep holding money in fiat options.
- Security. An investor has to feel safe that the tokens can be stored safely by that person to sell at a later stage. This means that there has to be a record confirming that the investor holds/owns the token. With fiat currency, this record is kept by the central exchange. But with a token other people need to be motivated to record a ledger of your purchase.
Under the concept of incentive theory, why would numerous people offer to record a ledger of your purchase and maintain the security of this transaction? There has to be a benefit for these people for providing this service. After all, a bank holds your money so they can use it to lend to others at a higher interest than they pay you. This gives them profit.
Therefore the model of operations in the token should be structured to reward participants who contribute positively. This means the tokenomics must ensure that they reward participants for holding the tokens and they must also reward participants who store the information of transactions through the blockchain technology.
Token Economics: Key types.
If you analyse gold, you will see that it offers several functions in addition to just storing value. Gold is used for jewellery. It is also used in electronics due to being a highly efficient conductor. Gold is used in dentistry and medicine. This differs from fiat currency which only serves as a store of value.
Tokens like gold, often serve other functions in addition to holding value. For Example, the Ethereum network allows other applications to be used as part of its technology. This includes smart contracts. In a recent article, we explained how these other functions are transforming the real estate industry.
One important aspect to understand about tokens is layers. There are two types. Layer 1 and Layer 2 tokens. This is an important aspect of tokens.
Layer 1 Tokens
Layer 1 tokens use their own blockchain, whilst also being used for powering all services in the blockchain. Prominent examples include Ether on the Ethereum network and BNB on the Binance Chain.
Layer 2 Tokens
Layer 2 tokens work on someone else’s platform. An example of this is OmniseGo which operates on the Ethereum network. This type of token will have a specific section in its tokenomics explaining how they create or retain value.
As well differentiating tokens by whether they operate on their own blockchain or whether they use another cryptocurrency technology is to segment a token by its purpose.
The utility tokens are an important classification of tokens you can encounter in tokenomics. They are made to give access to existing or future digital applications or services developed by the issuer. They may come in the form of an app or user token. They are not created for investment purposes. Possession of these tokens does not equal ownership of the underlying company and there is a lack of earnings potential from holding the tokens alone except the capital gain on the token’s market price. Utility tokens are basically useful for financing a network, and they are issued through an ICO (Initial Coin Offering).
Security tokens “are digital assets subject to governmental and financial regulations of a given country where they are issued or sold. They are designed to represent complete or fractional ownership interests in assets such as having a stake in a company, real estate, or intellectual property” To qualify as a security token it will have to pass the Howey Test. This shows that it operates similarly to a collective investment scheme.
Tokens are also classified as either fungible and non-fungible.
Fungible tokens are generally known for having the same value along with the replication facility. The example of the fungible token is evident in the case of Ether (ETH) on Ethereum. The value of ETH tokens is the same and could be replaced with each other as they have the same value.
Non-fungible tokens don’t share the same value. This makes them unique. Examples of this include pictures, collectables, some real estate, and artworks. Without any scope for replication, NFT use cases bring a higher value to non-fungible tokens than fungible tokens.
- Case study. Real Estate tokens can be either fungible or non-fungible depending on how it is structured. For example, an individual apartment which is structured as an individual token is non-fungible as there are no other tokens which share the same characteristics. This is because it relates to a specific property with land titles etc. However, if the same property had 100 tokens then it becomes fungible as there are now 99 other tokens with exactly the same characteristics. i.e. each token represents 1% ownership of the property.
As mentioned earlier in the article, token economics relies on a system of incentives for encouraging desirable behaviour in the ecosystem. The desirable behaviours in the intent of users for using a specific token can help in determining the token’s value. Incentives play a crucial role in token economics by motivating users to work for the advantage of a platform.
The developer of the blockchain uses certain strategies for controlling the rate of creation of new units and, subsequently, the total amount of currency in the system for keeping a check on the supply of tokens. This restriction of supply is a way to retain the value of the cryptocurrency by giving it a sense of scarcity.
In order for a token to work it needs to have a clear strategy for certain elements of its workings. We outline the key considerations below.
1. Price Stability
Price stability is an important consideration. Cryptocurrencies are known for their volatility. This can deter a lot of would-be users. For example, when using Sterling people have confidence in the currency that its value won’t halve overnight. unless a token addresses this issue it is seen as very speculative and will only attract speculators.
One area of growth is stable coins that retain a fixed price. This is achieved by investing in security from funds generated by the sales of tokens. However, the recent collapse of Terra shows that some of these coins are not as secure as people perceived. In our recent 2022 Cryptocurrency report, we explain how Terra collapsed and show how real estate tokens can offer a better solution for security.
2. Token Distribution
One of the key considerations in the working of tokens is the distribution strategy. If an ICO (Initial Coin Offerings) fails to get anyone to buy it then it would exist without anyone using it. Likewise, unless people are motivated to offer the services of authenticating transactions no one will have confidence in it.
Bitcoin got around this by offering mining options for people that verified transactions.
3. Business function
Frequently, tokens need to serve a purpose. A stablecoin needs to offer price security to motivate people to use it as an alternative to fiat currency. Whilst a real estate token needs to offer the buyer the option to see a capital gain, as it is competing with shares in housebuilders which offer long-term capital growth.
In addition, some coins will offer a dividend to motivate investors to hold onto the tokens long-term.
The governance of tokens is key aspect of tokenomics. The team which works for each project is responsible for creating rules to dictate the supply of tokens. This is always enclosed in the tokenomics section of each tokens whitepaper.
With coins such as Ripple, they allow token holders to vote on the governance of the tokens. This effectively gives control to the masses. This is similar to a listed company where shareholders can hold the board accountable for their performance. As the shareholders have the ability to get rid of the existing board if they choose.
Design of token economics
The design of the token model needs to be durable. This is because any weakness in its design is likely to be attacked by some market participants for economic advantage. Consequently, a robust token model would generally depend on a team comprising of programmers, economists, and mathematicians with academic and industry expertise. Their collective input would play a key role in ensuring its effectiveness.
All cryptos follow the consensus algorithm. This aspect of tokenomics encourages users on the network to achieve consensus during the validation of transactions. You can find the proof-of-work or PoW model as the consensus algorithm for Bitcoin and Ethereum.
Blockchain 101 states with the PoW algorithm, “miners verify transactions for securing the network through a solution of cryptographic puzzles in the blocks. As the network grows there’s is a reduction in the number of coins awarded to miners. Therefore, the equations that you have to solve for verifying transactions on the network become progressively more challenging. You don’t have to worry as this mechanism helps in creating scarcity alongside avoiding inflation.”
Other tokenomics models subscribe to the the proof-of-stake or PoS model. This is another form of consensus algorithm. Ethereum is planning to shift to the PoS model from the PoW consensus algorithm. Other notable crypto projects such as DASH are currently using the PoS model for consensus. The proof-of-stake consensus algorithm helps the holders of currency for staking their value in a wallet.
Designing a tokenomics model
The consensus algorithm can help you to design an efficient token economics model. With tokenomics, you need to think about the future and the objectives you want to achieve with the specific token project. The use of PoS and PoW models for consensus creates incentives that encourage network members. Both models have proven to increase participation in the network while improving security. Both are critical functions.
Strategies that restrict the supply can create a model where long-term the price of the token is likely to rise. One common method of accomplishing this is through the use of token burns. This is the process of sending tokens to an encrypted wallet that no one has access to. It in effect reduces the circulation and the price rises because of this.
Tokens are a massive growth industry. It is anticipated that within 10 years over 10% of the world’s assets will be held on blockchain in a process called tokenisation. How a token is likely to perform is dictated by its tokenomics. This is why understanding tokenomics is so important.
As a real estate company, we are mainly focused on developments within our industry. The effects of blockchain technology on real estate will be profound. It is likely to affect how we buy and sell real estate, as well as the conveyancing process. Companies and investors need to keep up-to-date with blockchain and tokenomics as this emerging technology will radically change our industry.