Understanding Tokenomics and Its Impact on Project Security

Researching and understanding a crypto project’s fundamentals is critical to assessing its long-term potential. Yet there are many people who either don’t know or struggle to understand what should be front and center when it comes to researching. This article aims to provide you with a better understanding of the different components that combine to form a vital element of any project: Tokenomics.

What Is Tokenomics? 

A blend of “token” and “economics”, tokenomics refers to the economic structure of a token within its ecosystem. Understanding tokenomics is essential for evaluating a project’s viability and security. It encompasses various elements, such as token distribution, supply, and economic incentives that influence the overall health and functionality of a blockchain project.

Key Components of Tokenomics

The structure of tokenomics can significantly impact a project’s long-term success and security. Well-designed tokenomics can foster a healthy and engaged community, ensure fair distribution, and provide the necessary incentives for network participation and security. Conversely, poorly designed tokenomics can lead to centralization and manipulation, and leave projects vulnerable to attacks.

So, let’s take a look at the key components of crypto tokenomics and how to address each of them.

Token Distribution

Token Distribution is a critical aspect of tokenomics as it shows how tokens are allocated among stakeholders like project founders, investors, and the community. When looking into distribution, key factors to consider include:

Fairness: Ensuring an equitable distribution of tokens to prevent excessive centralization.

Transparency: Clear and transparent allocation methods to build trust within the community.

Vesting Schedules: Projects will often want to incentivize their teams with their own project tokens as a means of payment. A vesting schedule means that over time, tokens become spendable by a team or their employees. These are often verifiable with tools such as Cryptorank. The risk of a project not having one is that the team could sell their full allocation at any time, causing a crash in the token price.

To prevent this, vesting schedules are implemented via smart contracts as a mechanism to drip-feed tokens to the respective stakeholders, limiting the overall impact on the token price.

Market Cap: The Market Capitalisation (MC) is the total value of all of the tokens in supply multiplied by the current token price. For example: Token A = $5/token and there are 123,000 tokens in the available supply. 

Therefore $5 x 123,000 Token Supply = $615,000 MC

Total Supply: This is the maximum amount of tokens that can be on the market. A fixed supply is often praised as a way to prevent inflation. If there is a mint function in the contract, then you should be aware that the total supply could still increase – depending on the actions of the owner of the smart contract.

Circulating Supply: Sometimes projects decide against releasing all of the tokens into the market all at once. Project A, for example, only wants to release 60% of its tokens at launch. If Project A’s Total Supply is 1,000,000 tokens, then the current circulating supply is 600,000 (60% of 1 million).

Burning Mechanisms: Smart contracts that automate the process of burning tokens. Burns can also be executed manually on some tokens.

Effective Token Distribution

A general rule of thumb is that any single wallet or group of wallets owned by the same entity should aim to hold less than 15% of the supply. Otherwise, in theory, the token price could drop significantly with a single 15% sell-off. Therefore an effective token distribution is one where the token allocations for the team, stakeholders, and advisors are relatively decentralized.

Example: Analyzing the holders’ chart of the PEPE token on Ethereum reveals that most of the supply is held by exchanges, which enhances liquidity and builds trust in the token. This means that no single entity can sell off a huge amount of tokens because the largest wallet holds only 1.1% of the supply (at the time of writing).

Flawed Token Distribution 

Generally, flawed token distributions carry much more of a significant risk to any participants in the protocol or project. If, for example, a project has just launched, yet 50% of the tokens are being held in the deployer wallet, then there is a significant centralization risk. Centralization risks are effectively points of vulnerability within a project because you have to consider your trust in the team AND their security practices to keep those tokens safe. If the supply was effectively distributed and a team wallet was hacked, the impact would be much more limited.

Token Supply

A token’s supply is usually talked about in three main ways:

• How many tokens are in circulation? (Current Supply)
• How quickly and how will the remaining tokens come into existence (Issuance)
• What is the total supply (Total Tokens or Fully Diluted Value)

Making sure the tokenomics strikes a balance, makes sense, and fits the function of the protocol or app that utilizes the token is the challenge.

Effective Token Supplies

An effective token supply is balanced, meaning that the supply is generally offset by the demand and they remain in equilibrium. Supply and demand is a natural phenomenon that occurs when anything of value is being bought and sold in a competitive market. If the supply of the tokens is far greater than the demand, the token price will fall. 

Conversely, if the demand is higher than the supply, the price will appreciate over time. Whilst there are other variables to be considered for every single token, supply and demand will play a fundamental factor across all tokens. Some examples of mechanisms employed to keep token supplies in check include:

Max Total Supply: If a token has a max total supply, it will usually be displayed in sites like Coingecko, labeled as the “Fully Diluted Value”, which is the total token supply * current token price.

Burning Mechanisms: Tokens like ETH burn a large portion of gas fees generated (referred to as the Base Fee). The burning mechanism, balanced with the staking rewards (given to validators who provide security for the network) aims to create a token supply that ultimately reduces over time, or at least keeps inflation in check.

Fixed Issuance Schedule: Some tokens don’t have a maximum total supply, but they may have a fixed inflation rate. Keeping a stable or algorithmic issuance increases predictability.

Predictability: When tokens change their tokenomics, investor confidence is usually (at least temporarily) shaken. Bitcoin’s long-term predictability of issuance is one of the key elements that drives its value.

Flawed Token Supply

A flawed token supply is one where the supply is greater than the demand. This is flawed because it hurts the price over time, impacting the community of investors. To bring in a real-world example here, think about government inflation: In the UK, the government aims for 2% which fosters continuous steady growth which is great for the economy. However, we’ve seen the impact of higher inflation (10%) over the past few years, especially in some countries like Venezuela where inflation is +100%. Inflation devalues the underlying currency, meaning that you need more of the currency to purchase the same items. It’s the same with cryptocurrencies – higher inflation equals a lower token price over time.

Incentive Mechanisms

Economic incentives designed to encourage specific behaviors from users and participants, play a crucial role in guiding user behavior and ensuring network security. 

Effective Incentive Mechanisms

These models reward participants for validating transactions and aligning their economic interests with the network’s security. Ethereum’s proof-of-stake (PoS) consensus model is one example of an effective incentive mechanism at work on a blockchain.

Flawed Incentive Mechanisms

Poorly designed incentive mechanisms can introduce various security risks, such as:

Collusion: A high concentration of tokens among a few holders increases the risk of collusion and manipulation

Sybil Attacks: Inadequate economic incentives may fail to deter malicious actors from launching attacks on the network. To explain, if you were to reward the same amount of tokens per wallet regardless of the staking amount, then you would run into Sybil issues. If you create a referral program, you will likely run into the same thing.

Designing around these things isn’t easy when trying to distribute a token fairly, but teams that don’t take this part seriously will have a bunch of bots claiming their tokens!

Token Utility

Utility refers to the practical use cases of the token within its ecosystem, such as governance, staking, or transaction fees.

Effective Utility

Governance: Clear and inclusive governance mechanisms allow token holders to influence the project’s direction.

In-App functionality: If a game or metaverse has its own token, it would make sense that items and other functions can be enabled via the token.

Flawed Utility

A flawed utility is not sustainable over time. As an example, there have been auto-staking/ auto-rebasing protocols that promised 1000s of percentage points per year in rewards. One particular example was 482,000% APY per year in rewards. Wen Lambo, right? Wrong! All you need to do is to swap the term ‘APY’ for ‘inflation’ and then you can see the exact problem. These types of utilities will crash the price by +98% within a few months if not a few weeks. 

Conclusion

Tokenomics, the economic structure of a token within its ecosystem, is vital for evaluating the viability and security of blockchain projects. This concept includes elements such as token distribution, supply, and economic incentives, which collectively influence a project’s overall health and functionality. 

Key components of tokenomics involve fair and transparent token distribution, effective incentive mechanisms, and practical utility within the ecosystem. Effective tokenomics foster community engagement and security, while poorly designed tokenomics can lead to centralization, inflation, and security vulnerabilities. 

In conclusion, understanding and analyzing tokenomics is crucial for making informed decisions about the potential and sustainability of blockchain projects, highlighting the importance of well-structured economic models in the evolving landscape of decentralized finance.

This article was written by Intelligence On Chain for Boring Security. Follow IoC on X here, and check out Boring Security’s X account, Discord server, and official website for more information.