The advent of cryptocurrencies introduced a new form of economics called Tokenomics. It is defined as the economics of tokens or cryptocurrencies.
The reason why this is a new and distinct form of economics, is because cryptocurrencies fundamentally behave differently than the government currencies we are used to. In short, cryptocurrencies can be designed to conform to a pre-determined (or changing) set of rules that end up shaping, and defining the value proposition of the coin. In this letter, I’m breaking down the various factors that come into play when evaluating the tokenomics of a cryptocurrency. You may use these factors to determine whether or not a particular cryptocurrency or investment is right for you.
How a coin is governed is arguably one of the most important factors. Why? It is because governance determines whether or not the rules of the coin can ever be changed. The more decentralized the governance, the less likely it is for the rules of the coin to change. In the case of Bitcoin, its rules are considered to be set in stone. Changing Bitcoin’s rules would require hundreds of thousands of participants to agree to and adopt the change, at the same time.
Governance goes on to determine key pieces of cryptocurrencies such as how resistant they are to censorship. We are going to look at two occurrences of an overexertion of power, and how in a different set of circumstances, that same power could be used for doing harm to coin holders.
KuCoin Hack of 2020
Midway through 2020, an exchange called KuCoin was hacked1 to the tune of $200 million dollars. The tokens that were stolen were largely ERC20 tokens, (tokens deployed on the Ethereum network). In the end, about $130 million of the stolen funds were able to be recovered by locking the stolen funds, and re-minting them back into the hands of the KuCoin Exchange.
Now, depending on where you stand on the issue, this can be seen as a big faux pas in the cryptocurrency space. The project administrators for the stolen ERC20 tokens were able to utilize their administrative privileges to freeze the stolen funds, and re-mint an equivalent amount back into the hands of KuCoin. If you’re like me, then you take issue with the fact that these administrative privileges exist at all. These ERC20 tokens are built with the ability to freeze funds, mint funds, and redistribute funds at will.
The project administrators agreed to perform these actions because people had lost money on KuCoin. However, there is really nothing stopping a government or a powerful institution who is compelled to exercise force on these project administrators to take similar action. The point is, the ability to take these actions on behalf of the entire cryptocurrency is antithetical to the entire point of cryptocurrency. To be a form of money that is free from control, censorship, and manipulation. Instead, these ERC20 tokens with admin keys built-in are 100% centralized in their governance, despite being deployed on top of Ethereum, a hypothetically decentralized network2.
The DAO Hack of 2016
The reason why I describe Ethereum as hypothetically decentralized is because of a hack that took place in 2016. There was a project called “The DAO” that had an aim of raising funds, and distributing it to projects. Funders of The DAO would give ETH and receive DAO tokens in return. DAO tokens doubled as voting power on the network, determining where the ETH would later be invested.
The DAO had raised $150 million worth of ETH, and the funds were being stored within the smart contract itself. A clever hacker analyzed the code, and found an exploit that would end up releasing all $150 million worth of ETH from the contract. This is exactly what happened, and it threw the entire Ethereum community into disarray. Shortly after the hack took place, the leaders of Ethereum decided the best course of action would be to rollback the blockchain to a point in time when the hack never took place. “Rolling back” the blockchain means reversing every “immutable” transaction that took place after the hack.
This demonstrated the fact that people still had the power to guide or even steer blockchain networks. It doesn’t exactly matter if there are 10,000 nodes in a network. If the project administrators and coders want to modify the trajectory of the project, they can. Individuals that had a problem with this way of dealing with the hack rebelled against the Ethereum founders, and forked the network into what is now known as Ethereum Classic (ETC). Ethereum Classic is the version of Ethereum wherein the hack was never reversed.
Who Pulls the Strings?
Along the same vein of thought explored earlier, the ability to rollback the blockchain invalidates the idea of decentralization. No one entity, or group of entities should have the ability to do this if we are ever to take seriously the notion that we have a global money that is free from control, manipulation, or censorship. If this manipulation of the network was able to take place by project administrators, then why wouldn’t it be able to take place arbitrarily by court or government order?
In my eyes, the value offering of a cryptocurrency drastically decreases when it is demonstrated that the coin and its network can be manipulated.
2. Supply & Inflation
This factor necessarily depends on the first (governance). If the network is able to be controlled in any way shape or form, then so too can the supply, and the parameters that influence it.
That being said, let’s assume a decentralized governance exists so we can focus on the factors that influence the value offering of the cryptocurrency, as well as the supply.
The questions that makes sense to ask about the supply of any cryptocurrency are as follows.
Is the supply…
flexible (fluctuates over time)
Is the new supply …
inflationary (increasing forever)
deflationary (decreasing forever)
disinflationary (supply increases slower and slower over time, eventually reaching a fixed supply)
algorithmic (supply is algorithmically adjusted based on parameters)
adjudicated (supply is determined unilaterally by a council or government)
The supply of any coin and how new supply is created obviously factors into supply and demand that ultimately determine price. If you can alter supply, then you can control the price. This is what happens when one entity has a monopoly on something.
Supply Regulating Mechanisms
Designers of cryptocurrency have come up with a number of very interesting ways of enticing investors. Whatever factors are built into the coin, end up influencing, at least in part, the decisions of investors in the marketplace. More often than not, the supply of cryptocurrencies are algorithmically adjusted. This simply means that code is ultimately responsible for making changes to the supply of the coin. This is the case with Bitcoin, and very few projects have opted for direct control of supply through adjudication.
There typically needs to be an incentive for anyone to participate in a cryptocurrency. For Bitcoin, there is the block reward. For other cryptocurrencies, you may stake your coins for interest. In most situations, rewards mean that the supply of the coin is increasing.
Burnings is actually one of my more favourite tokenomic strategies built into tokens. I regularly look for cryptocurrencies that are burning their tokens. Burning simply means that a certain amount of tokens are permanently removed from circulation. This decreases the supply, which increases scarcity, which in theory increases demand in the market as people value cryptocurrencies that are more scarce. The best example of a coin that has implemented burning is BNB. They started with 200 million tokens, and will burn a portion of the supply every 3 months until only 100 million tokens remain.
Burning does a couple of things from a tokenomics perspective. It actually incentivizes hoarding (HODLing) out of perceived future value of the coin. In this way, it strengthens the monetary base of any cryptocurrency. We can actually look at Bitcoin, and consider any lost Bitcoin (estimated to be 20%3) to be burned, and permanently removed from circulation. This again, adds to the scarcity, and thus perceived value of Bitcoin.
Rebase / Debase
A rebase4 is when every balance in every wallet holding a token is equally and proportionately altered. For example, a 10:1 rebase would take a wallet with 100 tokens, and alter it so that there is only 10 tokens. Since this is happening to every wallet without exception, all this does is decrease the total supply of the token. Rebases can also work in the opposite direction. A 1:10 rebase would give me 10 new tokens for every token I am currently holding. A wallet with 10 tokens would end up with 100. Token rebases are relatively new to cryptocurrency (Algorand5), but fairly commonplace in the world of government currencies.
A debase6 is where the supply of coins is increased, decreasing the value of all coins in circulation. Debasement goes hand in hand with inflation, or hyperinflation and typically results in ruin for those holding the currency that is debased. One of the biggest differences between a rebase and debase, is where the newly created money ends up. In the case of debasement, it is usually held by a select privileged few at the top of the hierarchy of control.
The Future of Tokenomics
This really is quite a huge topic. We but scratched the surface with what was covered above. Furthermore, there are other economic schemas that are emerging from this new digital era of finance. Memenomics have propelled by WallStreetBets’ TikTok and have thrown Dogecoin and GME (Gamestop) into the stratosphere in a matter of days. Ponzinomics is the economics of ponzi schemes and has been dominating the ICO and DeFi space since 2017. Rest assured we have not seen the end of the road for how new coins are built and designed. I will be covering them as quickly as they come up!
When I am looking for new cryptocurrencies to invest in, I always go through each of these factors in order to determine if there are any glaring red flags I should be aware of. That being said, these factors don’t predict short term price movements. Just look at Dogecoin for example. Terrible tokenomics, and astronomical gains. Since I am a long term investor, I use metrics, and factors that I can rely on. That is, factors that are set in stone, that have no chance of being changed.
I hope these points of analysis will help you guide your cryptocurrency investments.