Token Economics or “Tokenomics” is the topic of understanding a cryptocurrency’s supply and demand characteristics.

First, it is valuable to evaluate the following simple concepts in our traditional economic system to understand how these forces act at play.

Usually used interchangeably, yet both have different meanings and interpretations.

Money supply refers to all the currency and other liquid instruments in a country’s economy. This directly affects the percentage of interest rates in an economy. Change in the money supply is considered a critical factor in driving economic changes in the market. Monetary policy is used to control inflation, price levels, and business cycles. However, governments and private institutions solely determine the incentives to increase or decrease the money supply. This is a worrying prerogative, as the general public has little influence on money circulation. As of now, cryptocurrency is not considered part of the money supply. There are many reasons why this is not the case. Still, understanding that cryptocurrency is decentralized at its core makes it difficult for a government to pinpoint how much crypto its citizens hold.

Governments utilize measures of money to catalog the current monetary supply of a given country based on its liquidity. Each country has different ways to catalog these metrics, ranging from M0 to M5.

Reserve Money M0 =Monetary base of a country’s economy. High-Powered Money

Narrow Measure M1 = Includes all currency (like cash, no cryptocurrencies) in circulation, traveler’s checks, and checkable deposits.

Intermediate Measure M2 = Includes everything in M1 plus all savings deposits, time deposits below 100k USD, and retail money market funds balances.

Broad Measure M3 = Includes everything in M2 and time deposits larger than 100k USD, balances in institutional money market funds, and term repurchase agreements.

The United States Federal Reserve currently publishes the values of Narrow Measure of Money (M1) and Intermediate Measure of Money (M2).

Central banks are in charge of pumping money into the economy. This is done through monetary policy, which influences interest rates, sets bank reserve requirements, and influences open markets. Yet, the intrinsic value of this money is solely attached to a nation’s economic well-being measured by the Gross Domestic Product (GDP).

The value of money is determined by its demand. The same way goods and services are affected by how eager someone is to pay for something.

Money gets its value from three determinants:

Now that we better understand how our traditional economy works, drawing parallels between both ecosystems should be more intuitive. Overall we can make a significant distinction between traditional economics and token economics.

Also called non-feedback and feedback systems are terms usually used in engineering to denote how a system behaves. In economics, you will find externalities at the core of any process. These are unintended outcomes derived from some change. They can be positive or negative. Good examples for negative externalities are inflation from printing more money or air pollution from building a factory.

The traditional economy uses what is called an open-loop system. There is no space for state feedback. The desired outcome — or output, is independent of its input. This means that all monetary policy is created with the current state of the economy as a basis. Yet, the reaction produced in the economy is outside the scope of the policymaker. New policies will have to be drafted to address the problems of a new economic state.

On the other hand, Token economies are a closed-loop system. This means it can be dynamically changed through state feedback. The output is entirely dependent on the input. The input can be altered thanks to feedback and user participation. Here, there is greater control over the desired outcomes of economic policy, which can significantly improve stability long term.

Feedback can be submitted through official channels, by participating in the protocol’s decisions, or even through Decentralized Autonomous Organizations (DAOs)

Now that we can draw a parallel between traditional and token economics, we can start digging deeper into the basic concepts that define how the cryptocurrency ecosystem might be structured. It is essential to define the key factors that drive a cryptocurrency ecosystem.

These terms are both used interchangeably. Yet, some clear distinctions can be made. We must understand why these terms hold different meanings.

This is important as it helps us better understand the value generated in a token ecosystem. A blockchain creates value by including a mechanism aiming to solve a problem. A token generates value by using the existing technology and applying it to different use cases.

Similar to traditional economics, the supply of a cryptocurrency has a direct effect on its price. It is helpful to distinguish three different types of cryptocurrency supply:

Total Supply: Total amount of coins issued, regardless of where they are.

Max Supply: Maximum amount of coins that can ever exist within the ecosystem.

Circulating Supply: The number of coins currently in the market and owned by people.

As in traditional economics, changes in these supply subsets will directly affect the behavior of the markets where the coins reside. At the same time, we realize that the rules for these factors are much more flexible than in traditional finance. It is difficult to think about the maximum supply of the dollar. No defined set of dollars can ever exist in the economy. Yet, cryptocurrencies have the opportunity to decide for themselves if their supply would be unlimited — like fiat, or they want to cap it at a certain number — like bitcoin.

The power to manage supply resides on the mechanisms for distributing the cryptocurrency in question. Bitcoin, for example, uses proof-of-work to mint new coins. Which serves as a distribution and governance mechanism. Other protocols might use decentralized governing bodies to make these decisions democratically or simply leave it to the issuer’s own discretion.

The benefit is straightforward; with thousands of different cryptocurrencies, you find thousands of different mechanisms that can affect its supply. Each has pros and cons, but most are geared towards bringing a solution to traditional finance by utilizing decentralization at its core.

A token can derive its value from different things, but its primary function is to capture economic value from its own ecosystem. They do this by providing incentives and punishments that drive specific behaviors within the system. Tokens all have a shared goal. It can be world remittances like the Stellar blockchain (XLM), becoming a lending and borrowing entity like in Compound (COMP), or creating a storage network like with Filecoin (FIL). In the end, cryptocurrencies get their value from their utility. However, not all tokens are made with utility in mind.

There are many types of tokens and uses cases for them, but we will focus on only these three to have an overall idea of their use cases.

Utility Tokens: Utility tokens are integral for the ecosystem it was built for. These can be used to access features of a specific blockchain or even apps built on top of the blockchain — DAPPs.

Governance Tokens: These are utilized to drive decisions within an organization. A governance token can represent a vote or the stake of a person’s decision-making power within a decentralized entity.

Security Tokens: These are usually created with backing in traditional finance. They act as a more secure investment channel as they represent assets from the real world.

A consensus mechanism — or protocol, allows distributed systems to work together and stay secure. These mechanisms conceal a great deal of the logic utilized behind a blockchain; they are key concepts to understand how supply and demand works, and they set up the rules of an ecosystem. Among the most popular consensus we can find:

Proof-of-Work (PoW): In this protocol, a miner in the blockchain competes with others to create new blocks of information by solving a complex mathematical puzzle. The one that solves it the fastest is rewarded with a freshly minted native token. Then the block is shared in the network to publish transactions or smart contracts. This protocol takes a lot of energy to function, and decision power is in the hands of miners.

Proof-of-Stake (PoS): In PoS, the integrity of the network is maintained by allocating a share of this responsibility to a participant node holding tokens in it. This protocol is much more cost-effective than PoW, but it incentivizes holding tokens long-term to accrue more power within the system.

As of 2022, we can find many more consensus mechanisms available. Each of them tries to solve complex problems or improve consensus protocols already built. There is not an answer on what consensus is best, but understanding the ones where we participate is key to making sure you are safe and sound while participating in a token economy.

We can understand tokenomics as the set of mechanisms and characteristics that define a token-based economic system’s incentives, punishments, and behaviors. These are driven by many factors such as supply, demand, consensus mechanisms, and more.

Our traditional economy is vastly more complex than we can imagine. The forces controlling and shaping them give the everyday citizen little to no power over how its future is shaped. Cryptocurrency, and tokenomics as a practical study, is an opportunity for people to understand the power behind these complex economic ecosystems and participate in them. Like everything new, there are pitfalls in the crypto sphere, but having a basic understanding of what makes a token behave the way it does, will help you distinguish a solid crypto project vs. the next meme coin. Education and cooperation drive us a step closer to financial autonomy, creativity, and overall growth. The economy is changing. Will you?