Tokenomics 101: How to Differentiate Good & Bad Crypto

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Tokenomics is a combination of the words “token” and “economics.” It is the study of how tokens are designed, distributed, and used within a blockchain ecosystem. Tokens are digital assets that can be used to pay for goods and services, to provide access to resources, or to represent ownership of assets.

Why is Tokenomics Important?

Tokenomics is important because it can have a significant impact on the success or failure of a blockchain project. Well-designed tokenomics can create a sustainable economy that is powered by natural supply and demand, thus enhancing the value of the underlying token and creating a virtuous circle of continuous users and investors.

On the flip side, poorly designed tokenomics is like a recipe for disaster. It’s the tragic tale of inflation, deflation, and other nightmares that can turn a blockchain project into a sinking ship. Remember the Terra-Luna crash? That’s the cautionary tale we’ll be diving into later.

How to Evaluate Tokenomics (and Seven Tell-Tale Signs of Bad Tokenomics)

Knowing if a crypto project has good tokenomics is supremely important because it can affect the value of your investment–if a project has good tokenomics, its token will more likely appreciate in value over time, and if it has bad tokenomics, its token might appreciate, but never for long before it comes crashing down.

So what are we referring to when we talk about the “tokenomics” of a project? When evaluating the tokenomics of a blockchain project, it is important to consider a number of factors, including:

• The token’s supply: Will the token be scarce or inflationary?
• The token’s distribution: How are the tokens distributed to users and investors?
• The token’s utility: Does the token have a real use case?
• The tokenomics model: Is the tokenomics model sustainable in the long term? Some common tokenomics models include:

Proof-of-work (PoW): Miners earn tokens by solving cryptographic puzzles

Proof-of-stake (PoS): Token holders earn tokens by staking their tokens.

Utility tokens: Tokens are used to pay for goods and services within the blockchain ecosystem.

Governance tokens: Tokens give holders the right to vote on decisions about the development of the blockchain ecosystem.

Let’s expand on these.

Poor tokenomics can be a major red flag for crypto projects, and it’s crucial for investors to be aware of these potential warning signs. Here are some tell-tale signs of poor tokenomics in a crypto project:

1. Unrealistic or unsustainable token economics: Projects that promise unrealistic returns or have tokenomics models that seem unsustainable are often too good to be true. Be wary of projects that offer extremely high yields or make claims about the token’s value that don’t align with its actual utility.
2. Over-reliance on a single mechanism: Projects that rely heavily on a single mechanism to maintain their token’s value, such as an algorithmic stablecoin that depends solely on arbitrage, are more vulnerable to failure. Diversification in tokenomics is essential for resilience.
3. Pre-mined or large insider holdings: Projects with significant pre-mined tokens or large insider holdings raise concerns about potential conflicts of interest and unfair distribution. A fair and transparent token distribution is essential for a project’s long-term success.
4. Unclear token utility: Projects that lack a clear and compelling use case for their tokens are less likely to attract users and sustain value. A token’s utility should be directly tied to the project’s core functionality and value proposition.
5. Lack of community engagement and governance: Projects that lack active community engagement and governance mechanisms raise concerns about centralization and decision-making transparency. A strong community is often a key driver of project success and sustainability.
6. Frequent changes to tokenomics: Projects that frequently make changes to their tokenomics without clear justifications or community consensus indicate instability and potential mismanagement. Consistent and well-defined tokenomics are essential for long-term stability.
7. Overly complex or convoluted tokenomics: Tokenomics models that are overly complex or difficult to understand can be a sign of poor design or potential hidden risks. Simplicity and transparency are key for investor confidence.

The One About The Terra-Luna Collapse

A portrait of bad tokenomics; price history of the Terra Classic token (Source: CoinMarketCap)

The TerraUSD (UST) stablecoin and its native cryptocurrency Luna (LUNA) were once among the most popular and successful projects in the crypto space. However, in May 2022, the UST peg to the US dollar broke, and both UST and LUNA prices plummeted to near zero, causing a major disruption in the crypto market.

Several factors contributed to the collapse of UST, but poor tokenomics was a major underlying cause. The UST peg was maintained through an algorithmic mechanism that relied on arbitrage between UST and LUNA. This mechanism was inherently risky, and it was ultimately unable to withstand a period of sustained selling pressure.

Perhaps the biggest tokenomics flaw that contributed to the collapse of UST was its over-reliance on the Anchor Protocol. The Anchor Protocol, a DeFi platform on the Terra blockchain, offered a high yield of 20% APY on UST deposits. This high yield attracted a large amount of capital to UST, but it also created a significant risk for the UST peg. If UST holders lost confidence in the peg, they could quickly withdraw their UST from Anchor and sell it for US dollars, causing a downward spiral in the UST price. And this was exactly what happened.

The collapse of UST highlighted the danger of a risky algorithmic mechanism, the overconcentration of power in the Anchor Protocol, and the lack of transparency all contributed to the UST peg breaking and the subsequent collapse of UST and LUNA.

Conclusion

Tokenomics is a complex subject, but it is an important one to understand for anyone who is interested in investing in or using blockchain projects. By understanding the key elements of tokenomics, you can make more informed decisions about the projects you support so that you do not make unnecessary losses on your investments.