Investing in DeFi Projects | Tokenomics
Imagine buying a token waiting patiently for a pump, probably a 3x or 10x and all you get at the end is rug pulls, ponzi schemes, and pump and dump tokens.
This is what happens when you don’t understand tokenomics,you will make bad investments and eventually run into a loss. Not to worry about that,in this article I will be talking about tokenomics and important metrics to take note of before investing.
Let’s start with the definition.
What is tokenomics?
It simply means the economics of tokens. Let’s know what a token means first. A token is a type of cryptocurrency that represents a specific use in a Blockchain.
Tokenomics is the study of the various qualities that affect the supply and demand of a token. It is implemented via code by the developers of the project and can be found in the whitepaper of a project. If you can’t find the tokenomics in the whitepaper that’s the first red flag ❌❌.
A good structure in the tokenomics of a project will generate more value in the later future. Let’s look at some of the elements of tokenomics.
The reason a token was created is an important factor in the decision of choice of token. It is what drives demand for it. There are different reasons a token is created for;
- Payment of gas fees.
- Trading discounts.
- Security such as staking to secure the consensus mechanism.
- Generate revenue such as ICOs ( Initial coin offerings) and IDOs (Initial DEX offerings).
Before investing, check what the project hopes to solve. Is the need something the public has been earnest waiting for? or is it just any other common solution.
I’ll use BTC as an example.
In 2008, During the financial crisis Satoshi saw a problem with financial institutions. He wanted to bring back financial power to the hands of the average person. Bitcoin (also known as digital gold) came as a solution to the economic problems caused by lending rates and cheap credits.
Bitcoin’s use case is a unique one and is one of the factors why it’s still the largest cryptocurrency 13 years later.
TOKEN’S SUPPLY AND DEMAND
The supply of a token is the total number of token that exists on the blockchain. When a project launches, the team members decide how the supply is structured and how many tokens they are going to create. There are models of supply a token can have;
- Inflationary: in this case the supply of the token is not fixed. The developers can mint new tokens at will hereby increasing the supply of the token in the marketplace. Dogechain and Polkadot are inflationary tokens.
- Deflationary: Here the supply of a token is fixed and will decrease over time. There are different ways a project can decrease the supply but I will talk more on that in token burn. Examples of tokens that are deflationary are BNB, BTC, CAKE e.t.c
These models have an effect on how the token is valued. In an inflationary model; it’s perceived that the token won’t increase in price and can’t be profitable in the long run as there’s always excess supply. The more supply a token has, the less demand for it as there’s enough to go around for everyone.
Deflationary model tokens are generally profitable as constant burning or reducing the supply of the token leads to scarcity and more demand thereby increasing the price and being profitable in the long run.
NB: This doesn’t mean a token with unlimited supply is not profitable to invest in. Its supply is just one factor, there are metrics to consider before making a decision.
TOKEN INITIAL DISTRIBUTION
Token distribution is an important factor in tokenomics. It’s the percentage of tokens allocated to team members, communities, investors. Considering a project to invest in? Check the amount of tokens given to each sect; when investors are holding more than 40–60% of the supply. This is a red flag because investors can choose to sell off at any time which will bring about tanking the price of the token. A minimal amount to VCs is considered profitable and better.
Community is the bedrock of every successful project in Web 3. There needs to be a good % given to finance community projects like Hackathons, Grants and Social projects.
A project that has its community at heart will make sure there are enough funds to make that happen.
TOKEN INCENTIVE MECHANISM
Incentive mechanisms are systems built in place for users for interacting with protocols or blockchains. You can get rewards by staking tokens, providing liquidity to liquidity pools.
When compared to traditional financial institutions, interest rates in most protocols are appealing and almost unbelievable, but caution must be exercised if they are exorbitant. It’s a red flag if the Annual Percentage rate of a token is over 400%.
However, Long term Sustainability is what every project would want to achieve, if there are outrageous interest rates there’s a 90% chance it’s a ponzi token.
A way to keep inflation in check in crypto economics is to reduce the availability of the token. This is achieved by token burns.
Token burn is the withdrawal of crypto tokens by sending them to a burner wallet where they can’t be retrieved. This creates a scarcity mentality for users making them buy more of the tokens which in turn increases the price of a token.
There are various ways to burn tokens; manually sending the tokens to a burner wallet to which no one has access to its private keys making it inaccessible or a “burn function” written in the smart contract that issues the token.
Binance’s BNB started with a total supply of 200 million and is currently at 165 million. They adopted the token burn method to reduce the supply and have plans of doing so till it gets to half the total supply.
You should now have a fundamental grasp of tokenomics and be able to include it on your investment checklists. Tokenomics by itself cannot complete the task. There are metrics like Technical Analysis, sentiment analysis, and others. I hope you learned something new about investing. Share this article to keep others informed.
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