How to Read Tokenomics for Correct Investment

@dshishov

Crypto Lover, Bidsbee CEO & Founder

We all know that before investing in any project, it is important to check its tokenomics. But do you know what exactly to check? Well, of course, you will have a look at the market capitalization of the token, its circulating supply, distribution, and so on. But how can you understand from those numbers and percentages whether the token is good or bad?

Let’s have a look.

Token Distribution

We start with the beginnings: the token distribution. When the token is distributed initially, it is sold and/or given to investors, community, team, and developers; some part of the supply is reserved for a treasury.

Source: https://messari.io/

If you have a look at these examples, you will see that in the case of Ethereum, the biggest part of the tokens went for public sale, and only a small part was given to insiders, foundations, and others. In the case of Solana, a big part of the tokens was given to the insiders, but the community also received a decent share. Celo developers assigned only a small part of the tokens to the public sale; a bigger part went to the Celo community, but the major share belonged to insiders, foundations, and others.

Now, let’s have a look at how it impacts the safety of your investment.

If a disproportional share of tokens is given to early investors, it increases the risks of potential dumps and token price drops. If the team holds a significant share of tokens, it endangers the project decentralization and opens ways to market manipulation. Thus, look for a project with a fair token distribution (the main share of tokens is held by the community and public).

Token Supply and Demand

Here, we distinguish several parameters to have a look at:

• Maximum supply - how many tokens can be issued in total. In deflationary models, not all tokens are issued (mined or minted) from the very start. Over time, more tokens are released until all the tokens are in circulation, and no more new tokens can be created. In inflationary models, the maximum supply doesn’t exist, and new tokens can be released endlessly.
• Circulating supply - the number of tokens that are available in the market

Here is how the token supply impacts the token price.

Source: https://www.reddit.com/

It doesn’t mean that the fewer tokens are available, the better it is because each extreme creates additional dangers and pressures. There shall be a healthy balance between supply and demand for the project to grow.

So why a low supply is bad?

Projects with concentrated supply and low liquidity (low market cap) are more prone to pump-and-dump schemes. The fewer tokens are in circulation, the higher the probability is that a major investor will dump the token and cause its crash. When it comes to the excess of tokens, we have already found out that it lowers the demand and results in the token price plummeting.

Inflationary tokens

Based on the above facts, you may have concluded that inflationary tokens are bad to invest in. However, it depends on the token utility. Take Ethereum, for example. This token is inflationary, but it is used to ensure the operation of the Ethereum blockchain. Considering the number of projects running on the Ethereum blockchain, limiting ETH in supply would mean that, over time, no tokens would be available for projects to ensure their operations. It would be the end of Ethereum.

Therefore, not all inflationary tokens are bad and destined to die. However, when investing in a deflationary model, you need to be double careful and consider the token utility and whether the existence of the token would be reasonable in a deflationary model. If a team chooses an unlimited supply without any obvious reason, it is a bad sign because later, when the token price grows, they can mint plenty of tokens and cash out the liquidity.

Token burns and buyouts

To support demand and supply in an equilibrium, many projects burn tokens periodically or use their reserves to buy tokens out to further burn them or distribute them to stakers. These are the most common ways to reduce the token supply and boost the token price.

In the graph below, you can see how the BNB token behaves after periodic burns. After each burning event, a rally is observed. However, it is important to understand that a rally is not guaranteed, especially if a token has little utility or the project has some flaws.

Token Utility

The token utility is how a token can be used within its ecosystem. For example, a token can be used to access some ecosystem’s functionalities (BAT can be used to pay for the ad space), USDT serves as a mode of payment and stable investment, and similar. Once there is no reason to buy a token, users will stop doing so, and the token will crash.

While tokens without utility are bad for investment, it is better to avoid the other extreme when the token utility is too complex or redundant. Complexity may confuse users and slow down the project adoption thus resulting in the token price drop.

We speak about the redundant utility when the utility of one token overlaps with the utility of the other token within the same ecosystem without any obvious reason. This may be confusing and will diffuse the price of both tokens.

Bottom Line

The crypto realm is still in its early stage of development. This is why it is important to understand that even projects with the best tokenomics can fail. And this is why it is crucial not only to investigate all about the project you are thinking to invest in but also check whether this project can be impacted by external factors such as regulation, and what this impact can be. Finally, when it comes to investing in crypto, my final piece of advice would be very basic: diversify and never invest more than you can afford to lose.