Welcome to this week’s newsletter. If you’re considering getting involved with a Web3 project or investing a cryptocurrency, it’s important to understand the mechanics of supply and demand, i.e. tokenomics.
We’re going to cover the factors of supply and demand that determine the price of a token or cryptocurrency. A quick caveat that tokenomics is a fairly complex subject. This is intended to be an introduction rather than a complete guide.
Why is Tokenomics relevant?
Most people are familiar with cryptocurrencies like Bitcoin and Ethereum. But any Web3 project can spin up it’s own token. Last week, we dove into Stepn - a web3 app that pays you to walk or run. Stepn uses a native token called GST. Tokenomics is the mechanism that determines the price and long-term potential of these tokens. It’s important because it will help you evaluate the long-term viability of a cryptocurrency or a web3 project.
Price = Supply & Demand
Price in any market is determined by the supply and demand of a good:
- Left: When demand goes up, price goes up.
- Right: When supply goes down, price goes up.
This is no different when it comes cryptocurrencies and tokens.
Token supply is determined by the creators of most web3 projects. There are three areas to consider when thinking about token supply:
- Market cap
- Inflation or deflation
- Token distribution
1. Market cap
Circulating supply is the total number of tokens that are currently available in the market. For example, there are currently 120m Ethereum tokens circulating at the time of writing this article. The circulating supply multiplied by the current price of the token is called market cap.
Circulating supply alone doesn’t tell you much. Market cap is a signal of liquidity. It can be bought and sold easily. For reference, Ethereum’s market cap is $363 billion at the time of writing. On the other hand, GST (the native token for Stepn) has a market cap of ~$17 million. Stepn is a riskier bet compared to Ethereum.
2. Inflation or deflation
It’s worth looking at how the supply of tokens will change going forward. If everything else remained constant:
Prices fall when supply increases (inflation), and rise when supply decreases (deflation).
Most Web3 projects will publish their proposed inflation or deflation mechanism on their website. For example, Solana’s total supply of tokens is shown in the graph below. The token supply increases at the rate of 8% every year (i.e. annual inflation). The rate of inflation falls by 15% each year until it reaches it stays flat at 1.5%.
3. Token distribution
This refers to how tokens are distributed between various stakeholders like the founding team, community and investors.
Look for projects with a high proportion of community or user ownership.
Helium which is building a decentralised wireless network for devices is distributing 65% (network data transfer + hotspot infrastructure) of tokens to its users.
Large holdings by a single person or entity are generally considered a red flag. This is because tokens often carry voting power, and this means that one entity could determine the outcome of every proposal.
Unlike supply, demand is harder to evaluate. There are a limited number of “objective” datapoints you can look at. But this is also what makes investing in projects fun — you need to form a view of how popular you think that token will be.
4. Return on investment
Every token is ultimately a share of the project. Many tokens will give holders a share of earnings from the project. This is like a dividend from a share. Most projects express this as one of the following:
- Annual percentage return (APR): return on 100 assuming no reinvestment of returns.
- Annual percentage yield (APY): return on 100 assuming reinvestment of returns and therefore compounding.
Coinbase offers the following APR and APY for tokens.
The higher the return on investment, the higher the demand for the token.
However, it’s also important to question whether that return is sustainable. If a token is promising a 20% return over a year, ask yourself whether generating that kind of return is sustainable for the project. Most of the tokens above reward users for staking, a method of verifying transactions on the blockchain.
In any market, it’s important to assess whether the market is speculating a price increase or decrease. This is true for traditional markets, but even more so for Web3 because it has a much higher proportion of retail investors. This often called the “meme” effect, and tokens driven purely by this phenomenon are called meme coins.
For example, $DOGE launched as a “fun” version / joke of Bitcoin. In April 2021, the price of the coin shot up because Elon Musk tweeted support for the coin. The market picked up on this and demand for the coin increased. It has since lost most of its value but is still significantly higher than it was at the start of 2020.
It’s impossible to point to an objective data point, but you can form a qualitative view. Here are some useful questions to ask:
- How are folks talking about the prospect of the project on Twitter or Discord?
- Do users seem like long-term holders or short-term holders who want to make a quick buck?
- Is the current trend in price backed by strong fundamentals?
Investing purely based on market sentiment is risky.
I prefer to treat market sentiment as one of the factors to consider, but not the only one.
6. Token mechanics
It’s important to consider mechanics that might impact the demand for the token. The space is changing fast so it’s impossible to provide an exhaustive list. However, here are 4 important mechanics to consider:
- Staking: once Ethereum moves to its proof-of-stake consensus mechanism, users can stake their tokens to earn rewards.
- Governance: Curve, a decentralised exchange, allows users to lock up their tokens in exchange for the ability to vote on proposals.
- Burning: Luna is a token that is burned (removed from the market) in order to maintain the price of UST (a stable coin pegged to the US dollar).
In the case of staking and governance, users will have less of an incentive to sell because they lose utility. In the case of burning, if the demand of UST goes up more Luna is burned. If everything else was constant, the price of Luna will go up because supply has been reduced (read this if you’re interested).
Ultimately, the forces of demand and supply rule. Whilst some of the concepts are similar to traditional finance, there are 3 key differences:
- More data is available. For example, it’s common practice in Web3 to disclose how token supply is going to change over time. This is not the case for equities.
- Proportion of retail investors is much higher.
- It’s unregulated and therefore more risky.
Tokenomics is a critical topic for builders, investors and users in Web3. It can be overwhelming at times because there is no “right” answer. Looking at a token through the framework above can help you form a thesis on the token before you invest.