In this article, we understand how the demand and supply of tokens work and how we can analyze these factors to make informed decisions regarding a token’s value.
Tokenomics is a combination of the words “token” and “economics,” and it encompasses all economic aspects of a Web3 project, including supply, demand, and distribution of tokens. A token itself is a unit of digital currency deployed on a blockchain, similar to fiat currencies, with inherent monetary value that makes it tradable. Tokenomics provides a framework for understanding how these digital assets function within their ecosystems, influencing their value and utility.
To put it simply, tokenomics is the blueprint that shapes a token’s potential value. Since supply and demand are the primary factors influencing value, analyzing these elements is essential for designing a sustainable and effective tokenomics model.
Before diving deeper into how supply and demand work in tokenomics, it’s important to establish a foundational understanding by comparing these concepts to those in traditional economics.
In traditional economics, fiat currencies are designed to maintain a stable value (at least theoretically) and have an unlimited supply. Central banks can print more money when needed. According to the law of supply and demand, as the supply of a currency increases, its value or purchasing power tends to decrease, leading to inflation—assuming demand remains constant. In practice, the demand for a currency is influenced by various factors, including economic growth. If an economy grows robustly, the increased money supply can be absorbed without causing excessive inflation.
Central banks and policymakers consider many factors when adjusting the money supply, such as open market operations, adjusting interest rates (which can lower the velocity of money), psychological factors like public trust in the currency and the economy, and the demand for the currency itself (e.g., the US Dollar’s role in international trade).
While the basic principles of supply and demand apply to both fiat currencies and tokens, the implementation and implications are quite different due to the decentralized nature of blockchain technology and the broader use cases that tokens have in a decentralized economy, beyond just serving as a medium of exchange, store of value or unit of account.
In Web3 projects, the supply of tokens is typically predetermined and controlled by smart contracts or algorithmic issuance schedules. This means that the total supply and rate of issuance are usually fixed or follow a specific schedule, making it possible to predict how many tokens will be in circulation at any future point in time. Additionally, token distribution is often programmed to occur according to predefined schedules, which allocate tokens to various stakeholders, such as developers, investors, and users, in a transparent and predictable manner.
The demand for tokens is driven by several factors beyond just their use as a currency. Tokens can serve multiple roles within a decentralized economy, such as governance rights, access to a service or platform, staking rewards, and more. The demand for a particular token depends on its utility, network effects, and market sentiment.
Now that we’ve provided some context on supply and demand in tokenomics, we can delve deeper into the specific factors that influence these dynamics within decentralized economies.
To analyze token supply we will look at a detailed breakdown of the following key components:
The maximum supply of a token refers to the total number of tokens that will ever exist for a particular cryptocurrency. Understanding the maximum supply is essential because it sets the upper limit on the number of tokens that can be created, which directly impacts a token’s scarcity and potential value.
Tokens can either have a limited (capped) or unlimited (uncapped) supply. A limited supply means there is a hard cap on the number of tokens that will ever be minted. For example, Bitcoin has a capped maximum supply of 21 million tokens, ensuring that no more than 21 million Bitcoins will ever be produced. This scarcity creates a deflationary dynamic, potentially increasing the token’s value over time as demand grows.
In contrast, tokens like Ethereum do not have a maximum supply cap, meaning the supply can increase indefinitely. The continuous issuance of new tokens, such as through staking rewards, ensures a steady increase in supply. However, this does not necessarily mean the token cannot appreciate in value. Ethereum’s value is largely derived from its extensive use within its ecosystem, where ETH is used to pay for transaction fees and secure the network. As the Ethereum network expands and more decentralized applications (dApps) are built on it, the demand for ETH can outpace its supply growth, leading to potential value appreciation.
The circulating supply refers to the number of tokens that are currently available for trading and use in the market. It excludes tokens that are locked, reserved, or held by the project team for future use. It is a dynamic metric that can fluctuate due to token emissions, vesting schedules, or token burns. The circulating supply is a critical factor in determining a token’s liquidity and market capitalization, which is calculated by multiplying the current token price by the circulating supply.
For tokens like Bitcoin, which are positioned as a store of value, a gradually increasing circulating supply can create scarcity and drive demand. The controlled issuance of new tokens through mining or staking rewards helps maintain a balance between supply and demand.
For utility tokens used within decentralized applications (dApps) to pay for services, such as ETH for Ethereum or LINK for Chainlink, a higher circulating supply is often beneficial. It ensures sufficient tokens are available for transactions and services, supporting the overall functionality of the ecosystem.
It is important to note that initial circulating supply should be sufficient to enable smooth trading on exchanges without causing high slippage costs. High slippage occurs when large trades impact the token’s price due to insufficient liquidity. Additionally, a higher circulating supply can establish a larger float, ensuring more accurate price discovery and reducing the likelihood of price manipulation and volatility. Therefore, a low circulating supply, especially at launch, is often indicative of poorly designed tokenomics.
Token supply models in the cryptocurrency space generally fall into two broad categories: inflationary and deflationary. These models determine how a token’s supply changes over time, impacting its scarcity, value, and utility. Let’s explore each of these models in detail to understand their mechanisms and implications.
An inflationary supply model is characterized by an increasing number of tokens over time. In this model, new tokens are regularly added to the circulating supply, either at a constant or decreasing rate. Technically, most of the so-called inflationary token models seen today are actually disinflationary, meaning the number of tokens increases at a decreasing rate. A true inflationary model is one where the total supply of tokens increases indefinitely at a constant or accelerating rate, as seen with memecoins like Dogecoin (DOGE), which has no maximum supply cap and continuously issues new tokens through mining.
However, when discussing inflationary models in the context of this article, we refer to disinflationary models where tokens are added to the circulating supply at a decreasing rate over time. For example, the native token of Curve Finance, CRV, has a fixed supply of 3.03 billion tokens. Most of these tokens are allocated to the community as liquidity incentives on the platform. The emission rate of CRV tokens reduces by a factor of 21/4 every 365 days, meaning that token emissions can continue for 245 years before the total supply is exhausted. This shows that while the supply of CRV increases each year, it does so at a decreasing rate.
Source: https://dao.curve.fi/releaseschedule
For inflationary supply models to maintain or increase their price despite the growing supply, there must be a constant or increasing demand. For instance, CRV primarily functions as a governance and incentive token for Curve Finance users and is not specifically designed to be a store of value or an investment that appreciates over time. The primary benefit of holding CRV comes from its use on the platform, rather than from holding it in anticipation of price appreciation.
In contrast, deflationary supply token models involve reducing the amount of circulating tokens over time, typically through token burns. Burning tokens involves moving them out of circulation permanently. Several methods are used to implement burns in decentralized token economies. For example, in a Proof of Stake (PoS) consensus mechanism like Ethereum, validators can have a portion of their stake “slashed” (burned) if they act dishonestly. Additionally, a portion of the gas fees paid for transactions on the Ethereum network is burned, reducing the overall supply of ETH. This means that even though Ethereum has an inflationary aspect due to continuous token issuance, it also incorporates deflationary mechanisms to counterbalance this.
Some protocols also use their revenue to buy back and burn their native tokens, further reducing the circulating supply. Binance, for instance, utilizes 20% of its quarterly revenue to buy back and burn BNB tokens. This strategy helps control the increasing supply by regularly removing tokens from circulation, creating a deflationary pressure that can support the token’s price over time.
Source: https://www.bnbburn.info/
Another important consideration when analyzing the supply side is understanding how tokens are allocated and distributed among different stakeholders within the network. Token allocation typically follows various project-specific categories or “buckets,” such as public and private investors, development teams and founders, network users, protocol treasury, and liquidity pools. These allocations are determined based on the specific objectives the token aims to achieve within its ecosystem.
For example, the allocation strategy for a project like Curve Finance primarily focuses on incentivizing liquidity. A significant portion of Curve’s token supply is designated for liquidity mining emissions to incentivize community participation. This is because Curve Finance’s primary objective is to bootstrap liquidity on its platform, enabling it to offer low-cost trades to its users. By allocating a large number of tokens for liquidity mining, Curve ensures that there is enough liquidity on the platform to facilitate smooth and cost-effective trading, which aligns with its goal of being a leading decentralized exchange for stablecoin trading.
Source: https://resources.curve.fi/crv-token/supply-distribution/#total-supply-allocation
The allocation of tokens is crucial because it determines which stakeholders, such as investors, team members, and users, hold the tokens and influences their behavior and incentives. Different stakeholders have varying motivations and may react differently to market events. For example, if a significant portion of tokens is allocated to investors, there is a risk that they might sell off (“dump”) their tokens when the price increases, potentially leading to market instability. Similarly, if the founding team or developers hold a large share of the tokens, they could potentially sell their holdings, negatively impacting the token’s price and reducing the value for other holders.
To mitigate these risks, projects should carefully plan and communicate their token allocation strategy, including development costs and team allocations, before launching a token. This transparency helps build trust within the community and aligns the interests of all stakeholders.
The allocation strategy must be complemented by a robust distribution strategy. Tokens allocated to different stakeholders, such as investors, team members, and users, should be subject to appropriate vesting periods and cliffs to ensure the project has enough time to develop and accumulate value. Proper vesting schedules help prevent large quantities of tokens from being sold off immediately, which could lead to significant price volatility and undermine the token’s long-term value.
For example, many successful projects today, like Polkadot (DOT), use a one-year cliff for team and investor tokens, followed by a linear vesting schedule over three to six years. This approach ensures that a large amount of tokens are not released into the market immediately, allowing the project time to establish itself and build a strong community and user base. This time frame has generally been effective in allowing projects to gain traction and stabilize in the market.
However, there is no one-size-fits-all rule for distribution strategies. The key is to balance token demand and supply to ensure that, when tokens are unlocked, there is sufficient liquidity and positive market sentiment to absorb the new supply.
Analyzing token demand is more complex than analyzing token supply because it involves understanding the broader Web3 landscape and the specific use cases of a project. In essence, analyzing token demand involves identifying the reasons why people would want to buy and hold the token—whether for accessing services, participating in governance, or utilizing other utilities within the project’s ecosystem.
The core of token demand comes from the problem the project aims to solve and the value the token provides to its users. This can include various utilities such as paying for transaction fees, accessing premium features, or having voting rights in a decentralized autonomous organization (DAO).
Let’s explore how some of the most popular and proven utilities in the market effectively drive demand for tokens.
At its core, staking involves depositing tokens into a smart contract to earn yield. These deposits can either be time-locked or flexible, depending on the staking mechanism in use. Staking generates demand for a token by incentivizing users to purchase and lock up their tokens in exchange for rewards, participation in governance, or contributing to network security.
For example, in Ethereum’s Proof of Stake (PoS) consensus mechanism, validators are required to stake Ether (ETH) to validate transactions on the network. In return, they earn transaction fees and newly minted ETH as rewards. Regular users who wish to stake can buy ETH from the market and delegate their tokens to validators, allowing them to earn additional yield. Alternatively, users can utilize liquid staking platforms like Lido Finance, which enables them to stake their ETH while maintaining liquidity, earning yield without locking their tokens.
This staking activity effectively removes ETH from the market, creating a sense of scarcity. If demand remains steady or increases, the reduced supply can lead to upward price pressure. As of now, there are approximately 34 million ETH staked, valued collectively at over $90 billion, representing about 28% of ETH’s market capitalization.
Source: CryptoQuant
Many DeFi protocols offer various staking mechanisms to generate yield for their investors. Given that most DeFi users are quite sophisticated, the decision to choose one protocol over another often hinges on the yield percentage being offered. Therefore, when assessing the demand for a token that provides utility through staking or yield farming, it is crucial to consider the competitive yields available in the market. Users are likely to migrate from one protocol to another in search of better returns, so understanding the yield dynamics and how they compare across different platforms is key to evaluating the token’s potential demand.
Tokens can function as access rights, allowing users to access specific services by paying with the platform’s native token. For example, on the Ethereum network, users must use ETH to pay for gas fees when conducting transactions, deploying smart contracts, or interacting with decentralized applications. The cumulative amount of fees collected by the network can serve as a strong indicator of demand for the token. This principle applies not only to Ethereum but also to other Layer 1 blockchains that require their native tokens for transaction fees, such as Binance Smart Chain (BNB) or Solana (SOL).
In the realm of play-to-earn games, native tokens often serve as access tokens, allowing players to purchase NFTs and participate in various in-game activities. For instance, in Decentraland, the MANA token is used to buy virtual land, goods, and services within the virtual world, driving demand for the token based on the platform’s user engagement and transaction volume.
Moreover, many tokens also provide governance rights, enabling holders to vote on project proposals and participate in protocol governance. Examples include Uniswap (UNI), SushiSwap (SUSHI), and Jupiter (JUP). In these cases, demand can be gauged by examining the platform’s usage metrics, transaction volumes, and active participation in governance activities.
Understanding demand for tokens involves analyzing both primary and secondary markets. The primary market reflects the fundamental use of tokens within their native ecosystem—which we already covered. A significant portion of demand in the crypto space also comes from the secondary market, where prices are heavily influenced by market sentiment. Market sentiment encompasses the emotions, perceptions, and reactions of investors to various factors, including news, media coverage, and regulatory developments, which can dramatically affect demand and price volatility.
Market sentiment can significantly drive demand for tokens. Even the most robust tokenomics and utility-based demand can be swayed by the broader market’s mood. Positive sentiment, fueled by factors like influential endorsements, favorable media coverage, or bullish market trends, can increase demand as investors flock to buy tokens, anticipating price appreciation. Conversely, negative sentiment, driven by regulatory crackdowns, negative news, or general market downturns, can decrease demand as investors sell off tokens to avoid losses.
To analyze speculative demand driven by market sentiment, several methods and tools can be used:
Platforms like Twitter, Reddit, and Telegram play a critical role in shaping market sentiment in the crypto space. Analyzing trends, influencer opinions, and community discussions on these platforms can provide insights into the prevailing sentiment around a particular token.
Tools like Glassnode, Santiment, and Nansen offer on-chain analytics that track transaction volumes, wallet activity, and trading patterns. A sudden spike in transactions or large movements by whale addresses (addresses holding large amounts of a cryptocurrency) can indicate changes in market sentiment.
For short-term speculative demand, technical analysis (TA) is crucial. It involves studying price charts, identifying patterns, and using indicators such as Moving Averages, Relative Strength Index (RSI), and Bollinger Bands to predict price movements based on historical data and market behavior.
Understanding broader market trends, such as bull and bear cycles, can also help gauge speculative demand. For example, in a bull market, sentiment is generally positive, and demand for tokens may increase as prices rise. Conversely, in a bear market, sentiment is often negative, and demand may decrease as prices fall.
To accurately analyze supply and demand in tokenomics, it is crucial to consider both the primary and secondary factors influencing a token’s value.
Token supply analysis involves understanding key metrics like maximum supply, circulating supply, and inflationary or deflationary models, all of which impact a token’s scarcity and market dynamics.
Demand analysis, however, is more complex and requires a deep dive into the token’s utilities, such as governance rights, staking rewards, and access to platform services. The demand is not solely based on the token’s inherent utility but also heavily influenced by market sentiment and speculative behavior.
The collapse of the Terra ecosystem serves as a cautionary tale of the consequences when demand is artificially inflated and not supported by sustainable supply models. At its peak, LUNA had high demand driven by attractive yields from protocols like Anchor, but an imbalance due to excessive token minting without proper reserves led to its dramatic downfall. This underscores the importance of a balanced approach in tokenomics, where both supply and demand are carefully managed to ensure stability and long-term value.
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