Tokenomics: What it is and why it's a key driver of a coin's price

Tokenomics is a word that gets thrown around a lot in the cryptocurrency world. But what exactly is it? It's one of the most powerful forces shaping

Tokenomics is a critical factor in determining the future value of a cryptocurrency. It outlines how the cryptocurrency will be managed, including aspects like the total number of coins to be issued, the rate of coin issuance, the possibility of burning coins, and the impact of other factors on the coin's supply.

These elements influence the rate at which new coins enter circulation and whether any coins are removed, ultimately affecting the cryptocurrency's price. For instance, cryptocurrencies often highlight their deflationary tokenomics to support the coin's price.

In 2022, Ethereum shifted from a proof-of-work to a proof-of-stake system, significantly reducing its net issuance in an effort to become deflationary. It also implemented a mechanism to burn coins during transactions, leading many to conclude that its supply is now net deflationary.

Essentially, Ethereum's issuers "rigged" the coin's tokenomics to support its price, enabling it to rise over time but not guaranteeing it. While everyone discusses how a coin's deflationary nature drives up its price, supply is only half the equation; demand ultimately determines a coin's price movements.

There are numerous items in short supply that are nevertheless worthless, like the glasses in your kitchen cabinet. Limited supply is meaningless without demand for an object or a cryptocurrency.

Any cryptocurrency is worthless without demand because its value is solely determined by what people are prepared to pay for it. As a result, out of the 20,000 or more cryptocurrencies in existence, only a small number are actually valuable, and almost all of them are essentially worthless.

However, managing the supply of a popular cryptocurrency—one for which there is already demand—can drive its price higher (or lower) because it encourages traders to buy. They can purchase knowing that the coin's issuers won't overinflate it, which attracts demand and creates a virtuous circle.

These psychological dynamics are crucial for manipulating crypto prices. By increasing enthusiasm for coins with relatively fixed or shrinking supplies, prices can rise indefinitely. So, part of the process involves generating greater enthusiasm around coins with deflationary properties.

Bitcoin, the first cryptocurrency, has well-studied and highly deflationary tokenomics. It famously has a maximum of 21 million coins available for mining, and even that limited issuance slows over time, until the total supply is issued around the year 2140. As issuance slows, Bitcoin mining requires more and more energy and expense.

However, there are other favorable tailwinds for Bitcoin's supply. While 21 million coins is the maximum number of outstanding coins, some estimates suggest that around 3.7 million coins have been lost forever. They may have been purchased early in Bitcoin's life, when coins were cheap and it was a novelty. But if Bitcoin owners discarded hard drives containing these coins, they're likely permanently unavailable and effectively dead. So the real maximum supply is even lower than the potential maximum.

On the supply side, Bitcoin benefits from ever slower issuance and a capped number of coins. But it also benefits from a herding effect as the most popular cryptocurrency, as well as the perception that it’s a scarce resource. On the demand side, Bitcoin analysts keep ratcheting up price targets, driving “Bitcoin fever” ever higher and stoking demand for the coins.

So supply is fixed and demand may continue rising, potentially leading to lollapalooza effects on the price, as it has already for an asset that was created out of thin air. However, if demand dries up for any reason — say, if quantum computing can break the coin’s cryptography and effectively counterfeit coins — Bitcoin’s price could fall to nothing. Again, it’s vital to remember that the only thing supporting Bitcoin’s price is the expectation that someone else will buy it for a higher price.

Bitcoin is backed by nothing by sentiment, unlike stocks, which are backed by the assets and cash flow of an underlying business. So investor beware.