Bitcoin supporters often cite its hard-capped supply of 21 million units as a reason to be bullish. They believe this constraint helps protect it from inflation and will make it more valuable in the long run.
On the flip side, skeptics don't believe that a hard-capped supply alone is enough to warrant a bullish outlook. Moreover, not every cryptocurrency has this feature.
So is a hard-capped supply really that important? And what other attributes should investors be aware of when evaluating a cryptocurrency? Let's explore these questions through the lens of tokenomics.
What is tokenomics?
Tokenomics is the study of how a cryptocurrency or NFT's supply is structured. Crypto investors can use it as a tool to help evaluate whether a cryptocurrency's price is likely to go up or down over time.
In crypto discussions, you may come across the idea that a specific cryptocurrency's tokenomics are "good" or "bad." Some crypto investors might look to buy coins with favorable tokenomics because it could mean they have a higher chance of appreciating in value.
Note that tokenomics is not the only factor that can impact price. A cryptocurrency could have favorable tokenomics but still collapse because it fails to generate demand, gets banned by regulators, turns out to be a scam, or loses value due to other factors.
How does tokenomics work?
Tokenomics consists of multiple metrics. Investors may look at as many metrics as possible, or just a few, depending on their strategy. Below are some fundamental ones commonly used by crypto investors. Note that this list is not exhaustive.
The basics of supply
Like many other markets, the quantity of supply can impact a cryptocurrency's price. Many crypto investors believe that too much supply, for example, can dilute a cryptocurrency's value, potentially leading to lower prices.
There are a few foundational terms to know when evaluating a cryptocurrency's supply.
- Maximum supply: The total number of coins that will ever exist. This varies according to each cryptocurrency. For example, Bitcoin has a hard cap of 21 million units (as determined by its pseudonymous creator Satoshi Nakamoto), whereas Ethereum's development team chose not to set a hard cap on maximum supply.
Many crypto investors think that coins with infinite supplies (i.e., no maximum supply) are more prone to inflation. In light of this, some crypto investors prefer cryptocurrencies with limited maximum supplies. However, others believe that cryptocurrencies with infinite supplies can still be valuable if they implement mechanisms like burning, which we'll talk about later.
Note that skeptics might suggest that the supply of a cryptocurrency is less important compared to its demand and utility, among other factors.
- Total supply: The total number of coins that exist at this moment. One way to understand this is through the lens of bitcoin. The last bitcoin is expected to come into existence after it's mined around the year 2140. So while it has a maximum supply of 21 million, not all 21 million units exist right now. As of early 2024, the total amount in circulation is above 19 million.
Total supply can help investors figure out how much new supply is still to come.
- Circulating supply: The actual number of coins out of the total supply that can be traded or held by the public. This metric can be important because not all coins in the total supply are available to everyone. Some may be staked , reserved for early investors, or set aside for special purposes by the development team. In light of this, a cryptocurrency's total value is usually calculated with circulating supply, rather than total supply, as you'll see below.
- Market cap: The cryptocurrency's total value. This is calculated by multiplying the circulating supply by the coin's current price. Cryptocurrencies are typically split into 3 categories by market cap: large caps, mid caps, and small caps. As of early 2024, coins with a market cap of over $10 billion like bitcoin and ethereum are generally considered large caps, those from $1 billion to $10 billion are classified as mid caps, and those below $1 billion are considered small caps.
Some crypto investors looking for high growth may gravitate toward small and medium-cap cryptocurrencies, while those who prioritize stability may prefer large caps.
- Fully diluted market cap: This metric is calculated based on the maximum supply. In simple terms: maximum supply multiplied by the coin's current price.
Crypto investors may use this metric to get a sense of what the market would look like if all the coins in existence were circulated.
One way to research these metrics is to use coinmarketcap.com
Burning mechanisms
Some cryptocurrencies—especially those with infinite supply—use a burning mechanism to help control inflation of supply. "Burning" is a mechanism that essentially deletes units of cryptocurrencies, removing them from circulation and lowering the total supply.
One example of this is Ethereum, which does not have a maximum supply. The Ethereum algorithm burns a portion of its transaction fees (remember that sending ethereum requires a fee). In other words, every time someone sends ethereum, a portion of the total supply of ethereum is destroyed. The network can burn coins at a higher rate than new ones are created, which can at times make its supply deflationary despite its infinite supply. You can track its metrics at ultrasound.money.
Many crypto investors believe a strong burning mechanism is vital for controlling inflation of supply if a cryptocurrency has infinite supply.
Ownership distribution and vesting
Crypto investors may also pay attention to a cryptocurrency's ownership distribution.
Development teams may set aside a certain number of coins for themselves or for early investors (often institutions that provided funding, such as venture capitalists). Ownership distributions break down how much of the supply is reserved in this manner, providing context on how much control insiders may have.
If a development team has given coins to themselves or early investors, there may also be a vesting period. This is where the owners of these coins are not allowed to sell their assets before a predetermined date. One of the goals of implementing a vesting period is to prevent insiders from selling their coins too quickly, a move that may cause the price to plummet. This is also known as a "rug pull."
Mining and staking
Both mining and staking can increase a cryptocurrency's supply. Many cryptocurrencies pay miners in newly created coins (a process called "issuance") for validating transactions and minting new blocks to their blockchain, or pay stakers in newly created coins for similar processes.
Investors may want to research how a cryptocurrency's mining or staking rewards are structured before buying. One consideration to note is that issuing too many new coins too quickly has the potential to negatively affect price (if supply outpaces demand). Bitcoin's pseudonymous founder Satoshi Nakamoto attempted to navigate this problem by implementing halvings, which periodically decrease the rate at which new bitcoin is released into supply.
Why is tokenomics important?
Tokenomics is important because the price of a cryptocurrency is impacted by the laws of supply and demand. Many crypto investors think that too much supply can negatively impact a coin's price. On the flip side, too little supply can also be undesirable if most of it is held by a small group of people. Tokenomics may help crypto investors assess these factors.
It's worth reiterating that a coin's price isn't guaranteed to go up just because it meets certain tokenomics metrics, as tokenomics is not the only factor that impacts price. A cryptocurrency could have all the right supply qualities but still collapse because it fails to generate interest, gets banned by regulators, turns out to be a scam, or loses value due to other factors. Investors should remember that crypto is highly volatile, has an uncertain regulatory environment, and may be more susceptible to market manipulation than securities.
Since crypto holders don't benefit from the same regulatory protections applicable to registered securities, and holdings aren't insured by the Federal Deposit Insurance Corporation or the Securities Investor Protection Corporation, you should only buy crypto with an amount you're willing to lose.