How to analyze the Tokenomics of a project? 

The recent rally in financial markets has given a glimmer of hope to the cryptocurrency ecosystem. Even so, we have learned throughout our training in cryptocurrencies that these rallies do not indicate that the bear market has just ended and that we are going straight to breaking all-time highs. At the same time, with the beginning of a new year also come the first launches of new projects. So we thought it would be best to prepare for this wave of new launches with cryptocurrency training on how to analyze a project's tokenomics.

What is this about tokenomics? 

Well, let's start this training in cryptocurrencies by first defining what tokenomics are. The word tokenomics refers to the study of the economics of cryptocurrencies and tokens, hence the derivation of its word “Token” and “Economics”. This allows investors to determine the quality and value of potential investments that can be made in certain projects, from the number of tokens issued, the distribution among investors, their unlocking periods, purpose... Now we will see, but first of all We are going to differentiate a token from a currency, which may seem the same and are not.

What is the difference between a token and a coin in cryptocurrency? 

While both terms are often used synonymously, they are totally different. The term currency generally refers to a cryptocurrency that runs on a layer 1 blockchain, that is, from its own. The term "token", however, can have different meanings:

• It can refer to a cryptographic asset created by a layer 2 protocol and must comply with the rules of the base blockchain you are using. For example, ERC 20 tokens, ERC 721 NFT tokens.
• More generally, any crypto asset can also be called a token. Tokens have functions such as enabling votes or acting as digital representations of real-world assets.
• A token can also be used as a payment within the protocol. While a token is not generally recognized as money, its value depends on how the overall project is performing.

How do we differentiate an L1 from an L2?  

Another issue that we must take into account when analyzing a project is whether it has devised a new blockchain or has been built on top of another. Let's start by taking a closer look at the layers of a blockchain because it is important for your cryptocurrency education that you understand these concepts. The first thing we need to know is whether a coin or token runs on layer 1 (L1 or Layer 1) or layer 2 (L2 or Layer 2). An L1 blockchain runs independently of other blockchains, examples of L1 tokens are ETH on Ethereum, AVAX on Avalanche, MATIC on Polygon, etc. An L2 solution is a third-party protocol that is based on a layer 1 blockchain system. For example, the Maker protocol is based on Ethereum. It is an L2 protocol, so MKR and DAI are L2 tokens. L1 blockchains and L2 protocols affect each other. If the L1 blockchain provides easy-to-use, fast and secure infrastructure, it will attract more L2 projects. If the L2 projects are performing well, it has positive effects on the L1, increasing the value of the L1 cryptocurrency. 

How can we investigate the ecosystem of a blockchain?️

It is clear that there is a lot of dependence between different cryptocurrencies and tokens. It is important to get as complete an overview of these correlations as possible so we can stay ahead of them and take advantage. What we are initially looking for is a blockchain ecosystem that shows potential for future growth. That tells us that there is a robust layer 1 blockchain that hosts multiple layer 2 applications that offer good use cases and has user traffic. To understand the ecosystem of a blockchain, we can search on portals such as I Coinmarketcap.co o Coingecko.

On the home page, you can find categories that you can view, but we can also search for the name of an L1 blockchain and search its ecosystem. Coinmarketcap will show us a list of all the projects that are in some way linked to the selected blockchain. From the list, you can choose individual projects and access more information such as market data, charts, news, links to other sources, etc.

Overview of decentralized finance (DeFi) for each blockchain. 

If we want to visualize, for example, projects that are part of the decentralized finance (DeFi) ecosystem, we can look at Defillama to look at the projects that make up the ecosystem of each blockchain. This can give us a clearer vision of what can really be built within a cryptocurrency ecosystem. Why do I mention this? Because there are some blockchains like TRON (TRX) that have a very large market capitalization and total value locked (TVL, we will explain below). 

But these values ​​are deceptive at first glance, given that nothing has been built within the TRON blockchain, except for an algorithmic stablecoin that has lost parity with the dollar for months and is only used to carry out USDT transactions for the low cost of gas fees on the TRON blockchain. It is also an indication of value to see which blockchains it has been deployed on, given that the more blockchains that are available, the more trading volume it provides to the protocol. This in turn generates more organic user traffic, in turn providing more reach to the project itself. 

Is it an original blockchain or a forked blockchain? 

What you should also consider in this context is whether a blockchain is original or forked. For example, Ethereum Classic is a fork of Ethereum. Litecoin and Bitcoin Cash are forks of the Bitcoin blockchain. It is important to know what modifications the forked blockchain made to understand how it is better or worse than the original blockchain. For example, Bitcoin Cash will never have as many users as Bitcoin. 

However, Binance Smart Chain (BSC) is a successful fork of the Go Ethereum protocol but with a different consensus mechanism. It should be noted that these forks can be completely separated from the source blockchain (just as Bitcoin Cash did with Bitcoin Core), better known as hard forks, or if improvements have been implemented in the code but respecting the original ( soft fork in English). 

Users/Active users.    

One of the fundamental metrics for our cryptocurrency training on tokenomics analysis is the number of users on the blockchain. This is because a large number of addresses available on a blockchain means that it has a lot of use and, consequently, has more trading volume. 

At the same time, it also allows the protocol in question to generate more income by charging commissions for using its network. Although the number of total users must be taken into account versus the number of active users, since a blockchain can have many registered addresses but have few active ones, which translates into low commercial activity and less income. 

Protocol revenues. 

Another of the determining factors to analyze the tokenomics of a project is to look at the protocol's income. Within this income we must evaluate different metrics, such as the volume of commissions, income of different terms (annualized or monthly) or ratios such as the P/S (market capitalization/annual income) or the P/F (market capitalization/ commission income). The importance of analyzing the income of a protocol is fundamental, since it will reveal the possible path that the project will take during the following months.

What should we analyze in a token? 

Once we have seen all the basic information on how to analyze a blockchain, we are going to go into depth about the types of tokens that we can find in the cryptocurrency ecosystem, a very important part of our training in cryptocurrencies:

Utility tokens vs. security tokens.  The purpose of a token is essential. For example, holders can use tokens as payments, to cover transaction costs, allow access to services, lock their assets (PoS) or for governance of a protocol through votes. A utility token usually has specific use cases. For example, some tokens allow the user to access a product or service on the blockchain. Others give the user the right to vote (governance tokens), as we can see in Decentralized Autonomous Organizations (DAO). For example, members of the Investment Training LAO (FiLAO) must vote on governance proposals using the FIG token. 

Security tokens are similar to stocks. There are two categories of security tokens:

• Asset Tokenization: A traditional financial asset is represented by tokens on blockchains. For example, shares that represent the ownership percentage of a company can be tokenized. Additionally, ownership of a unit of gold can be tokenized and represented on the blockchain (such as PAXG on the ERC-20 network).

• Asset Origination: The token represents a digital financial asset that is already on the blockchain. Tokens are created through asset creation, for example through staking or mining.

In the US, companies that want to issue security tokens must be regulated by the SEC. Blockchain projects that do not comply with these regulations risk being fined or shut down. As a result, it is important to know if the token you want to invest in is a utility token or a security token and above all its origin to know what regulations it is subject to. 

Token Supply.️ 

When analyzing the supply of a token, we must take into account the following points:

• total supply– The number of tokens created minus the tokens that have been “burned.”
• Maximum supply– The total number of tokens that can be created per code. For example, Bitcoin's maximum supply is 21 million BTC, while USDT has no defined maximum supply. 
• Circulating supply: It is important to look at the circulating supply of the token, because it influences the market capitalization of a token. We must also look at the initial distribution of the tokens at the time of release to the public (known as Token Allocation). The amount of tokens in the hands of investors, the team, and the liquidity of the protocol can influence many factors. 

Market capitalization. 

This is the total value of a protocol's tokens on the market. One of the best indicators of the economic value of the token. Some projects issue a large number of tokens at a very low price, such as $0.0001 per token (like Shiba). Offering the tokens at these prices is to make investors think that the price can easily rise many figures, which leads them to invest with great euphoria. Not to mention that they encourage pure speculative trading, where huge amounts of money are invested in projects that contribute nothing (which translates as gambling). 

But the reality is that if the market capitalization of the token is already very large, the price of the token is unlikely to rise much. It is best to look for projects with long-term foundations in tokenomics. The larger the market capitalization, the more difficult it is to manipulate the price, although all cryptocurrency prices are usually manipulated by whales. Market capitalization is calculated by multiplying the circulating supply of the tokens against the current price of the token. 

Fully diluted market capitalization.  

Apart from the market capitalization, we can find the diluted market capitalization, which tells us the theoretical market capitalization if all the tokens were in circulation on the market. To be sure, we should always double check the data on block explorers because some of the information on websites like coinmarketcap or coingecko is not updated correctly. These block explorers allow us to evaluate this metric well and in turn consult on-chain data, for example, transactions, gas rate prices or network difficulty. 

Is the token premined?⛏️ 

Premined means that the token has already been created before its launch. This happens a lot in ICOs (Initial Coin Offer or Initial Coin Offer in Spanish). Many L2 tokens, such as ERC 20 tokens, are pre-mined for advisors and early investors to reward them. Why is it important to know if a token is premined? Because premined tokens are often distributed internally before the general public can purchase them. If a significant amount of tokens are in few hands on launch day, the price of the token can be easily manipulated by them and negatively affect the price of the token and the investors of the project. This occurred, for example, when the Shiba token (SHIB) was launched, where it was announced that Vitalik Buterin (co-founder of Ethereum) had a large part of the SHIB supply and he decided to sell all of his tokens to donate them to the charity. This negatively affected the price of the SHIB token.  

Token allocation and distribution.️ 

It is very important that we look at how tokens are allocated and distributed at the beginning of their creation and launch. We have this information available in the project White Paper and on websites such as messari.io o icodrops.com. Remember to check the headlines in a block explorer, because sometimes the information in the Whitepaper or on other websites may be out of date.

For ICOs, we also have to find out at what price the seed phases or private sales have been held. This information can be found in a project's Whitepaper and on websites like the ones we mentioned above. If the token is already listed on an exchange, we can compare the pre-sale price with the current price. If the pre-sale price is very low, early investors who entered in the early stages could liquidate their positions to obtain a profit.  We must also look at whether they will have a vesting period (monthly/quarterly/total distribution) or whether they will have a lock period (a certain amount of the token is blocked for a period of time to avoid the sudden sale of a large amount that causes the token to fall. the price). If a large amount of the token is locked, we need to check the release schedule. When more tokens are released, it will affect the token price and market capitalization. If the project unlocks a large number of tokens at once, it will have a high probability that the price will drop drastically due to adding a lot of supply to the market. 

Is the token model inflationary or deflationary?️ 

This affects the supply of the token. If a cryptocurrency or token does not have a maximum supply it means it is inflationary. Some projects use a token burn mechanism to control price inflation. We must keep in mind that burning token to reduce supply does not mean that the price will increase for sure. The value of the token comes from the value it provides to users rather than how much supply there is. 

One of the big news we witnessed for the cryptocurrency ecosystem over the past year was the improvements made to the Ethereum network. The implementation of EIP-1559 introduced the deflationary concept in the supply of ETH, where a portion of the transaction fees paid to miners was “burned.” This means that the more the network is used, the more ETH is burned and therefore the supply is reduced. This, together with the migration to the Proof of Stake/PoS consensus model, has contributed to witnessing deflation on the Ethereum network for the first time in history.  

Total Value Locked (TVL/Total Value Locked).

The total locked value of a protocol is a great indicator to be able to give it the closest value speaking in figures. This value shows us the amount of tokens that are locked within the protocol, either through liquidity pools (LP) or through staking pools. Likewise, when we see that a protocol has a TVL much higher than its current market capitalization, it is a sign that this protocol still has a long way to go and that the project holders themselves trust it by blocking their assets to form part of the governance of the protocol or even to generate passive income or incentives. 

On the other hand, when we see that a protocol has little TVL and a much higher market capitalization, it has to put us on alert since it may be a sign that people no longer trust the project and simply hold their tokens without any further purpose. beyond holding them. We can find this data within web pages such as the one mentioned above. Defillama o Defipulse.

Have you done or are you planning to do an airdrop? 

On some occasions when analyzing the tokenomics of a project, we can see that a part of the supply granted for community incentives can be reserved to celebrate an airdrop of the project's token. This can have two types of effects on the token's valuation. On the one hand, offering a portion of the token supply for free to the community can positively influence community adoption to encourage the use of the token, translating into a greater volume of new addresses and trade. We witnessed this case in September 2020, when Uniswap airdropped UNI tokens to users who had interacted with the Uniswap DEX. This airdrop distributed 400 UNI tokens to each user who met the conditions, increasing the value of said airdrop to a maximum of $18.000. 

Although on the other hand, we can also witness strong selling pressure from users who prefer to liquidate their tokens to be able to reinvest that capital in other projects. This situation has also been witnessed recently with the launch of the token that we showed you during the last cryptocurrency training installment; the token Flare network (FLR). As we explained to you, the price of the FLR token plummeted at the time the long-awaited Flare token airdrop was distributed.