What Are Layer 1, Layer 2, Deflationary, Inflationary Coins or Tokens; A Guide To Tokenomics

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Before investing in a cryptocurrency, it is always recommended you make a thorough analysis of the specific coins or tokens you are considering in order to best manage the risk of your investment. Such analysis requires a scrutiny of each cryptocurrency’s main aspects. However, investors are not limited to investing only in cryptocurrency coins but also in tokens. These tokens have value, too. When you conduct an analysis into whether you should invest in a token, that’s known as Tokenomics.

Upon entering the world of cryptocurrency, crypto assets, Exchanges, Tokens and Coins there is always a discovery of learning. Learning about existing coins and exchanges, about new coins and new exchanges, new regulations, and new opportunities. One of the principal methods to understand what and why of various coins or tokens is to understand Tokenomics. Through this relatively new “methodology” of the world of crypto an investor begins to learn and understand the economic goals of a specific token or blockchain.

Tokenomics combines the words “token” and “economics.” The focus of tokenomics is to analyze why a token has value, and why it’s reached the price that it has or what the future price possibilities. By looking at various factors which define the world of cryptocurrencies, tokenomics provides answers to the economizing problems of tokens and their functionality in blockchain technology.

Tokenomics is the study of tokens, how they work, what purpose(s) they have and what factors need to be considered before investing in cryptocurrencies. This is where it derives its name. More generally, tokenomics is anything that can influence the value of a token — including the token itself.

But before diving into the world of tokenomics, let’s briefly explain tokens.

What Is a Token?

Tokens are units used for a specific purpose and have a value based on their characteristics. Tokens are usually considered as valuable assets that serve more than just a currency. For instance, football tickets can be considered tokens, because they can either be used to go watch a football game or traded for something else.


In the same sense, tokens can be found in cryptocurrencies as well. These tokens can have various functions within a network besides being used only as trading assets. The concept of tokens in cryptocurrencies grew larger with the creation of Ethereum. The Ethereum network was the first blockchain technology that offered more decentralized services to people, rather than just transactions. Just as transactions require money in order to be completed, these decentralized services in the Ethereum network require tokens. In the Ethereum network, these are known as ERC-20 tokens.

Tokens can be categorized into two main types: Layer 1 and Layer 2.

Layer 1 tokens are native to a particular blockchain and can be used for fueling every service within it. Some examples of Layer 1 token in cryptocurrencies would be Ether (ETH) on the Ethereum network, BNB in the Binance chain and LCX in the Liechtenstein Cryproassets Exchange. For example, the LCX Token ($LCX) is a utility token issued by LCX AG. The LCX Token is a utility Token which may be used to pay all fees associated with the services offered by LCX AG, for example, trading fees at LCX Exchange, fees for LCX Terminal subscription, fees for custodian solutions in LCX Vault; fees for exchange transactions for all crypto assets; exchange fees for fiat-crypto-fiat transactions; processing fees; and other fees within the LCX ecosystem.

Layer 2 tokens are used for decentralized applications within a network. For instance, OMG tokens are Layer 2 because they’re used for OmiseGO, which is a decentralized project within the Ethereum network.

Another way of classifying tokens is based on their usage. There are two types of tokens: security and utility tokens

The Howey Test

Security tokens are considered investment contracts. To be considered as investment contracts, these tokens need to entail an investment of money, profitability, and common enterprise — and to come from the computational efforts of others. This process of contract verification is known as the Howey Test. Hence, tokens that pass the Howey Test are considered security tokens. An example of a security token would be the way Siafunds (SF) work on the Sia network.

Utility tokens are those tokens that ensure the financing of a network. Usually, utility tokens are given out through an initial coin offering (ICO) to fund development of the project. For instance, the Basic Attention Token (BAT) is a utility token that was initially distributed through an ICO. It can now be used in decentralized advertising on the Brave browser, running on the Ethereum network.

Tokens can also be categorized as fungible or non-fungible.

Fungible tokens have the same value and can be replicated. Since fungible tokens are the same for everyone, you can replace one ETH with another because they have the same value.

However, non-fungible tokens (NFTs) do not have the same value because each NFT is unique. NFTs are usually tokenized assets such as pictures, artworks, collectibles, and real estate, etc. Since NFTs are unique they cannot be replicated. This can make their value higher than that of fungible tokens.

Coins vs. Tokens

So, what are the similarities and differences between coins and tokens in the world of cryptocurrencies?

Similarities

  • Decentralized
  • Coins and tokens both work in blockchain technology in a decentralized manner. This means that using tokens or coins in cryptocurrencies does not require third parties or central authorities who would normally regulate these services.
  • Value
  • Coins and tokens may both have a value. While the price factors might differ for coins and tokens, they may both be purchased or sold at the amount required.

Differences

  • Independence
  • Coins can be used with an independent blockchain. This operability is what gives coins an advantage.
  • Change in value
  • There are many external factors that determine the price of a coin. However, the change in the value of a token is heavily tied to variation in the value of the cryptocurrency on which the token is based.
  • Purpose
  • Coins, as the name suggests, are designed for the purpose of representing a monetary value. Tokens, on the other hand, can be created for the purpose of running other services within the blockchain.

Which Tokenomics Factors to Consider When Investing

There are many factors which can determine the price of a token and a cryptocurrency. However, several of these factors are quite important to keep in mind if you want to invest.

Total Supply and Market Cap

When looking at a cryptocurrency, it’s important to look at the total supply of coins. Usually, cryptocurrencies that have a limited total supply may have an increasing value in the future. This happens because scarcity causes a shortage in the market. Shortage requires an increase in price in order to reach an equilibrium. On the other hand, if the supply is unlimited, the future price may not increase as much as it could if the supply were limited.

The supply of a cryptocurrency has a strong correlation to market capitalization. Market cap is the total amount of the circulating supply times the current price of one token. The fully diluted market cap is a hypothetical estimate of the market capitalization if the total supply of a cryptocurrency is in circulation.

Even if one cryptocurrency has a larger supply than another, it doesn’t mean the market supply is necessarily bigger. The same can be said about the price of a cryptocurrency. A higher price doesn’t necessarily mean that the market cap of a cryptocurrency is larger than that of other ones.

Market cap is an important factor to consider before you invest. A lower market cap might mean that the cryptocurrency has more potential to grow. This is the case with small-cap cryptocurrencies (less than $1 billion worth of market cap). Large-cap cryptocurrencies (more than $10 billion worth of market cap) might be a safer investment, but their growth potential tends to be smaller.

Allocation and Distribution

Before a cryptocurrency is launched, the allocation of the tokens can be done by either fair launch or premining.

Fair Launch

Fair launch is the allocation of a cryptocurrency in an organized way after it is released. The tokens are allocated through mining, and the amount of mining usually depends on the computational power of the nodes in the blockchain.

Premining

Premining, on the other hand, is the allocation of a cryptocurrency before it is launched. This is done through an ICO (Initial Coin Offering), which secures funding for the development of the cryptocurrency.

These two models have a huge impact on how tokens are distributed.

If a cryptocurrency is fair-launched, then the distribution is more focused on nodes with higher computational powers, since they can mine more tokens. It is considered “fair” because in this way, those who invest more in mining are rewarded more than those who invest less.

If a cryptocurrency is premined, the tokens sold through ICO are usually sold to institutional investors and the team behind the cryptocurrency, rather than retail investors. Hence, token distribution is not well-balanced when institutional investors own a larger share of the total supply. Therefore, such investors can drastically change the price of a cryptocurrency by selling the tokens at once.

Vesting

When a cryptocurrency is premined, people running the cryptocurrency can decide to lock up the circulating supply and release the tokens gradually over time. This assures retail investors that institutional investors won’t get a hold of all their tokens at once and cause an unbalanced market. However, it is important that the release of tokens is logical, meaning that the distribution is done at low amounts throughout the years.

Inflationary Token Models

In the world of digital assets, there is a wide variety of different token models, many with unique mechanisms and features. Despite this variation, almost all token models generally fall into one of two categories — inflationary and deflationary models.

Inflation refers to the change in the value of the existing tokens after the release of many tokens at one time. If many tokens would be in supply, there would be a surplus. And whenever there’s a surplus, a decrease in price follows. Deflation, on the other hand, is the opposite of inflation, where the possibility that the existing supply may decrease causes an increase in the price of the tokens in circulation.

An inflationary token model is one where new tokens are added to the market over time, often through some regularly-timed model. This is best demonstrated from a cryptocurrency like Bitcoin which issues 12.5 new Bitcoin every 10 minutes as a reward for mining the next block. Sometimes new tokens aren’t issued via mining, but by the company which created the tokens selling them off to fund operations. This can be seen from a company like Ripple (XRP) which has sold off around $1 billion worth of tokens over the past year alone.

Outside of cryptocurrencies, almost all traditional fiat currencies operate on inflationary models, with the United States inflating its currency by ~2% per year for the past several years. In the worst cases, this inflation can increase uncontrollably as the governing bodies of the currencies run themselves into massive debt and print more and more money to pay off their debts. Examples of this can be seen from the recent hyperinflation disasters in Venezuela and Zimbabwe where citizens have been carrying wheelbarrows of cash to grocery stores to pay for their food. These countries provide a stark warning about the dangers that inflation can present.

Despite these dangers, the gradual inflation of currencies can have some benefits. For example, many economists agree that the 2% inflation of the U.S. Dollar allows the reduction of people’s debt, the increase of their wages, and an increase in general spending. However, most of these benefits don’t apply within the world of cryptocurrencies. Even for the most liquid and popular digital asset, Bitcoin, prices have seen massive rises in the face of it’s “Halvening”, suggesting that the lower the inflation of a cryptocurrency, the higher its intrinsic value may be as seen by the general public.

Deflationary Token Models

A deflationary token model, as one may expect, is one where tokens are removed from the market over time. Tokens can be removed from the market via a variety of methods including token buy-backs and token burns from the token creators. The main benefit to models like these is that they prevent the market from being flooded with excess tokens as more are mined, created, or sold off by the creators. While some may argue that decreasing the supply will decrease the actual availability of the token, this is fortunately not the case with cryptocurrencies, as they are divisible up to the 100 millionth, essentially eliminating this problem.

The main issue that deflationary tokens present is that they will often be seen as a security in the eyes of regulators. This is because the deflationary mechanisms used to buy the tokens back from the market are generally dependent on the success of the company. If the company performs well, more tokens can be bought from the market which will often improve the health of the ecosystem, and if the company does poorly, they will not have the resources to buy as much off the market leading to an excess supply and often an unhealthy ecosystem. Because of this direct relationship between the success of the company and the health of the token ecosystem, these deflationary tokens will almost always be classified as a security.

Fortunately, however, if the creators of the token are careful and follow all necessary guidelines around the distribution and sale of the token, there will be no effect on the health of the ecosystem from its classification as a security.

Staking and Utility

Staking is the process of locking tokens for a specific period (depending on the cryptocurrency) in order to receive a passive income or reward from the network. The problem with staking is that the staked tokens cannot be moved until the staking period is finished. If a large number of tokens are staked, then the supply will be more limited during the staking period. This can influence a cryptocurrency’s price. There are some cryptocurrencies that have a lower staking time, or no staking time at all. Because of this, big price increases or reductions might not occur because the tokens can easily be bought or sold by the users.

Utility refers to the usage of the tokens. In simple terms, the utility of a token is what makes people buy more tokens and, as a result, increase the price of a cryptocurrency.

The Team and the Community

The team behind a cryptocurrency is another factor worth considering. For instance, one of the reasons why BAT (Basic Attention Token) has been a success is the team that runs it. Academically credible people — such as Brendan Eich and Brian Bondy — induced trust in the BAT project before it was even released.

The community is also an important factor. At the end of the day, without the people that are going to buy tokens, a cryptocurrency is worth nothing. So, the team behind the cryptocurrency needs to make sure they establish a good relationship with the community, as well as try and expand that community.

Bitcoin vs. ETH Tokenomics

Bitcoin and Ethereum are the two biggest cryptocurrencies, based on their market capitalization. Let’s look at the Tokenomics of these two and see their differences.

  • Total supply
    • Bitcoin has a limited supply of 21 million BTC, while Ethereum has an unlimited supply.
    • Market Cap
    • Bitcoin has a market cap of around $940 billion as of April 2021, while Ethereum has a market cap of $260 billion. Both are large-cap cryptocurrencies, meaning that their potential to grow is not what it was when their market caps were below $1 billion.
  • Allocation
    • Both BTC and ETH were fair launched, although a large number of ETH was also premined.
    • Distribution
    • The top 100 BTC owners own 32% of the total BTC supply. The top 376 ETH owners own 33% of the total ETH supply.
  • Vesting
    • Since Bitcoin was fair launched, it does not need vesting. Some Ethereum tokens, though, are in the process of vesting.
  • Inflation
    • Since Bitcoin has a limited supply, it is inflation-free and its price can rise as it becomes scarcer. Ethereum, however, is likely to inflate because of its unlimited supply.
  • Staking
    • Staking can occur in Proof-of-Stake (PoS) blockchains. Since Bitcoin has a Proof-of-Work (PoW) blockchain, it cannot be staked. Ethereum tokens can be staked. Some people stake their ERC-20 tokens for developing Ethereum 2.0.
  • Utility
    • Bitcoin utility serves as the “gold” of cryptocurrencies. Ethereum tokens vary in terms of utility. As a network, Ethereum’s utility allows people to run decentralized services by requiring gas fees. More services, more gas fees. More gas fees, bigger market cap.
    • Team
      • An intriguing factor behind Bitcoin’s success was its unknown founder with the pseudonym of Satoshi Nakamoto.
      • As for Ethereum, Vitalik Buterin’s insights and charisma were the stepping-stone to establishing credibility.
    • Community
      • Both Bitcoin and Ethereum have enormous communities, as they are the two biggest cryptocurrencies in the world.

The Bottom Line

To conclude, Tokenomics is everything related to a token in cryptocurrencies. Each Tokenomic factor should be carefully analyzed before investing in cryptocurrencies.

Tokenomics is a relatively new field of study, but it can become one of the future’s biggest economic subfields.

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