Cryptoeconomic Design

The Role of Incentives

It was once commonly said that “blockchain is the technology behind Bitcoin.” The reverse is equally true: “Bitcoin is the technology behind blockchain.” This phrase highlights the role that Bitcoins themselves play in incentivizing miners to keep processing transactions: if new Bitcoin were not minted every block to reward miners, only the ideologically zealous would mine the chain itself. This would not produce sufficient hash power to secure the network. The protocol could not mint new Bitcoin to compensate miners if there were no Bitcoin.

By S+C’s estimates, the historic capital investment in mining Bitcoin is likely north of $15 trillion USD throughout its history. Bitcoin did not hire these miners, form these companies, or even fund the ecosystem of services built around the core network and its mining. The large-scale economic activity emerged in response to a set of incentives that no one entity can arbitrarily change. These incentives are critical for securing distributed economic systems.

S+C calls the development of this set of incentives,“Cryptoeconomic Design.”

What is Cryptoeconomic Design?

Breaking ‘Cryptoeconomic Design’ into its constituent terms helps clarify its meaning.

Crypto: Immutable rules enforceable by participants. Cryptography enables easy verification of data changes while also removing the costs and benefits of a centralized decision-making authority.

Economic: Actors responding to incentives in the face of scarcity. The introduction of provably scarce digital artifacts is powerful at motivating people in a digital environment. This is often underappreciated in the industry.

Design: A miniature economy intentionally made suitable for particular ends. These systems are designed to produce particular outcomes or maximize the contribution of particular resources, such as hash power. It is not just the study of distributed incentive systems (‘cryptoeconomics’) but rather the creation of previously non-existent systems.

In cryptoeconomic design, the incentives should not radically change after launch, as the incentive infrastructure’s rigidity is what attracts miners and developers to build value-adding services around a platform. The fact that no one entity controls it means value added to it can’t be arbitrarily taken away. This substantially distinguishes cryptoeconomic design from design of centrally managed digital point systems, such as airline miles or virtual gaming currencies, in which central entities can control supply, relative value, and even basic ownership. The rules should be (mostly) right on launch.

ICOs Distorted the Purpose of Tokens

Incentives in cryptoeconomic design are instantiated in a set of rules built around a provably scarce tradeable instrument of value–that is, a cryptographic token. Bitcoin was the first ‘cryptographic token.’ Cryptoeconomic design has been part of the blockchain industry since Bitcoin, which is to say, since blockchain’s birth.

Yet the ICO era took cryptoeconomic design in a new direction. The outpouring of money invested in token projects and the (mostly true) widely held perceptionthat one could raise capital with only a whitepaper meant everyone wanted a token. With the ERC-20 standard,everyone could readily have one.

Design in this era became conflated with a particular token variant, what S+C describes elsewhere as ‘payment tokens’—a token whose only core function (aside from supporting an ICO) is to be an application or network’s sole means of payment, akin to tradeable fair tickets or arcade-specific physical coins. This variant suffers major drawbacks, including radically complicating usability and forcing issuers to contend with price volatility, yet attracted greater attention from projects and investors than lesser known but more compelling designs. The ‘incentive systems’ payment tokens uniquely enabled seemed more like a non-equity capital raise, though as Smith + Crown has noted, there is much more complexity to ICOs (which stretch back to 2014) and tokens than fundraising.

Cryptoeconomic design can do better at creating incentives for distributed networks and communities. The end of the ICO era does not diminish the massive success of the first cryptoeconomic design project (Bitcoin), and compelling design remains a tool for projects to ensure enduring achievement. Some things that could be forgotten should not be lost.

Smith + Crown Series on Cryptoeconomic Design

Smith + Crown has been thinking deeply about cryptoeconomic design since we launched six years ago. Before Ethereum, meta-tokens, and the rise of the ICO, people were forking core cryptocurrency codebases and tinkering with key variables. This also was cryptoeconomic alchemy. Many ideas that were born in this era became much easier with Ethereum and the tools available today, and amidst the noise of the ICO era, genuinely novel experiments in incentives were being developed and launched.

S+C was part of that, workinng with a small select group of projects to design cryptoeconomic systems and apply the power of distributed incentives to different platforms, products, and protocols. Among these:

• Caspian: an institution-grade asset management system
• Sharespost (GLASS): a network to enable compliant settlement of securities and infrastructure for liquidity sharing across DEXs and exchanges.
• Metadium: an identity-focused smart contract platform based in Korea.

We bring to our research the insights from our practice, and we bring to our practice insights from our research.

Smith + Crown will be producing a series of memos detailing our insights into and methods of practicing cryptoeconomic design. Future series will focus on core token function, supply controls, protocol governance, how the technology architecture impacts the incentive architecture, and what’s next for cryptoeconomic design.

Readers interested in these upcoming releases can sign up for the newsletter for updates on S+C releases.

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