The Use of Incentives in Crypto

– November 13, 2021 Reading Time: 8 minutes

One of the timeless lessons of economics is that incentives matter. If we want people to respect the rules of trade with their fellowmen rather than exploiting them, then the institutional rules of the game should be structured in a way that incentivizes cooperation and disincentivizes undesirable behaviour.

This commonsensical insight is found in every Econ 101 class, yet it is a lesson that modern politics violates on a daily basis. Popular left- and right-wing proposals to regulate corporations or to tax the wealthy flagrantly trample over this fundamental lesson of getting incentives right, when politicians naively assume workers and corporations are saints who will simply continue to produce wealth, even when the politics of the day egregiously persecutes them for it.

In reality, regulations and taxation create disincentives for workers to be productive, or even worse – incentivise corporations to redirect efforts toward lobbying for corporate welfare, or billionaires to offshore their wealth to low tax jurisdictions, thereby impairing economic progress.

To understand the importance of incentives, modern policymakers should take heed/lessons from the world of cryptocurrency. As of November 2021, Bitcoin is a highly secure currency with a $1.15 trillion market capitalization. Built on its back is a fast-growing $80 billion decentralized finance (DeFi) industry that seems to work just fine without the need for onerous banking regulations. For the uninitiated, DeFi is a decentralized, online banking ecosystem where anyone can make use of their crypto to participate in a wide array of financial products from simple lending/borrowing to complex forms of margin and derivative trading.

To a large extent, the world of crypto relies on well-designed market mechanisms that make use of price incentive structures. This article summarises how crypto developers get incentives right, and why it is a fundamental economic lesson that should be applied universally.

Blockchain protocols are fully transparent

The central difference between crypto and fiat currencies lies in the rules that govern its supply.

The rules by which central banks control fiat money are shrouded in secrecy and subject to arbitrary manipulation. Central banking bureaucrats lack residual claimancy, and have no personal incentive to promote good long-term governance since they will not be around to own the bad outcomes of tomorrow. As the authors of the 2021 book Money and the Rule of Law put it, the rules of central banking institutions often lack generality and predictability – the very aspect that typifies cryptocurrencies.

This is in stark contrast with most cryptocurrencies. The Bitcoin blockchain for example, is well known for its creator Satoshi Nakamoto’s finite 21 million coin supply rule. This rule is what bakes in the certainty of the token’s long-run fixed supply, laying the tracks by which the entire Bitcoin ecosystem runs on.

Yet, the 21 million supply is not a rule etched in stone. In theory, Bitcoin developers can propose changes to this code and miners who work around-the-clock to validate and secure Bitcoin transactions for block rewards (called “proof-of-work” validation) can collectively decide to adopt a new code that benefits themselves. The new code could inflate the Bitcoin supply, make Bitcoin easier to mine by reducing the complexity of the computational problems to solve, or increase the rewards miners receive for validating transactions.

While it would be tempting, it is unlikely for these groups to pursue such self-serving cartelism because of the way Bitcoin’s design ensures that miners have “skin in the game.” Bitcoin miners invest significant capital into high-end computing equipment to validate nodes. Then they get paid in Bitcoin rewards. Minerdaily estimates that the costs to mine one single Bitcoin in 2021 lies in the range of $7,000-11,000.

Given the public nature of Bitcoin’s blockchain, these self-serving rules would become apparent to all if adopted. If Bitcoin suffers a reputational hit and its value drops, these miners have plenty to lose. Thanks to the transparency of public blockchains, strong incentives exist for Bitcoin miners not to engage in any opportunism as their actions may be perceived by the public as a form of rent seeking.

Other forms of block validation in crypto such as “proof-of-stake” that are increasingly adopted by many newer blockchains like Ethereum adhere to the same lessons of economic incentives, but in varying forms. On proof-of-stake blockchains, validators are required to stake upfront a percentage of their own capital in order to verify transactions. A validator who erroneously or intentionally processes malicious transactions triggers a punitive mechanism that results in the liquidation of their staked capital. Just like proof-of-work validation, the reward would not be worthwhile. Even if the perpetrator successfully executes such an attack, his reward for doing so is a depreciating asset that has taken reputational damage. It is through this method that blockchain protocols at its very base layer create direct incentives for good governance and disincentives for opportunism.

Market incentives pervade every aspect of the DeFi ecosystem too

Crypto’s good incentive structures begin at the blockchain layer (known as Layer-1), but it doesn’t stop there. Since early 2020, the DeFi space in crypto has exploded, envisioned as a permissionless finance system where users can lend, borrow and trade crypto without the need for traditional banks as a middleman. This decentralized world of banking is still nascent, but its fast development is exciting to watch. Similarly on this “Layer-2” of the crypto world, DeFi applications and services make use of many price incentive structures toward a myriad of purposes. Perhaps the most prominent example can be seen in the ubiquitous use of liquidity pools.

Your first foray into crypto probably involved buying Bitcoin or Ether with fiat on a centralized exchange (CEX) such as Binance or Coinbase. Crypto’s strong ethos of decentralization has prompted developers to build decentralized exchanges (DEX) which facilitate trading through liquidity pools running on smart contracts. Traders on a DEX then buy and sell cryptocurrencies from these pools, instead of a traditional order book system where buyers/sellers transact directly with each other.

DEXs employ a myriad of incentive mechanisms that attract users to deposit capital for interest (known as yield farming). First, buyers and sellers who transact in these liquidity pools pay a percentage of trading fees to yield farmers, tying a direct incentive for them to keep the liquidity pool full. Second, DEXs reward yield farmers with “liquidity provider tokens” to further incentivize the supply of capital. Should these pools become illiquid, smart contract algorithms automatically increase the rewards in trading fees and tokens for providing capital exponentially, incentivizing new capital owners to supply capital. For example, when the largest lending/borrowing platform Aave experienced a liquidity crunch because of sudden capital flight, its annual percentage yields (APY) for lending DAI quickly surged from 6.5% to 24% within a day to quickly attract capital owners.

Liquidity pools are deployed across many DeFi apps, such as credit lending and borrowing services (e.g. Compound and Aave), where lenders are incentivized to stake and lock up their cryptocurrencies into liquidity pools in return for rewards. While the details may differ across the DeFi ecosystem, the economic logic is the same – the problem of illiquid markets is solved by incentivizing users to provide liquidity in exchange for rewards.

Another example of a smart incentive structure can be seen in crypto stablecoins. Because of the volatility of cryptocurrencies that renders them unusable for economic trade, companies like Tether and Coinbase developed intermediary stablecoin currencies pegged to the value of the USD (by holding real world financial assets) to mitigate this problem. A concern then arose around the centralized and regulatory risks from one institution maintaining this bridge between fiat and DeFi.

This quickly prompted the development of decentralized stablecoins. The DAI cryptocurrency (exchangeable with Ether) is the most popular example of such a stablecoin that relies on price incentives to equilibrate its coin towards a 1 USD valuation. When the market value of DAI rises above 1 USD, a profit opportunity is presented for users to mint higher-than-average DAI with Ether to sell, increasing DAI’s supply and thereby putting downward pressure on the price of DAI.

When DAI drops below 1 USD, owners of DAI can do the opposite: Sell DAI for Ether at a better rate and apply upward pressure on DAI’s price towards 1 USD. In short, DAI maintains its USD peg by relying on price incentives, so users are able to (indirectly) put their Ether to use as an equity asset.

As DeFi grows, crypto users will find less of a need to rely on centralized third-party intermediaries such as private companies like Binance that face giant pressure under regulatory scrutiny.

Incentives and governance

Within DeFi, incentive structures are not only applied at the fundamental mechanisms of its product, but also in the overall governance of the entire application which decides how these applications are developed. This is done through the issuance of their own tokens, which serve as a governance token that enables users to vote on product/protocol changes.

Governance tokens achieve two things. First, they function similarly to traditional equity stocks by giving users a form of ownership. These tokens are tradable, and therefore allow users to have a “voice” by selling the token. Second, the governance feature gives users skin in the game and incentives to vote for sound governance proposals, and empowers users to exercise that voice and make concrete governance decisions through voting.

Despite its name, decentralised finance is not completely decentralised. While users have power to decide how the protocols are governed, developers still maintain control over some key making decisions such as the monetary policy of the app’s native token, or how funds will be used. The economist Chris Berg puts it well: DeFi applications are borne out of central design in its initial stages, then over time undergo a process of decentralization by which some centralized control is ceded to users. A parallel that can be drawn here is a nation-state’s formation of a liberal democracy, where base rules are created in its political constitution, deciding the rules of voting and democratic elections, and how those rules could be subject to change.

Governance tokens have also enabled a new mode of user-owned digital organization that have been called the future of work. These digital communities, called Decentralised Autonomous Organizations (DAOs), can function formally as a hierarchical corporation or in a loosely organized fashion where workers can contribute as little as two hours of work a week to a full 40-hour week. What makes DAOs different are its low entry barriers of participation and its immutable shared treasury that is enforced on the blockchain. Depending on how much work users put in, the DAO collectively decides how much they are paid in governance tokens, making economic incentives their primary design strategy to motivate community development.

The option to exit

The economist Albert Hirschmann wrote extensively on the interplay between the roles of “exit” and “voice” in political governance. Hirschmann argued that the predatory behaviour of nation-states is curbed when citizens are able to back up the threats of exiting (voice) with the action of withdrawal (exit).

Perhaps the best example of such is the American system of federalism which allows citizens to “vote with their feet” by uprooting across states, curbing the exploitative impulses of opportunistic politicians. This is also the same logic that disciplines businesses from offering an inferior product or service in a competitive market, or what differentiates an authoritarian monarchy and a liberal democracy where voters have political choices.

It is in this aspect of the crypto ecosystem where it excels. The barriers of exiting a cryptocurrency for a user is almost costless, unlike the exit barriers for fiat currencies that citizens are locked into using because of central banking monopolies over a geographic jurisdiction. These low costs of exit discipline blockchain developers from predatory governance, and give them strong incentives to promote the type of user experience that aligns with what users expect of the currency they hold. Developers must be hypersensitive to any divergence from the core philosophy and principles of their product offerings to avoid suffering reputational harm in the eyes of consumers.

The option to exit similarly applies to developers. Developers conflicted on a set of changes are able to exercise the threat of exit by “forking” the network. By doing so, developers can take the existing network on a different trajectory from their colleagues. The Bitcoin Cash (BCH) network is a prominent example of one such hard-fork after a long-standing 2017 scaling dispute between developers on the increment of the Bitcoin network’s block sizes. Ethereum, as it is known today, was a hard fork in 2016 from the now Ethereum Classic network after the community and its developers could not come to an agreement on how to resolve the loss of funds from a hack that exploited a vulnerability in its code.

In short, hard forks are the outcomes of disagreements within the community stemming typically from major and contentious changes to a blockchain. No such option exists in the fiat world if you are unhappy with your central bank’s monetary policy, save for emigrating to another zip code. This is why central banks can continually debase and inflate our money, simply because citizens have no other choice in the matter.

The option to exit for both users and developers sends a strong disincentive signal to existing blockchain developers to manipulate the network for self-serving reasons, due to how they might be swiftly punished by market competition. The crucial point is that even if these options are never really exercised, the mere threat of dissent is powerful enough to discipline bad governance. Unlike nation states or oligopolistic markets (think utilities, telecommunications or social media) where the costs of consumers/producers exiting are high, or where exit options are scarce, the bulwarks against predatory governance are far weaker.