Using Incentives in Crypto

This sound understanding can be found in any textbook on economics, but modern politicians violate this rule every day.

To understand the importance of incentives, modern politicians must take into account the lessons from the world of cryptocurrency. According to Coinmarketrate.com As of November 2021, Bitcoin is a highly reliable currency with a market capitalization of $1,200 trillion. A fast-growing $80 billion decentralized finance (DeFi) industry was built on the basis of BTC, and this industry seems to be working just fine without the need for burdensome banking regulations.

For the uninitiated, DeFi is a decentralized online banking ecosystem where everyone can use their cryptocurrency to participate in a wide range of financial products, from simple lending/borrowing to complex forms of margin and derivative trading.

Blockchain protocols are completely transparent

The main difference between cryptocurrency and fiat currency is the rules governing its offer.

The rules by which central banks control paper money are shrouded in secrecy and can be subject to arbitrary manipulation. Central bank bureaucrats are devoid of residual claims, and do not have personal incentives to promote good long-term management, because they simply will not be there tomorrow. As the authors of the 2021 book “Money and the Rule of Law” write, the rules of central banking institutions often lack universality and predictability – this aspect is typical for cryptocurrencies.

This is in stark contrast to most cryptocurrencies. The Bitcoin blockchain, for example, is well known for its rule of limited supply of 21 million coins. This rule is the key to confidence in a long-term fixed coin supply, paving the way for the entire Bitcoin ecosystem to work.

However, the 21 million offer is not a rule set in stone. Theoretically, BTC developers can propose changes to this code, and miners who work around the clock to verify and secure Bitcoin transactions to receive a block reward (the so-called “proof of work” check) can collectively decide to adopt a new code that benefits themselves. The new code can increase the supply of BTC, simplify mining by reducing the complexity of computational tasks that need to be solved, or increase the remuneration received by miners for verifying transactions.

While it would be tempting, it is unlikely that these groups would pursue such self-serving cartelism due to the way Bitcoin’s design provides miners with an “interest in the game.” Bitcoin miners are investing heavily in high-performance computing equipment to verify nodes. Then they get rewarded in BTC. According to Minerdaily estimates, the cost of mining one BTC in 2021 lies in the range of $7,000 to $11,000.

Given the public nature of the Bitcoin blockchain, these self-serving rules will become obvious to everyone if they are adopted. If Bitcoin suffers a reputation blow and its value drops, these miners will have something to lose. Thanks to the transparency of public blockchains, they have strong incentives not to resort to any opportunism, since their actions can be perceived by the public as a form of benefit seeking.

Other forms of block verification in cryptocurrencies, such as “proof of stake” (POS and DPoS), which are increasingly used in many new blockchains, such as Ethereum (ETH), Decimal Chain (DEL), etc., are based on the same lessons of economic incentives, but in different forms. In proof-of-stake blockchains, validators must make an advance as a percentage of their own capital to verify transactions.

A validator who mistakenly or intentionally processes fraudulent transactions triggers a punitive mechanism that leads to the liquidation of their established capital. As with proof-of-work verification, the reward will not be worthwhile. Even if an attacker successfully carries out such an attack, his reward for this is a depreciating asset that has suffered reputational damage. It is through this method that blockchain protocols at the most basic level create direct incentives for good governance and deter opportunism.

Market incentives permeate all aspects of the DeFi ecosystem

Good crypt incentive structures start at the blockchain level, known as level-1, but don’t stop there. Since the beginning of 2020, the DeFi space in cryptocurrency has grown dramatically, conceived as a financing system without permission, where users can lend, borrow and trade cryptocurrency without the need for traditional banks as intermediaries.

This decentralized world of banking is still in its infancy, but its rapid development is interesting to watch. Similarly, at this “Tier-2” of the cryptocurrency world, DeFi applications and services use multiple price incentive structures to achieve multiple goals. Perhaps the most striking example is the widespread use of liquidity pools.

The strong spirit of Crypto decentralization has prompted developers to create decentralized exchanges (DEX) that facilitate trading through liquidity pools powered by smart contracts. Then traders on DEX buy and sell cryptocurrencies from these pools, instead of the traditional order book system where buyers/sellers make transactions directly with each other.

DEX uses a variety of incentive mechanisms that attract users to invest capital at interest (known as crop cultivation). Firstly, buyers and sellers who carry out operations with these liquidity pools pay a percentage of trading fees to bring crops to farmers, which is a direct incentive for them to maintain a full liquidity pool.

Secondly, DEX rewards farmers who grow crops with “liquidity provider tokens” to further stimulate capital inflows. If these pools become illiquid, smart contract algorithms automatically increase the reward in the form of trading commissions and tokens for providing capital exponentially, encouraging new owners of capital to provide capital.

For example, when the largest lending/borrowing platform Aave experienced a liquidity crisis due to a sudden capital flight, its annual interest yield (APY) for DAI lending rose rapidly from 6.5% to 24% during the day in order to attract capital owners quickly.

Liquidity pools are deployed in many DeFi applications, such as lending and borrowing services (for example, Compound and Aave), where lenders are interested in betting and fixing their cryptocurrencies in liquidity pools in exchange for remuneration.

Although the details may differ in the DeFi ecosystem, the economic logic is the same – the problem of illiquid markets is solved by encouraging users to provide liquidity in exchange for rewards.

Another example of a reasonable incentive structure can be seen in cryptocurrency stablecoins. Due to the instability of cryptocurrencies, which makes them unsuitable for economic trading, companies such as Tether and Coinbase have developed intermediate stablecoin currencies pegged to the value of the US dollar (by storing real financial assets) to mitigate this problem. Then there was concern about centralized and regulatory risks from one institution supporting this bridge between fiat and DeFi.

This quickly led to the development of decentralized stablecoins. The DAI cryptocurrency (exchanged for Ether) is the most popular example of such a stable coin, which relies on price incentives to balance its coin towards a valuation of $1.

As DeFi grows, cryptocurrency users will rely less on centralized third-party intermediaries, such as private companies like Binance, which face enormous pressure due to regulatory oversight.

Possibility of exit

Economist Albert Hirschmann has written extensively about the interaction of the roles of “exit” and “voice” in political governance. Hirschmann argued that the predatory behavior of nation states is restrained when citizens can back up the threat of exit (voice) with the action of exit.

It is also the same logic that prohibits businesses from offering a substandard product or service in a competitive market, or what distinguishes an authoritarian monarchy from a liberal democracy where voters have a political choice.

It is in this aspect that crypto ecosystems stand out. Barriers to exiting cryptocurrencies are almost free for the user, unlike exit barriers for fiat currencies, which citizens cannot use due to the monopolies of central banks in a geographical jurisdiction.

These low costs discipline blockchain developers from predatory management and give them strong incentives to promote the type of user experience that matches what users expect from the currency. Developers should be hypersensitive to any deviations from the basic philosophy and principles of the products they offer, so as not to harm the reputation in the eyes of consumers.

The ability to exit is similarly applicable to developers. Developers who conflict over a set of changes can take advantage of the threat of an exit by “branching” the network. By doing so, developers can bring the existing network along a trajectory that is distinguishable from the trajectory of their colleagues. The Bitcoin Cash (BCH) network is a prime example of one such hard fork after a long-standing scaling dispute in 2017 between developers over increasing the block sizes of the Bitcoin network.

Ethereum, as it is known today, was a hard fork in 2016 of the Ethereum Classic network after the community and its developers could not come to an agreement on how to solve the problem of losing funds as a result of a hack that exploited a vulnerability in its code.

In short, hard forks are the result of disagreements within the community, usually arising from serious and controversial changes in the blockchain. In the world of paper money, such a possibility does not exist if you are dissatisfied with the monetary policy of your central bank. That’s why central banks can constantly devalue and inflate our money simply because citizens have no other choice in this matter.

Conclusion

The possibility of an exit for both users and developers is a strong deterrent signal for existing blockchain developers. This prevents manipulation of the network for selfish purposes due to the fact that they can be quickly punished by market competition.

The key point is that even if these opportunities are never realized, the mere threat of dissent is strong enough to discipline poor governance.

Unlike nation states or oligopolistic markets (for example, utilities, telecommunications or social networks), where the exit costs of consumers/producers are high, or where exit options are limited, the bastions against predatory management are much weaker.