Token Distribution and Open Cryptoeconomic Networks

The Unspoken Challenge of Designing an Equitable Finance 3.0

Bitcoin is often touted by its anarcho-libertarian supporters as a pure implementation of free markets to monetary systems. There is not central authority controlling it, and people can join and leave the system whenever they want. With its decentralization, proponents argue that the Bitcoin network is more secure and fair because there is no central point of authority in the system, eliminating the ability of a malicious actor to attack the network or manipulate the currency. With this decentralization and openness, cryptocurrency advocates argue that Bitcoin presents a fairer and freer monetary system that liberates the masses from the shackles of exclusionary institutional finance.

While there are some truths to these claims, most Bitcoiners (and cryptocurrency supporters in general) fail to understand how early adoption will impact the currency in the future. Even in the present, we can see how the Bitcoin protocol enables centralization through mining, while a capped supply fundamentally limits the amount of Bitcoin one person can hold. As more and more people join the cryptocurrency world, it is important to understand how the distribution of tokens in these networks will affect both their behavior and freedom of future participants. Understanding token distribution is critical not just for Bitcoin, but any cryptocurrency or token, especially as we build more complex cryptoeconomic systems.

The Token Distribution of Bitcoin

Bitcoin, being the first of its kind, is the preeminent cryptocurrency. There are two main factors to understand when trying to understand the impact of token distribution on a cryptocurrency network: one, the monetary policy of the cryptocurrency network, and two, how money is moved and exchanged in the cryptocurrency network. In the Bitcoin protocol, both of these are simply defined.

The Bitcoin supply is capped at 21 million. Bitcoin are generated as block rewards through the proof-of-work consensus mechanism, which are cut in half every so often. This monetary policy is simple and deflationary; eventually, no more Bitcoin will be created. The primary reason for the block reward is to incentivize miners in the network, especially in it early stages when the network was being bootstrapped.

Money in the Bitcoin network is moved and exchanged through two mechanism: transactions and transaction fees. The first of these, transactions, is relatively simple; one entity transfers some amount of Bitcoin to another. The second is another result of the Proof-of-Work consensus mechanism: transaction fees that users pay to miners to incentivize the miners to include their transactions in the next block.

From these two features of the Bitcoin protocol, it becomes clear who is at the center of Bitcoin monetary policy: the miner. Given the difficulty of being a Bitcoin miner, this raises questions about Bitcoin’s long term ability to become a truly open, decentralized financial system used by billions of people across the globe. With the rise of ASICs, the barrier to actually mining has become almost insurmountable. It is impossible to profitably mine Bitcoin without either joining a mining pool (which even then requires the purchase of an ASIC mining computer) or starting a large-scale mining venture. In other words, while Bitcoin may initially have been a system designed such that anyone could mine with on their computer, the modern reality is that the capital cost for becoming a miner prevents many from actually participating in the network this way.

What are the consequences of this? Well, the main one is the centralization of the Bitcoin network at the mining level. There are three mining entities that together make up more than 50% of the hashing power in the network. These mining entities thus have enough of the hashing power to control the network and make decisions without the agreement of anyone else, even those running a full node on the network. This is really no different than our existing financial systems, in which a handful of large bank could work together to fundamentally change the way the system operates.

The second main consequence is the aggregation of Bitcoin in the hands of a few. Even now, the distribution of Bitcoin has been consolidated to early adopters (those who mined Bitcoin when it was easy to or bought Bitcoin very early). While libertarians will argue early adopters should be rewarded for making the choice to join the system early, this argument does not really address how this aggregation of wealth will affect the financial system built on top of Bitcoin.

If we divide 21 million Bitcoin by the number of people currently on the planet (~7.5 billion), you get .0028 Bitcoin per person. With 16 million Bitcoin already issued and distributed, the average person will likely own a lot less than .0028 Bitcoin. Many early adopters of bitcoin likely well-off, affluent communities (likely technologists with steady access to the Internet). Meanwhile, the tail adopters of Bitcoin will be the digitally illiterate and those with sporadic access to the Internet, a demographic that strongly intersect with the ‘unbanked’ (the people Bitcoin supporters claim will be helped the most by the new open financial system). The token distribution of Bitcoin is really just recreating the the existing wealth distribution. With this wealth distribution, the problems with economic inequality will simply continue, and the ‘unbanked’ will remain excluded from the economic systems that currently oppress them.

The Token Distribution of Ethereum

Ethereum has many of the same problems as Bitcoin, with the addition of premined Ether adding to the wealth aggregation of the network. However, there are two critical differences between the Ethereum network and the Bitcoin network that, in my opinion, make Ethereum more likely to succeed as an open financial system.

The first is the monetary policy of the system. Ethereum is still deflationary, but the supply of Ether is not capped. While in the Bitcoin protocol, the block reward will be eliminated once 21 million Bitcoin have been issued, in Ethereum, the supply will continue to grow. Ethereum is still deflationary because relative to the total supply of Ether, this block reward decreases, so I think of its monetary policy as a medium between the highly inflationary systems we use today and Bitcoin’s strictly deflationary policy.

The second is the proposed change of the Ethereum protocol from a Proof-of-Work consensus mechanism to a Proof-of-Stake consensus mechanism. Essentially, rather than use computational power to decide the next block in the chain, Proof-of-Stake allows people to stake Ether, which in turn allows them to be randomly selected to propose the next block. This eliminates mining in the consensus mechanism, instead relying on economics.

As explained above, the economics on mining naturally lend themselves to centralization into a few mining entities. However, it is unclear whether the economics of staking will result in the same thing. Unlike mining, which is a free form competition (those with the best mining set up win), there is a probabilistic factor in Proof-of-Stake, along with a barrier of entry that can be adjusted. The capital cost of participating in the Proof-of-Stake consensus mechanism is the amount of Ether required to stake. This capital cost is variable, and in my opinion, is likely to be lower than mining, especially because staking requires fewer operational logistics (buying rigs, setting them up, tracking the innovation in ASICs and GPUs).

With a lower capital cost, I believe that the Ethereum Proof-of-Stake consensus mechanism will be functionally more participatory and open than the Proof-of-Work consensus mechanism. Yet, even then Ethereum has questions: given the premine and existing aggregation of wealth, how do we prevent the Ethereum economy from making governance decisions that adversely affect the average participant?

Token Distribution in Cryptoeconomic Systems

The ICO craze has lead to a proliferation of protocols and decentralized applications that rely on their own cryptoassets. These new tokens are used for a variety of different reasons, from acting as currencies to pay for services, governance staking, and reputation. Yet, most of these tokens are distributed initially to a small set of early adopters that believe in the project. This mechanism of token distribution introduces serious challenges and barriers to the success of these projects.

The main problem with this mechanism of token distribution is incentives. ICO participants of tokens often aren’t people that want to use the token: they are investors who want to see the price of the token increase. This leads to creators of the token defining success as an increase in price, which leads to product mismanagement and focus on market perception, rather than building the protocol or application. Since many ICO participants are investors looking for return, this token distribution mechanism incentivizes holding the token, rather than using it, since investors won’t sell the token until the price hits their target.

Even with tokens that have clearly defined utilities, there are challenges facing token distribution. One of the most exciting use cases for tokens is governance; holders of the token can stake their tokens for protocol changes. Yet, at its core, this mechanism of governance assumes that the token distribution aligns with the success of the protocol. If the holders of a token are investors, not users of the protocol, they will govern a protocol differently, in a way that may adversely affect the protocol for users.

Another emerging cryptoeconomic system is a token curated registry. These are essentially lists whose membership is determined by who owns the token; holders of the token can also stake their token to resolve the disputes. Yet, again, with current token distribution mechanisms, there can often be misalignment between the goals of the token curated registry and the outcome. If you have an ICO for a token used in a TCR, the mediators of the list become early adopters, which makes it difficult for the TCR to grow and evolve.

Even these two cryptoeconomic use cases of tokens introduce challenges around token distribution, but there is one main takeaway. Tokens must be designed in ways such that the tokens are distributed in a way that aligns with the overall goal of the token. This likely includes mechanisms by which the token is transferred towards actors who use the platform and are invested in its cryptoeconomic efficiency and equilibrium, not necessarily in the token’s financial growth.

What does all of this mean?

Ultimately, cryptocurrencies represent the first mass scale digital implementation of decentralized economics and game theory. We are seeing the challenges in doing this; in my opinion, one of the critical features of these systems is token distribution- not because of its importance to security, but because of its importance to impact. Cryptocurrencies have the potential to create open, permissionless financial systems, allowing anyone, anywhere to participate fully in the global economy.

Yet, if we simply replicate the current economic conditions digitally, financial systems built using cryptoeconomics will simply become identical to our current financial systems: exclusionary networks with asymmetric information access leading to high barriers of participation. The distribution of a token is intimately related to the cryptoeconomic behavior of the underlying system, and understanding how this distribution changes and evolves with the various incentives of the system are critical to ensuring these new systems can realize their potential.

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