Incentives Drive Innovation: Examining ZCash’s Block Reward Distribution

Last week I felt as if a time machine had taken me back to the late 90’s. That’s when I was involved with an internet start-up and got to watch endless dotcoms pop up like critters in an out-of-control game of whack-a-mole. With each IPO the hype and valuations grew greater and more ridiculous. A company that was almost literally an idea on a napkin would be valued in the billions of dollars. Something similar appears to be happening lately with cryptocurrencies, and ZCash is the latest darling of the genre. On the day of its release ZCash soared in value, due both to its extremely limited initial supply as well as its promise of a truly private cryptocurrency. Time will tell if its stratospheric valuation will hold long-term.

The ZCash Block Reward

ZCash does show a lot of potential, particularly in the area of privacy. Other cryptocurrencies will be well-served to study its attempt to be a truly anonymous digital currency. That’s not to say ZCash is beyond criticism, and in fact there are some aspects of the cryptocurrency that arouse questions, such as its trusted setup. However, in this article I want to focus on one aspect of ZCash that has courted controversy: its innovative block reward structure.

A quick primer on block rewards: the money supply of cryptocurrencies are generated over time, and in most cases, cryptos follow the model set by Bitcoin. On a regular fixed schedule new coins are created, which increases the money supply. The schedule on which they are created and the total number created varies by cryptocurrency, but typically the supply is limited and is mostly generated in the first decade or so of the cryptocurrency’s lifetime. Who gets these newly minted coins? For Bitcoin, and for a lot of cryptocurrencies, they go exclusively to the miners, who protect and secure the network. This incentive structure (originally created by Satoshi Nakamoto) is both simple and brilliant. A decentralized network needs to be secured, but people need more than just altruism as an incentive to secure it. The block reward incentivizes miners to ensure the network is stable and secure.

ZCash Block Reward Schedule (Source: https://z.cash/blog/state-of-the-network-2016-10-31.html)

But are miners the only actors who should be incentivized by the block reward? Are there not other actors who contribute to a cryptocurrency’s success and should therefore also be incentivized?

Envy and Resentment

ZCash, like Bitcoin and most cryptocurrencies, also rewards miners with newly generated coins. However, unlike Bitcoin, ZCash does not designate 100% of its newly minted coins to miners. Instead, during the first four years of its existence, a full 10% of the entire ZCash money supply (2.1 million of the 21 million ZEC total) will be allocated to founders, employees, advisors, and investors, as well as to the ZCash Corporation and ZCash Foundation.

Non-Miner Block Rewards (Source: http://www.coindesk.com/the-structure-and-valuation-of-zcash-vs-bitcoin/)

Some in the crypto community have argued that such a reward structure is either unfair or counterproductive to the long-term health of ZCash. By allocating such a large portion of the money supply to what are essentially insiders, those on the outside are unfairly left out in the cold. (This practice is modeled after IPO’s, where various insiders are able to purchase company stock at a price set before it goes public and potentially skyrockets in value). Simple envy is the root cause of this complaint: many people don’t like to see others succeed, especially financially. It’s a bogus argument. A secretary who was an early employee of Microsoft and made millions doesn’t take any money away from non-Microsoft employees. In fact, the high value of Microsoft stock was a sign that the company offered something of value to the rest of the world. So the rich secretary reflects that everyone benefited from Microsoft’s success.

There is also the argument that allocating a large portion of the block reward to insiders will hurt ZCash’s long-term prospects. By granting millions of ZEC to insiders, ZCash supposedly punishes regular holders by “gifting” ZEC to certain individuals over others. This complaint fundamentally misunderstands incentives and how they drive innovation.

Setting Incentives Properly

Everyone has incentives. For most people, money is an important incentive to work. More accurately, what money buys is an important incentive. But money isn’t the only incentive in life. Love, altruism, fame, power, and desire for societal change can be powerful incentives that can drive people to do incredible things. But, in the end, everyone needs food and shelter, which means everyone needs at least some money.

This fact has always posed a problem to decentralized open-source projects. After all, there is no central company paying the bills, and so those who work on such a project must either work on it part-time, supplementing their income elsewhere, or find a way to monetize their work on the project. This has been an issue with Bitcoin since its beginning. Since only miners receive a monetary reward from the protocol itself, everyone else involved with the Bitcoin project — including its developers — must find other means of making money. Thus, the incentives to work on improving Bitcoin are limited.

The first stab at solving this problem was the creation of the non-profit organization The Bitcoin Foundation. The idea was that The Bitcoin Foundation could promote Bitcoin while raising funds to pay the key developers of the protocol. This setup is modeled after The Linux Foundation, a non-profit that promotes Linux and sponsors the operating system’s key developers. Such a solution, however, simply moves altruism as the primary incentive from non-paid developers to generous benefactors of the project. In Linux’s case, such benefactors were available and willing to donate; with Bitcoin, that didn’t happen.

When it was clear that The Bitcoin Foundation would not be a viable long-term solution, the for-profit company Blockstream was set up. Blockstream would help with Bitcoin development and also create products and services surrounding Bitcoin which would generate revenues for the company. This is similar to the model of Red Hat, a Linux company which helps with the development of the open-source operating system, but also makes money offering services and products on top of Linux. Blockstream would allow developers to get paid and thus continue with development, which in turn allows Bitcoin itself to adapt and grow.

However, as opposed to an open-source operating system like Linux, Bitcoin depends on a single set of developers. If users don’t like the contributions of Red Hat, it would be trivial to fork Linux and go in an entirely different direction. But Bitcoin is not so easily forked due to the valuable currency attached to it. A fork might have the same initial codebase, but wouldn’t have the same monetary value. This is why development of the project quickly came under the control of the Blockstream-sponsored developers, unlike the situation with Linux, which has many corporate contributors. However, these developers’ incentives are divided: what is good for Blockstream the company might not always be what is good for Bitcoin itself. For example, if Blockstream wants to make money on “Layer 2” solutions, then it has an incentive to configure Bitcoin itself to be compatible with their Layer 2 solutions, or even develop it in such a way to prevent the protocol layer from offering those solutions. Incentives are not necessarily aligned with the best interests of Bitcoin.

The Future of Cryptocurrency Block Rewards

These issues have led others to try to find funding solutions in the protocol layer itself; specifically, in the distribution of the block reward. Dash was the first major cryptocurrency to implement a different block reward structure. Since September 2015 Dash has offered 45% of its block reward to “Masternode” owners — a tier 2 network which provides advanced services to the protocol. Dash also allocates 10% of its block reward to its budgeting system, which allows anyone to propose projects that help Dash. Approved projects are then funded directly from the blockchain.

ZCash is taking this model one step further. Those most directly connected to the long-term success of ZCash — such as its developers, founders, and investors — are rewarded in ZEC directly from its blockchain. Like miners, these groups contribute to the advancement of ZCash and so are incentivized in ZEC to do so. After all, if miners, who provide but one service to the success of a cryptocurrency, are rewarded from the blockchain, why shouldn’t all the other actors involved be rewarded? This is the logical evolution of Satoshi’s original idea. There is nothing sacrosanct in only rewarding miners for their work; the important concept that Satoshi introduced was that those who make integral contributions to the network and the protocol can be rewarded from the network itself.

Of course, how best to distribute the block reward to all actors involved in a cryptocurrency is open to debate. Should miners get 45%, or 90%, or some other percent of the reward? How much value do they bring? Likewise for developers, investors, advisors and others involved in the development of the cryptocurrency. But ZCash’s (as well as Dash’s) innovative block reward structure appears to be a model worth imitating for future cryptocurrencies. Perhaps, even Bitcoin itself should consider incorporating something similar. Economics is all about incentives, and the cryptocurrencies with the best built-in incentive structures are likely to be the long-term winners in the future of money.

Disclaimer: The author owns some of the cryptocurrencies mentioned in this article, including Bitcoin and Dash (but not ZCash).