The Incentive Protocol

Tanner Philp
Aug 31, 2018 · 6 min read

Coordination in decentralized systems is all tied to incentives. The Bitcoin white paper is an 8-page playbook for an incentive protocol. The block reward is a set of rules and procedures outlining how supply is distributed to incentivize specific actions (mining). The result is a coordination of resources around a shared objective — this was only made possible by the appropriate incentives. For this ecosystem to take life amongst a group of actors, unknown to each other, there needs to be an explicit protocol to obfuscate the need for trust.

The thickness of protocols has been a topic of discussion since Joel Monegro first presented the Fat Protocols Thesis. In short, it posits that the majority of value is captured at the protocol layer, which I would agree with; however, it’s important to first align on the definition of protocol as I believe it is often used as a direct synonym for any of the underlying infrastructure in a given blockchain. A protocol, by definition, is the set of rules and procedures to produce a desired outcome.

Every blockchain does have an inherent protocol embedded in the consensus mechanism but to view these protocols at the infrastructure layer as exhaustive would be taking an incredibly narrow view. At the time of Joel’s post, the majority of innovation was happening at the infrastructure layer, which makes sense, there needs to be sufficient infrastructure in place to support usable applications. So it’s not a stretch to see why many read the “Fat Protocols” thesis as the “Fat Infrastructure Protocols” thesis.

I would argue that for many token economies, the majority of value will accrue to components above the underlying infrastructure via an incentive protocol for the application layer.

Value is generated where the actors garner “utility” (specifically in quotations given the overuse and nebulous nature of this term). Utility is a fluid concept, entirely subjective and contingent on the demands of the network participants. For some, an open, permissionless consensus protocol provides the highest level of utility where the primary concern is a store of value, for example. For others, a permissioned consensus protocol with higher throughput may provide the highest level of utility where the primary concern is fast micro-transactions, for example.

Consensus protocols in permissionless blockchains are capital intensive to combat bad actors. By making it expensive to validate transactions there is a negative incentive to act maliciously. The converse requirement is a high level of positive incentives allocated to the validators of the network i.e. the Bitcoin block reward.

In a permissioned consensus model, the actors are known. The higher level of coordination mitigates the need for large negative financial consequences to combat malicious activity, conversely reducing the requisite incentives to participate in consensus (often the participation is tied to tangential incentives). This flexibility unlocks explicit incentivization of actions at the application layer.

At first blush this would suggest a counterargument to the Fat Protocol thesis given its original assertion of a thin application layer; however, I believe this position is complementary. Token economies have evolved, in large-part due to the commoditization of infrastructure, effectively abstracting the value proposition of novel consensus models.

Peter Thiel posited that over a long enough time horizon, everything either becomes monopolized or commoditized. The open and collaborative nature of decentralized systems leaves the components of infrastructure open for commoditization. If incremental innovations to consensus protocols are commoditized, the value proposition of each competing chain is derived from a set of trade-offs — Kyle Samani wrote a great piece about this and the race to network effects here.

Decentralization is not a destination; it is a spectrum. Value accretes at specific junctures on the decentralization vs. pragmatism spectrum, where a set of trade-offs are made. Much of the infrastructure in-market is built to optimize for decentralization, forcing applications to build around hard constraints. This is a compromise that not all developers are willing to make. With the evolution of commoditized components at the infrastructure layer, they won’t have to. Today, marginal movements on the spectrum render disproportionally high improvements in standard measures of consumer experience (latency, throughput, UI). Many of the current junctures on the spectrum will regress to the mean, with a few focal points where there are fundamentally different needs depending on the desired utility of the network i.e. store of value vs. small micro-transactions.

Developers of consumer apps have a high level of pragmatism with a bias to consumer experience because they understand the needs of their users, and those needs often do not include incrementally higher decentralization. They include: how easy is it to use, how fast is it, and how many of my friends are using it. The network needs to be sufficiently decentralized such that the fundamental properties of the network (supply, governance, allocation) are maintained.

Bootstrapping network effects through an incentive protocol

A token native to the network is a powerful tool to generate network effects. Early adopters are implicitly locked in given their stake and are economically aligned to drive network adoption.

Traditionally, in consumer tech, network effects are a fundamental pre-requisite for the application to generate value for its users i.e. all my friends are in the network, therefore I want to spend my time here. A tokenized application layer has a chance to eradicate this constraint. If a token underpins a core user experience, there is explicit value for the users of the network. The inherent scarcity creates an economic incentive to be an early adopter and drive network adoption. Users are implicitly locked in, given their stake, effectively empowering the innovators and early adopters to be agents of network effects.

Moving past the cohort of early adopters is the Bermuda Triangle of scale — many have approached, few have emerged. Crypto is a tool to propel past the sticking point and cross the chasm by democratizing the opportunity to have skin in the game. Owning a stake of a finite supply is a powerful incentive. With network tokens powering the user experience, this is no longer exclusively afforded to developers and VCs.

The implicit incentives of being an early stakeholder can be amplified by an incentive protocol, allocating supply to specific actions. This is made possible by making trade-offs at the infrastructure layer to free allocation to other network participants, either through a bifurcation of incentives or alternative incentives to the validators i.e. grants, fees, staking.

Referral bonuses are a rudimentary analogue to an application layer incentive protocol. PayPal, for example, gave users initial seed capital in their account and would add referral bonuses for inviting new users. Imagine the value of that initial referral bonus grew as the network grew. Given utility would, in theory, be a function of the network value, this purchasing power would be a function of network effects. Metcalfe’s law would suggest the value of a network token would grow at a rate of N2. A powerful incentive to be an agent of network effects.

Why this matters

It is not enough to shoehorn a token into an app. As noted, the token has to be core to the user experience, either creating new behaviours or amplifying existing behaviours.

The rise of digital has created a new economy. The opportunity to be a creator now extends to anyone connected in the digital ecosystem. Emergent digital native user behaviours are generating value in a peer-to-peer digital economy. The role of the developer is no longer to create value for users, it is simply to facilitate value creation in these communities. With users at the center, generating unique value for each other, a token economy can generate the right incentives for stakeholders to lean in, if architected appropriately

What this means for applications

A shared incentive protocol at the application layer decouples the network from the end-user application. Traditionally, app developers compete for a finite share of user’s time and brand’s ad spend. User experiences underpinned by a token moves the network outside the walled-garden, elevating it to a meta level, where users are empowered to move cross-application. The shared incentive for app developers is to increase the utility of the network, which they are a participant in, not the owner of.

This paradigm shift disrupts conventional wisdom of a zero-sum game. Optimizing for end user experience often comes with its own set of trade-offs; and collaborating with other apps is often reductive to the bottom-line. With a shared currency layer, these threats can be reversed and leveraged as force multipliers.

Efficient infrastructure enables flexibility for a network to incentivize economic activity within an application. Think of developers like miners, only instead of validating transactions, they are facilitating transactions in their consumer applications. This could be a catalyst for main-stream consumer adoption as well as aligning developers to work together, instead of killing each other in their fight against monopolies.

All of this may come across as altruistic. To that, I would argue that it is early. Digital has unlocked new human behaviours; the emergence of crypto has unlocked new behavioural economics to match. It may be early, but the nature of decentralization and distributed systems is democratizing development to the commons and we’ll see innovation and behaviours that fundamentally change the way we operate. I’m excited to see where this goes.

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