CRYPTO ECONOMICS
I. Introduction
Contemporary society is expeditiously embracing decentralized solutions for human interaction. Increasingly complex frameworks, theories and models are needed to understand the issues facing contemporary societies.[1] Crypto-economics as a discipline is an attempt to create models that allow the analysis of interrelationship in increasingly complex frameworks of human interaction in distributed systems. Most commonly accepted public blockchains are a product of crypto-economics.
The term “Crypto-Economics” has been defined in several different ways.[2] Most commonalities in definitions for the term crypto-economics include the use of cryptography and incentive design to created networks, applications, and systems.[3] Further, crypto-economics is interdisciplinary. Economics examines how individuals and groups respond to incentives. Connecting it to traditional economics, crypto-economics is mostly associated with mechanism design, a sub-discipline of economic theory and mathematics.[4]
Yet, crypto-economics is more applied cryptography than economics.[5] Considering money as an engineering problem as well as considering technology from the perspective of economic incentive design and security, problems in economic terms are unique elements of this discipline and may feel counterintuitive for economists and engineers alike.
Crypto-Economics is subject to limitations. The crypto-economic system design’s strength and endurance depends in large part on its assumptions about human reactions to economic incentive designs.[6] Shaping future human behavior through incentive design is limitedly successful[7] because the social engineer speculates about human future mental states and corresponding belief systems. Future human reactions may in fact be entirely different than anticipated by the social engineer and incentive designer.
Token models and their design and incentive optimization within their design are at the core of economic designs in distributed systems. This article evaluates these well-established token models. Because the economic experimentation inherent in crypto-economics continuously generates new token models and incentive designs for tokens, the token model examination herein is naturally incomplete.
II. Economic Designs for Distributed Systems
Decentralized economic incentive designs necessitate a convergence of disciplines.
Figure 1: Crypto Economics — a Convergence of Disciplines
Crypto-Economics really is just economics and, in fact, may be a misnomer. Yet, several disciplines and analyses in such disciplines are necessary to examine decentralized economic incentive designs. Figure 1 illustrates the different disciplines that contribute to the analysis of incentive designs in decentralized systems. The unique and unprecedented combination of disciplines and factors in the analysis of incentive designs in decentralized systems may legitimate the labeling of that analysis as Crypto-Economics.
1. Economic Experimentation
Emerging decentralized economic incentive designs allow unprecedented economic experimentation. As blockchain-based emerging technologies mature and evolve, incentive designs in decentralized system provide unparalleled opportunities for experimentation with economic models, stability mechanisms, and policy tools. Importantly, the emulation of existing economic incentive designs and policy tools in entirely new economic structures of decentralized systems could allow the examination of interactions and feedback effects of otherwise completely separate economic subject. In particular, incentive designs in decentralized systems may enable the study of economic incentive design on human behavior and token prices. In that sense, crypto-economics may enable the analysis of an effect of micro on macroeconomics and vice versa.
The economic experimentation in crypto-economics may be enabled by the creation of new economic ecosystems and entirely new economics. Each of these new economies are created with the design of a currency and can have unique monetary and fiscal policies and regulations. The infrastructure for these economies is computational.
2. Challenging the Theory of the Firm
The economic experimentation enabled by decentralized incentive designs could challenge the existing assumptions in the theory of the firm.[8] Ronald Coase suggests that firms exist to reduce transaction cost e.g. firms are a response to the high cost of using markets.[9] While easily defined concepts can be opened up for market evaluation through a contractor, firms are needed for more complex contracts and concepts that necessitate an employee with a fixed salary who follows changing instructions. The employee requires the existence of the hierarchical structures of the firm, defined concepts can be opened up for market evaluation through a contractor, firms are needed for more complex contracts, and concepts that necessitate an employee with a fixed salary who follows changing instructions. The employee requires the existence of the hierarchical strictures of the firm.
Decentralized solutions for human interaction can challenge the basic assumptions of the theory of the firm. In other words, the role of the firm may change if decentralized solutions help lower the cost of using markets exponentially. Emerging decentralized technology solutions show promise to lower transaction costs for a significant portion of market transactions. More particularly, decentralized autonomous organizations (DAOs) can be seen as market meritocracies unlike traditional firms that can over time make market transactions for human interaction ever more efficient. Arguably, DAOs can replace the otherwise needed functions that are supplied by the firm that acts as the coordinator and monitor of a team because DAOs can more efficiently measure the contribution of each DAO member to the finished work product and allocate respective rewards accordingly. Trust enhancing technologies, such as reputation verification in decentralized autonomous and anonymous systems, can support that process, ensure that DAOs work even more efficiently, and in the process further lower transaction cost over time.
3. Macro vs. Micro
Crypto-economics necessitates macro and microeconomics, just like traditional economics. By way of definition, traditional macroeconomics deals with the overall economy, inflation, employment, gross domestic product, among other considerations. Microeconomics, on the other hand, deals with supply and demand in individual markets for goods and services. The macro / micro split is largely institutionalized in traditional economics.[10]
Macroeconomic questions arise in crypto-economics in the context of token supply and timing as well as allocation of tokens to constituents. Central banking functionality is implicitly part of the incentive and token design setup and as such rather similar to macroeconomics. Whereas macroeconomics addresses the overall economy and examines employment, GDP, and inflation, among others, macroeconomics in decentralized incentive designs examines the timing, quantity of token creation and allocation of tokens. Token designer and other decision makers act as virtual central banker s for the respective token economy. Inherent in this setup is the democratization of monetary policies for the respective token economy. Whereas policy designers, central bankers, and economists previously coordinated market design and economic regulations in centralized systems, these functions are taken over by the token designer. This creates a serious problem for many token economies as the designers lack the qualifications and functions that are orchestrated by multiple institutions and their staff in centralized central banking.
Microeconomic questions arise in crypto-economics because the token design necessitates solutions for token value generation, token enabled economic interaction, and design of incentive mechanisms for token holders that are individually rational and incentive compatible. Whereas traditional microeconomics examines the supply and demand in individual markets for goods and services and their interaction, crypto-microeconomics evaluates metrics for the value proposition of tokens. Crypto-microeconomics also examines the interactions enabled by the token as well as the incentives for agents/token holders to participate in the respective token economy in an effort to ensure fairness and promoting honest behavior.
4. Monetary Policy
Monetary policy in decentralized economic incentive designs emulates centralized monetary policy and adds new elements. Centralized monetary policy mechanisms are orchestrated by the Federal Reserve Bank (FED) of the United States. Its monetary policy mechanisms include the discount rate,[11] reserve requirements,[12] open market operations,[13] and interest on reserves.[14] Monetary policy in crypto-economics refers to the interaction of token supply, token release, and the maximum issuance of tokens in a given token issuance. An issuers’ ICOs strategy can pre-define monetary policy by predetermining the fixed number of tokens created and issued in the ICO. A maximum token issuance in combination with controlled token supply releases can result in small increases in demand driving token prices higher.
Several aspects related to the release mechanisms for tokens help manage the supply of tokens in circulation. For instance, escrow accounts can hold tokens that were not issued in the ICO. Such escrowed tokens may be released for future issuance to finance future projects of the issuer or support operational financing. To avoid a token price crash, token escrow accounts should provide usage and access controls that assure investors that escrowed tokens will not be issued at a discount. Lockups of escrowed tokens for a specified time period or phased releases can also help minimize the risks of token price crashes.
5. Fiscal Policy
Fiscal policy tools in centralized economies typically revolve around government spending and tax policies. To increase business activity in an economy, the government can increase the amount of money it spends, often referred to as stimulus spending, as opposed to deficit spending.[15] Government tax policies may stimulate centralized economies by lowering taxes. By increasing taxes, governments can remove money out of the economy and slow business activity.[16]
Fiscal policy in decentralized economic incentive designs emulates centralized fiscal policy and adds additional factors. The economic benefits token holders receive from holding tokens are a key concept associated with quasi fiscal crypto policy. Two central questions help illustrate this point: 1. What is the underlying value of the issued tokens?, and 2. What factors contribute to the value appreciation or depreciation of the issued tokens? For instance, linking commercial benefits such as discounts and other benefits with token usage can incentivize token holders to use the services etc. associated with a given token.
Several benefits are associated with the quasi fiscal tool of adjusting commercial benefits of tokens in decentralized economic incentive designs. First, the increase in commercial benefits associated with a token heightens the aggregate demand of the given token supply. Second, commercial benefits associated with a token issuance can help offset depreciated supply scarcity, e.g. the effects of a large issuance / supply of a given token in circulation. Third, commercial benefits associated with tokens can be adjusted as a form of quasi fiscal policy to control the flow of tokens in a given issuance through indirect economic incentives. Adjustments in commercial benefits can help manage operational cost changes for the issuer and the external competition with other token issuers experienced by the issuer, among other factors. Fourth, adjusting the commercial benefits associated with a given token issuance avoids more drastic monetary policy intervention by way of emergency sales or building token reserves or a decrease or increase of token supply in circulation.
To create a more significant effect, the quasi fiscal policy tool can be combined with monetary policy. If the aggregate demand for a given token issuance increases through better commercial benefits associated with the tokens, the issuer can simultaneously increase the total supply in circulation. Options for increasing the total supply of tokens in circulation include issuing escrowed tokens or even secondary issuances. The combined effect of quasi fiscal policy (increasing benefits associated with the tokens) and monetary policy (increasing the token supply in circulation) may or may not have an effect on the market price of the respective tokens. The balance of commercial benefits of a token offering and associated use cases of the token in combination with supply scarcity is critical in the issuance of a token offering.
[1] “The market was seen as the optimal institution for the production and exchange of private goods. For non-private goods, on the other hand, one needed the government to impose rules and taxes to force self-interested individuals to contribute necessary resources and refrain from self-seeking activities … Scholars are slowly shifting from positing simple systems to using more complex frameworks, theories, and models to understand the diversity of puzzles and problems facing humans interacting in contemporary societies.” Elinor Ostrom, Beyond Markets and States: Polycentric Governance of Complex Economic Systems, Nobel Prize Lecture at 408 (Dec. 8, 2009), in Lex Prix Nobel, 2009, at 408, 409.
[2] “Cryptoeconomics is: ‘A formal discipline that studies protocols that govern the production, distribution, and consumption of goods and services in a decentralized digital economy. Cryptoeconomics is a practical science that focuses on the design and characterization of these protocols.’” Vlad Zamfir (Cryptoeconomicon CCRG), What is Cryptoeconomics?, YouTube (Feb. 1, 2015), https://www.youtube.com/watch?v=9lw3s7iGUXQ; “The Ethereum Wiki defines cryptoeconomics as ‘the combinations of cryptography, computer networks and game theory which provide secure systems exhibiting some set of economic dis/incentives.’” The Ethereum Wiki, Ethereum, https://theethereum.wiki/w/index.php/Cryptoeconomics (last visited Sept. 11, 2018).
[3] Josh Stark, Making Sense of “Cryptoeconomics”, Medium: L4 Media (Nov. 16, 2017), https://medium.com/l4-media/making-sense-of-cryptoeconomics-5edea77e4e8d.
[4] Id.
[5] Id.
[6] See KARL R. POPPER, THE POVERTY OF HISTORICISM 83–93 (1957) (discussing the sociological and theoretical underpinnings of trial- and- error social- engineering); Wulf A. Kaal, Evolution of Law: Dynamic Regulation in a New Institutional Economics Framework, in FESTSCHRIFT ZU EHREN VON CHRISTIAN KIRCHNER 1211, 1212 (Wulf A. Kaal et al. eds., 2014).
[7] See “Game theory & economics require speculation about subjective mental states & ignoring the many possible motives beyond proximate incentives.” Nick Szabo (@NickSzabo4), Twitter (Jul. 5, 2017, 4:08 PM), https://twitter.com/nickszabo4/status/882738070616809472; Andrew M. Colman, Cooperation, Psychological Game Theory, and Limitations of Rationality in Social Interaction, 26 Behav. & Bain Sci. 139 (2003).; contra Herbert Gintis, Hayek’s Contribution to Reconstruction of Economic Theory, in Hayek and Behavioral Economics 111 (Roger Frantz & Robert Leeson eds., 2013).
[8] See Coase Call, Economist: Economics Brief (Jul. 27, 2017). One of the first papers for these ideas was 1972 by Armen Alchian and Harold Demsetz. They defined the firm as the central contractor in a team-production process. It is thus like a “mini-society with a vast array of norms beyond those centred on the exchange and its immediate processes,” wrote Mr Williamson. Such a contract stays in force mostly because its breakdown would hurt both parties. And because market forces are softened in such a contract, it calls for an alternative form of governance: the firm. Jeremy Liu, Blockchain, Decentralisation, and the “Theory of the Firm”, Medium: The Pointy End (Dec. 12, 2017), https://medium.com/the-pointy-end/blockchain-decentralisation-and-the-theory-of-the-firm-92649c62350d.
[9] R. H. Coase, The Nature of the Firm, 4 Economica 386 (1937).
[10] G. Chris Rodrigo, Micro and Macro: The Economic Divide, Fin. & Dev. (July 29, 2017), http://www.imf.org/external/pubs/ft/fandd/basics/bigsmall.htm.
[11] BOARD OF GOVERNERS OF THE FEDERAL RESERVE SYSTEM, The Discount Rate, Federal Reserve: Policy Tools (2018), https://www.federalreserve.gov/monetarypolicy/discountrate.htm.
[12] BOARD OF GOVERNERS OF THE FEDERAL RESERVE SYSTEM, Reserve Requirements, Federal Reserve: Policy Tools (2017), https://www.federalreserve.gov/monetarypolicy/reservereq.htm.
[13] BOARD OF GOVERNERS OF THE FEDERAL RESERVE SYSTEM, Open Market Operations, Federal Reserve: Policy Tools (2018), https://www.federalreserve.gov/monetarypolicy/openmarket.htm.
[14] BOARD OF GOVERNERS OF THE FEDERAL RESERVE SYSTEM, Interest on Required Reserve Balances and Excess Balances, Federal Reserve: Policy Tools (2018), https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm.
[15] Fiscal stimulus is a term for tax cuts or new government spending that increase aggregate demand. Fiscal stimulus can be helpful when unemployment is high and economic output is less than its potential. Peter Olson and Louise Sheiner, The Hutchins Center Explains: Fiscal stimulus and the Fed, Brookings: Up Front (Jan. 26, 2017), https://www.brookings.edu/blog/up-front/2017/01/26/the-hutchins-center-explains-fiscal-stimulus-and-the-fed/.
[16] What is Quantitative Tightening, FXCM: Market Insights, https://www.fxcm.com/insights/what-is-quantitative-tightening/ (last visited Sept. 11, 2018).
