This post was initially posted as a first draft of a chapter published in the book Token Economy, and was updated on April 3, 2020 with the final version of the chapter.
Purpose-driven tokens incentivize individual behavior to contribute to a collective goal. This collective goal might be a public good or the reduction of negative externalities to a common good. Purpose-driven tokens introduce a new form of collective value creation without traditional intermediaries. They provide an alternative to the conventional economic system, that predominantly incentivizes individual value creation in the form of private goods.
Public blockchain networks can be described with many metaphors: (i) distributed ledger, (ii) universal state machine, (iii) governance machine, (iv) accounting machine, and (v) decentralized autonomous organization. However, all these characteristics are derived from the fact that the Bitcoin network and similar distributed ledgers are first and foremost (vi) incentive machines. Proof-of-Work revolutionized collective value creation in the absence of intermediaries. It introduced a consensus mechanism to get network actors to collectively manage a distributed ledger in a truthful manner, by rewarding them with tokens. The idea of aligning incentives among a tribe of anonymous actors introduced a new type of public infrastructure that is autonomous, self-sustaining, and attack resistant (read more: Part 1 — Bitcoin, Blockchain, & other DLTs). This has since inspired many projects to build on this principle of incentivizing behavior with what I call a “purpose-driven token”. With purpose, I refer to the idea of a collective goal in addition to maximizing one’s personal profit. The collective goal might be a public good (for example, a P2P payment network) or the reduction of negative externalities of a common good (for example, the reduction of CO2 emissions).
Bitcoin’s Proof-of-Work introduced a novel approach that transcends classic economic value creation. The protocol provides an operating system for a new type of economy that can transcend nation states and individual organizations. The open-source nature of the Bitcoin protocol allowed anyone to take the code, copy and modify it, and issue their own purpose-driven network. Networks like Ethereum took the idea of collective value creation to the next level by providing a public infrastructure for creating an application token with only a few lines of code. With these application tokens, we can now create completely new types of economies with a simple smart contract that runs on a public and verifiable infrastructure. These tokens are an easily programmable vehicle to model individual decision making processes into a smart contract. Any purpose can be incentivized. Any behavior can be modeled. Examples of different types of purpose-driven tokens are:
- Incentivizing consensus on the state of a network: In a Proof-of-Work network, consensus among the nodes is reached by incentivizing miners with native network tokens to use their computing power to secure the network. The aim is to reach distributed consensus among untrusted network actors on the state of the network. The reward mechanism is based on the assumption that all network actors are potentially corrupt, therefore the process of writing transactions to the blockchain is intentionally made difficult and inefficient, making it costly for malicious actors to attack the network. Bitcoin, Ethereum, and similar networks provide a public good similar to the ones governments usually provide to their citizens: public utility networks like railroads, waterworks, or electricity grids. However, as opposed to state-controlled public goods, blockchain networks have distributed upkeep, development, and control, which are all aligned and incentivized by the native token. In the case of Bitcoin, the public good represents a P2P payment infrastructure. In the case of Ethereum, the public good represents a P2P computing infrastructure. But Proof-of-Work is not the only incentive mechanism to achieve universal state. Alternative consensus protocols are being researched and developed that might be faster or more resource efficient (read more: Part 1 — Bitcoin, Blockchain, & other Distributed Ledgers).
- Incentivizing social media contributions: Steemit is a blockchain-based social network designed to incentivize content creation and content curation. Any user can join and contribute for free, and as such contribute to the public good. The aim of this P2P social network is to reward those who contribute to the growth and resilience of the social media network. Steemit is an application similar to “Facebook” or “Reddit” but as opposed to Facebook or Reddit, the network is collectively governed and maintained. Contributors to the network get rewarded for contributing to the underlying blockchain infrastructure (Steem blockchain), or for uploading or curating content on the Steemit Website. How much you get paid is a function of the number of contributions, and the popularity of your contributions. Examples for other networks incentivizing contributions are “E-chat,” Akasha,” “Minds,” or “Golos” (read more: Part 4 — Steemit).
- Incentivizing contributions to a listing: Token Curated Registries (TCRs) are a cryptoeconomic mechanism designed to incentivize the collective curation of public lists or content feeds in a social network. The collective goal is a useful and high quality list. Tokens are used to provide an economic incentive to curate the ranking of information in such a list. The mechanism of a TCR aims to align token holder incentives in order to produce lists that are valuable to consumers and provide a reliable signal of quality on something a user cannot directly observe. Each list has its own native token(read more: Part 4 — TCRs).
- Incentivizing CO2 emission reduction: Cryptographic tokens issued by a smart contract can also be used to incentivize individuals and corporations to act in a sustainable manner. In such a setup, individuals and organizations who can prove that they reduced CO2 emissions can be rewarded with a token which is created (minted) upon such proof. Depending on the design of the token, the CO2 rewards could be exchanged for some other services provided by the organization issuing these tokens and can vary greatly from project to project. Tokens might be tied to the identity of a user (non-fungible), or they might be designed to be tradable (transferrable). They might be designed to expire after a while, or have unlimited durability. “Vienna Kultur-Token,” “Sweatcoin” or “Changers” incentivize riding a bike, walking, or using public transportation instead of using a car. Other projects incentivize the production or consumption of renewable energies such as “Solar Coin,” “Electric Chain,” and “Sun Exchange.” Alternatively people could be incentivized with a token every time they prove that they have used less energy by using energy efficient devices, turning the lights off as in the case of “Energi Mine” or “Electron.” Alternatively, one could be incentivized for planting trees (Proof-of-Tree-Planted), or cleaning a beach (Proof-of-Bottles-Recycled), reduction of food waste, and many more, examples of which are: “Plastic Bank,” “Earth Dollar,” “Bit Seeds,” “Eco Coin,” “Earth Token,” and “Recycle To Coi.”
Purpose-driven tokens provide an alternative to conventional economic systems, which predominantly incentivize individual value creation: private actors to extract rent from nature or from the workforce, and transform these into products, often externalizing costs to society, while internalizing (and maximizing) private profits. However, this new and collective value creation phenomena that Bitcoin introduced will likely need much more research & development and a long phase of trial and error until we can better understand the potential of incentivizing contributions to a public good. Operational use cases are still limited.
The “monetary policy” of purpose-driven tokens can be regulated by a smart contract governing the issuance and rights management of these tokens. These tokens can be fungible (tradable for other tokens of the same kind) or non-fungible (identity-based reputation tokens). CO2 tokens, for example, could be designed to incentivize only the person who earned the tokens (non-transferrable). Tokens could also come with an inbuilt expiry date. Bitcoin and other blockchain protocol tokens have been designed to be transferable and thus tradable. Tokens can be programmed to have limited transferability so they can be only exchanged for products and services within the community, therefore never leaving the internal system and being exchanged for fiat money, but still useful in the internal economy of a network (community currency).
The study of economics, public choice theory, theory of public goods, and behavioral sciences will be essential for a better understanding, and as a result, also a better design and engineering process of purpose-driven tokens (read more: Part 4 — How to design a Token System).
Public Goods & the Tragedy of the Commons
In economics, the term “public good” refers to goods that any individual can use without paying for them (non-excludable, or permissionless), and where use by one individual does not reduce availability to others (non-rivalrous, or unlimited). Public goods that satisfy both conditions only to a certain extent are referred to as impure public goods. Public goods can be provided by a government, or be available in nature. Global public goods have no geographical restrictions, and are globally available. Examples thereof are: knowledge, the Internet, and certain natural resources.
The Bitcoin payment network could be seen as a new form of tech-driven public good, albeit an impure one. Upkeep and maintenance of the network is collective and permissionless. Usage of the network is permissionless and non-rivalrous, but only as long as capacity limits are not reached. In their current form, public blockchain networks don’t scale well and can be considered as rivalrous when the network becomes clogged. P2P social networks and Token Curated Registries are also tech-driven public goods.
Public goods tend to be subject to free-rider problems, where some individuals consume a public good without (sufficiently) contributing to their creation or maintenance. If a certain threshold of people and institutions decide to free-ride, the market will fail to provide a good or service for which there is a need. Open-source software is a public good that is typically subject to the free-rider problems. The Bitcoin protocol is also a good example for this free-rider problem, as only a few contribute to the code, with little or no direct incentive to do so, but many people use it. Tokenized social media networks or token curated registries also face many free-rider problems that need to be anticipated when designing the token governance mechanisms (read more: Part 4 — Steemit & Token Curated Registries).
If public goods become subject to restrictions, they become club goods or private goods. Exclusion mechanisms might be in the form of memberships, copyright, patents, or paywalls. Club goods represent artificially scarce goods. Permissioned ledgers could be seen as such club goods, where only members of the federation (club) have access to the distributed ledger and can write transactions to it (read more: Part 1 — Bitcoin, Blockchain, & other Distributed Ledgers).
Common goods are similar to public goods, as they are non-excludable (permissionless), but they are rivalrous, which means that the consumption of a good by one person excludes others from consuming it. Examples of common goods are water and air, forests, and natural resources in general. They are public but scarce, often to varying extents. If natural resources are exploited or polluted beyond their sustainable capacity it affects others from consuming them. “Tragedy of the commons” occurs when individuals withdraw resources for their own short term profit, disregarding collective dynamics of individual behavior and long-term consequences to the common good. Tragedy of the common might be avoided with regulations to limit the extraction of the goods beyond a sustainable level.
While the world‘s fish stocks can be seen as a non-excludable resource, they are finite and diminishing because of continuous deep sea fishing by different private actors worldwide. State-of-the-art public ledgers are on some level always rivalrous, and have more public good character, at least currently. This might change as the technology evolves. Purpose-driven tokens can be programmed to maintain or restore a common good, and could possibly resolve many tragedy-of-the-commons problems society faces today. CO2 tokens, as previously described, could provide a mechanism for “nudging” individuals to collectively contribute to the reduction of negative externalities of a common good.
Positive & Negative Externalities
Our current economic system predominantly incentivizes individual value creation in the form of private goods. Private goods come with private property rights attached that prevent others from using the good or consuming its benefits, unless they pay for it (excludable). With physical goods, consumption by one person prevents that of another (rivalrous). The case is different for digital goods, but artificial scarcity can be created with digital rights management tools (copyright protection). A private good can be rented out to another person, granting temporary access rights. Patents also create artificial scarcity by providing temporary monopolies. They are legal mechanisms to enforce excludability for anyone else to use the patented technology.
The creation of private goods often leads to “negative externalities” to common goods, like the environment. Such negative externalities are regulated by local, national, and international organizations, with laws (mostly negative incentives), taxation (negative incentives except tax break legislation), nudging (positive incentives), and privatization (market mechanisms). Externalities in economics refers to the costs or benefits that affect a person or community, who did not choose to incur that cost or benefit. “Negative externalities” are a result of activities of people and institutions that cause an indirect cost (negative effect) on other people or institutions. Pollution is an example thereof. Consuming goods with a negative CO2 footprint is another. Manufacturing can cause air pollution, imposing health and clean-up costs on the whole society. If those costs are not internalized through government regulation, those who create the externalities will continue to do so. “Positive externalities” can arise if, for example, two neighboring farmers have positive ecological effects on each other. Incentivizing CO2 emission reduction with a token could be another example of a positive externality. that could contribute to the wellbeing of a common good, like contributing to a better air quality of a city. Even though the collective production of public goods can result in positive externalities, it does not necessarily exclude other negative externalities. If not well designed, purpose-driven tokens can have positive and negative externalities: while Proof-of-Work is an essential mechanism for the maintenance of a public good, the act of Bitcoin mining itself is energy intense, producing negative externalities to society.
Behavioral Economics & Nudging
The current design of tokenized networks is faced with many “free-rider” and “tragedy of the commons problems” that need to be anticipated when designing the token governance mechanisms of these tokenized networks. Furthermore, most approaches of modeling of tokens are based on the assumption of rationality: all agents act egotistically and logically consistent with their preferences and beliefs, and base their decisions on full use of information. Current consensus mechanisms are based on the idea of a neoclassical economic theory and the concept of a rational economic actor — “homo economicus” — who reduces economic decision making to simple profit maximization based on an individual profit maximization and the idea of “perfect selfishness.” While the idea of “perfect selfishness” and rationality assumptions might make sense in the context of machine consensus, as consensus isn‘t actually directly managed by humans and almost exclusively bot activity, such rationality assumptions might not make sense for the mechanism design of human behavior towards CO2 emission reductions, contributions to a social network, or contributions to a token curated list.
Alternative economic theories, such as behavioral economics, are based on the assumption that individual action is more complex. Behavioral economics is a field of economics that studies the economic decision process of individuals and institutions are impacted by other factors than economic rationality. Psychological, emotional, emotional, cultural, cognitive and social factors are also taken into account with the conclusion that people make over 90 percent of their decisions based on mental shortcuts or “rules of thumb.” Especially under pressure and in situations of high uncertainty humans tend to rely on anecdotal evidence and stereotypes to help them understand and respond to events more quickly. It is assumed that the rationality of individuals and institutions is “bounded” by time and cognitive limitations, and that good enough solutions are preferred over perfect solutions. Behavioral economics builds on the learnings of cognitive psychology, a field of psychology that studies mental processes.
Nudging suggests build on the assumption of “bounded rationality” and suggests that individuals can be supported in their decision making process by, for example, placing healthier food at sight-level in supermarkets to increase the chance of selection by buyers. Nudging is a concept developed in 1990s and was adopted by some politicians in selected countries. Behavioral economics has been applied in the context of policy making, business environments, and for modeling machine learning algorithms. Critics, however, argue that nudging equals psychological manipulation and social engineering. Purpose-driven tokens can also be used to “nudge” or “steer” individuals toward certain actions, like reducing CO2 emissions. However, any type of governance system is steering of collective action and per definition aims at social engineering. Behavioral economics and methods like nudging can therefore provide important tools when designing the token governance rules of purpose-driven tokens as a means to provide public goods.
Cognitive Psychology & Behavioral Analysis
Tokenized incentives are not a new thing and have been experimented with in psychology to condition behavior. In psychology the term “token economy” refers to a type of behavior modification program using “operant conditioning,” which was described by A.E. Kazdin in 1977. In behavioral analysis the term operant conditioning refers to a learning process through which behavior is modified by reinforcement or punishment. It studies the relationship between behavior and external stimulus or events that influence behavior. Nudging can be seen as a collective behavioral conditioning tool that derived from disciplines like behavioral analysis and operant conditioning. Kazdin was also critical in controlling human behavior, attitude, and thought, and pointed out the ethical implications that could lead to totalitarian control. While he describes “behavioral technology” as ethically neutral, he states that the governance process of deciding the purposes and how much control interferes with individual freedoms, determines whether this system will be used or abused. Various authors before him discussed the use of behavioral principles to design society, and these concerns are similar to the concerns related to nudging theory.
In the mechanism design of purpose-driven tokens, such ethical considerations need to be made. There is much we can learn, and not only from the ethics of behavioral economics. Related disciplines like engineering and cybernetics have also developed ethical principles that can be relevant to token engineering. Business ethics as part of the philosophy of economics also deals with the philosophical, political, and ethical underpinnings of business and economics. Engineering ethics, for example, require that anything you design, especially public infrastructure, be rigorously and carefully tested to minimize risk of harm; engineering in infrastructure fields has licensing and liability for engineers who fail to practice due diligence or respect best practices. The cybernetics discipline has the concept of “second order cybernetics” where you are aware of your interventions, which makes you part of the system you are designing or attempting to influence.
Over the past years, the data science and AI communities have, for the most part, disregarded these principles, probably as a result of profit maximization over ethics. Ethical discourse in the business context was very often sacrificed over short-term efficiency thinking. This was a systematic problem that started with universities, like my own alma mater, eradicating business ethics from the general curriculum of studies back in the 1990s. Integrating ethical principles from engineering, cybernetics, and economics with modern AI expertise is the closest thing available to a reference case for cryptoeconomic design of purpose-driven tokens.
Behavioral Finance & Behavioral Game Theory
Behavioral finance studies why market actors are economically “irrational” and resulting market inefficiencies such irrational behaviour and how others can profit from such (predictable) irrationality. Among others, behavioral finance explains how reactions to new information affect market movements such as bubbles and crashes. Findings from behavioral finance are important aspects to consider when modelling purpose-driven tokens and DeFi market mechanisms, some of which are discussed in Part 4 — Token Curated Registries.
Behavioral game theory is a subfield of behavioral economics that analyzes the interaction of strategic decisions made by different market participants. It required the understanding of what motivates people towards their actions. Applied methods are game theory, experimental economics, and experimental psychology that study the paradoxes in decision making by participants in a game. It provides alternatives for traditional decision making models, such as “regret theory,” “hyperbolic discounting” and “prospect theory.” For example, people might want to minimize the feeling of regret after having made a decision, and might therefore assess their options based on how much regret they might suffer from the outcome of their strategies.
The design of purpose-driven tokens uses game theory to model human reasoning into an automated steering mechanism formalized by the protocol or smart contract and should account for the behavioural complexities. There is, furthermore, an entire class of games in the network science literature, called “network formation games” that cover everything from how academic citation and collaboration networks emerge, to Twitter graphs, etc.
As the field of cryptoeconomics and purpose-driven tokens matures, it is likely that behavioral finance and behavioral game theory will find its way into the cryptoeconomic modeling of such purpose-driven tokens. Many tokenized use cases like consensus protocols, token curated registries (TCRs), token bonding curves, and algorithmic stable tokens were built on assumptions of rationality: all agents act egotistically, profit maximizing, and logically consistent with their preferences and beliefs, and base their decisions on full use of information. However, as we have learned from the research in behavioral disciplines, this assumption needs to be complemented by other forms of behavour. It is therefore necessary to enlarge the assumptions of current cryptoeconomic primitives by taking concepts from behavioral economics, and behavioral finance, and behavioral game theory, and cognitive psychology, which could help develop more sophisticated cryptoeconomic mechanisms.
Mechanism Design & Token Engineering
The design of consensus protocols is related to a sub-field of economics called “mechanism design” which deals with the question of how to design a game that incentivizes everyone to contribute to a collective goal. Mechanism design theory uses economic incentives in combination with cryptography. The aim is to achieve a desired goal in a strategic setting where it is assumed that all players act rationally. It is also referred to as “reverse game theory” since it starts at the end of the game, then goes backward when designing the mechanism. Hurwicz, Maskin, and Myerson were awarded the 2007 Nobel Prize in economics for their research on Mechanism Design.
Not every token needs to be a product of cryptoeconomic mechanisms. Asset tokens such as security tokens can simply represent property rights or access rights utilizing simple smart contracts. Purpose-driven tokens, on the other hand, need purpose-oriented mechanisms. Token mechanisms design, also referred to as “token engineering” an emerging field, best practices beyond Proof-of-Work and Proof-of-Stake are scarce, and many of the existing use cases have considerable design flaws. Incentivizing CO2 emission reduction with a token, for example, is not trivial and probably requires at least as much rigorous research as was needed to develop Proof-of-Work. The use case is more complex and requires data feeds from the outside world, such as hardware oracles and software oracles. The mechanism design of most existing purpose-driven tokens fail to integrate more complex behavioral dynamics into their protocols. In order to be able to adequately address issues of “tragedy of the commons” and “free-rider” problems we need a much more nuanced mechanism design of these tokens.
“Token engineering” is an emerging term with a more interdisciplinary approach that was coined by Trent McConaghy in his article, “Towards a Practice of Token Engineering.” He defined token engineering as the theory, practice, and tools to analyze, design, and verify tokenized ecosystems. He draws similarities between creating token mechanisms and electrical engineering, swarm robotics, operations research, software engineering, civil engineering, aerospace engineering, complex systems design, public policy design, and in specific economics, and to robotics, machine learning, and AI. All these disciplines share a heavy dependence on the mathematics of optimization and decision making (read more: How to Design a Token System).
However, due to the social nature of tokenized networks, mechanism design and market design as subfields of economics and public policy need to be included in the list of relevant fields. The protocols that govern an autonomous network of actors, including their rules, agents, nodes, tokens, and governance structures, resemble nation states, not companies. One therefore needs to analyze tools that nation states use to model their agents’ behavior: macroeconomics, microeconomics, and specifically behavioral economics, behavioral finance, behavioral game theory, and some heterodox schools, like institutional economics, ecological economics, and complexity economics. It will be necessary to identify existing models, approaches, and solutions, and evaluate if and how they can be adapted for the creation of useful mechanisms in the context of tokenized networks with the aim to achieve a collective goal.
Economics and mathematics, and even engineering disciplines, have already developed various models and approaches to formalize economic motives and mannerisms of rational agents, which have been and still are being used by national governments, regulators, and institutions. The question to resolve is whether and to what extent these economic models can be applied in the context of token-driven ecosystems. This can be done by (i) identifying similarities between token economics and existing scientific fields of economics, but also robotics, automation, and control engineering, which also provide methods to work despite uncertainty. There is also much to learn from Cyber Physical Systems (CPS), which control power grids that represent decentralized physical infrastructure with varying environmental conditions and decentralized strategic agent behavior on the part of the power consumers. Furthermore, by (ii) formalizing network-design and network-evaluation models for tokenized ecosystems based on existing economic and mathematical models, and by (iii) designing a bottom-up token engineering framework to enable future state-of-the-art design of ecosystems.
Creating a mechanism is an optimization problem that aims to maximize an objective function for individual actors (such as their revenue or reputation), under a set of constraints. While Ethereum and similar protocols have made it possible to create any type of token with a few lines of code using a simple smart contract that runs on a public infrastructure, we still (i) lack archetypical building blocks and standards, also referred to as “cryptoeconomic primitives” ; (ii) We also lack the necessary modeling and forecasting tools to design the governance functionalities of those tokens, especially for more complex types of purpose-driven tokens that intend to auto-incentivize some kind of behavior in a network of autonomous agents; (iii) Furthermore, there are few best practices for token design. While a lot of tokens have been issued through token sales over the last few years — mostly for fundraising purposes, most of these issued tokens lack proper functionality and mechanism design. So far, there has been little overlap with the academic community studying this field and the developers of many “purpose-driven tokens.” The community of token issuers will be advised to use methods and findings from mechanism design, when designing purpose-driven token protocols.
About the Book
Token Economy was published in 2019 an gives an overview of the mechanisms and state of the Web3 & the socio-economic implications of tokens, and deep dives into selected tokens use cases: Basic Attention Token, Steemit, Token Curated Registries (TCRs), purpose-driven tokens, stable tokens, asset tokens, fractional ownership tokens, Libra & Calibra (Facebook), and many more.
About the Author
Shermin Voshmgir is the Author of the Book “Token Economy“. She is the director of the Research Institute for Cryptoconomics at the Vienna University of Economics, and the founder of BlockchainHub Berlin. In the past, she was a curator of TheDAO, and advisor to various startups like Jolocom, Wunder and the Estonian E-residency program. In addition to her studies at the Vienna University of Economics, she studied film and drama in Madrid. Her past work experience ranges from Internet startups, research & art. She is Austrian, with Iranian roots, and lives between Vienna and Berlin.
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