Token Engineering — The design of decentral marketplaces with Bitcoin as example

First published in German at BTC-ECHO: https://www.btc-echo.de/ueber-token-engineering-und-das-wesen-eines-dezentralen-marktplatzes-am-beispiel-von-bitcoin/

How to design sustainable decentral marketplaces on the blockchain? Which new forms of interaction are enabled by blockchain technology in contrast to traditional marketplaces? Which incentive mechanisms bring market participants to freely contribute their time for value generation within the network?

This article outlines how Token Engineering solves these issues. The focus is set on decentral digital marketplaces on which coordination and trust are achieved by sound token design. For the first time in history, this new form of collaboration is feasible through the open and censorship resistant technology blockchain. In this article, Bitcoin serves as example for sound token design.

Public blockchains facilitate decentral marketplaces

Blockchain technology allows the creation of networks which are not dependent on a central authority. Ideally, this is achieved by fixed rules the market participants agree on when they become part of the network by their own choice. These rules are anchored in computer code on the protocol level. Compliance to these rules is enforced by the network. This is in strict contrast to traditional economic collaboration in which a breach of law can only be pursued by inefficient and time consuming legal processes. Additionally, national boundaries are abolished since these networks are open to everyone independent of national jurisdiction.

Bitcoin is the best example for a decentralized network. No entity has control over Bitcoin but instead it is decentrally managed by the community and open to everyone. One can contribute in the so called “mining” process, in the further development of the protocol or by merely using the protocol for transactions. In the process of mining, the contributing participants — called “miner” — provide hashing power for validating transactions and for ensuring the security of the network. The basic features and rules of Bitcoin are fixed in code since the launch of the Bitcoin network in January 2009.

Economic incentive mechanisms in decentral networks

Several technical, economical and game theoretical mechanisms are deployed to enforce market rules in decentralized networks. On the one hand, market participants receive a reward for providing valuable work to the network. On the other hand, market participants are punished when they abuse the network for personal gain, provide work of very low quality or try to strain the network unnecessarily (e.g. by spamming). All rules must be enforceable without a central entity since the network is operated by no juristic person and participants are usually anonymous. “Staking” is one means to achieve this: Before a participant may perform actions on the network, he has to pledge a financial commitment in the form of token (stake). In case of misbehavior, which is a behavior that is not in alignment with the network rules according to the protocol, the participant loses his stake.

Miners must have a financial incentive for providing their costly energy and for investing in expensive mining hardware which keeps the Bitcoin network running. This is ensured by a predetermined reward per block. The first miner who validates the next block receives this predetermined reward which is composed by the transaction fees and the block subsidy, whereas the former is varying and the later is fixed. At the time of writing, the block subsidy is 12.5 bitcoins. The block subsidy is halved every four years with the next halving to occur in May 2020. Miners have an incentive to contribute their energy also with reduced block subsidy since they receive the transaction fees.

Bitcoin is designed in a way that there is no possibility for fraud in terms of a sybil attack and extracting value without providing value for the market. This is due to the fact that consensus is comparably easy to achieve in the Bitcoin network as compared to more complex marketplaces. For achieving consensus, the Bitcoin network merely requires proof that energy was spent in the validation process which is called “proof of work”. This solves the double spending problem without relying on a central authority: There is no possibility to spend money more than once. Only transactions that comply with the rules are accepted by the network which excludes double spending transactions. That is why it is important as a payee to wait for the confirmation of the network to exclude fraud.

Inherent trust through predefined rules which are enforced by code automatically

It is necessary that the rules are publicly accessible and fixed in code for market participants to trust that the protocol rules are enforced. This is what is meant by the term “trustless”. Changes are only possible through certain governance mechanisms in which the agreement of the majority of the network is needed. The token holders have an interest in improving the network since their token corresponds in a share of the network. An increase in value of the network should reflect in an increase in token value. This also means that the network belongs to all token holders since they determine the further course of the network and they participate in its value increase.

The Bitcoin code is publicly accessible to anyone and it is equipped with fixed rules. There are hardly any changes on protocol level since the launch of the Bitcoin network. The few changes were only possible since the majority of the network agreed to them.

Establishing supply through initial block subsidy

There must be sufficient supply and demand for a marketplace to run smoothly. However, usually the demand rises only when there is already enough supply. Therefore, one needs to focus on the supply side. Uber and other centralized marketplace giants first invest in establishing the supply side. In decentral marketplaces, the emission of tokens serves as a basis to build up the supply side of the network. The initial emission of token and the block reward allow to finance building up the supply side by rewarding market participants for valuable work. This is feasible even before consumers demand the services and products of the network through which the supply side is financially sustained eventually. The issuance of block subsidies in the form of tokens usually occurs in regular time intervals.

Only through mining one can receive the block subsidies of the Bitcoin protocol through which new bitcoins are emitted. In the first four years since launch, 50 Bitcoins were emitted per mined block. These block subsidies are an incentive for miners to deploy their energy and hardware for keeping the Bitcoin protocol running.

A token without connection to a real world asset has only value when it follows sound money principles

Sound money principles are applied in token engineering to design an economically sound and sustainable token. Sound money theory is based on two principles:

1. Consideration of the interests of the market participants and logical deduction of their behavior (praxeology)
2. Facilitating a free market in which the best network and token prevails

The first principle was already explained in chapter “Economic incentive mechanisms in decentral networks”. The second principle can be approximated by the demand for the token since this mirrors the decision which network market participants chose. The demand is influenced by the utility of the token which is in turn determined by several factors. For assessing the demand, it is necessary to consider the interests of the network participants (see principle 1 above).

Which factors influence the utility of a token? The token allows the network participants to access the network and perform certain actions. More aspects that influence the utility of a token are: censorship-resistance (resilience against manipulation and misuse of the system), robustness (uptime), limited supply (limited inflation), network effects, competition, etc. Censorship-resistance plays a superior role in decentral systems because data integrity has utmost priority. The supply side of a token is usually predetermined in the protocol — at least this is how it should be for a well designed token because investors and users of the protocol need to know what they get themselves into. It is absolutely crucial to know if there is a limited amount of token and how many tokens are issued when because this greatly influences the price development (the higher the token supply, the lower the price assuming constant demand).

Bitcoin is the most secure monetary system until now. More precisely, Bitcoin is the most secure distributed database on the world on which only data of a specific form can be stored (Bitcoin transactions). The Bitcoin token serves as an access token to a specific amount of data storage in this database (blockspace). Here network effects kick in: The more people use Bitcoin, the more useful the blockspace becomes — namely for transactions with even more parties.

Apart from that, the monetary policy of Bitcoin is predetermined by the protocol and basically unchangeable.This gives the Bitcoin protocol a totally new form of predictability and therefore security for all those investing in Bitcoin. More precisely, it is not possible to mine more than 21 million bitcoin based on the protocol. Every four years, the amount of newly generated bitcoins is halved. This corresponds to a drastic reduction of newly mined bitcoin in regular time intervals. Since Bitcoin does not allow arbitrary inflation and manipulation, it is called the hardest money in existence.

Bitcoin faces such strong demand only due to its exceptional design. The demand for the Bitcoin token makes market participants have an interest in devoting their time and money for the Bitcoin network be it through mining or through continuous development of Bitcoin based applications such as the lightning network operating as layer 2 on top of the Bitcoin protocol.