Economic incentives in open-source networks

“Never, ever, think about something else when you should be thinking about the power of incentives” ~ Charlie Munger, Vice Chairman Berkshire Hathaway

How to optimize incentives and align individuals’ interests has been a topic in economics and business for a long time. Adam Smith argued in the 18th century that “individual ambition serves the common good”. By that he meant that the best overall economic benefit for all can be achieved when individuals act in their own self-interest.[1] However, the real world is complex with many unknown variables. Behavioral economics argues that people are subject to cognitive biases and heuristics that can make them act irrationally, especially in complex situations. Furthermore, game theory has shown that the best overall outcome is achieved not by basing decisions purely on self-interest, but also taking into account how others will act. Incentive systems can be very effective, but if not designed correctly, can lead to suboptimal outcomes.

This article will explain how;

  1. blockchain technology can be used to align incentives and drive behaviour;
  2. decentralized open-source networks will rival traditional business models.

Blockchains as incentive machines

In 2008, for the first time in history, one technological invention solved the Double Spending Problem and the Byzantine’s Generals’ Problem. It enabled peer-to-peer (P2P) value exchange without the need for a central server or trusted authority. This invention has now grown into the most well-known decentralized network in the world; the Bitcoin network. Its creator — a (yet unknown) person (or group of people) called Satoshi Nakamoto — argued that the Bitcoin network will remain stable as long as participants in the network follow their own economic self-interest.[2] Nakamoto designed a self-sustaining network where miners are incentivized to maximize the security of the network.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. Never a year passes that I don’t get some surprise that pushes my limit a little farther” ~ Charlie Munger, Vice Chairman Berkshire Hathaway

Warren Buffett and Charlie Munger have been some of the fiercest critics of cryptoassets but they do understand the power of incentives. Traditionally, the way to align incentives in any system was by implementing rules and laws governed by a central authority or organisation. Blockchains - in combination with cryptoassets (e.g. tokens) - offer the ability to achieve incentive alignment through decentralized value exchange. Incentives can be programmed into the protocol’s software as an integral part of the network itself. This way, a tokenized ecosystem can be designed to optimize a specific goal, task or utility.

As priorities of (groups of) actors in the network can shift over time, there is a need for a decentralized governance system which can coordinate change. Blockchains will enable many different governance and incentive systems to exist in parallel and to be tried and tested over time.

Tokenized ecosystem design is still in very early stages of development and research. It combines different disciplines and fields of expertise like game theory, mechanism design and economics. I would recommend reading work of Trent McConaghy for an introduction to token engineering and mechanism design here.

Blockchains are incentive machines; they can get people to do stuff by rewarding them” ~ Trent McConaghy

How it will affect traditional business models

The traditional business model for distributing, organizing and allocating economic resources has been around for many hundreds of years. Open and decentralized blockchain technology will provide an alternative way of distributing value. Instead of the majority of value in an industry being concentrated in a handful of corporate power houses, value can be distributed in the form of fractional ownership of the network itself, represented by a cryptoasset. It will not affect every sector or business and it also won’t be ‘black or white’. There are already many hybrid structures where for-profit companies are building (semi-)decentralized networks. This in turn gives rise to possible conflicts of interest when projects have both equity and token holders. As an investor you should pay careful attention to the ownership structure of blockchain projects and whether founders’ priorities lie with building a decentralized network or generating profit for their company.

This might lead to the following questions:

  • Why would open-source networks have such significant impact now, while they didn’t before?
  • Why won’t the big software corporations simply build it themselves?

Why would open-source networks have such significant impact now, while they didn’t before?

The short answer: Economic incentives as an integral part of the network.

What differentiates the most successful open-source projects is that most of them are backed by either one company or a group of companies. Open-source projects without financial backing often have a worse user experience as developers are not incentivized to work on the project. So, it’s hard for an unbacked, decentralized open-source network to ever obtain a critical mass of users necessary to reach significant network effects (as described in Metcalfe’s Law).

Examples of open-source networks that did succeed without a company backing it are the protocol layers for the old internet (TCP/IP) and email (SMTP). As revolutionary as the ‘internet of information’ eventually proved to be, it took multiple decades before the protocol reached a critical mass of users and gained widespread adoption.

With blockchain technology, incentives can now be programmed into the network’s software to align participants and compensate developers. It will drive & accelerate adoption, usage and developer activity. Many different decentralized applications will be developed which will rival their centralized counterparts on pricing, security, transparency, (private) data protection and, eventually, quality & user experience.

“You won’t see mass adoption until the user experience does not feel like something new and that is still five to six years away.” ~ Mike Novogratz (July ’18)

Why won’t the big software corporations simply build it themselves?

The short answer: It’s contrary to their business model.

Let’s take as an example Google and Facebook, two of the largest companies in the world with a business model built on monetizing user data. They store your data on a central server and analyze it for target advertising. Blockchain technology allows for an internet protocol layer to be built where users can stay in control of their own data.[3] Users might be one privacy scandal away from choosing a decentralized alternative. That’s not to argue that these companies will be out of business anytime soon, they will probably divert and adapt. It does, however, make the point that it doesn’t make sense for these companies to partake in building certain decentralized software infrastructure. They will contribute in other areas, but not where it threatens their core business.

Final thoughts

We have only just seen the beginning of what the combination of open-source software, P2P value exchange and network effects can achieve. With blockchains we can drive behavior through incentives and that opens up possibilities for improvement in private sectors, but also in the public sector.

Well-designed incentive systems embedded in a decentralized open-source network have the potential to challenge the traditional business model and change the way resources and value are allocated. In the public sector, services like cleaning city streets, maintain public parks, provide security, care for the elderly, civic engagement, etc. can all potentially be governed by using incentives to coordinate people.

What’s important is how these incentive systems are designed. If well designed, incentive systems can be very effective in equitable resource allocation, coordination and driving cooperation. If done poorly it can lead to perverse behavior and bad actors exploiting flaws in the system at the cost of others. Token engineering and incentive design still have a long way to go but provide us with the potential for radical change.

In a future article I will discuss the value proposition of different types of cryptoassets and why most (i.e. not all) cryptoassets currently in existence probably should not be worth anything.

[1] Geolib.com. (2018). Adam Smith Wealth of Nations, Book 1 Chapter 2, Of the Principle which gives occasion to the Division of Labour. [online] Available at: http://geolib.com/smith.adam/won1-02.html

[2] Nakamoto, S. (2008). Bitcoin: A peer-to-peer electronic cash system. https://bitcoin.com/bitcoin.pdf

[3] https://blockstack.org/whitepaper.pdf