The Internet of Blockchains: Part 3 — Network Effects & Proof of Stake
In Part 2 we discussed network effects in the context of the Cosmos Hub. In this post, we will focus on a key innovation in Proof of Stake networks: a mechanism that creates incentives for communities to build network effects.
The NFX venture fund estimates that 70% of the value created by technology startups since 1994 was driven by network effects! So it (a) pays to understand how they work and (b) pays for all stakeholders to go to every effort to nurture them. But network effects are notoriously hard to build. That is why successful startups are known as unicorns: the failure rate is extremely high. For every Uber, there are tens of thousands of “Uber for X” startups that never achieve critical mass, where they can match supply and demand across geographies, offerings etc. When a network effect scales to its full potential, hundreds of billions of dollars of value can be created. But the probability of this happening is very low. The good news is that the expected value across a well-chosen portfolio of networks can deliver great returns (just ask Union Square Ventures).
So what is the connection between Proof of Stake (PoS) networks and network effects?
Last week when I explained the staking economics of a Proof of Stake (PoS) network to a banker friend of mine, he was a little bemused. His intuition of money comes from the “time value of money”. It is the basis for almost everything they do. For bankers, money is created as debt. The person who borrows pays interest. The person who lends gets interest. Money today is better than money tomorrow. So to find out what a future income stream is worth today, you “discount it” by a factor based on the risk involved i.e. by how likely are you to actually get the money. This is at the heart of trillions of dollars of trades every day: bonds, treasuries, repos, CDs, etc. Even stocks are priced based on future income discounted back to today.
The banker’s intuition told him to find out where the interest payment is being made (or more specifically what interest rate — the price of money — was being paid), as this would explain the nature of the transaction and shine some light on the risks being exchanged. But this worldview doesn’t work for a Proof of Stake network and the intuition of the “time value of money” is fundamental to this misunderstanding.
To see why let’s shift back to the tech investor mindset above. Here money is earned based on a principle that we might call “the network effects value of money”. In this worldview, money is not created as debt, nor is the value captured as interest. Wealth is instead created by building a network that provides value to its users and capturing some of that value. As network effects grow according to the square of the user base (or maybe n log n at scale, see Metcalfe’s Law) the best way to build wealth is to scale a network globally. This effect is most mostly clearly visible with centralized networks, e.g. Google Adwords connecting publishers to advertisers, Uber connecting commuters to drivers, and so on.
The reason why crypto is getting so much attention in technology circles right now is that it has the potential to meaningfully reduce the high failure rate of these networks. As we have seen, scaling networks is hard. Anything that reduces this failure rate will increase the expected returns of investing in this space. If it turns out that crypto-powered networks are easier to scale than a typical (non-crypto) two-sided markets like Uber or Airbnb, then crypto networks will out-compete (and eventually take over from) non-crypto networks.
Proof of Stake networks utilize rewards to build network effects. Recognizing that network effects are hard to build, they reward community members that contribute to the network. They ask token holders (aka delegators) to make decisions about who runs the network nodes, via the validator marketplace we discussed in Part 2. By engaging token holders in this way, they incentivize attention through the mix of rewards and slashing. This is interesting from a psychological perspective: ongoing dopamine hits as gains accrue, loss aversion associated slashing risk, an IKEA effect as they are now actively contributing to the running the network. Together these things create a deeply engaged community, who then wants to spend more time on governance, evangelizing the network and contributing to the codebase. Validators, aware that they are being measured by these highly engaged delegators, now compete on the value they can add. So they write blogs and research reports, record podcasts, organize events, and get involved in governance. They build Dapps and tools like block explorers and wallets and contribute to the codebase and protocol specifications.
That is why trying to map crypto rewards in a PoS network to banking terms like interest is doomed to failure. It misses where the value is created and how it is captured. Inflation of PoS token supply is not about interest or yield. Instead, it creates a mechanism to fund public goods and community building on a massive scale. As the value of a network grows faster than the number of participants, this can have a very significant impact on the probability of success. It allows decentralized networks to grow faster with much lower failure rates than any other business model we have seen before.
This is the reason why smart investors have stayed in crypto. With 70% of the value created in the last quarter of a century being attributed to network effects, there are many reasons to believe that crypto-powered network effects will drive much of the growth in the next 25 years.
Stay tuned for more insights into the Internet of Blockchains in Part IV.