EPNs — Part 3: Example of EPN and Network Effects

In Part 1 of this series, we introduced the concept of the Economic Protocol Network (EPN), networks that are built on blockchain technology. In Part 2, we looked at how EPNs encourage participation by distributing network value. In this article, Part 3, we’ll explore an example of how EPNs operate in the wild. In Part 4, we’ll share a framework that can help developers design EPNs effectively and sustainably. And finally, in Part 5, we’ll explore how they might be deployed in games.

To understand how EPNs operate, it makes sense to take a look at a real-world example of blockchain protocol and token network effects in action.

Compound is a decentralized finance application, built on top of Ethereum, that offers users an algorithmic savings and loan experience for ETH or other currencies based on the Ethereum Network, such as USDC, DAI, REP, WBTC, BAT, and ZRX. It also has its own ERC-20 governance token, $COMP, which enables its holders — the Compound community — to participate in managing the protocol by proposing, debating and voting on changes.

At the protocol level, Compound brings together different participants with opposite, but complementary motivations. These are:

1. Suppliers of tokens and cryptocurrencies seeking yield, who can earn interest by depositing digital-asset collateral.
2. Borrowers of tokens and cryptocurrencies seeking utility and/or leverage, who pay interest in exchange for borrowing assets.

Compound uses on-chain smart contracts to put tokens and cryptocurrencies into secure custody and to determine the interest rates paid for lending or borrowing assets, removing the need for centralized bankers or mediated loan approvals. Because these decisions are made via an algorithm in a transparent marketplace, participants can make their own private assumptions about forward interest rates and currency valuations, deciding for themselves whether supplying and/or borrowing makes sense.

The Compound protocol’s network effects look like this:

1. Interest rates adjust continuously based on supply and demand
2. High liquidity from more collateral deposits incentivizes borrowing when rates are low, while low liquidity from fewer collateral deposits incentivizes supply when rates are high
3. The Compound protocol rewards users for covering the positions of “borrowers” that violate minimal collateral thresholds
4. The protocol’s transparency and extensive documentation and open access to the Compound team itself (including a responsive presence of their own Discord channel) has made it easy for third parties to build applications on top of Compound.

If we remember from our prior Networks series, there are two tiers of network effects we need to consider — first order and second order — and, since this is a multi-sided network, we need to consider the “same side” and “cross side” effects for each:

Compound has effectively incorporated economic incentives into its protocol to bootstrap participation and generate network effects, while creating an environment for developers to improve their protocol, which will further add to network effects as new applications are built on top of and around Compound.

But these are the basic protocol network effects. Because Compound is an EPN, there’s another layer of effects to consider — those generated by the Compound governance token $COMP.

Compound’s decision to create the $COMP token is firmly rooted in the principles we outlined in Part 2 of this series.

The success of Compound as a decentralized finance application and of $COMP as its application token, built using Ethereum’s ERC-20 token standard, also boosts the success of the Ethereum Network and its native cryptocurrency ETH. To illustrate this, consider that as economic activity increases on Compound, more people lock up ETH or other ERC-20 tokens, which makes ETH a more scarce commodity and a more commonly used exchange currency, while also requiring more ETH to pay for transaction fees. The availability of more transaction fees encourages new miners to join the Ethereum Network, thus making it larger and more secure.

Of course, there are still many ways that this system could fall apart. For example, if a player or a set of players amassed an exceptionally large amount of $COMP — enough to effectively dominate the system without challenge. But there are ways to design EPNs so that this possibility is made extremely implausible.

So, how does one design EPNs to maximize effectiveness and minimize the potential for abuse? We’ll cover that in our next article, Part 4: EPNs and the PRESTO framework (coming soon.)

Interested in contributing to our Community Economics series? We’d love to hear from you. Comment below or email us here at cec@forte.io.

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