On the Origin of Blockchains: Part III

James Brodie
Jun 13 · 9 min read

Network Success is Driven by Incentive Design

Having already covered how decentralised networks can expand and colonise a niche as well as how blockchain elements are like genes that define the behaviour of a network, it is time to explore one of the most critical factors in a network’s success — its incentive design.

Incentive design matters because it encourages existing participants and new entrants to help grow a network.

Good incentive mechanisms are designed to enhance the growth of individual network participants and/or encourage new network participants to run the software and increase the size of that network.

Most blockchain elements are responsible for defining network participants behaviour. However a special type of element, in the form of an incentive mechanism (introduced in Part II of this series), is responsible for driving the growth of a network.

These mechanisms reward network participants for contributing towards or participating within the network in the form of the network’s native cryptoasset. Consequently, cryptoassets reflect current and future value generated within the network and are a result of work performed by stakeholders.

In the same way that resources (in the form of food) are metabolised into the building blocks of life in the biological world (proteins, carbohydrates and fats), resources in this digital world (e.g. hashpower) are “metabolised” to form the building blocks of decentralised networks i.e. cryptoassets.

Metabolism
/mɪˈtabəlɪz(ə)m/
noun — the chemical processes that occur within a living organism in order to maintain life.

Simply put, accelerating growth rates are representative of good networks with strong incentive design.

Stimulating Growth in Decentralised Networks

Incentive mechanisms are like “growth factors” for blockchains. In biology, growth factors respond to the environment, encouraging metabolism, and are responsible for the growth of individuals and the proliferation of a species.

In decentralised networks, the incentive mechanisms award network participants with native cryptoassets in return for contributing towards and cooperating in the network. This mechanism encourages the increase in individual participants using the network.

We have previously used the real-world analogy of food being metabolised by an organism to form the building blocks of life; that is taking energy in the form of calories to create something of value for the organism, such as blood or muscles.

In decentralised networks, energy is fed into the system in the way of work committed (e.g. mining) or any other form of network participation. Here, the energy is converted by the incentive mechanism into something of value for the network participant, a cryptoasset. This cryptoasset can be thought of as a vehicle for storing the energy contributed to the network, in the way we would store energy consumed from food. The cryptoasset can then be redeemed at a later date for network access and use.

Metabolite
/mɪˈtabəlʌɪt/
noun — the intermediate products of metabolic reactions catalysed by various proteins (enzymes) that naturally occur within cells and are directly involved in normal growth, proliferation, development, and reproduction.

In other words, these cryptoassets can be thought of as metabolites. Collectively, they represent the total value of the network, which equates to the energy that has been input and therefore its potential output. They can be used by a network participant to access the services and products provided by the network.

Incentive Mechanisms Generate Metabolites

Networks can be evaluated by their ability to incentivise participants to contribute work or commit resources and consequently produce cryptoassets. These cryptoassets can be thought of as stores of energy that can be traded or used at a later date.

The total value of a network’s cryptoassets can be considered a measure of:

1) The “fitness” of network participants

2) The general health of the total network (e.g. hash power)

These cryptoassets go on to accrue value proportionally to the energy and work being contributed to the network, although this is not always accurately reflected by its price in the market.

Not all network participants have the ability to contribute to the network and therefore gain rewards. However, some may still want the ability to participate as a user in the network and so will have to acquire the cryptoasset through other means.

Investing in the cryptoassets (i.e. metabolites native to the decentralised network) should be thought of as investing in the future potential and growth of the cryptoasset’s corresponding network.

Critically, only those networks with participants incentivised to contribute to the network will prosper. Therefore, it is very important to understand how and why a network may have better incentive design than another competing network, so as to make the best investment decision for future returns.

Monitoring network specific metrics provides insight about the growth, proliferation and health of the network; a topic that will be covered in much more detail in a later part of this series.

Network Participant Growth

The first blockchain incentive mechanism invented was bitcoin mining. It incentivised network participants to validate bitcoin transactions and secure the Bitcoin network by providing cryptoassets (bitcoins) in return.

Idle computing power existed within the environment as a resource (referred to as hashpower) and some network participants were able to access this resource. These network participants would observe and verify transactions occurring throughout the network and use hashpower to run the incentive mechanism: crunching a cryptographic puzzle defined by the consensus mechanism.

When a network participant solves the cryptographic puzzle (as defined within the cryptographic rules blockchain element) it gets to include all of the transactions that it observed into a new block and it is rewarded with 12.5 bitcoin (the block reward) plus any transaction fees.

In other words, the network “consumed” hashpower which was converted into the “metabolite” bitcoin. This bitcoin could be used at a later date by a network participant to access the network — send bitcoin around and pay a small bitcoin fee to a miner to process that transaction.

In this way, a network participant was able to grow, with the number of cryptoassets they hold representing their “fitness”.

Network Proliferation

This incentive mechanism (converting hashpower to BTC) worked so well because the environmental resource was available to so many. It encouraged others to join the network and participate. As bitcoin’s value grew, so did the network.

As the network grew, so did the security of the network, which in turn led to bitcoin becoming more useful as a store of value and medium of exchange within the network.

If the metabolites are perceived to be valuable, it encourages the network to proliferate. This is important because, as was mentioned previously, the number of network participants who are contributing to the network and generating new cryptoassets is representative of the total network’s health.

Digital Scarcity

At this point, it is worth noting that the real genius behind Bitcoin was the invention of digital scarcity.

These metabolites are digitally scarce, meaning they cannot be copied or counterfeited. Furthermore, Bitcoin was the first form of digital scarcity that did not rely on a central issuer standing behind it — it was trustless.

Unlike mp3s or jpegs, if Alice is to send Bob a cryptoasset, Alice no longer has a copy; thus resolving the ‘double spend problem’. If the network contribution is perceived as important to the network participants, and there are enough of them, then this digitally scarce metabolite gains value.

In Bitcoin’s case, the value was in a trustless, permissionless, programmable money.

The scarcity comes is therefore a consequence of the fact that it takes a certain amount of work to create a bitcoin. When considering the value of a single bitcoin, you must consider the amount of proof of work that has been put into that network. In this way, there is no direct competition between the scarcity of a bitcoin and another cryptocurrency, such has litecoin, as they required different forms of work to produce. However, there will be competition in how the market perceives the value of each.

As decentralised networks that commoditise other computer resources come online, the design of their incentive mechanisms and the creation of scarcity will play a major role in any network’s success.

S-Curve Growth Adoption

Logistic population growth is the term used in biology to describe when a population’s growth rate decreases as the population reaches carrying capacity (see left graph below). It reflects the maximum number of individuals in a population that the environment can support.

When this is compared to Everett Rogers’ Diffusion of Innovation Model (see right graph below), which outlines how innovation is communicated over time among the participants in a social system¹, the pattern of growth in the early stages is very similar.

For blockchain networks, the financial incentive mechanisms will make the curve of adoption much steeper than is typically observed as participants are much more incentivised to join the network. Looking again at the shape of logistic population growth above, it is remarkable how closely this biological growth pattern mirrors S-curve adoption rates of the major transformative technologies over the years (see below).

If you believe that blockchain is an emerging technology that has the potential to transform society, as the internet did, then one only has to look at the adoption rates of previously transformative technologies to recognise we are at the start of a steep adoption curve.

For specific networks, the better the incentive mechanism, the more the network will grow. These are the foundations of network effects that will form a moat around a blockchain project and its corresponding network. Those with the best incentive designs will have the best chance to grow into their niches most quickly.

The Importance Of Good Incentive Design

Cryptoassets are generated through network participants interacting with an incentive mechanism. As such, cryptoassets are the glue that align all the stakeholders within a network.

Good incentive design will encourage network participation and value accrual to a cryptoasset. However, it is important to note that value will also be derived from other parameters like supply schedule and velocity.

It is important to note that there are plenty of bad incentive designs out there too — a major example is misalignment of participant behaviour. Therefore, scanning species for their respective genes, which include incentive mechanisms, as well as the resources available and the quality of the cryptoasset produced from those resources is crucial to understanding value.

Continuing ‘On the Origins of Blockchains’

So far, I have investigated niches, networks, blockchain elements, and incentive mechanisms through the lens of biology in ‘On the Origins of Blockchains’. In the next piece, I will go back to the start of the original blockchain network, Bitcoin, to trace its evolution and explain its limitations.


References:

[1] Rogers, Everett (16 August 2003). Diffusion of Innovations, 5th Edition. Simon and Schuster. ISBN 978–0–7432–5823–4.


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ID Theory

ID Theory is a a London-based long-term cryptoasset investment firm.

James Brodie

Written by

Chief Investment Officer at ID Theory

ID Theory

ID Theory

ID Theory is a a London-based long-term cryptoasset investment firm.