Inflation Funding in Practice in Delegated Stake Based Protocols

One of the trickiest challenges in the decentralized governance of blockchain protocols is figuring out how to continue to fund and incentivize new participants to work on the core protocol ecosystem itself. Those who already hold a significant amount of token in the network have an incentive to improve it. They don’t need any 3rd party to pay them or offer them compensation or bounties for their work, because they believe that if they work to improve the network, then they will see appreciation. But new entrants who are excited and attracted to the mission of the project — those who weren’t able to generate or buy enough token in the early days of the network to build up a meaningful stake — have a less clear path to receiving appropriate compensation for these contributions.

If protocols anticipate this challenge, and account for the desire to provide a path for talented, interested contributors to capture value through their contributions, without having to purchase a token directly, this can result in healthy governance features that allow the protocol to grow and thrive over time, reshuffling ownership towards those who are contributing the most on a continuous basis. Inflation funding is such a mechanism, and this post will share an overview of the concept as well as some observations of inflation funding in practice on live protocols.

Funding via direct investment versus funding via inflation

In a traditional protocol, there are no built in mechanisms for rewarding diverse ecosystem contributions. A PoW network like Ethereum uses inflation to reward miners for providing security, but it does not have a direct way to reward developers for building something really useful to the ecosystem like a block explorer. Instead, the block explorer, or other forms of community building and contribution, must be funded more indirectly. Either existing holders of Ethereum must transfer ETH or fiat currency to the developers in exchange for their time and work, or investors must seek an alternative (potentially compromising) business model in order to receive future upside from their work, such as advertising, in order for it to be worth their time. There’s an indirection here between protocol -> miners -> investors -> contributors.

This indirection and associated direct investment is a transfer of value from one party to another. The investor is willing to give up some of their position in the short term, in order to hopefully grow the value of their remaining position by a larger amount over the longer term.

It is worth asking whether it’s possible to use inflation funding to incentivize contributions rather than direct investment. In this case, the protocol would directly reward token to the team behind the example block explorer. No stakeholder in the network has to transfer any of their existing token or fiat to the contributor, however the result of minting new token is that all existing holders do get diluted and own less of the total network than they did previously.

There have been a number of great posts and proposals about governance mechanisms that use inflation to fund continued development:

To summarize some of the benefits of inflation funding rather than direct investment:

  • Protocol contains built in mechanisms to reward token to new contributors rather than just stagnant existing participants.
  • Dilution may be easier to swallow for existing holders than making the active decision to transfer some of their existing token to a new party.
  • Active participation and contribution is a way to avoid dilution — and this is good — you want to encourage active participation.
  • Incentives are continuous, rather than only existing in the early days or conception of the network.

The ideas for how inflation funding may work in an existing protocol are conceptual, but they often suggest some sort of proposal from one party — say the company behind the development of our example block explorer — and community voting on the acceptance or rejection of this proposal. It’s considered that the proposal contain an amount of new token (inflation) to be generated as compensation for doing the proposed work. New protocols like Tezos attempt to embed these sorts of governance decisions directly, and protocols like The DAO attempted to route financing based upon community governance towards projects that may provide a benefit to the ecosystem. The spirit behind these mechanisms are great, but of course there are some challenges:

  • How to determine when that token gets released over time?
  • How to determine if the work passes qualitative thresholds for quality and feature completeness?
  • How to revoke the inflationary reward in the case of a fraudulent proposal or bad actor?
  • How to get community participation in the review of and voting on proposals?
  • How to set an economic policy for total amount of inflationary “budget” per week/month/year/etc.

To address all of these challenges up front in protocol design is a very complex, guess-and-check, kind of task. A governance system may need to be built and be iterated upon simply to administer these sorts of parameters. However, in delegated stake based protocols, many of these challenges are addressed organically.

Inflation funding built into a delegated stake based system

In a delegated stake based system (DPoS or non-consensus based delegated staking), a protocol can achieve many of the benefits of both direct investment and inflation funding. This is because these protocols contain decentralized mechanisms for routing variable amounts of inflation towards nodes on a discretionary basis, and this decision can be reviewed on a user-by-user level without requiring protocol wide consensus or voting.

As a quick background, the starting point in a stake based system with inflation is that a user receives inflation in proportion to how much token they stake relative to the total amount of token staked. By participating, they maintain or grow their network ownership and do not get diluted. If a user stakes 10% of all the staked token, they receive 10% of the inflation.
Now in a delegated stake based system, a user delegates their stake towards another user (a validator) who’s performing complex work on their behalf. In exchange, the validator optionally keeps commission from the inflation. So for example, in the case of a user who stakes 10% of the total network stake, and delegates towards a validator who’s charging a 10% commission, the user will receive 9% of the inflation, and the validator will keep 1% as their commission.

This commission based mechanism is a powerful force. It allows a contributor to the network to compete and campaign for delegation through demonstrated performance. A purely operational actor may compete for delegation by advertising the lowest possible commission to cover their costs — let’s say a 1% commission. But an ecosystem contributor, such as the developer of our example block explorer or a community builder, can attempt to advertise a much higher commission — 10%, 20%, even 50% or more depending upon the timeframe and value of their ongoing contribution.

Existing token holders can review this information and decide to delegate some of their token towards those who are contributing in order to route future inflation towards them. It is a reinvestment in the ecosystem in the sense that they are giving up future token that they could otherwise be rewarded themselves, but it is not an investment in the sense of taking existing token out of their pocket and transferring it to the contributor — only newly minted inflationary token flows to the contributor, not previously existing token. What are some of the benefits of this, relative to the proposal/vote/review/revoke process mentioned above?

  • Funding is routed via future inflation in a fluid, community driven way, rather than directly transferring existing token out of a stakeholder’s pocket.
  • The new contributor builds up a token balance over time, and eventually has a big enough stake to fund their own development through participation rather than requiring outside development.
  • This future inflationary token can be revoked at any time by any delegator who doesn’t believe that the contributor is holding up their end of the contribution bargain. But this doesn’t require full protocol consensus or voting, it can be handled on a delegator by delegator basis and everyone can make their own decision.
  • The contributor can change the proposal terms at any time — require more funding, less funding, more competitive rate, etc by adjusting their parameters in response to competitive forces as they go. Delegators will react accordingly.
  • It allows participants starting from zero token to build up their own stake through contribution without having to buy token.
  • It does not require complex guesswork in terms of designing a perfect governance mechanism for protocol proposals, grants, bounties, and treasury management in advance of seeing the network play out over time — it is fluid and enables many experiments to be run without major negative consequences.

Stake based inflation funding in practice

At Livepeer we’ve combined this sort of stake based inflation mechanic along with an inflationary policy that incentivizes active participation and punishes speculation. The result is a hands-off, decentralized policy that both encourages people to play the direct role of video transcoder and delegator on our network, but also enables the funding and rewarding of 3rd party contributions to the ecosystem. How has this played out?

While many delegators have staked towards the nodes that provide the maximum short term economic return, there is a significant amount of stake delegated towards efforts that route funding for projects towards ecosystem contributors:

  • Supermax has built an incredible protocol explorer for Livepeer, and has run a campaign for a node which has allowed them to build up a stake worth thousands of token in the early days of the network (and growing every day). It’s difficult for a decentralized open project like Livepeer to coordinate payment for a tool amongst the thousands of worldwide network participants who get value from Supermax, but it’s easy for many community members to make the decision to stake some % of their token towards this node.
Supermax Livepeer Dashboard
  • The Berlin Livepeer community has come together to run a node with a high commission aimed at helping local creators connect with their communities through Livestreaming and cryptocurrency. It has consistently placed in the top 4 transcoders on the network and earns 100’s of LPT/day in commission to grow the community:
Transcoder Election Dashboard
  • Livepeer core is running a different sort of community node experiment as well, and rather than holding back a large % of LPT before network launch to manage a developer grant fund or VC style ecosystem fund like some blockchain projects, we’re using a community node and inflation funding to route discretionary grants over time towards people who want to participate in the community in ways that a traditional blockchain protocol may not reward directly.
  • There are already talks and experiments about having some of these nodes be run by Aragon DAO’s such that they are truly decentralized themselves and the inflationary proceeds can be governed using different sorts of mechanisms and experiments.

And while we’re super excited to see the early positive results of inflation funding baked into the Livepeer protocol, it’s also important to mention and acknowledge that some facets of these ideas have been playing out across other stake based protocols in the ecosystem for years, through mechanics like Steem Witness campaigning and Decred’s decentralized development pool.

Challenges ahead

While there’s a lot to like about built in inflation funding in delegated stake based protocols, there are of course some challenges that are introduced via these mechanisms as well.

Receipt of inflationary token now becomes partly a social and political process. PoW has the property that everyone is on an equal playing field by providing hash power to secure a network. In a DPoS scheme with campaigning, those who are better at communicating to the wider audience of stakeholders may have an advantage over those who aren’t as strong in the communication and evangelism department. Over time, the hope is that the work and contributions will speak for themselves. And of course, seeking investment is always a social and demonstrative process anyway — by lowering the barriers and allowing any stakeholder to help provide funding simply by delegating, access is more open, and a wider array of projects should be able to gain attention and delegation.

The work required to run a node and provide value to the network may be different than the type of skill that the contributor is providing. For example, a community builder may not be equipped to run secure hardware at scale to secure a network in the role of validator. This is a legit concern, and should be addressed by groups that come together to play complements in these shared roles, such as DAO’s, or by the many validation-as-a-service projects that are popping up — who will run the infrastructure for you, while you focus on the contribution that you are suited to make yourself.

There is a lot of work involved in reviewing, delegating, and monitoring candidate validators. Delegators have to respond to both economic shifts, security and protocol shifts, and now also social and political campaigns for contribution. This is actually not a weakness, it’s a strength. Delegation is meant to be an active role, and active QA, review, and participation ensure quality in the network. This is why delegators are qualified to receive inflationary token in the first place. Protocols shouldn’t give out token for passive, inactive, non-contributors — they should route token and increased ownership towards those contributing value. And the ability to contribute value across many facets — including rewarding valuable ecosystem contributions — is an important part of the job.

In Summary

In the first 50 days of Livepeer’s existence as a live protocol on Ethereum’s mainnet, it has been very confirming and positive to see the results of the built in inflation funding to reward those who are doing work and contributing to the ecosystem. A nice balance has been achieved between running the infrastructure which powers the network efficiently, and encouraging other non-direct forms of contribution that also benefit stakeholders in different ways. Inflation funding in delegated staked based networks allows:

  • Opportunity for new community entrants to build up meaningful stakes in exchange for work.
  • Fluid, organic, decentralized funding for ongoing development.
  • Positive and community oriented social component of the protocol ecosystem to form.
  • Ability to conduct smaller opt-in governance experiments without needing to apply to the network as a whole. This decouples the pace of experimentation from the pace of broader protocol development.
  • Increased accountability and opportunity amongst token holders and delegators to provide value to the network through choosing how inflation funding gets routed.
  • A sustainable path for future development of core ecosystem over time, as ownership gets continuously rebalanced towards those who provide work of various forms to the network.