Incentives, ICOs and the New Digital Frontier: What’s Driving Token Sales?
In our article, “Bitcoin’s True Value,” we discussed how the direct value of bitcoin was in fact the underlying technology that makes its payment system possible: blockchain. But just as it took many years for bitcoin to enter the social psyche as a legitimate currency, it also took years before the seemingly boundless value of blockchain staked its claim in the future of our digital world. In 2017, investors are chomping at the bit to invest in blockchain companies and startups through ICOs, or token sales. This phenomenon has crowdfunded over $2.3 billion dollars to-date, and shows few signs of stopping. But what led to all of the hype around blockchain?
In 2014, the cryptocurrency community was split. Realizing that the blockchain technology could be uncoupled from the currency built on top of it, people began to speculate as to how the blockchain could be otherwise used. The movement forked between those who viewed bitcoin as money, and those who wanted to experiment with decentralized systems. This chasm cuts to the core of a fundamental question that seems to prevail in the cryptosphere: are humans dominated by their altruistic or selfish urges as a whole? While the two “camps” in the bitcoin split cannot simply be labeled as selfish and altruistic, the divide differentiated those who viewed blockchain through the one-dimensionality of bitcoin, and those sought to use it for building a better digital universe. While the decentralized, transparent and permanent nature of blockchain means it can lend itself easily to an altruistic cause, it doesn’t mean that all of the players in the game are in it for the right reasons. There will always be selfish, and even malevolent actors in any open source system, so it is important to ward against them. Satoshi Nakamoto recognized this in his whitepaper, and that’s why he built into bitcoin an incentive structure. Incentives will be crucial to the success of future blockchain endeavours, but considering them more closely helps to explain why blockchain has experienced its current boom.
Although there is some debate about the utility of incentives in blockchains, they have- up to this point- proved necessary to the success of the decentralized ledger. Incentives are used to solve what is known as the Byzantine General’s Problem, or in game theory, Byzantine fault tolerance (BFT). The central problem surmounts to this: in a system where consensus is necessary, how can we reach a unanimous agreement in the absence of trust? The key problem in a decentralized digital currency is that no one knows who or what to trust. Bitcoin’s answer to the Byzantine General’s Problem is the proof-of-work protocol (PoW) on top of the blockchain:
“…the general idea behind this protocol is that it makes it as difficult as possible for someone to manipulate a vote due to the significant expenditure of resources (time, electricity, and processing power) required. To log a vote, each “general” would have to complete a very difficult mathematical problem that would be instantly shared with the others, who would then have to solve another difficult problem on top of it. This chain of “work” creates an ironclad transaction history while making it prohibitively expensive and time-consuming for attackers to rig anything.”
By using the proof-of-work protocol, individual actors are disincentivized to falsify a transaction, but incentives are also used to encourage participants to preserve the protocol. Bitcoin “miners,” the people who record these transactions, are rewarded with 12.5 bitcoins every time they use computing power to successfully verify the blockchain. The Ethereum platform uses a different system, called proof-of-stake (PoS). In PoS, validators must put up a sizeable ante of Ethereum in order to participate in the system. If validators do not act in the system’s benefit or engage in malevolent activity, they risk losing their stake.The power of incentive structures is evident through the growth of bitcoin from a nine-page whitepaper to a multi-billion dollar cryptocurrency in less than a decade. Because of these incentive structures, participants are pushed towards maintaining the common good of the blockchain even if their individual interests are divergent. But what happens when all investors’ incentives are perfectly aligned? This is the key to understanding why ICOs have exploded and it begins with an understanding of an argument known as “fat protocols.”
In computing, a protocol is “a shared set of fundamental rules that enables applications to be built.” For example, a fundamental protocol of the Internet era was HTTP, which determines how we send information through the web. Protocols like HTTP have generated insurmountable amounts of money, but the value they produced was captured by the applications that were built on top of them. With HTTP, applications like Google and Facebook own the majority of the wealth, while the protocol itself is run by a not-for-profit. What the new digital currency of “tokens” allows for is a new way to design and monetize protocols. With these new cryptocurrencies, “value will be captured by those building and investing at the blockchain protocol layer because of the financial incentives that are baked into the network’s design.” Participants are incentivized to grow the network because if the network expands, the token asset appreciates as demand for the network increases. Now, investors can monetize the network at the protocol rather than application level, which was never possible before blockchain. Unlike the internet boom, the digital foundation of the future marketplace is being parceled out into units that you can pay for through the protocol. These “fat protocols” are like virtual real estate for the internet of value, and owning a piece of that real estate could mean big money. But more than money, the incentive system that tokens are built around are creating entirely new business models that can serve altruistic ends.
Because decentralized protocols are not centrally owned, there is no one to limit their growth. There is no central authority to slow innovation or push it in a certain direction. Right now, the space seems limitless, and that’s driving investment, which is furthering innovation. The adaptability of neutrally owned smart contracts are creating a paradigm shift in how software applications will be written, allowing society to use tokens to do things they never could before. These new tokens seem to symbolize a joining of altruistic and selfish forces: those who envision a brighter digital future can make money while spurring its growth. Venture capitalist Nick Tomaino describes the networks surrounding the tokens as “internet tribes”: each tribe has a different use case and different belief, and is surrounded by people who have ownership in the product and want to bring it to the world. With everyone’s incentives aligned to growing the network, it’s no wonder the market has exploded. And while there is still much speculation and a high-risk of investment, it’s an incredibly exciting time to watch our ever-evolving digital space.
