Economics of Tokenized Incentives 3: Token Value Won’t Align Stakeholders
I often hear people in the blockchain space assert some form of the following argument: if a platform creates a native token, such as a utility token that can be used to purchase services provided on the platform, the creation of the token by itself will align the incentives of users to act in the best interests of the platform. For example, someone might say, ‘token holders will contribute to building the value of the platform, so that more users will want to join the ecosystem, which will drive up the token’s value, rewarding those participants with gains on their holdings.’
This description outlines a pay-for-performance incentive scheme in which participants are rewarded according to the performance of the token value. Choosing the right performance metric is essential for a pay-for-performance scheme to perform well. Unfortunately, token price is a poor performance metric for incentivizing the types of behaviors that blockchain platforms want — and need — their participants to engage in.
Performance metrics need to satisfy two criteria to be effective:
- They must be aligned with the goals or overall long-run value of the platform.
- They must be a function of activities or behaviors that are under the control of individual payee.
Token value as a performance metric fails to satisfy either of these.
First, the value of a token is not well aligned with the long-run value of the underlying platform. There are many types of tokens, and the value of each depends on the underlying rights that the token provides. A utility token, for example, derives its value from the goods or services that the token can buy in a single transaction, and therefore limited in breadth of value it reflects. Unless your token is backed by equity, the value of the token is not related to the long-term value that the platform founders are trying to maximize.
However, even if token value was perfectly aligned with network value — the way that a company’s stock price is aligned with shareholder value — token value still fails the second criterion for a good performance metric. Blockchain platforms should not rely on token value alone to generate participant incentives for the same reason that employers do not compensate employees solely based on the performance of their company’s stock price: They are extremely blunt instruments that will not encourage the great variety of activities required to generate value for the organization or platform overall.
The economics literature on incentives tells us that there are five types of problems that can result from a poorly chosen performance metric such as token value.
1. Innocuous Gaming
Users may take actions that increase token value but do not have a positive impact on the value of the platform.
Speculative investments can cause the value of the token to rise even if nothing is changing with respect to development or usage of the platform. Some token holders may take actions to increase the value of the token — for example, through through information campaigns — without doing any work to increase the value of the underlying platform.
2. Malicious Gaming
Users may take actions that increase token value to the detriment of platform value.
This is a more serious version of Innocuous Gaming above. For example, specific market manipulations could be detrimental to platform value. An entity could hoard tokens in order to artificially restrict supply, thereby increasing the token price but creating a liquidity shortfall that slows or even halts regular business on the platform.
3. Multitasking
Users may only take the actions that have the largest impact on token value, neglecting other activities that are essential to enhancing platform value.
There are many different activities that contribute to the value of a blockchain platform. A single reward mechanism — such as increasing token value — cannot provide appropriate incentives for all of them. It is likely that some activities will have a much larger impact on a participant’s remuneration than others, and participants are likely to focus their efforts where token rewards are greatest rather than what is best for the platform.
4. Free riding
Some users may not engage in value creating activities at all, relying on the actions of others to boost token value.
Rewards from rising token value are reaped by any token holder, not just those who are contributing value. This creates the problem commonly known as free-riding. Each token holder would prefer to not contribute while benefiting from the contributions of others, rather than contributing resources to the platform function at personal cost.
5. Risk misalignment
Users may not be motivated to engage activities that increase platform value because those activities do not sufficiently increase token value.
As I discussed above, the value of the token may not be strictly increasing in the value of the platform. For example, if the user base of the platform is no longer growing at a sufficient rate, then even if improvements are being made to the platform — delivering additional value to the existing user base — the demand for the token may not rise and the token price could be stable. In this case, participants will not have reason to incur the costs associated with improving the platform, if the only way to reap rewards is via token value increase.
Which of these problems a particular platform will face depends on the other elements of their platform, including the behaviors that the platform needs to incentivize and the types of activities users engage in.
So if a native token will not automatically align stakeholders, how should blockchain founders go about designing incentives? The first step is understanding the activities that drive value for the platform, and then designing a targeted rewards scheme or schemes, incorporating effective performance metrics and optimizing the size of rewards, to incentivize these behaviors.
Performance-based rewards are not the only mechanisms that impact participant behavior and provide participant incentives. There are a variety of economic structures, such as reputation systems and pricing mechanisms, that are required to facilitate participation and value exchange on the platform. Learning the principles of distributed marketplace design will help founding teams create the platforms and communities they envision.
