Understanding Cryptoeconomic Design
Smith + Crown has been studying and practicing cryptoeconomic design for over six years. This article, adapted from a recent webinar, introduces cryptoeconomic design, highlights its potential, and shares frameworks developed by Smith + Crown useful for understanding, researching and applying cryptoeconomic design.
- Cryptoeconomic design is an emerging interdisciplinary field still building towards shared definitions and frameworks.
- Cryptoeconomic systems can be imagined as a multi-layer stack of technical, economic, and business rules, with four aspects useful for describing the vast majority of cryptoeconomic systems: token function, circulation rules, trustless mechanisms, and governance.
- A working understanding of the concept of a cryptoeconomic system is a prerequisite for more mature industry discussions.
What is Cryptoeconomic Design?
Cryptoeconomic design is a new and highly interdisciplinary field, heavily intertwined with the blockchain industry and having roots in mechanism design, economics, game theory, and cryptography. Cryptoeconomic design cannot be fully understood without knowledge of the underlying technologies (‘crypto’), the financial incentives that motivate action (‘economic’), and the human behaviors that issuers are integrating into their protocol (‘design’). Broadly, it is the application of cryptographically-enforced incentive systems to achieve secure, distributed networks and economies.
Each component of this phrase is critical to understanding the concept:
- Crypto – Change-resistant rules defined in code are autonomously enforceable by participants. Cryptography enables verification of data changes while also removing the costs and benefits of a centralized decision-making authority.
- Economic – Actors respond to incentives in the face of scarcity. The introduction of provably scarce digital artifacts is a powerful tool to motivate users in a distributed, digital environment.
- Design – A miniature economy tailored for application-specific ends. These systems are designed to produce particular outcomes or maximize the contribution of particular resources, such as hash power. It is not only the study of existing distributed incentive systems, but also the creation of said systems in a novel way.
While still in its relative infancy, cryptoeconomic design presents a variety of powerful tools to build secure decentralized protocols and applications.
History of Cryptoeconomic Design: Bitcoin Mining, the First Iteration
Examining the origins of cryptoeconomic systems helps introduce the notion of cryptoeconomic design and demonstrates such systems’ potential. Though the concept of cryptoeconomic design certainly did not exist when Satoshi authored the original Bitcoin whitepaper, Bitcoin represents the first to-date-successful application of cryptoeconomic design. In particular, this manifests through the Bitcoin mining network. The following chart shows the estimated investment in Bitcoin mining infrastructure, nearly $13 billion to date.
The notable aspect here is not the specific amount invested or growth rate, which is exceedingly difficult to precisely measure. Rather, what is notable is that this scale of investment happens without a central coordinator or governing body: there is no Bitcoin company deploying such capital or developing the ASICs that dominate the mining process today. Instead, this investment has grown from a variety of independent parties around the world organically, all motivated (at least in part) by the novel cryptoeconomic design and set of economic incentives that the Bitcoin PoW process offers to help secure the network. Bitcoin’s highly functional cryptoeconomic design contributes to its successful operation, with the timing of its release and appeal to cypherpunk and libertarian ethos helping the design find initial adoption.
Bitcoin has spurred a family of like projects with similar elements. Inspired projects’ experimentations with cryptoeconomic design run a broad gamut: from mere band-wagging, to satire, to well-intentioned but naive, to narrowly incremental, to at-odds-with-itself, to novel but unknowingly flawed, to even, perhaps, truly transformative. As good design incorporates historical lessons, such examples represent a bounty for researchers hoping to understand a system’s likely behavior. A theoretical framework, a common language useful in describing, analyzing, and evaluating the various interrelated elements of cryptoeconomic design, is the key necessary for designers to make best use of this toolset.
The Smith + Crown Cryptoeconomic Design Stack
In order to provide an anchor framework useful for understanding the wide variety of cryptoeconomic designs in production today, Smith + Crown has developed the Cryptoeconomic Design Stack. Blockchain-based systems can be imagined as layers of technological, economic, and legal rule sets whose interactions, tradeoffs, and implications should be fully considered by projects considering deploying them.
The three ‘layers’ of the stack are the following:
1. Off-Chain Human Behavior
In describing a cryptoeconomic system, it can be useful to characterize the stakeholders and user types that interact with the network; design goals for crytpoeconomic system can involve incentivizing user groups to perform key platform functions, considerations around game-able mechanics inform rewards engine design, and speculators behavior can affect token price in ways affecting the token’s suitability for a planned function. User or stakeholder groups are typically non-exclusive and can include:
- Consensus Participants. Some users interact with a network by performing key functions or services— Bitcoin and Ethereum miners, Augur reporters, Dash masternodes, EOS block producers, etc. Protocol-issued rewards are often designed to influence such users’ behavior.
- End Users. Some users interact with a network to utilize its designed functionality. End users notably include both individuals and organizations (businesses, governments, charities, etc.), some groups of which may have unique needs, such as with respect to throughput or custody.
- Developers. Some users interact with a network by extending its uses. This includes building software dApps or protocols which interact with the network, and manufacturing or running hardware that broadens the network’s adoption (mesh nodes, point-of-sale systems, mining rigs, etc.).
- Investors and Market Speculators. Some users interact with a network by funding it directly or by funding its supporting elements’ creation. Speculator-influenced price discovery is often important; token price, in theory, should be influenced by all lower layers, though current market conditions show mixed evidence of this.
- Malicious Actors. Some users interact with a network exploitatively. Cryptoeconomic systems can create perverse incentives, rewards engines may be subject to gaming, and tokenized wealth may be a target of crime. Cryptoeconomic design often considers how decisions might introduce or mitigate attack vectors.
- Lobbyists and Regulators. Some users, people affected by the network, or advocates thereof, interact with the network via political or legal processes that can influence a network’s adoption and useability. (For example, the behavior of exchanges in their efforts to delist Zcash and Monero, can be influenced by anti-money laundering laws shaped, in principle, by advocates of impacted parties and the technology.)
2. Off-Chain Digital Infrastructure
Humans typically interact with some form of mediating centralized software that, in turn, enables them to interact with an underlying distributed system. Such infrastructure is rarely open source, can be first-party or third-party, and is able to handle unexpected changes through frequent upgrades and is therefore not trustless.
Examples of elements at this layer include:
The blockchain is the root-level distributed database that supports all of the above aspects of the stack. At a basic level, it is code executed by nodes in a distributed environment. Every cryptoeconomic system must account for unique possibilities and constraints in a distributed environment. The blockchain layer is often intentionally difficult to change, and acts as a largely immutable source of truth.
Examples of elements at this layer include:
The above Stack is a useful starting place in describing a system to see where rulesets influence each other, which software and entity controls which rules, and who ultimate users might be. Such an exercise is useful for potential project supporters to ensure they understand the system enough to trace and articulate critical relationships and potential disjunctions. It is also useful for projects and project architects to understand the interdepencies among the entire ecosystem they are proposing to facilitate.
Subsystems of Cryptoeconomic Design
Beyond the layers of the cryptoeconomic stack, four component systems are generally key to most cryptoeconomic designs. Cryptoeconomic systems, as a whole, have as components token function, circulation and supply, trustless mechanisms, and governance processes. Design choices for each component system typically set constraints for other systems’ design—cryptoeconomic designers must consider how subsystems will function together so to instantiate the attributes intended for the whole.
Token function, which Smith + Crown explores in more detail here, defines mode of use and rights of a holder. Token functions are non-exclusive, in that tokens can have multiple functions, and non-exhaustive, in that new functions may emerge. A wide variety have been used throughout industry history; the following chart shows a collection of notable examples.
CIRCULATION & SUPPLY
The circulation aspect of cryptoeconomic design describes the circumstances and mechanisms in which tokens are distributed to network participants. In general, this takes place in two phases: an initial distribution at the genesis block or deployment of the metatoken smart contract, and an ongoing distribution to provide a continual reward once the network is live. Key examples of initial distributions include token sales (ICOs, IEOs, STOs, SAFTs, etc.), airdrops, and lockdrops; further discussion of considerations for token distribution mechanisms is found here.
A primary purpose of the initial distribution is to bootstrap and incentivize the early network. Types of ongoing mechanisms include mining rewards, staking rewards, minting, burning, and per-block treasury allocations. These ongoing mechanisms primarily serve as an ongoing subsidy to incentive contributions to the network, often for participation in consensus through block rewards.
Underlying most cryptoeconomic systems are some version of ‘state’—the set of statements about the system that are true but only because everyone agrees they are true (and their beliefs might be backed up by cryptographic proofs). Maintaining ‘state,’ broadly defined, involves a set of economic games played in an adversarial environment. The design of such games, called in established economic literature as ‘mechanism design’, is the heart of this subsystem, though tracing its relationship with all other systems requires a broader set of analytical tools. Examples include Satoshi’s “longest chain” mechanism for Bitcoin’s state, Ethereum’s uncle rewards and the gas market, and Augur’s oracle mechanic to report off-chain events on chain.
The final major aspect of cryptoeconomic systems is governance, which defines how protocol rules may change at all levels of the stack. This includes both network governance, such as forks and on-chain treasury distributions, as well as business governance, such as the relationship between the issuing entity and the network. Zcash’s recent governance discussion highlights the role of the off-chain issuer and ostensible maintainer of the network. Network governance can take place both on-chain and off-chain; for example, Decred’s governance occurs largely on-chain through the Politeia proposal system, while Bitcoin and Ethereum development occurs through informal, loosely-coupled off-chain procedures.
Conclusion: Mature Industry Dialogues Require a Working Understanding of Cryptoeconomic Systems
As this introduction to the topic illustrates, cryptoeconomic systems are complex and cryptoeconomic design better proceeds cognizant of the many relevant factors influencing system’s ultimate behavior and attributes. Yet the concepts are also fundamental: a basic, working understanding of the concept of a cryptoeconomic system allows readers to participate in important industry dialogues in a more critical and informed manner. Many of Smith + Crown’s more advanced research pieces presume competency with this notion.
While elements of this framework may come to be refined over time (interdisciplinary contributions are expected to lead to sharper categories), readers are now better prepared for discussions of nuanced topics. Those readers looking for an extended introduction are encouraged to watch the original Nomics webinar from which these materials have been adapted; the webinar may be found at crowdcast.io (registration is required). Beyond these introductory materials, the podcast addresses such topics as:
- Where is cryptoeconomics today? What are key market indicators. (19:11)
- Why are token functions a key source of value? (41:53)
- What are the cryptoeconomic factors in play with stablecoin projects? (1:05:00)
- How are Steemit and Zilliqa examples the industry can learn form? (1:30:12)
- What might 2020 and 2021 bring to the space? (1:36:17)