Crypto: The Power of Incentives

Incentives are important, which is one of economics’ many timeless teachings. The institutional rules of the game should be set up in such a way as to reward collaboration and discourage bad behavior if we want individuals to respect them rather than take advantage of one another.

This obvious realization is taught in every Econ 101 course, but contemporary politics routinely disregard it. When politicians naively assume workers and corporations are saints who will simply continue to produce wealth, even when the politics of the day egregiously persecute them for it, they blatantly ignore this fundamental lesson of getting incentives right. This is why popular left- and right-wing proposals to regulate corporations or to tax the wealthy trample over it.

In actuality, laws and taxes deter people from being productive and, in the worst cases, encourage businesses to fight for corporate welfare or wealthy individuals to move their wealth abroad to avoid paying taxes, which impedes economic growth.

Modern politicians should pay attention to and learn from the bitcoin industry in order to comprehend the value of incentives. Bitcoin is a very secure currency with a $1.15 trillion market worth as of November 2021. Built on its foundation is the decentralized finance (DeFi) sector, a $80 billion market that is expanding quickly and appears to function without the need for onerous banking rules. For those who are unfamiliar, DeFi is a decentralized, online banking ecosystem where anybody may use their cryptocurrency to take part in a variety of financial products, ranging from straightforward lending and borrowing to intricate derivative trading and forms of margin.
The cryptocurrency market is heavily dependent on well-thought-out market processes that make use of pricing incentive structures. This article summarizes how cryptocurrency developers create the correct incentives and explains why this is a key economic principle that ought to be applied to all situations.

The blockchain protocols are completely open

The regulations that control the supply of cryptocurrencies are the primary distinction between them and fiat currency. The regulations that govern how central banks manage fiat money are opaque and open to arbitrary manipulation. Since central banking bureaucrats won’t be alive to take ownership of tomorrow’s negative results, they lack residual claimancy and have no personal motive to support excellent long-term governance. According to the authors of the 2021 book Money and the Rule of Law, central banking organizations’ regulations frequently lack universality and certainty, which is precisely the feature that distinguishes cryptocurrencies.

In sharp contrast to most cryptocurrencies, this. For instance, Satoshi Nakamoto’s restricted 21 million coin supply constraint is well known for being the driving force behind the Bitcoin blockchain. This rule lays the foundation upon which the whole Bitcoin ecosystem functions by ensuring the assurance of the token’s long-term fixed supply.

The 21 million supply, however, is not a set regulation. Theoretically, Bitcoin developers can suggest changes to this code, and miners—who continuously verify and secure Bitcoin transactions for block rewards (a process known as “proof-of-work” validation)—might choose to adopt a new code that is advantageous to themselves. The new code may increase the amount of Bitcoin available, make it simpler to mine Bitcoin by lowering the difficulty of the computational puzzles, or raise the incentives miners earn for confirming transactions.

The way Bitcoin’s design ensures that miners have “skin in the game” makes it unlikely that these groups will pursue such self-serving cartelism, despite how enticing it would be. Bitcoin miners spend a lot of money on cutting-edge computing hardware to validate nodes. They are then compensated with Bitcoin prizes. According to Minerdaily, one Bitcoin will cost between $7,000 and $12,000 to mine in 2021.

Given that the blockchain for Bitcoin is public, if these self-serving rules were to be implemented, everyone would be able to see them. These miners stand to lose a great deal if Bitcoin’s reputation takes a knock and its value declines. Strong incentives exist for Bitcoin miners to refrain from any opportunism due to the possibility that the public may interpret their conduct as a kind of rent-seeking due to the transparency of public blockchains.

The same principles of economic incentives apply to various forms of block validation in cryptocurrency, such as “proof-of-stake,” which is increasingly being used by many newer blockchains like Ethereum. Validators must stake a portion of their own money up front on proof-of-stake blockchains in order to validate transactions. A punitive mechanism that results in the liquidation of a validator’s staked money is triggered when one of them unintentionally or maliciously processes fraudulent transactions. The incentive would not be worthwhile, just like the confirmation of proof of labor. Even if the culprit is successful in carrying out such an attack, his prize is a reputationally damaged asset that is depreciating. By using this technique, blockchain protocols at their most fundamental level directly encourage good governance and disincentivize opportunism.

Market incentives are present throughout the entire DeFi ecosystem as well

The blockchain layer (sometimes referred to as Layer 1) is where cryptocurrency’s strong incentive systems start, but they don’t end there. As a permissionless financial system where users can lend, borrow, and trade cryptocurrency without the requirement for conventional banks as a middleman, the DeFi space in cryptocurrency has flourished since the beginning of 2020. Although the decentralized banking industry is still young, it is thrilling to see how quickly it is developing. Similar to how DeFi applications and services use a variety of price incentive systems on this “Layer-2” of the crypto world, they serve a variety of functions. The widespread usage of liquidity pools is arguably the most notable illustration.

Purchasing Bitcoin or Ether with currency on a centralized exchange (CEX), like Binance or Coinbase, was probably your first venture into cryptocurrencies. Because of the strong decentralization ethos of cryptocurrencies, developers have created decentralized exchanges (DEX), which enable trading through liquidity pools powered by smart contracts. Instead than using the conventional order book approach, where buyers and sellers deal directly with one another, traders on a DEX purchase and sell cryptocurrencies from these pools.
DEXs use a variety of incentive schemes to entice users to deposit money in exchange for interest, or yield farming.

First, yield farmers receive a portion of trading costs from buyers and sellers that interact in these liquidity pools, providing a clear incentive for them to maintain a full liquidity pool. Second, yield farmers are rewarded by DEXs with “liquidity provider tokens” in order to further encourage the flow of capital. Should these pools become unprofitable, smart contract algorithms automatically boost trading costs and token incentives for capital contributions exponentially, encouraging new capital owners to contribute capital. For instance, the leading lending/borrowing platform Aave swiftly increased its annual percentage yields (APY) for loan DAI from 6.5% to 24% within a day to quickly attract capital owners when it encountered a liquidity shortage due to sudden capital flight.

Many DeFi apps use liquidity pools, including credit lending and borrowing services (like Compound and Aave), where lenders are rewarded for staking and locking up their cryptocurrency into liquidity pools. The economic rationale is the same throughout the DeFi ecosystem, even though the specifics may vary. The issue of illiquid marketplaces is resolved by rewarding users that offer liquidity.
Crypto stablecoins are another instance of a clever incentive structure. Companies like Tether and Coinbase created intermediary stablecoin currencies tied to the value of the USD (by storing real world financial assets to offset the volatility of cryptocurrencies that makes them unsuitable for commercial trade to ameliorate this problem). The hazards of centralization and regulation from one institution preserving this link between fiat and DeFi thus became a source of concern.

This led to the creation of decentralized stablecoins quite fast. The most well-known instance of a stablecoin that depends on price incentives to equilibrate its coin towards a 1 USD valuation is the DAI cryptocurrency (exchangeable with Ether). Users have the option to profit when the market value of DAI climbs above 1 USD by minting more DAI than usual with Ether to sell. This increases the supply of DAI and lowers the price of DAI.

Owners of DAI can act in the other way when the price of DAI falls below $1 USD: they can sell DAI for more money in Ether and push the price of DAI back up to $1 USD. In other words, DAI relies on price incentives to preserve its USD peg, allowing users to (indirectly) use their Ether as an equity asset. Users of cryptocurrencies will no longer need to rely as heavily on centralized third-party middlemen like private enterprises like Binance that are under intense regulatory pressure.

Governance and incentives

In DeFi, incentive structures are used not just for the core operating principles of the company’s products but also for the overall application governance, which determines how these applications are created. This is accomplished by issuing their own tokens, which act as a governance token and give consumers the ability to vote on modifications to products or protocols.

Tokens for governance accomplish two goals. First, they provide users with a form of ownership, much like conventional equities stocks do. Since these tokens may be traded, users can have a “voice” by offering the token for sale. Second, the governance component gives users a stake in the outcome, provides incentives to support good governance initiatives, and gives users the capacity to utilize their voice and cast actual votes for governance decisions.

Decentralized finance is not entirely decentralized, despite its name. Users have the ability to alter how protocols are run, but developers still have the last say in some important decisions, such as how money will be spent or the monetary policy of an app’s native currency. Chris Berg, an economist, says it best: DeFi apps initially follow a centralized design approach, but over time they go through a decentralization process in which some centralized control is given to users. The development of a liberal democracy within a nation-state, where fundamental laws governing democratic elections and voting procedures are established in the political constitution, might be compared to this.

A new type of user-owned digital organization that has been dubbed the future of work has also been made possible by governance tokens. Decentralized Autonomous Organizations (DAOs), the term for these online communities, can run formally as a hierarchical corporation or in a loosely organized manner where employees can put in as little as two hours per week to a full 40 hours per week. Low entry barriers to participation and an irreversible shared treasury that is enforced on the blockchain are what set DAOs apart. Users are paid in governance tokens based on the amount of work they contribute, with economic incentives serving as the main design technique to encourage community development.

The choice to leave

The relationship between the functions of “voice” and “exit” in political governance has been extensively discussed by economist Albert Hirschmann. Hirschmann stated that individuals’ ability to back up their threats of leaving (voice) with actual departure (exit) reduces nation-states’ predatory behavior.

The American federalist system, which enables citizens to “vote with their feet” by moving between states, may be the best example of this. This system helps to restrain politicians’ avaricious tendencies. This is the same reasoning that prevents companies from providing a subpar good or service in a market that is competitive or that distinguishes between an authoritarian monarchy and a liberal democracy where citizens have a choice in their government.

It shines in this area of the cryptocurrency ecosystem. In contrast to exit obstacles for fiat currencies, which citizens are forced to utilize due to central banking monopolies over a certain geographic area, cryptocurrency exit barriers for users are nearly entirely free. These low exit costs keep blockchain developers from engaging in predatory governance and provide them with strong incentives to support the kind of user experience that is consistent with what holders of the currency expect from it. To prevent damaging their reputation in the eyes of customers, developers must be acutely aware of any departure from the primary philosophy and principles of their product offerings.

Developers also have the choice to leave. Developers who disagree on a particular set of improvements can threaten to leave the network by “forking” it. Developers can steer the current network in a different direction than their peers by doing this. Following a protracted 2017 scaling disagreement between developers over the increase of the Bitcoin network’s block sizes, the Bitcoin Cash (BCH) network is a well-known example of one such hard-fork. After the community and its developers failed to reach an agreement on how to deal with the loss of funds from a hack that exploited a weakness in its code, Ethereum, as it is now known, was a hard fork in 2016 from the network that is now known as Ethereum Classic.

In a nutshell, hard forks are the results of community disagreements brought on often by significant and contentious changes to a blockchain. If you disagree with your central bank’s monetary policies, the only choice in the fiat world is to move to a different zip code. Because citizens have no other options, central banks are able to continuously debase and inflate our currency.

Due to the possibility of being promptly punished by market competition, the option to depart for both users and developers strongly discourages existing blockchain developers from manipulating the network for their own self-interest. The important thing to remember is that even if these choices are never actually used, the fear of dissent alone can punish poor leadership. The barriers to predatory governance are much fewer than they are in nation states or oligopolistic markets (such as utilities, telecommunications, or social media), where it is expensive or difficult for customers or producers to leave.

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