Governance and tokenomics: Lessons from the 0x cryptocurrency
Decentralised governance is more radical and more difficult than most give it credit for.
Decision-making is hard, especially when an entire community comprised of many individuals needs to make a decision. Humans have yet to find an ideal solution to this problem, but other species of community-oriented animals have become extremely good at it.
To date, the human race's most widely-deployed solution to this problem is to delegate decision-making power to central authorities.
The usual idea is that these central authorities focus their energy on finding the best solution for the community, while the rest of the community agrees to adhere to their decisions regardless of whether they personally agree. This kind of system is very efficient, but has a tendency to make sub-optimal decisions that lean towards the best interests of the central authority rather than the community as a whole.
Various communities have tried to improve on this basic system by adding elements like democratic elections.
Consider the community called the United States of America. It uses a central authority, dubbed the president, to help remove frictions and keep the community moving in the same direction. It also includes democratic mechanisms to better align the goals of the president with the goals of the community, and a secondary authority structure called the senate to decentralise the system a bit and help control for the possibility of misalignment between the goals of the president and the community in general.
It's alright but starts running into problems stemming from individual authority entities in the system being incentivised towards goals other than the good of the community.
The problem is compounded by the community's primary incentive mechanism, a thing called money, being mostly created and controlled outside the bounds of the power structure itself. This gives third parties the ability to inject new incentives into the authority structures to exert control over the community's decision-making system. It's also a systemic vulnerability since a rival community can use money and other incentives to deliberately inject counterproductive goals into the authority structures for the purpose of damaging the community as a whole.
In the long run, the decision-making system that was originally intended to streamline the community towards the same goals gets pulled in many different directions, and the decision-maker's incentives are out of alignment with the best interests of the community itself.
The crypto difference
Cryptocurrency presents a very different paradigm.
First, they're often intended to be completely decentralised and able to function in their own best interests without discrete authority structures. Theoretically, this tends to result in better decision-making outcomes.
Second, the incentive structures (that money thing again) can be built into the system from scratch and programmed to be automatically distributed in a way that keeps the motivations of community members and decision-making structures aligned with the best interests of the community itself.
On paper, you now have a community that's able to efficiently make good decisions while being immutably incentivised towards the good of the community as a whole, all inside a streamlined and mostly automated framework.
In the ultra-speculative world of crypto cash grabs, this might be one of the less-appreciated world firsts that distributed ledger technology brings to the table.
But it's still largely uncharted territory, and it's just plain hard to create a sustainable, tamper-proof and technically-feasible system that jams together a community's power structures, incentives, economy and overall viability as a useful commercial product.
That might be why it's so fascinating to watch coins keep trying.
The 0x Protocol
The 0x Protocol is intended to simultaneously be a community, a power structure, an incentive system, a functional token system and a practical and economically viable product. Right now, it's consciously exploring ways of juggling these elements.
Usefully, it's intended to facilitate trades across decentralised exchanges. This is not only practical, but also gives the community a very clear set of goals and participants which makes it easier to identify all the moving parts.
Also, it might help wean the cryptocurrency ecosystem off its reliance on the centralised exchanges which ironically still serve as the backbone of the decentralised crypto industry, but don't necessarily share the same goals as their users.
Let's meet the moving parts of the system.
This is anyone who uses, owns or interfaces with 0x (ZRX) tokens.
Those who actually use the 0x Protocol can be divided into two groups: Relayers and Traders.
- Relayers. These are the for-profit entities that run nodes to conduct decentralised exchange transactions. They're the ones who maintain order books for the decentralised exchange system.
- Traders. These are the ones who trade. These are the people who buy and sell on decentralised exchanges through the Relayers. Decentralised exchanges that use the 0x Protocol would also fall into this group because they're going through the Relayers.
Both groups are essential. The Relayers are the ones who actually keep the system running, while the Traders are the customers who use it.
As a self-evident rule of thumb, entities will pursue their own immediate goals, even if it's not necessarily sustainable in the long run.
In the case of the Relayers and Traders, both naturally want the community as a whole to grow and succeed, but won't see eye to eye on the finer details and are more immediately motivated to achieve separate goals.
For example, Relayers might want higher network fees while Traders want lower fees. An imbalance to either side might see immediate benefits for one of the groups, but could destroy the system in the long run.
The network needs both Relayers and Traders to keep running, so the system needs to find a way of maintaining balance between the groups.
There are three immediately apparent ways this could be done:
- Make the incentives for balance stronger than their own incentives. For example, this could be done with a fancy economic model that varies fees based on the ratio of Relayers to Traders or other factors. The Havven stablecoin aims to maintain its price peg with this kind of model. The downside is that these artificial incentives can be a point of friction and can undermine the actual functionality of the system through unnecessary fees, inflation, etc.
- Ensure both groups have authority to prevent unilateral decisions. By introducing a governance system, the platform can add decision-making power to balance existing incentives, rather than risk making an economic mess by adding unnecessary incentives. But this is a point of friction in its own right and opens up new risks.
- Do both. This is what the 0x Protocol is going for.
Authority and economy
The ZRX token is the multi-purpose glue that holds the 0x Protocol together. It needs to simultaneously serve as the following:
- An authority token. This is more typically called a governance token. ZRX grants voting rights to users and is essentially a kind of transferable piece of authority. Generally, within the rules of the system, the more ZRX someone has, the more power they have.
- An incentive mechanism. ZRX needs to get moved through the system in a way that appropriately incentives and compensates all parties to keep the system running without acting against the best interests of the community.
- A store of value and an economically viable product. A worthless token is no good as an incentive, and there's no value in authority over a worthless network. A more valuable token can better grow a network, which in turn gives it even more value.
Juggling the first two is hard enough, but you also need the third one to bring it together. Purpose gives a token value, and value gives a token purpose.
This chicken or the egg problem is, incidentally, one of the reasons ICOs are so widely used in cryptocurrency. It lets projects assemble a community, create and distribute tokens, and insert monetary value all at the same time, before actually launching a project. Most ICOs are shoddy cash grabs, but sometimes it's the only real way to get a system off the ground.
But balancing these three needs doesn't happen overnight. It takes months or years of meticulous work and dealing with the problems caused by the solutions.
The crux of it all might be that directly marrying a community's economy to its governance model presents a lot of opportunities and is the only real way of making it all work, but it also opens up an extremely wriggly can of worms.
The problems with the solutions
One of the problems that the United States of America, 0x, EOS and other democratic-style communities frequently encounter is that governance is a pain. For most people, getting involved will carry immediate and guaranteed downsides (can't take the day off work, can't be bothered, it costs money, etc) and only very vague benefits (my vote doesn't matter).
In strictly mercenary terms, there are few reasons to stand up and be counted, which might be why there are so many proverbs focused on emotional appeals to the contrary.
In Australia, where voting is mandatory, participation is estimated to be somewhere in the low 80% range. In the USA and UK, it tends to sit in the 50% range, and in EOSland, it was below 15%.
This was one of the governance problems 0x ran into. Traders are mostly just using the platform as a service and don't really have any stake in its ongoing development the way Relayers do. Without any real reason to vote, they have no reason to hold tokens, and without any reason to hold tokens, it's not worth locking up the capital just for some voting rights that they don't really want.
Most other participants are in a similar position and simply do not want the headache that comes with voting and governance.
This might not be a problem in itself, except that it shifts the balance of governance power mostly to the Relayers, who naturally tend to accrue stakes through network fees and have more direct reasons to be involved in governance, but are still just one of several essential cogs in the machine.
The solution was mandatory token stakes for large Traders to ensure that Traders maintain a voice in the system and that the balance of power doesn't unsustainably skew to Relayers. But this caused new problems. It is an unnecessary point of friction for users who just wanted to make money and are now forced to stake capital in an economic democracy to buy the decision-making power they don't even want.
Solutions to the solution's problems
Discussion is shifting to look at ways of building up the third pillar, token value, to better support the governance and incentive pillars.
The idea is that mechanisms like mandatory staking and voting rights will go down much easier if the ZRX token becomes a more reliable store of value, so holding those mandatory capital reserves can be a better investment in its own right. This would also result in more incentive to participate in the governance of a more valuable token.
But this is a slippery slope. Deliberately focusing on the third can lead to losing sight of the forest for the trees and can also cause problems of its own.
"You can't force value into a token. Period," says 0x co-founder and CEO Will Warren. "Grafting artificial incentives onto a token... inherently adds friction (more gas per trade) to the detriment of users.
"Sometimes velocity sinks and other schemes are a natural byproduct of good technical/economic design. Unfortunately, they have increasingly become an explicit goal rather than a natural byproduct, akin to social apps optimising for 'virality' by using all kinds of dark patterns (e.g. spamming email/phone contacts)."
Carefully adding value
Louis Aboud-Hogben, head of research at Wyre Capital, has been giving it some thought and released a series of widely-read proposals.
He notes that from a commercial standpoint, the governance and incentive pillars are essential in a world where open source code makes it easy for competitors to directly replicate each other's technology. The technology itself might be easily replicated, but the living community itself is unique and is where the real value accrues. At the same time, he points out that most crypto exchange customers tend to have little platform loyalty and are perfectly happy to go elsewhere if they find a better deal, so the third token value pillar is essential to maintaining the others.
"Token economics should be a key pillar within most crypto go-to-market strategies, as they can be a formidable tool in driving adoption," he argues. "We also see a dynamic arising where the network effects generated by strong token models will have an ability to erode a competitor’s first mover advantage, as well as add to the defensibility of a project's incumbency within a particular vertical."
Essentially, the best governance model in the world is no good without the right tokenomics, and shoring up that value pillar stands to reshape the community's landscape anyway by bringing in more users and boosting adoption, which can help tweak the governance and incentive structures.
He also points at the risk of upcoming competitors undermining 0x with similar technology and functionality, but more aggressive emphasis on the third pillar.
"Given the emerging industry structure surrounding cryptocurrencies, it is likely that technological differentiation will not be sustainable, and technology leaders should prepare themselves for disruptive competitors coming to market with aggressive tokenised incentive schemes," Aboud-Hogben said.
He proposes two specific changes to the token economy value pillar, and how they can in turn affect the incentive and governance pillars.
The first is a token burn to remove from circulation a small portion of fees paid in each transaction. The idea is that this deflation will drive more enthusiasm and perceived value for the coin itself.
It could also create more incentive for people to hold tokens in the long run, bringing some out of circulation and further boosting value.
It could also create a direct incentive for Relayers to re-broadcast other Relayer orders, adding to the liquidity of the network and better serving customers, Aboud-Hogben argues.
As it stands, there's an opportunity cost and no benefit, for Relayers to do so, he says, but adding a token burn system creates an incentive.
"Creating a token burn also gives the protocol firepower to re-issue some of these previously burned tokens in order to incentivise behavior that adds value to the network. This is the crux of the second element of our proposed model."
Opt-in incentives for market makers
"This system is designed to drive greater liquidity to the network by rewarding market makers with either fee discounts and/or by paying them fees in ZRX."
The idea is that market makers can stake ZRX for rebates or a fee discount as well as pay fees all in one bundle at the end of the staking period to save on gas costs. This will give Traders a direct financial incentive to hold ZRX tokens.
Aboud-Hogben also proposes a system where staking market makers can use the governance model to vote to include specific assets in that incentive system.
"Under an on-chain governance mechanism, ZRX holders vote to include particular assets in the incentive system, and define a fee discount and rebate level for each," he suggests. "The idea is that fees will be discounted for makers providing further liquidity for already liquid assets, and that fee rebates may be paid for makers providing liquidity for illiquid assets. This drives liquidity to where it is most needed."
An appropriately balanced system can give market makers tempting incentives, especially when providing the assets that need the most liquidity at the time. The incentives should be calibrated, he says, so that they rarely if ever return more to the market makers than the amount they saved in fees. If it does, a fragment of the token burn pool can cover it without interrupting the deflationary model.
It's all about the Benjamins
As you can probably imagine, it's extraordinarily difficult to balance the pillars and create a functional system. Where do you even begin?
In the case of 0x, it began with governance and the realisation that it's essential for satisfactory ongoing development, can be an effective defence against the hard forks that might occur if one party doesn't like the way the project is headed and can help create value by adding functionality to a token right from the start.
"It is fair to say that the 0x team’s current focus with respect to the ZRX token is around governance, which is a good place to start. People often consider governance mechanisms as a defensive measure against hard forks, and there is also a view that governance rights can accrue value to a token (such as ZRX)," Aboud-Hogben says. "I struggle with these concepts, as any governance decision that is valuable enough to an individual stakeholder (or genus of stakeholders) to justify significant value accrual to the governance token will likely be significant enough to justify a hard fork."
Token value, he argues, is a much more compelling defence against hard forks, can serve the same unifying functions as the governance pillar and creates its own aura of incentives.
"Making the ZRX token a desirable asset will be more effective in preventing hard forks and maintaining network participants' commitment to the protocol. Creating a vested interest in the long term prospects of a protocol token will increase the incentive for disagreeing parties to find a compromise. The network effects and incentives generated by end users owning significant stakes in the token will increase their loyalty to the protocol, and reduce the competitive viability of any fork."
The big picture
Central authorities have been a useful tool in humanity's toolbox since the start of time. And like all other inventions, it's been gradually shaped and reshaped by technology and sensibilities over time.
As far as anyone knows, it took a few million years, give or take, of tribal wandering before someone in a toga invented formal democracy. This nifty addition would be tacked onto the central authority system to improve its decision-making, reduce the chances of messy revolution and similar. Other inventors would add their own features over time, like different suffrage settings (citizens only, men only, unisex, etc), and various systems of checks and balances.
But these were all just system upgrades rather than completely new inventions, and the results have been kind of underwhelming at times.
Automated decentralised governance, on the other hand, is a brand new never-before-seen tool for the toolbox. It's not the right tool for the job in all situations, but it's almost certainly going to be quite useful in the future.
When you watch cryptocurrencies like the 0x Protocol struggling with governance and tokenomics and other facets of this multi-dimensional chicken or the egg problem, you're watching it trying to do something that's never been done before.
Disclosure: At the time of writing, the author holds ETH, IOTA, ICX, VET, XLM, BTC and NANO.
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