Blockchain platform founders must use economic design if they want to build platforms that deliver value to their users. While most founders recognize the need for tokenomics, this is only one piece of a much larger economic picture.
Economic design is a set of tools that helps economic systems to function effectively. Blockchain platforms are essentially mini-economies written in code. Users adopt them to engage in mutually beneficial interactions with others, and they rely on the platform’s contracts, marketplaces, currencies, and rules of decision-making to help them do so. Having appropriate economic structures, working together towards a common platform goal, maximizes the probability that users are satisfied with their experience and will want to return.
Major technology companies have long recognized the importance of economic design to their success. Amazon, eBay, Microsoft, Google, Yahoo, and AirBnB are just a few of the platforms that employ dozens of economists. Using a combination of economic theory, mathematical modeling, data analysis, and experiments, these economists continually improve the design of products and services, such as recommendation engines, ad auctions, and reputation systems. In other contexts, economists have been brought in to design everything from school choice to labor markets to spectrum auctions. Throughout these various settings, economists leverage decades of academic research to identify problems that destroy value, and accordingly craft and test design changes that increase revenues, profits, and user satisfaction.
A particularly exciting aspect of blockchain is that it brings together so many varied areas of economics. In this post, we outline the platform design framework — the Prysm Group House — that we use to guide economic design and analysis. This framework is the basis of our custom economic design solutions for blockchain projects, providing the blueprint for designing an economic system from the ground up. It also formed the outline for our mini-course on economics for blockchain professionals that we gave in November 2018 at the University of Southern California.
Components of Blockchain Platform Design
An effective economic design for a blockchain platform requires a strong foundation, which includes the value proposition of the intended product and the early-stage funding to begin its development. Both of these must be established before economic design can be fruitfully applied.
- Value Proposition and Early-stage Financing and Capital Investment
First and most importantly, the founding team must identify the value proposition of the project. Who are the intended users, and what will they hope to gain from using this product or service? While this appears to be an obvious point, many platforms do not have a well-defined idea of who their target customers are, their overall needs, and how their platform will provide value to them. These insights can be gleaned from customer discovery, market intelligence, and the previous experience of the founding team in relevant industries. As we’ve discussed previously, a thorough understanding of what value the project will deliver to whom is an essential input into effective economic design.
Next, the team will need to raise funds to support the development of the technology and the design of the economic mechanisms of the platform. The optimal method for raising this early capital — including whether to sell equity or create and issue a token — is a complex topic with legal, regulatory, and corporate governance considerations.
The full design of a native token comes towards the end of the economic process because it is informed by the specific economic mechanisms that are used on the platform, which are not yet defined at this stage. Therefore, if founders choose to raise money using a token sale, they must be careful not to commit to token policies that they may later want to change.
After the foundation is laid, the main components of the economic design can begin. These components — -contract design, market design, and information systems — -shape the behavior of platform participants so that the founders’ vision of the platform can be achieved.
- Contract and Transaction Design
In a typical transaction, one party pays another party to provide a good or service. There are a variety of problems that can arise in the execution of contracts, such as the buyer not sending payment or the supplier not providing the service as described. Typical problems arise from moral hazard (the inability to properly share risk and monitor behavior) and adverse selection (asymmetric information regarding the quality of goods or services).
Blockchain is often touted as a trustless system which helps to alleviate these sorts of issues; however, actually ensuring that a contract is executed as agreed upon, and that all parties receive the benefits they expected, requires careful design of the contract and related mechanisms. Economic levers that can be used in transaction design include:
- Contract terms
- Escrow services
- Dispute resolution services
These elements may vary in importance depending on the specific context in which a transaction takes place. For example, decentralized blockchain-based peer-to-peer marketplaces have learned that powerful dispute resolution services are an essential trust building component that allows users on the platform to comfortably engage in transactions.
- Market Design
Before transactions can be executed, buyers and sellers must be able to find each other and negotiate mutually beneficial transaction terms. Designing well-functioning marketplaces is a complex endeavor. Some of the many issues that can arise include congestion (buyers and sellers not being able to find each other), unraveling (users choosing to opt out of the market), inefficient matching (users would be better off transacting with alternate trading partners), suboptimal pricing mechanisms (one or both parties does not receive the appropriate surplus), and inefficient or ineffective procedures for negotiating terms.
Market design has numerous components, including:
- Matching of buyers and sellers
- Pricing mechanisms
- Negotiation of terms
Again, the relative importance of each of these elements depends on the specific setting at hand. An online e-commerce platform such as eBay, which sells many highly differentiated goods and has thousands of users, relies heavily on effective matching of transaction partners and well-designed reputation systems. In contrast, a procurement auction may depend less on matching and focus more on the design of the pricing mechanism.
- Information Systems
Information, whether it is used by market participants or by platform algorithms, is critical to supporting the goals of contract and market design. Information mechanisms feed into other economic structures; for example, pay for performance contracts depend on performance metrics, which are selected and have their risks mitigated by the designers of the platform. Similarly, if a marketplace is intended to allow buyers to select among sellers of various abilities, then those abilities need to be communicated to buyers in a way that minimizes risk of manipulation and cheating. Information systems can include structures such as:
- Performance metrics
- Quality standards
- Reputation systems
The information systems of a particular platform are designed to support the function of its main economic mechanisms. Their design must take into account the way users are likely to interact with these informational tools based on their own motivations and goals.
- Token Economics and Design
Only after the economic design of the platform is complete should token design take place. Tokenizing something just for the sake of it is never a good idea — there should always be a compelling business reason to introduce a blockchain-based token, and the economics of the token needs to fit with the rest of the design of the platform.
A well-designed token is more than a means of exchange or a store of value. It must be designed so that it supports the incentive, market, and transaction design of the platform, as well as fulfilling the needs of those who use it for traditional currency purposes. Designing appropriate token economics involves creating a token that fulfils the fundamentals required by the platform, and then verifying that equilibrium token values will sufficiently compensate any platform participants who receive their compensation in tokens.
For a utility token, the design elements will include:
- Fundamental value drivers
- Monetary policy
- Token distribution mechanisms
What is important is that the token is designed with its specific use case or cases in mind. The same token, for example, should not be used both as a medium of exchange and for investment.
The design of security tokens is more complex and varied, because they can be used to represent items of value both on and off-chain. Carefully thinking through the property rights that a security token bestows is essential for the token to behave the way the platform founders desire.
Finally, blockchain platforms — especially decentralized ones — need governance.
Governance is the set of decision processes or systems that allow for a platform to adapt over time to changing conditions or new information. The design of a governance system must be flexible enough to allow for adaptation under unforeseen circumstances, which is when it will be most needed. However, rules, mechanisms, and processes are typically put into place in order to ensure that the needs of particular stakeholders, such as platform users, are served by the decisions that result from a governance system. The economic fields of social choice (the study of decision making by groups) and contract theory (which covers decisions made by representatives) both provide frameworks that can inform the design of a governance system.
How to design governance depends on the specific decision to be made and can include:
- Proposal processes
- Delegation/representative decision-making systems
- Voting systems
A critical lesson from social choice theory, a field which dates back to Kenneth Arrow’s work in the 1940s, is that a decision-making process should not be copy-pasted across all governance decisions. The design of a governance process should be custom-fit to the purpose.
Economic design is everywhere, and blockchain founders need to understand how it shapes the behavior of their users and therefore the success of their platform. “No design” is not an option — economic structures are ubiquitous, and it is in any founding team’s best interests to think critically about how they can be designed to best advance the goals of the platform.