- Cryptoeconomics is a combination of cryptography and economic incentives that are used to design and secure protocols such as blockchains and the applications built on top of them.
- However, cryptoeconomics cannot account for all important factors in governance decision-making, and a reliance on it alone can lead to undesired outcomes.
- Schneider argues that pairing cryptoeconomics with political systems can help overcome the limitations of cryptoeconomic governance.
- Vitalik Buterin agrees with Schneider’s conclusions and argues that just as cryptography created a new space for innovation in economics and finance with blockchains, it can also create a new space for innovation in social and political systems.
Is cryptoeconomics alone sufficient to govern blockchains and blockchain applications, or is a political layer required alongside?
Schneider, N. (2021). Cryptoeconomics as a limitation on governance. Available at: https://osf.io/wzf85?view_only=a10581ae9a804aa197ac39ebbba05766 or Cryptoeconomics as a Limitation on Governance — Nathan Schneider
Buterin, V. (2021). On Nathan Schneider on the limits of cryptoeconomics. Available at: On Nathan Schneider on the limits of cryptoeconomics
Cryptoeconomics has fundamental limitations. A foundational innovation in the blockchain space has been the shift from trust-based guarantees to a type of confidence machine. Rather than trusting an institution or brand, blockchains rely on a combination of cryptography and economic incentives – cryptoeconomics. Vitalik Buterin (2018) defines cryptoeconomics as “fundamentally about the use of economic incentives together with cryptography to design and secure different kinds of systems and applications”. Both PoW and PoS blockchains are secured using cryptoeconomics.
However, as the wider ecosystem and application development have progressed, challenges have emerged about how these systems can be most effectively governed. Of particular concern is how a focus on economic logic can crowd out anything that isn’t financialised. As Schneider notes: “The things not visible to the market, that is, become unthinkable and impossible. If the market cannot see a changing climate, there is no motivation to act on it.” Markets are an effective mechanism to manage the supply and demand of certain types of goods and services, however, they are not effective at managing more intangible forms of value such as trusted relationships or a sense of community. Schneider describes processes that manage non-financialised value as politics and argues that we need to design and structure political processes that can facilitate discussions about non-financial value and incorporate it into the decision-making structures of decentralized infrastructure – both protocols and applications – where appropriate.
Challenges managing non-financial forms of value are not unique to the crypto space, they present in a wide variety of contexts with a direct corollary to governance and economics in the real world. When discussing GDP as a broad descriptor of a country’s performance, Stiglitz (2018) writes: “What we measure affects what we do. If we measure the wrong thing, we will do the wrong thing. If we don’t measure something, it becomes neglected, as if the problem didn’t exist.” In the crypto space, we can apply a similar logic about what is on-chain, and what is off-chain – it is much easier to manage and account for what is on-chain. The broad implication is that being unable to adequately manage or account for value that isn’t on-chain or financialised – captured through economics or tokenomics – often results in its exclusion from consideration in decision-making structures, which can result in undesirable governance outcomes.
Schneider describes three ways these governance limitations present in the blockchain space: persistent plutocracy, discounting externalities, and suppressing participant interests. Plutocracy – defined as governance by the wealthy – is present in this space. PoW and PoS blockchains tend to provide power in proportion to a given node’s buy-in on the network through either computing power or token holdings. Applications built on these networks mostly follow the same logic using coin holder voting – 1 token equals 1 vote. Buterin (2018) provides a comprehensive account of how plutocracy can generate negative outcomes. Broadly speaking, power defaults to those with more tokens, who then make decisions based on their self-interest which is often at odds with the broader community’s desires.
The discounting of externalities is a well-recognized problem. Anything the system cannot see, cannot be accounted for. Environmental concerns, specifically climate change, is the premier example of this. PoW consensus mechanisms use significant energy – often from fossil fuel sources – which are incentivized by the cryptoeconomic security model. The externalities – climate change – are not captured in the blockchain ecosystem. Both of these factors lead to the final problem – participant interests are suppressed. Economic logic can only capture a slice, a facet, of the things people value. Concepts such as trust, fairness, legitimacy, credible neutrality, and sense of community are not captured in economic logic. An inability to structurally account for these factors can result in their exclusion from consideration in governance processes, which suppresses participants’ interests.
Schneider argues that pairing cryptoeconomics with political systems can alleviate these limitations by introducing a mechanism for people to influence protocols which is not dependant on economics/token ownership. Cryptoeconomics has significant value as a tool, but only in limited contexts – it is not a silver bullet that solves all governance problems. Incorporating the political dimension alongside cryptoeconomics could introduce more democratic tools for decision-making which can improve the function of the ecosystem. Importantly, these types of political decisions are already active in the ecosystem alongside cryptoeconomics, as Buterin (2017) notes “Miners are generally following the direction favoured by the community, which is itself gauged via social consensus aids similar to those that drive hard forks.”
The evolution of the ecosystem over the past few years has increasingly demonstrated the importance of the political dimension. When reflecting on the evolution of the Gitcoin protocol in response to the Sybil attacks in round 9 of Gitcoin grants, Kelsie Nabben (2021) writes that “Governance, even that of the decentralised variety, surfaces politics. All infrastructure is political, whether it is through human involvement or the rules that humans encode in systems. How this interplay between the social and technical entanglements of decentralised systems and their politics can be leveraged by the incentives and transparency that blockchain-based systems afford, remains to be observed.”
Nabben (2021) highlights the importance of the interplay between social and technical systems, which is echoed by Buterin (2021) in his critical analysis of Schneider’s paper. While the problems with cryptoeconomics mirror economics more broadly, the use of cryptography to create blockchains has created a new space for economic and financial innovation. Buterin (2021) argues that the same can be true for political systems – incorporating cryptography can create new spaces for social and political innovation. “Cryptography allows everyone to verify that some governance procedure was executed exactly according to the rules. It leaves a verifiable evidence trail of all actions, though zero knowledge proofs allow mechanism designers freedom in picking and choosing exactly what evidence is visible and what evidence is not.” Just as a combination of cryptography and economics has created a new era of technological and financial innovation with blockchains, perhaps a combination of cryptography and politics can unleash a new era of social and political innovation.
Overall, the interplay between economics and politics in a cryptography context raises a number of important questions. Democratic systems traditionally rely upon a 1 person equals 1 vote system, however representing identity on-chain is a persistent problem as current iterations of such systems are vulnerable to Sybil attacks. There also exists significant potential for innovation in this area, politics in the real world is constrained by existing bureaucratic and administrative systems which were designed before the widespread use of digital technology. Cryptography can bring innovations in the speed, granularity, privacy and transparency with which individual political preferences can be aggregated, allowing for more dynamic decision-making at scale.
- Do you think a political system is required alongside cryptoeconomics for effective governance in the crypto space? Can we ever trust in code – ie ‘code is law’ – without relying on social consensus at some level?
- If traditional finance and blockchains both require a combination of politics and economics, what are the benefits or differentiating factors that adding cryptography provides?
- What are the underlying requirements to bring political preferences on-chain?
- What are the most important areas for political systems to be integrated into the crypto/web3 design space?
- Are there areas where political systems might not be necessary on-chain? Where?
- How might an increased level of granularity of people’s opinions and preferences, enabled by decentralized ledgers, change how democracy functions?
Discussion of coin-based voting (Vitalik Buterin)
Discussion on plutocracy in onchain governance (Vitalik Buterin)
On the importance of legitimacy, and how it interacts with cryptoeconomics (Vitalik Buterin)
Characterising the sybil resistance problem (Kevin Owocki, Gitcoin)
Retrospective of the political and economic actions taken to retain the legitimacy of Gitcoin following a sybil attack during round 9 of the grants program (Kelsey Nabben, RMIT University).
Comparison of brand based agreements vs math based agreements (Chainlink)
Book on how a focus on economic logics can impede good governance decision-making in the real world – a corollary to the problems the crypto space faces (Stiglitz et al)