Crypto Currency Online: The Future of Blockchain Needs Economics

Markets as clearinghouses

Summary:

Tokens fund startups to make markets without marginal transaction fees
Markets can improve the efficiency of allocating goods among parties
Lots of markets are possible!

A marketplace in Hong Kong.

The power of markets is that they allow us to allocate assets efficiently between parties. One source of inefficiency is externalities, a cost or benefit incurred by a party that did not choose to receive it.

A famous economic result, the Coase Theorem, proves that if parties that can conduct trade on an externality with perfect competition, we will get an efficient allocation of assets regardless of who holds the property rights to start with. Brave’s BAT Token, for instance, cites the Coase Theorem in the Appendix of its whitepaper, explaining its product as a market for attention between users and advertisers, with a negative externality being the “social cost” of intrusive ads.

A problem is that the theoretical result holds only under two rather strong assumptions: 1) that there are zero transaction costs, 2) that both parties have perfect, symmetric information about the good.

Current venture funding models prevent the rise of marketplaces. Startups that are trying to start marketplaces not only have to prove they can grow, but that they have a profit model. In more traditional financing, this forces them to add a layer of transaction fees or costly centralized verification.

Moreover, the value of marketplaces relies heavily on network effects, and new entrants require a lot of capital and following right from the start. This is partly why incumbent marketplace services, like Craigslist, have rarely been challenged even when they don’t actively innovate. Even current innovators in the space, such as Facebook Marketplaces, are loss-leaders bankrolled by other verticals.

These issues are partly resolved by the I.C.O. funding model. With cryptographic tokens, the scarcity of tokens are externally verified by default; as a result, founders can be transparent about allocating a reasonable portion of minted tokens as a founder’s reward. With developments in blockchain platforms, there’s a lot of developer money being thrown into lowering transaction fees for payments. Moreover, funding through token offerings is, for now, very front-loaded: with the capital that token offerings raise, these new startups will be much more equipped to take on wealthy incumbents.

And many types of markets are possible! For instance, arbitration markets. Smart contracts can and do go wrong. Arbitration markets can let contract owners freeze contracts that run in a disputed manner, and stake tokens to pay a market of arbiters to decide on what action the smart contract should perform: an analogue would be “settling out of court.”

Prediction markets like Augur produce markets where users can stake bets on how likely events are going to happen, and produce predictions of the future through the wisdom of crowds.

All of these markets have precedents, but the crypto ecosystem is making them easier to implement and scale.

In summary…

Smart contract products can align incentives to ensure coordination:

Over multiple periods of time
Without clunky legal arbitration or backing from trusted institutions
With liquid secondary markets for everything!

It’s arguably true that a trusted central authority can already implement these without the use of cryptographic guarantees. Most mechanism design experiments are carried out by national and state governments, on university campuses, or large tech companies like Google and Facebook.

But token offerings can spread applied market design research into more industries, aligning incentives among more market participants. Smart contracts, unlike existing mechanisms, carry the promise of auditable code and distributed ownership. As platforms mature and templates for contracts emerge, these products will only become easier to build.

It’s not that anyone expects all, or even most, of these markets to succeed. All I know is if I had 1 ETH for every time an economics nerd talked about prediction markets to me before 2016, I’d be pretty rich. Augur, the prediction market, raised several million dollars and is now valued at over half a billion.

If you’re a nerd who ever wanted several million dollars to design cooperative mechanisms, now is as good a time as any to get stuck in.

Brian Ng is a writer and economist who has worked for Lightyear.io / Stellar Foundation and TGG Group, where he worked with economists as Steven Levitt and Daniel Kahneman on economics and data consulting projects. He graduated with a degree in Economics from the University of Chicago.

Much thanks to friends who made helpful comments on the draft, particularly Evan J. Zimmerman and Greg Colbourn.

Disclaimer: the author holds small amounts of tokens in some of the publicly available assets that are mentioned. Opinions here do not represent those of any employer or affiliated organization.