One of the themes I come across when reading about blockchain is the idea that tokens incentivize good governance and counteract bad behavior: because tokens are valuable only if the product/platform that issues it is valuable, token holders will actively participate in the governing and development of the issuing product/platform in order to keep the value of their tokens high. My question is, how robust is that assumption, especially when we consider free-riding and the concentrated costs/dispersed benefits problems that we routinely see in the regular economy?
The specific case that I’m going to consider is an interesting blockchain company called AdChain. AdChain was built by MetaX in conjunction with blockchain behemoth ConsenSys and industry group Data & Marketing Association. They look to use token economics to tackle the multi-billion dollar problem of digital advertising fraud, where websites use bots to create fake “impressions” to scam ad dollars from advertisers. I first encountered AdChain when one of their team members spoke at a blockchain summit I attended in March 2018, and I was very intrigued by the problem they were solving as well as the economics embedded in their model. They had an ICO in June of 2017 and raised $10 million in a day, and went live on the Ethereum Mainnet in late April 2018. I’m not going to evaluate their tech, their team, or their business model, other than to say that they are indeed tackling a very important problem. Instead, because they are such a perfect example of a token economy making many of the common assumptions that other token economies make, I want to unpack the economics outlined in their whitepaper and think about the implications.
What’s a rational token holder to do?
Basically, AdChain is a whitelist of trustworthy websites for advertisers to spend ad dollars on. Websites apply to be listed on Adchain by buying and then staking adTokens. Existing token holders can challenge an application by staking their own tokens, which then initiates a platform wide voting period where other token holders vote on whether to admit the applicant (votes are token weighted so the more tokens you have the more votes you have). The winner (the applicant or the challenger) gets the tokens that the loser had staked, with some proportion going to the winning voters as well.
They key assumption here is “applications for apparently fraudulent or low quality domains will be challenged by rational adToken holders” (adToken white paper, p. 3). This assumption is based on the idea that adTokens are valuable only if AdChain is a credible whitelist that advertisers want to use and websites want to apply to, so to keep the value of adTokens high, token holders will be diligent in weeding out bad applicants. This is a specific case of a general assumption in the cryptocurrency community that holders of tokens will be incentivized to actively govern and participate in the community. The question for us is, how likely is this?
Concentrated costs, dispersed benefits
The “real world” example most analogous here is probably stocks, where holders of stocks also get to vote on certain aspects of the company, with the expectation that stockholders will participate in the governance of a company to increase the value of their stock. In corporate governance however, it’s long been known that for many shareholders it’s actually more rational NOT to actively govern but to free-ride off the efforts of others, because governing is expensive to you, but the benefits of your governance is dispersed among the whole community. This problem can be partially mitigated by having large shareholders, but even so, discipline is rare, and the presence of many short term speculators who have no interest in long term governance will further weaken oversight. AdChain tries to mitigate this by offering a significant reward for active governance (the winner gets the loser’s staked coins) – this is a great idea, and it’ll be interesting to see whether it’s enough to overcome free-riding, since even with this “governance bounty”, much of the benefits are still dispersed.
Another potential challenge facing this token economy is the asymmetric incentives between applicant websites and token holders. There’s a well studied phenomenon in political science where small special interests are able to defeat policies that benefit the much larger society because the costs of the policy falls on a concentrated group while the benefits are widely dispersed. US sugar subsidies are a prime example, where ending the subsidies will save consumers $2.4 billion per year, which amounts to less than $10 per individual consumer but will be a big loss for the sugar industry, so the sugar lobby is much more motivated to keep the subsidies in place than consumers are to eliminate those subsidies.
In AdChain, the incentives of fraudulent websites to cheat the system and get on the whitelist may be higher than the governance incentives of token holders. The benefit to the platform of preventing one bad website from sneaking in is dispersed among all token holders, but the cost to that rejected website is concentrated. What’s at stake for a website applicant is not only the tokens it stakes but its future ad revenue, so it has more at stake than token holders who might challenge them, giving website applicants more incentive than potential challengers to spend resources mobilizing voting blocs. That said, even fraudulent websites would have an incentive to maintain some level of integrity to the whitelist, so it would be very interesting to see how participants actually behave and what kind of balance, if any, can be reached.
Not a problem?
Practically, the problems of dispersed benefits may be mitigated in AdChain’s case and in the case of many blockchain startups. A “large” shareholder in a public company might have as little as 10% ownership or even less, with thousands of other shareholders holding tiny pieces of the company. Contrary to the idea of widespread democratic participation that many people have of ICOs, AdChain’s ICO, like many ICOs, had a small number of participants (“whales”) who bought large stakes, with nearly 40% of tokens publicly offered going to a single buyer. This means the benefit to keeping the platform safe is in fact quite concentrated. That said, we do not know how dispersed ownership will get once tokens are floated on exchanges. Depending on how many of these whales are speculators looking to dump vs real investors in the platform, the effectiveness of AdChain’s economic model may vary greatly.
AdChain went live only recently. As with most startups, it’s hard to say how the product will turn out simply by theorizing ex ante. The token economy may in fact be a completely new case with no comparable analogies to the current economy. And with all good startups, models and assumptions can change on the fly. Six months after going live, every blockchain startup will probably end up drastically different from their white papers, just as regular startups differ greatly from business plans once they launch. But to the extent that blockchain companies continue to raise funding via token offerings before they have visible traction, and given how important token incentives and governance is, it could be helpful for token investors and entrepreneurs to consider the possible limitations of token economic models the same way they consider limitations in technology models.
I, for one am rooting for this startup and other blockchain startups tackling important real world problems. I’m excited to see how these mini economies unfold as more companies go live and put their assumptions to the test.