Market design is an emerging economic field concerned with making existing markets better and inventing new ones through good engineering. It investigates the best ways to ensure that marketplaces allow everyone to come out ahead, and has already resulted in life-saving inventions such as kidney exchanges, solutions to tough problems like school choice, and tools to ensure fair and agreeable job placements.
Another emerging technology is the digital token, a tradeable unit customized with software capabilities provided by globally-distributed programs known as smart contracts. Thus far, the use of many tokens has been weighted towards speculative activities by investors, but there are far more interesting properties than speculation worth examining through the perspective of market design.
When infinite demand meets finite supply, there is scarcity, but with thoughtful resource allocation, happiness remains a distinct possibility.
Principles of Market Design
In The Handbook of Market Design, Vulkan and Roth introduce three important principles for the successful engineering of markets: sufficient thickness, limited congestion, and safety.
- Thickness: A healthy market must have enough participants willing to transact and create benefit through trade, and to further attract more participants. For example, buyers prefer to have access to many sellers, and vice versa. Generally, stores and shoppers are not interested in dead malls.
- Congestion: The market must mitigate traffic jams to enable the free flow of transactions. Though this may be caused by an increase in thickness, it must be managed so that all participants have sufficient time to consider their options, or they may be forced to act on incomplete information. For example, many women on dating websites receive more solicitations than they have time to evaluate, resulting in a poor experience for all participants.
- Safety: Participants must feel safe to transact on the marketplace and to reveal their true preferences. Without proper safety, participants may wish to transact outside of the market or attempt to “game the system” which adds a barrier to entry for other participants. Trades may become too encumbered with uncertainty to occur; for example, refusal to sign a contract or lack of enforceability significantly contribute to deal friction.
Additionally, certain markets must operate under the constraint of repugnance: negative social sentiments about certain activities that may harbor no direct harm to the willing participants, such as prostitution or the sales of kidneys.
Furthermore, through the use of experiments, it may be possible to test certain market designs without paying the full upfront cost of assembling and bootstrapping a marketplace.
Blockchain technology may be the excitement of the decade, with initial coin offerings reaching record levels and many businesses turning their strategies towards blockchains in attempts to capture new opportunities. At the core of many of these projects is the digital token, a tradeable unit customized with software capabilities provided by globally-distributed programs known as smart contracts. Many tokens are traded on Internet exchanges, and are priced in digital currencies such as Bitcoin and Ether, or even in traditional currencies such as USD and EUR. Thus far, the use of many tokens has been weighted towards speculative activities by investors, but there are far more interesting properties than speculation worth examining through the perspective of market design.
How can tokens help build marketplaces? Using the principles above, it may be possible to identify several mechanisms in which tokens serve as worthwhile inputs.
Token Price and Network Value
Tokens can belong to networks, which have valuations. A network is the collection of the technology, infrastructure, processes, and network effects that drive a specific microeconomy. For example, the collection of Bitcoin users, miners, nodes, and developers form the bitcoin network. Similarly, the respective components for Ethereum constitute the ethereum network.
Tokens can be engineered so that their prices are to some degree tied to the network’s value. This serves as an important input to and output from network behaviors. Consider the Bitcoin network, in which the price of one bitcoin acts a lever for mining activity; because mining rewards are fixed in bitcoin, an increase in the USD price of one bitcoin will also increase the attractiveness of mining activities, and vice versa.
Principles of Market Design Applied to Tokens
Tokens can be used to help markets by increasing thickness, reducing congestion, and providing safety. Instead of thinking about if a system should require staking, it may be more meaningful to ask if a system’s users require adequate market safety to comfortably transact. Rather than blindly allocating mining rewards, a network can be tasked to achieve specific levels of network activity, or market thickness. Web developers do not write their programs in low-level assembly language. Projects too can benefit from higher-order tooling for expressing and achieving their ultimate goals.
Projects with tokens will often set aside a reserve of tokens for “mining,” an activity which aims to reward behaviors that strengthen the network. In the Bitcoin network, the mining activity consists of solving cryptographic puzzles to provide transaction settlement capabilities to users of the currency. The creator of Bitcoin observed that early miners take outsized risk on their resource investments for a fledgling network, and thus should stand to receive an outsized reward for their participation. Thus, the rewards for mining in the Bitcoin network diminished over time.
By disproportionately rewarding early adopters to spur network growth at the most critical junctures, a network can provide fair incentive to its participants scaled to the impact of their contributions towards growing a strong network economy. When the reserved portion of tokens are completely mined, the project is expected to have taken flight and able to sustain itself off of transaction fees alone. To put this another way, mining can be used to increase market thickness by shepherding network effects to sustainable steady states.
Strategic partnerships with organizations or companies in relevant industries can drive early adoption and bootstrap network effects. For example, in Uber’s partnership with American Express, the ridesharing company provided credits to Amex card holders to attract new users while Amex could offer more benefits to its existing users. Likewise, some projects send preallocated or newly-minted tokens to entice network participation. Networks that inflate their supply to build partnerships should only do so if the added value of the partnerships exceeds the cost of dilution across finances and control.
Many P2P marketplaces pay users to refer new users if the prospective increase in network value surpasses the payment amount, as was pioneered by PayPal in the early 2000s. Reserved tokens can serve this purpose too, but at even steeper incentives as rewards may then scale to the benefits that the referrals bring to the network. One important concern that must be addressed is sybil attacks, in which attackers create many new fraudulent accounts to collect referral bonuses, thereby sapping the network of its resources without delivering value.
Many token economies require the payment of network fees in tokens. When token prices are correlated to network value, it is more expensive to run the same transaction on a more valuable network. In general, popularity drives network value, and the resulting increase or decrease in token price has a self-regulating effect on the congestion of transactions.
Those more willing to transact will offer higher fees to convince the network to give their transactions preferential treatment. In return, the higher fees may attract more transaction processors to eventually lower the fees. This works well when the value of a network activity to its participants is scaled to the fee they must pay, well-aligned with pricing theory — more use means more cost.
In the Ethereum blockchain, fees are paid in Gas per computation step taken in smart contracts, penalizing large programs while encouraging efficient programming. This fee structure is used to meter a rival good: the network has limited computational capacity, as all compute nodes on the network must run every smart contract, effectively limiting the network computational capacity to that of a single node. Scarce resources must be rationed, and fees can serve as mechanisms to do so.
In another example, Bitcoin transaction fees during the craze of late 2017 climbed as high as $37 per transaction. High prices have done a lot to discourage frequent or low-volume transactions which would further congest the network. Whether this is considered a market failure or success depends on the goals of the network, but it is wise to remember that mechanisms do buckle down and sometimes fail to deliver on their key objectives. The Bitcoin community is very familiar with the political turmoil and strife that occurs with differing high-level network goals held by different camps of participants.
The lens of congestion reveals an open problem in today’s prominent decentralized networks: “full nodes” host and share the entire transaction histories of the network for free, yet they are critical to network performance and consistency. While there are incentives for the operation of full nodes, they are often not directly financial and difficult to model. For example, due to growing industry interest and the rapid pace of adoption, the Bitcoin network can take several hours to weeks for a full sync on commodity hardware. Furthermore, transactors pay once and forever replicate to all full nodes that join the Bitcoin network.
Grading transactions, metering bandwidth, and charging access fees are ways to mitigate congestion by leveraging market forces. They can help important transactions enjoy more consistency, unlock premium performance for those willing to pay, and create new revenue streams for node operators. They can also coexist with a free basic access layer to encourage widespread adoption.
When denominated in the native token, membership deposits can track the network value and provide scaling barriers to entry to discourage low-quality listings. With the assumption that membership quality is correlated with ability to put up entry fees, a network with rising value will have higher quality membership.
Businesses love stability: infrastructure, property ownership, and functioning legal systems are important catalysts that firms need to thrive. If an enterprise were to leverage open-source technologies as its core building blocks, it would be at the whim of the project maintainers.
Tokens can help businesses and individuals shape open-source development efforts through voting and similar mechanics. Because businesses have an interest in maintaining their underlying infrastructures, there is value in participatory rights as they can be used to secure a long-term development roadmap.
When tokens are augmented with smart contracts, they provide many computer-enforced guarantees around deal mechanics that must usually be drafted into legal contracts. For example, a good faith deposit implemented with a smart contract can be confirmed by all parties that the funds will be transferred to the payee upon deal expiry.
Attestations are beliefs about reality that can be accounted. When they are used on a blockchain, they typically take the form of a digital reference to more concrete body of evidence. Examples of blockchain attestations:
- A signed digital reference to an image of a state-issued license for conducting Know Your Customer (KYC)
- A website address to an API on an official manufacturer’s website which provides confirmatory responses to valid serial numbers, along with a cryptographic proof of the device’s claimed serial number
- A phone number and business hours, regularly validated by reputable and independent 3rd parties
- A signed digital reference to a scanned PDF proof of $1MM in liability insurance
Attestations improve market safety by giving participants more knowledge about their prospective counterparties and therefore seeding trust. People feel safer dealing with people they can trust.
Staking requires network participants to put up safety deposits that may be arbitrated in a dispute. An arbiter may review a transaction and decide to award damages to a wronged party, paying from the safety deposit. Along with a safety deposit minimum, the network can effectively evict bad actors. When participants have “skin in the game,” they are less likely to act erratically and put more thought before violating rules.
Conclusion & More Resources
Market design is a powerful paradigm that can help create new online marketplaces in a sustainable fashion. Tokens should exist to serve important purposes or they will only add friction to participation. Through the pillars of market thickness, congestion, and safety, we can orient tokens, smart contracts, and game-theoretic mechanisms towards higher goals.
The best place to get started in market design is Alvin Roth’s very accessible book, Who Gets What and Why. A more technical dive can be found in The Handbook of Market Design by Nir Vulkan and Alvin Roth, which goes into specific mechanisms such as auctioning and voting. Other books related to market design include:
- The platform, which deeply incorporates market design, is one of three pillars in Brynjolfsson’s Machine Platform Crowd.
- Matchmakers by Evans explores the specific benefits to customers of online marketplaces and also how their founders have learned to bootstrap new ones.
- The Economics of E-Commerce by Vulkan is now a decade and a half old, but even more relevant today. It gets into the nuts and bolts of search costs and the varying degrees of commoditization in online markets.
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