Aligning Incentives in a Deflationary Economy

Tanner Philp Blocked Unblock Follow Following Nov 30, 2017

No one wants to be the one who bought pizza for 10,000 bitcoin (~$100M at today’s spot rate), but it’s safe to say that most wouldn’t mind being the person selling the pizza. The next thought that often comes to mind is: “imagine if they had just held onto it instead.” This is much easier to say in hindsight, but at the time, those 10,000 bitcoin were worth ~$40 and the opportunity cost of spending them seemed low. However, the reason the $10k Bitcoin pizza has become an infamous part of folklore is that a fixed supply currency, like Bitcoin, operates in a deflationary economic state.

Deflation and inflation are relative to the purchasing power of the consumer. In a deflationary economy, the consumer price index (CPI) decreases over time, which means the relative purchasing power of each unit of currency increases over time. The result is an incentive to save, not spend, yet traditional economic theory suggests that the health of an economy is based on the volume, velocity, and variety of spending. Beyond the necessities of life, the advent of new innovation increases the demand for currency, so the central clearing houses print more money to keep up. The typical target is net positive inflation, pushing the (CPI) higher. The result is a higher incentive to spend now, disincentivizing the consumer to save.

Consider this: a consumer purchases a house, and they are able to lock-in a fixed rate mortgage with $1,500 monthly payments. In an inflationary economy, relative purchasing power of that $1,500 becomes lower and lower every year, making the monthly mortgage payments easier and easier to pay as time goes on, assuming wage increases are in-line with inflation. The incentive is to spend.

In 2008 we came face-to-face with the implications of incentivized spending and maximizing for the present. At the turn of the century the common belief was that the best indication of economic health was the rate the populous was spending. To incite this behavior, interest rates were held low, and the cost of borrowing was too low not to borrow. Icelanders were realizing immediate arbitrage returns by borrowing Kronar and flipping it into other foreign currencies — literally being paid to borrow. In North America, people were able to borrow so low that everyone was parking big cars in big driveways in front of big houses.

This party came to a screeching halt in 2008. The incentive to spend proved to be unsustainable. The ability to manipulate the market through control of the money supply and its derivative products proved to be detrimental — trust was broken and people got hurt. At the same time that everything came crashing down, the world was introduced to a new financial system that cuts through these artificial incentives in the form of Bitcoin, a cryptocurrency.

A cryptocurrency is a fundamental shift in thinking — that the best way to ensure financial sustainability is in an open, transparent, and collaborative system. Cryptocurrencies create an open, trustless environment for value creation, and a key characteristic is a finite supply. The resultant impact of a financial system underpinned by a cryptocurrency is a deflationary economic state.

A deflationary economy creates an incentive mechanism that has unique implications in crypto-economic development. Traditional econometrics are not enough to measure the health and sustainability of an economy like Kin because economic development is not measured solely through appreciation of the underlying token. The mission of Kin is to create an ecosystem of digital services for daily life so the measures of economic development requires a more holistic approach that combines econometrics with implicit value creation for ecosystem participants. This vision is only truly realized if Kin reaches a state of mass user adoption and facilitates the exchange of real value. We believe the Kin economy is uniquely architected in a way to do both.

What makes Kin powerful is that the participants of the Kin Ecosystem are economically aligned to create value and drive ecosystem growth — everyone participating becomes a stakeholder. As a holder of Kin, I possess a powerful tool that acts as a medium of exchange of value in this ecosystem of digital services. This amount of Kin I hold will always represent X% of the total supply because of the inherent finite supply. So as the ecosystem matures and the breadth of spending opportunities increases, the demand for Kin goes up. This inherent scarcity drives the underlying value of my X% higher: higher demand/fixed supply = higher value. In order to effectively get there, all stakeholders need to be aligned. The digital services are the empowerment tools for consumers to generate value.

In traditional centralized business models, people buy equity and then sit on the sidelines while the company works to appreciate that value. In a decentralized business model, not only is everyone invited to participate in growing the ecosystem — everyone is economically aligned to collaborate. The power of decentralized business models, underpinned by a cryptocurrency, is the alignment of incentives. In an ecosystem of centralized entities, the incentive is to capture market share and extract the most value from that market share. This leads to competition and maximizing consumer/producer surplus. The benefit of competitive markets is consumer choice and efficient pricing. The issue is that it creates a walled-garden approach to innovation. As the industry moves closer to monopolization and the barriers to copy strategy are increasingly diminishing — especially in digital services where there is minimal overhead costs — the implicit tax on society in an ecosystem of centralized entities is that collaboration is disincentivized.

The cost to society in a monopolistic economy is the deadweight loss, where the dominant player maximizes for producer surplus, leaving consumers on the sideline, who could have participated in an efficient market. In the digital economy there is minimal marginal cost, so the deadweight loss comes in the form of lost opportunities in innovation, because a monopoly (Facebook) could take that innovation (Snapchat Stories) and implement it into their product. This further increases their monopolistic position in the market. More great reading on this subject — here.

Deadweight

The true power of a decentralized ecosystem underpinned by a cryptocurrency is that it shifts the strategy from competition and extracting the most value, to collaboration and maximizing consumer value. This increases consumer choice and efficient pricing, which is the core value proposition of a market based on competition.

With the right mechanism design, digital services in a decentralized ecosystem are incentivized to maximize for value creation within the ecosystem, not necessarily within their service exclusively. A decentralized ecosystem is most efficient when the goal is to be copied — this accelerates innovation and value creation. It moves the incentive from “how much of the pie can I get?” to “how do we make the pie bigger?”. However, with a fixed supply, as the pie grows the economy experiences deflation, which creates an interesting consumer incentive to hold instead of spend — the paradox of purchasing power.

Much of the industry is focused on the infrastructure to facilitate mass scale, but the latency and transaction fees aren’t the only hurdles for mass consumer adoption. These variables are requirements driven — to reach mass scale, there needs to be stakeholders wanting to transact. The issue is that stakeholder incentives are misaligned in many crypto-economies. The real reason it’s going to be difficult for me to start buying my coffee with a cryptocurrency isn’t that it’s slow and transaction costs are high (although that’s enough to deter me alone). The problem is the opportunity cost of spending it — no one wants to be the guy who spent 10,000 bitcoin on a pizza.

This begs the question: how will cryptocurrencies enter into the conversation as a ubiquitous medium of exchange in consumers’ daily lives? We asked ourselves this question from day one and have developed an economic framework that we believe will effectively incite a high velocity of transactions in a deflationary economic state.

Incentive Alignment

The Kin Rewards Engine (KRE) is aptly named the engine because it drives economic alignment and incentivizes productive participation in the Kin Ecosystem. The KRE pays out a daily reward to the digital services driving transaction volume; the total daily reward is distributed proportional to the transaction volume generated in each digital service on that day.

This process is analogous to mining the Bitcoin block reward, elevating the same fundamental process of network sustainability from the infrastructure layer to the application layer. In the context of Bitcoin, miners compete for the block reward by dedicating large amounts of hash power to the proof-of-work system in order to capture the block payout. This arms race has resulted in an inordinate amount of electricity being dedicated to the mining process. At the time I’m writing this, the energy consumed in the mining process is more than 8 in 10 countries in the world. That’s enough electricity to power 2.4M American homes.

In the context of Kin, the recurring payout is distributed to the digital services driving transaction volume. The arms race of computing power at the infrastructure layer (Bitcoin) moves to an arms race of consumer experience development at the application layer (Kin). The incentive for digital services in the Kin Ecosystem is to optimize for consumer value by facilitating great ways to exchange value. The KRE payout removes the need for a digital service to tax users and advertisers, or take a piece of transactions in order to sustain their business. The KRE empowers digital services to focus on facilitating direct value exchange in a consumer-to-consumer (C2C) economy — effectively driving productive participation.

The key to a sustainable C2C economy is a fundamental shift in thinking for a digital service to be a facilitator of the creation of value. This is contrary to the constructs of traditional business models that are set-up with the objective of being the providers of value to consumers. The Kin economy is architected in a way where the core mission is to empower all stakeholders to provide value to each other.

This effectively takes the burden off of them to always be the source of value creation — a digital service moves from a value provider to a value facilitator. By removing the burden of always having to be the one providing value, digital services are now incentivized to work with others to create an environment of community driven value creation. This could be facilitating direct C2C or facilitating a consumer’s connection to another digital service that provides value.

Redistribution of Increased Circulating Supply

The second important impact of the KRE is a system that stimulates redistribution of increased circulating supply to the stakeholders in the ecosystem that generates velocity of transactions. As noted above, the daily payout is distributed to digital services driving transaction volume. This payout provides the operator of each digital service the opportunity to re-distribute a portion to their ecosystem to stimulate transaction volume, and subsequently, continue to capture a part of the daily reward. The second derivative benefit of the redistribution is a powerful tool to drive positive user action within that service by incentivizing user behavior that contributes to growth, retention, user stewardship, etc.

Redistribution creates low barrier adoption for users, is a strong retention tool, and can be used to reinforce positive behaviour. This is an effective way for any consumer to uniquely generate and capture value and is a force multiplier for productivity of good stewards within digital communities — that’s powerful.

Economically, this assumes a level of rationality of a digital service operator. A rational operator would redistribute a portion of the payout to their users because, if done effectively, this will stimulate more transactions and increase the expected payout of the KRE in the future.

Earning & Spending

The premise of Kik Points (page 10 of the Kin whitepaper) was to see if Kik could effectively be a user’s first job. The issue with other digital currencies, like Bitcoin, was that no one earns their pay-check in them. The process of transacting with a digital currency was disjunctive in that everyone earns their pay-check in fiat currency. To transact with a digital currency you have to convert, then spend, and then the counter-party has to convert back into fiat to pay their bills. The same is true of most cryptocurrencies today — high friction for high velocity.

We were able to reduce the friction by giving users the opportunity to earn and spend directly in one uniform digital currency, and the result was a daily transaction volume that consistently outpaced that of Bitcoin over the same time period:

Kik Points was a centralized currency, and its impact was limited to the users within the Kik Ecosystem. On the other hand, Kin is not bound to one application or product, and is orders of magnitude more powerful because it is decentralized. Users are not bound to earning and spending within one service, like Kik. They can move between all of the digital services that are central to their daily life, earning and spending with a uniform currency that underpins the value exchange in this decentralized ecosystem. Some services may end up being the place where a user does most of their earning. For example, a user may earn Kin on a livestreaming service by creating great content and spend that Kin on a movie ticket. The interoperability of Kin reduces friction and facilitates a higher frequency of transactions. As the ecosystem grows, we will see more and more ways to earn and spend, which will truly power our digital lives.

Earning Kin through ecosystem participation is not the only way to gain access to the Kin Ecosystem, and we believe this will become more frictionless over time. There are a lot of great projects facilitating the exchange of currencies — this is powerful because participation in the Kin Ecosystem can now generate utility outside of our digital lives, and vice versa. In the future, what if creating a great livestream could help a user pay for textbooks or even part of their tuition?

Cryptocurrency is one of the fundamental innovations in the past decade, but remains in a nascent state as the collective community drives towards scale. Mass consumer adoption will require scale at the application and infrastructure layer, which are mutually dependent. We believe Kin has established a strong economic framework to generate productive ecosystem participation, and we’re excited to see that grow in scale and impact.