Crypto Law Insider is the leading legal authority for entrepreneurs and investors in the cryptocurrency and blockchain ecosystem.
Every blockchain project relies on a variety of stakeholders to ensure that it functions smoothly, its code is updated regularly, and that the needs of its users are addressed. At the core of this is 1) the project’s governance structure (i.e., how it makes decisions) and 2) its economic structure (i.e., how it incentivizes stakeholders to participate in the project).
These structures set the foundation for how decisions are made, funded, and executed. No matter how powerful an idea is, somebody must bring it to life.
Thus, determining a blockchain project’s economic structure is one of the most important decisions that must be made, as it can fundamentally shape the culture and sustainability of a project.
Though there are many different economic structures that have evolved to sustain different blockchain projects, ultimately the goal is establishing a model that incentivizes key stakeholders sufficiently.
When Bitcoin splashed onto the scene, it introduced the first decentralized economic model. This involved assigning a block reward to miners to incentivize them to dedicate their computing power to create blocks and secure the blockchain.
This was Blockchain Economics 1.0. It was revolutionary, but as with every new technological innovation, it wasn’t perfect. In the years since, we’ve seen many new permutations of Bitcoin’s decentralized model of funding, with adaptations to encourage greater and more sustainable growth.
To understand how decentralized funding works and to help you determine the best economic model for your blockchain project, below is a short description of how different projects fund themselves and incentivize people to participate in their ecosystem.
Traditional Corporate Funding Model
For centuries, businesses have operated in more or less the same way. Funding is raised through revenue and/or investors, and the people who work on the business are given remuneration for their work in the form of salaries, stock options, and other benefits, all of which is managed centrally by the company’s accounting department.
At their core, crypto projects are software development companies and though they leverage blockchain infrastructure in the technology they create, not all projects utilize blockchain to manage their internal business structures. Instead, many stick to traditional models of funding.
Some examples of traditionally funded companies in the blockchain space are ZCash and Ripple, which are venture funded and run like any other corporation. Ripple, the company behind the XRP token, also has a services arm that provides consultancy services to banks and financial institutions, which provides another source of revenue to add to their treasury.
With funds raised through revenues and outside investment, central managers of these projects are able to hire developers, designers, and whoever else they need to help the project grow. The main benefit of this model is that when work must be accomplished, there are discretionary funds that can be spent towards it. Conversely, the main drawback of this model is that the success of a project depends heavily on how competently the central managers can raise outside investment and allocate those funds towards productive projects.
1.0 Bitcoin Block Rewards
When Bitcoin came onto the scene everything changed. For the first time in history, that central accounting department was no longer needed. Instead, rewards were programmed into the code to provide those who mined the cryptocurrency with an automatic blockchain reward.
This reward incentivized miners to dedicate their computing power to keep the network running and validating transactions. As a result, people around the world set up mining rigs to contribute to the network.
While this model undeniably worked for Bitcoin, there is one prominent weakness. Only miners are directly incentivized to perform services in the Bitcoin ecosystem.
Developers, who contribute code to Bitcoin’s repository, upgrade it and fix bugs receive no reward for their work. Similarly, Bitcoin’s node operators receive no compensation despite contributing their time and computing resources to ensure that the system is secure and a full record of the ledger is properly shared across the network.
So why do developers and node operators voluntarily participate in Bitcoin?
Since Bitcoin was the first blockchain project, many people got involved because of the novelty of the project and the ideology behind it. Also, as more and more people became invested in the coin, they had a financial incentive to dedicate their time and effort on improving the project.
But from a business perspective, it is very risky to rely on Bitcoin’s economic model. It works for Bitcoin since it is the oldest, most prestigious blockchain project and has a large base of loyal and ideological supporters. However, this does not mean that a similar funding model will work for other projects, particularly projects that are launched in 2018.
2.0 Dash Block Rewards: Introducing Masternodes & Treasury
The founders of Dash saw the drawbacks to the Bitcoin economic model and decided to take things a step further. They borrowed the idea of funding through the block reward but adjusted it to reward other key stakeholders.
The result was to split the block reward between miners (45%), masternode operators (45%) and the Treasury (10%). The funds in the Treasury are available for hiring developers and other team members needed to operate a billion dollar organization.
Due to Dash’s unique governance model, Masternode owners are the only stakeholders entitled to vote on Treasury proposals giving them the sole power to determine the direction of the project. Masternode owners are required to hold a minimum of 1,000 Dash coins (roughly $193,000 at today’s market prices) so they have significant skin in the game.
When compared to Bitcoin, it is clear that Dash’s economic incentives have contributed to a more sustainable system with longer-term growth in mind.
3.0 Horizen Block Rewards: Non-Voting Node Operators & Treasury
Though Dash made significant advances in governance and economic structures, many critics of Dash argue that Masternode owners have too much power. Why are Masternodes so expensive and why should Masternode owners also make Treasury funding decisions?
This brings us to Blockchain Economics 3.0: Horizen (formerly ZenCash).
Like Dash, Horizen has implemented an incentive-driven model, ensuring that each stakeholder receives a piece of the block reward. In Horizen, 70% of the block reward is awarded to miners, 10% to the Treasury, 10% to Secure Nodes and 10% to Super Nodes.
However, unlike Dash, Secure Node operators only need to stake 42 ZEN (roughly $700 at today’s market prices). So Secure Nodes are more affordable to operate than Masternodes and therefore appeal to a larger spectrum of industry participants.
As a result, Horizen has the largest node network of all cryptocurrency projects, with over 18,000 Secure Nodes. It’s pretty amazing to think that a relatively small project like Horizen (ranked 75th on CoinMarketCap.com) has the most nodes of any cryptocurrency project!
But this shouldn’t be too surprising to anyone who’s taken Economics 101. Everything comes down to the fact that you get what you incentivize. Horizen was the first project to incentivize mass node operations, and so it was able to attract more node operators to its project than anyone else.
What does this mean for Crypto Law Insiders?
One of the main advantages to open source code is how quickly improvements can be made. We’re seeing this firsthand not only in the rapid development of new applications, but also with innovations in blockchain governance and funding structures.
The most prominent trend we’re seeing through the evolution of decentralized economic structures is experimentation to find the right balance of incentives for key stakeholders.
While miners maintain the sanctity of a network, there are a number of other crucial tasks that support the growth of a project—from development to marketing and much more.
As much as we might like to believe in charitable spirit to help crypto projects advance, what we’re seeing in practice is that these tasks will only be performed well when they are incentivized. Thus, it is our opinion that with time we will see an even more nuanced splitting of the block reward to incentivize new and different stakeholders.
Understanding this is crucial when launching your crypto project. The funding model you chose will fundamentally shape the culture and sustainability of your project. To ensure the long-term success of your project, be sure to strategically allocate the rewards paid out to incentivize your key stakeholders.
Dean Steinbeck is the Managing Director of Crypto Law Insider, the leading legal authority for entrepreneurs and investors in the cryptocurrency and blockchain ecosystem.
Dean is a US corporate lawyer with a focus on data privacy and technology. With over 15 years of experience representing VC-backed software development companies, Dean has found himself at the center of multiple blockchain projects and is currently recognized as one of the top attorneys in the cryptocurrency space.
Dean currently serves as General Counsel for Horizen (formerly ZenCash), a privacy-oriented cryptocurrency and cutting-edge blockchain platform. Prior to Horizen, Dean was General Counsel at TigerConnect, the leading communication platform in the US healthcare market. His experience gives him an in-depth knowledge of the legal intricacies within blockchain technology, data privacy, intellectual property, venture capital funding and regulatory compliance. Click here to learn more about Crypto Law Insider.