Altcoins and Behavioral Mechanism Design

Altcoins and Behavioral Mechanism Design

Bitcoin maximalists claim that in the long-run, the only (crypto)-currency in existence will be Bitcoin. An Altcoin is a network that competes with Bitcoin’s function as a currency, and (currently) smaller than Bitcoin’s network. Judging by the number of tokens in the market, maximalists are not winning the argument, although the number of Altcoins in active use has decreased since 2018. As we come to the end of 2019, many more Altcoins vanished into oblivion. So in the long-term future, will there be a monopoly by one currency, such as Bitcoin, USD or Gold? Or will new and emerging technologies, and human behavioral adaption to those trends lead to hundreds, if not thousands of currencies in circulation?

I will argue that the long-run economic equilibrium consists of many tokens that are in competition with each other, and easily exchangeable with each other. This includes fiat currencies, such as the US Dollar, metals such as Gold, Bitcoin, as well as thousands of other tokens that serve unique functions in industry verticals. This is a prediction of behavioral mechanism design theory.

Although 10 years have passed since the Bitcoin paper came out, and cryptocurrencies have crossed $200B in market capitalization, none of the top Economic journals have covered Cryptoeconomics. When I asked several noted economists what they thought about this issue, the answers were fairly similar: Economists study the natural laws of economic behavior, just like physicists study the laws of nature. Cryptocurrencies don’t pose interesting economic questions.

I think it’s because economics departments are slow to accept change. Cryptocurrencies pose very interesting questions in monetary policy, behavioral economics, and mechanism design. The late Nobel-prize winning Economist Frederich Hayek would have realized his dream if he saw all the cryptocurrencies in circulation now [see “Denationalization of Money”].

Hayek argued for the existence of many currencies that compete with each other, and are easily exchangeable with one to another. The advent of programmable money, i.e. cryptocurrencies, changed the primary functions of money. Since functions can be programmed, industries, niches, and communities will want their own currency to better conduct economic activity.

Maximalists argue that there will be only one currency due to Network effects. In the logical extreme, every person can create their own token, for example, the RayCoin. And RayCoin could be programmed to be completely personalized to suit my family’s utilities and preferences. For example, offering 99% discounts at my favorite coffee shops, and books, and restaurants. However, others may not value RayCoin to the same extent. And without others willing to accept the currency, it is useless. Currencies like the US Dollar, backed by a powerful government and military, have strong network effects. Bitcoin is the most prevalent cryptocurrency and its strength grows over time as the network grows. For example, Coinbase has 20 million Bitcoin users, and the number grows as more people and businesses accept it.

There is a point where the utility programmed into the token, addresses the needs of a group of users. And these group of users forms a sufficiently large network to make it a viable currency. And whether a token has the potential of creating a sufficiently large network can be guided on the basis of mechanism design.

Before we go into that, let’s take a brief digression to history. Most of the major civilizations settled on Gold as the de facto currency standard [See “Power of Gold” by Peter Bernstein]. However, Gold was illiquid and paper money became more prevalent, against the Gold standard. In the United States, driven by a liquidity crunch, “Altcoins” called scrips became prevalent during the Depression-era. Banks no longer had access to cash, and businesses issued scrips for trades.

Scrips, or paper tokens, were also prevalent in geographically isolated hubs of economic activity, such as mining towns. Because cash was hard to come by, mining companies issued scrips that could be redeemed by workers at the company store, often at a great markup. These scrips eventually fell out of existence as people preferred cash or were outlawed.

These tokens have not prevailed from the past, so why should they exist in the future? This time around there are two technological advances, namely the internet and blockchain, that allow easy exchange and decentralization. People would demand an easily exchangeable token, and a centralized issuer, like the mining company, could not dictate pricing that deviated very far from market norms.

The market will demand many cryptographically secured decentralized tokens because of a) human economic behavior. b) mechanism design.

Since the primary economic users of a cryptocurrency are humans, these are (some) universal behavioral factors that will appeal to a network of users.

• Mental Accounting: As shown in field experiments by Nobelist Richard Thaler, people budget money into mental accounts for expense categories. I might budget $100 every month to spend on coffee. If I purchase $100 equivalent of CoffeeCoin, which gives me my allocation of coffees every month that many coffee shops would participate in.
• Loyalty: Users of the token get rewarded for conducting transactions within that ecosystem. An example is reward points at Starbucks, that can be tokenized. Shoppers get benefits such as discounts and free merchandise, and they would prefer using these tokens to transact over the common currency since they are incentivized to do so.
• Signaling: Users can use tokens to signal their belonging to a group, such as a nation. Or to signal a certain status. Imagine a token where only a minimum amount needs to be spent but can be spent in smaller amounts. Users can choose to pay in those tokens over the popular currency to signal wealth or to get exclusive access based on wealth.
• Context-Dependence: Certain ecosystems are “worlds within worlds”. Such as entering a casino like MGM, or a theme park like Disneyland. Within the world, the transactions make can more sense in DisneyCoin than USD or Bitcoin. 100 DisneyCoin for a ride or 1000 DisneyCoin for merchandise makes more sense than 0.0001 BTC or 6.78 Euros. This leads to more seamless economic transactions that are preferred by the customers and businesses alike.

Published at Tue, 31 Dec 2019 19:33:14 +0000

{flickr|100|campaign}