Prelude

This is the first post in a series about cryptoeconomics. My primary goal here is two-fold:

  1. Provide an in-dept explanation of current cryptoeconomic challenges and evaluate the tradeoffs of various networks' approaches to those challenges.
  2. Explain the cryptoeconomic design of Nervos Network's layer 1 blockchain, the Common Knowledge Base (CKB). As a developer at Nervos Network, it is the blockchain project I am most familiar with at this point and our economic model makes long-term sustainability a top priority. Even though I am not writing this series as a representative of Nervos, I am aligned with Nervos on a philosophical level.

This first article will lay some requisite ground work on cryptoeconomics about two fundamental use cases of currency: as a medium of exchange and as a store of value. I will then explain how users who fall into one category or the other tend to have different sets of incentives & how the satisfaction of one set of incentives tends to conflict with the other set. Finally, I explain that regardless of whether or not high performance/scalability can be achieved on the same layer as security and decentralization (without compromises) at some point in the future, it will never be the best approach.

Dichotomy of MoE vs SoV

Money in any form functions in two ways: as a medium of exchange (MoE) and as a store of value (SoE).

Medium of Exchange

A good is used as a medium of exchange when it is not acquired for its own sake but purely for the sake of trading it for some other good or service. A good of this type is called "money". An effective medium of exchange has the following properties:

  1. It is easily divided or grouped into precise quantities so that it can be easily exchanged for a good of any amount of value (it's easier add and subtract bills than smash a lump of gold into precise pieces).
  2. It is easy to transport (it's easier to carry a wad of cash than a big bag of gold nuggets).

A universal index of value is much easier to work with than exchanging goods and services directly. In a large market, more and more participants have the opportunity to specialize in the goods and services they offer to differentiate themselves from other participants. The more specialized producers in the market become, the more likely the following scenario is for any given provider of some good or service:

  1. Provider A wants some service B
  2. Provider B has some service B
  3. Provider B does not want the good or service provider A can offer in exchange for service B

So, a direct exchange system limits specialization. Yet, specialization is great because providers of special goods or services are able to put all of their capital, labor, and other resources into making a great product. They can pour everything they have into providing something great rather than providing a multitude of goods that are "just-ok".

This is why indirect exchange is a natural evolution to a growing economy. A good medium of exchange is one that's quick to use, easy to transport and easy to divide or group into smaller or larger quantities. Further, a medium of exchange is itself a particular type of good, but it's a good for which the primary function is that it can be used to measure the value of other goods and be traded for those goods.

Store of Value

Another important function of money is that it retains value over time. You would not want to store your wealth in a form that will quickly degrade in value. For example, tomatoes would not be an effective way to store one's wealth because they have a short shelf-life.

It's possible for a good to function as both a medium of exchange and a store of value and in fact many people treat fiat currency this way. The ideal form of money would be both.

An SoV good must maintain scarcity over time to avoid the following situation:

  1. Person A acquires a large volume of money X
  2. The available supply of money X decreases, increasing scarcity
  3. Person B sees an increase in demand of money X (because a large portion of the supply was acquired)
  4. Persons C, D, and E also see an increase in demand and decide that they will acquire money X as well
  5. Person B happens to be the manufacturer of money X and decides to create more and then sell it to persons C, D, and E
  6. Person B produces so much more of money X that the value of X is diluted, causing A, C, D, and E to all be poorer than they were to begin with

The level to which an SoV good can maintain scarcity over time is a ratio between the amount of the good that exists and the ease with which more of this good can be produced. A good that is highly difficult or costly to produce is capable of maintaining scarcity over time.

Economic Problems

Inherent Conflict Between MoE and SoV

Cryptocurrencies are used as both MoEs and SoVs. However, the effectiveness to which any given currency achieves the goals of one use case or another varies drastically.

For a cryptocurrency to be a good store of value, it needs to retain that value over time. For a cryptocurrency to retain value over time, the network that secures this asset must remain secure and decentralized. Nobody wants to store their wealth in an unsecured vault where it could be stolen and introducing centralization means that those who store their wealth must now cope with some level of counterparty risk.

For a cryptocurrency to be a good medium of exchange, the users must be able to transact quickly and conveniently with the medium of exchange. That means they need to quickly acquire the MoE and quickly exchange it for some other good.

Ideally, a user could simply store their wealth in a strong SoV cryptocurrency and easily and quickly transact with that currency whenever they want to.

Unfortunately, the means by which a network achieves high security and decentralization and the means by which a network achieves high transaction throughput & performance are in conflict.

To maintain decentralization, an SoV network needs to restrict the computational and storage requirements of the system so that the participation barrier remains lower. The more costly it is to participate in the system, the lower the number of participants and the greater the level of centralization.

To maintain high levels of security, an SoV network needs to continuously compensate participants in the network responsible for validating transactions and it also needs to have strict, global consensus requirements.

MoE users want higher transaction throughput and cheaper transaction fees. SoV users want high security and decentralization. The methods by which a network achieves higher transaction throughput or cheaper transaction fees decrease security and decentralization. The methods by which a network achieves higher security and decentralization decreases transaction throughput or increases transaction fees.

The Need for a Layered Approach

There is a trend towards layer 2 solutions to optimize for transaction throughput and lower fees, while layer 1 platforms are relied on for their security and value preservation.

Even though achieving ideal security, decentralization and scalability properties on layer 1 is difficult, that doesn't mean it is impossible and many research teams are trying to achieve all ideal properties at the same layer.

Even if it is possible to achieve all ideal properties on the same layer, such a solution will most likely never be better than a layered approach.

First, a layered approach allows for simpler protocols that are easier to reason about and develop. This is because it removes the need to consider tradeoffs for one set of properties vs another set: in a layered architecture, layer 1 only needs to consider security, consensus, and censorship-resistance, even if that means limiting transaction throughput. On layer 2, systems can optimize for transaction throughput and cheaper fees without worrying about compromising security and decentralization as much because they use a strong layer 2 for settlement and repudiation. The alternative - attempting to optimize for all properties on the same layer - severely limits which optimizations are acceptable: optimizations that strengthen one property but dramatically weaken another property cannot be pursued.

Second, a layered approach allows for greater specialization and sophistication. The larger the set of responsibilities of a single system, the more thinly spread the system's resources are. Although the important resources (bandwidth, storage, processing power, etc) of a dominant MoE network are different from those of a dominant SoV network, this does not mean that optimizing for both at the same layer is not more resource-costly than optimizing for each at different layers. This is because decentralized networks must compensate providers of each resource. For each necessary property that requires compensation, the amount of compensation that can be dedicated towards each of these properties is reduced. I

People will naturally choose getting more compensation over less compensation, making systems that compensate for too many properties less competitive than systems that compensate for fewer properties, all other things being equal.

Even if it is possible to achieve security, decentralization and scalability on the same layer, the layered approach will always perform better because each layer can dedicate all of its resources, including human effort and labor, to their respective goals.

Recall that in a growing economy, opportunities for producing more sophisticated and specialized goods & services arise but for this to happen, a more-universal medium of exchange is required. Otherwise, specialization is limited due to the increased likelihood of being unable to find a provider who has what you want and wants what you have. Without the universal MoE, growth is also limited in the sense that the diversity of goods and services produced is limited. Further, the quality, sophistication, and performance of these goods and services are limited because resources must be spread thin rather than concentrated.

In the same way that a growing economy  - with a universal "layer" or "medium" of exchange - tends towards increased specialization, so too does a scalable blockchain solution - with a universal layer of security for settlement and repudiation - tend toward a specialization (or division) of responsibilities. In a market where providers are constantly competing to be the best, a layered approach has to emerge, as it allows for more effective allocation of resources and human labor.

It is not that it is necessarily or even likely impossible to achieve all ideal properties on the same chain: it's simply not as desirable. A layered approach allows for greater specialization of each blockchain (and therefore a larger set of solutions), greater simplicity of each layer, and more effective allocation of resources.