“Show me the incentive and I will show you the outcome” - Charlie Munger

A lot of institutions today are based on being a trusted entity (think custodian who holds your stocks, escrow accounts, banks and other lending companies, Ticketmaster, etc.). These institutions add complexity to transactions, but people will prefer to go the safe, trusted method.

For example, think about want to attend a concert. A ticketholder simultaneously wants to sell a ticket to the concert. You likely wouldn’t trust a stranger as they may have created a fraudulent copy of the ticket, so you defer to paying slightly more to purchase from a trusted entity like Ticketmaster. The ticketholder, having not found someone to purchase their second-hand ticket, resorts to returning the ticket to Ticketmaster, being charged another service fee in addition to the service fee charged for originally purchasing the ticket. In total, the original ticketholder paid Ticketmaster two service fees and the new ticketholder paid a service fee to purchase their ticket.

This is the result of a centralized world where we cannot trust each other, so these trusted third parties must mediate for us. While there are pros and cons for both centralization and decentralization, society is moving towards decentralization as a response to the pitfalls of a centralized system.

The underlying issue that I have with centralization is the seeming imbalance of incentives. While people with morals would know not to insider trade (and there has not been much issue in the past), it is becoming more and more common for this to take place as the punishments are light, if any. As such, insiders seek the positive risk-reward profile of insider trading as the benefits exceed the penalties. We would ideally like to have our leaders uphold ethics in their decision making, but a misaligned system will eventually be broken.

The best outcomes in Web3 result from protocols where everybody’s best interest is to upkeep the protocol. This can be best exemplified in the Prisoner Dilemma theory. While one would like to trust their partner, the stable equilibrium of this particular example is that everyone will act in their own best interest and avoid jail time as much as possible, resulting in both prisoners trying to sell out the other for a promise of decreased jail time.

The reason blockchain is such an important technological innovation is the method in which strangers can trust each other. On the Bitcoin blockchain, the miners are incentivized to upkeep the blockchain because they are paid in Bitcoin. Bitcoin’s value is directly related to how well the protocol is maintained. A well-maintained blockchain attracts new users, and the circle continues.

Liquidity pools incentivize those with inventory to stake both sides of a trade. This allows traders to engage with the decentralized exchange to complete their trades for a small fee. The liquidity providers receive that small fee for their service. As the ratio between assets change, arbitrageurs are incentivized to enter and return the ratio of the two assets in the liquidity pool such that the prices of the two assets are returned to their market values. They earn a risk-free profit for doing so. In this model, everyone involved is incentivized and so the equilibrium will result in a successful protocol.

Going back to the Ticketmaster example, if the tickets were sold as NFTs on a blockchain, the ticket purchaser could see that the second-hand ticket was legitimate by looking at the blockchain, the trusted third-party source. The fee to transfer the ticket would compensate the miners upkeeping the blockchain.

I have thought a lot about incentives and human nature over the last little while, particularly in the context of Web3. The next blog post will discuss the misaligned incentives in NFTs.