Capturing Value in Open Finance, the Case about Nervos
Any kinds of public blockchain need to capture value, be it staking or computation, to prevent shrinking of internal value of the network due to sharp decline in token market price. The ability to capture value will alleviate the problem of users leaving due to bad market performance and prevent irreversible decline.
This is a rather long article, but an awesome one at explaining value capture!
The recent publication of Nervos economic model proposals has given rise to a wave of new discussions that boils down to two key questions:
“How can blockchain protocol layer capture value?”
“What kind of protocol assets can better capture value created in the ecosystem?”
In conventional economics, there is not much discussion about capturing value. Instead people focus on an important commercial agent in microeconomics, the firm. If we translated the same problems to the language of conventional economics, it would become “How does firm equity stock capture all the value the firm has created in its industry chain?” Now it’s very clear. all value the firm has created should become its cash flow and assets, including reputation, and be closely linked to stock price through the financial reporting system.
At this layer, there is no question about value capture because it is already assumed that currency/money captures all the value generated by society. Under this assumption, the firm doesn’t need to think about how to capture value, it only needs to earn currency or make money.
It is a different story when it comes to Open Finance. The protocol must help protocol assets to capture value created by the token ecosystem and survive. Protocols that cannot capture value will not survive in the long run. In comparison, firms do not have to think about whether the money they make show clear trace of value creation, the pressure on them is only about earning enough cash Flow to survive.
Value capture is critical to fuelling the ongoing development of open protocols such as 0x and Nervos.
For instance, 0x Protocol smart contract API has been frequently called by popular dapps such As Augur, Dapp Gods Unchained, and all kinds of relayers. At first glance, 0x seems to be very popular and successful. However, if we looked at ZRX, the native protocol asset of 0x, we would see that it doesn’t really reflect the popularity and usage of 0x, so it hasn’t captured much of the value that0x ecosystem creates. The inability to capture a significant amount of value created will decrease the likelihood of longterm survival of 0x Protocol.
So how does a protocol capture value it creates?
To answer that, we need to know what exactly are the kinds of values that a protocol needs to capture?
At least in the case of Nervos, the answer is quite clear. According Dan Zuller from Vision Hill, the values that need to be captured are social capital and tangible assets. Nervos has proposed a base layer as a Store of Value(SoV) platform. The layer seeks to capture the various states of upper layer assets and store them In CKB, state storage. The project makes the design choice that any state changes in both smart contract calls or transactions will be shown through state storage.
Defining and measuring value is the first step in capturing value. If we see blockchain protocol as an “organism”, then we would have a better understanding that in this case, value is any states or resources that can aid in the longterm survival of the protocol.
In “Sapien: A Brief History of Humankind”, wheat is said to have tamed humankind rather than humankind tamed wheat. In Order to contribute to the longterm survival of wheat, humankind has even changed its own hunter gatherer habit to adapt to the planting of wheat. Wheat has proven to be a very successful organism.
A successful blockchain protocol is just like wheat. It needs to continuously bring in resources and states that are helpful to its survival. A good example is Ethereum. Ethereum users have to pay fee to make transactions, which allows the miners who are responsible for the security of Ethereum to capture a share of the value created by the entire ecosystem. Let’s look at another example, an Ethereum believer seeks to mobilize his social network to find more developers to join the Ethereum community in order to help improve the protocol. The potential aid from more social awareness to help the protocol development is also valuable. Therefore, the most ideal protocol should be able to capture information of changes in value in the layers above the basic blockchain layer. There should also be a way for protocol asset to capture that value, providing energy for its longterm survival.
So long as the value stays unchanged, the form that value takes can be manifold. It can appear technically, such as complex algorithms and smart contract calls creating many possibilities for new combinations of applications; or through the reinvention of social collaborations by giving each participant more incentives to contribute in a value creation protocol framework. In this way, the value of cross chain protocols can be demonstrated by the extension of social scalability, and securing the entire ecosystem at the most fundamental public blockchain protocol layer.
Where are the areas for improvement For Nervos’ economic model?
Nervos attempted to position CKB public blockchain layer as a Store of Value platform. Therefore it treats global state storage resource as an anchor for showing value. It hopes to aggregate all the value created on the CKB chain and bind that to the occupation of resources. This is an ingenious idea. they also included an implementation program of this economic model.
However, we found there were definitely rooms for improvement, which we would like to share in this article after talking to the Nervos team.
Nervos supply schedule hasn’t considered the actual demand for global state resources, and instead copied that of Bitcoin by setting a fixed maximum and halving every four years. Whether such a supply schedule is viable has still remained to be tested.
The initially issued CKB is used to describe global state space. However, when we consider the CKB generated afterwards, then the most ideal situation is one where the global state space that is represented by the initially issued CKB should be connected to the potential demand of global state resource usage.
In the design philosophy of CKB, this connection should be achieved through price discovery mechanism, such as a market:
- If the number of initially issued CKB is more than the number of CKB in actual usage, that implies there isn’t enough demand for global state storage, leading to the decrease of CKB price and the rise in demand.
- If the initially issued CKB represents an oversupply of global state storage, then the price of CKB will rise.
It is more realistic to rely on market mechanism to deal with oversupply. Whereas if demand was bigger than supply, the second issuance will doubtlessly lead to supply been higher than demand, especially when a lot of people have locked CKB in NervosDAO. This will weaken the price mechanism.
Furthermore, demand curve moves according to price, but there is another factor involved in its price influenced action, the product’s price elasticity. If the product was insensitive to price changes, then changes in demand would have very little impact on changes in price.
Summing up these two points, if supply far outstripped demand, then very likely CKB price would delve into a death spiral, because the speed of growth in demand cannot keep up with that of supply. The continuous decline of CKB price would weaken miner’s incentive to secure the system’s security, leading to a fair amount of deterioration in system security.
Put simpler, if CKB represents a product that encompasses the entire potential global storage space, then its initial issuance could be seen as an initial launch of the product. If the supply and demand had already been set at this initial issuance stage, then a dilemma where supply determines demand might occur even with scarcity.
Imagine a product whose supply and demand are already fixed at its launch. If the demand was much greater than the supply, then according to the historical growth of Bitcoin, it wouldn’t be too big of an issue. What if it was the other way around? Then the product would become obsolete as eventually very few people would care to have it. Is there an example similar to a factory that is producing products based on market demand that can serve as a better reference for CKB issuance?
This can be achieved through a smart contract protocol.
If we plan to set initial issuance and future issuance to reflect the demand of global state storage space during their respective periods of issuance, will there be any changes?
This mechanism will be similar to Bitcoin’s difficulty adjustment mechanism. One way this could look like could be this: initial issuance and future issuances can be anchored on their respective period’s recent global state storage usage statistics, which can create a long term reversion to mean situation. The exact parameters can be obtained by community voting. Initial issuance should abide by the original scarcity principal just like Bitcoin, while future issuance should obey the initial distribution ratio. This can curb oversupply of CKB to some extent.
Another more extreme method is the introduction of a burning mechanism that could be complemented by a repurchase mechanism. The goal is to give some area of flexibility for the public blockchain. It is difficult to design and implement an autonomous burning mechanism, so existing burning mechanisms are usually carried out by the project team manually, who has full control in setting and executing policies.
Overall, we hope the CKB mechanism introduced by Nervos could effectively anchor ecosystem value to the bottom public blockchain layer. Through this mechanism, Nervos public blockchain should be able to provide comparable security despite changes in the upper layers in the Nervos ecosystem.
Below is The reply from Nervos founder Kevin Wang and community lead Ryan Chen
The problem raised exists, and every public blockchain network faces it. Regardless of PoW or PoS, the security of the consensus mechanism is linked to token price. Therefore significant fall in token price will lead to the decline of network’s internal value, leading to a drop In users and potentially becoming a prolonged slide.
If we simplified Bitcoin into a Store of Value(SoV) network, then the consequence of falling token price is less network security from hashrate, reducing Bitcoin’s core competitiveness in serving as a SoV. Sustained falling price will also decrease holder’s confidence, reducing Bitcoin’s price premium.
For Ethereum, a higher token price provides better security to all the assets on top of the platform. This problem will continuously weaken Ethereum’s asset platform competitiveness while having little impact on Ethereum’s capacity as a distributed computing platform.
In CKB, this problem equally exists. However, CKB tokens have the state storage design capability, so it has some flexibility to adjust. Fundamentally, the close connection between the core value of public blockchain and security property will lead to this inevitable problem.
If we simplify this problem, it would become “Can we design a protocol that can stabilize token price based on observable states on-chain?”
This problem is very difficult to solve. It is similar to designing a stable coin mechanism that relies on issuance to adjust, like that of the failed stable coin project Basis. Because the object for adjustment, the token price, cannot be observed, there is no way to design a negative feedback mechanism. It should also be noted that there are many factors that could have an impact on price, So it is impossible to only use issuance mechanism to effectively adjust the price.
The proposed plan by the author to improve Nervos is to keep CKB state storage usage in a relatively flexible range on the supply demand curve.
There is another problem that cannot be observed through fluctuations in price. The implementation of the plan requires the addition of some forms of trust, which contradicts the desired trust-less property of a public blockchain. Furthermore, assuming changes of on-chain states can effectively impact token price, then there must exist some arbitrage opportunities that can be created by impacting the global state. Eventually, this kind of issuance policy will increase uncertainty in the issuance policy and thus harm Nervos’ competitiveness in serving as a SoV platform.
While supply and demand of state storage could achieve some kind of dynamic equilibrium as stated previously, our hope is for storage to become a scarce resource. Because CKB is a common knowledge base, then the actual utility of this global common knowledge base is not only to serve as simple storage, instead it is storage that is continuously secured through global consensus by miners. Storage is not scarce by itself. Storage with consensus is also not scarce as it is very easy to create a chain, but network security is doubtlessly a scarce resource.
Adjusting issuance mechanism will also mean adjusting miner’s income. In the scenario that the author described, when token price is in a relatively inelastic range for supply and demand, reducing issuance could directly reduce miner income. If the adjustment method itself caused the system’s internal value to depreciate, would token price rise because of market condition? This is a difficult question to answer. If the goal was to keep the system secure enough, then increasing issuance might be a better choice. A relatively constant issuance policy provides more certain expectation to the mining community, allowing miners to invest in hardwares and long term service arrangement for basic infrastructure.
Overall demand has to rely on when would blockchain technology become a basic and ubiquitous infrastructure for human cooperation. Growth in this kind of external demand is a core factor in longterm growth of token price and protocol. As designers of a protocol, the more important consideration is to have a deep grasp of primary issuance mechanism. Optimization of security cost and expected blockchain implementation speed is necessary to ensure a successful project launch.
Here we develop a hypothesis: With the growth of ecosystem, demand for secured storage with consensus will increase while supply of this kind of storage space will become increasingly scarce.
On another note, secondary issuance takes into account the demand of said storage when adjusting supply and demand. Secondary issuance mechanism is issuing tokens to miners and NervosDAO directly based on CKB usage rate. This is not a direct policy, but rather a simple and effective incentive for miners to continue working on securing the chain.
Last but not least, Bitcoin supply inflation rate is halved every four years, Ethereum awards two tokens for every block created. These mechanisms provide more certainty to a project’s money policy: the ratio of outstanding capital and total capital. If issuance schedule is constantly changing, it will give a strong sense of uncertainty and discourage miners from participating in securing the ecosystem.
Written by Robin Gu and Frank Wang from X-Order
Edited by Kevin Wang and Ryan Chen from Nervos