Blockchain Economics Revisited
Three Things #95: November 26, 2023
I like to joke that I came to Ethereum for the tech, stayed for the people, and eventually left because of the economics. As I wrote last week I recognize that economics is nuanced and that it’s not something everyone pays attention to in blockchain, but they should.
I was never totally comfortable with Ethereum’s economics. The size of the premine always bothered me—why so many coins relative to total, eventual issuance? When people began making noise about “Eth is money,” without understanding what this actually means or how ridiculous they sound when they say it, it was sort of the final straw for me. I stopped contributing to Ethereum in 2019 for several reasons, but economics was a big reason.
Fast forward a few years and as we set out to design the Spacemesh economic model I did my best to correct a lot of these mistakes, or rather, to not make the same ones. This required a deep dive, studying in detail the economic model of existing blockchains: their coin allocation, their issuance mechanisms and inflation schedule, burn mechanisms (where relevant), governance of issuance and monetary policy, etc. It took a couple of years but we eventually finalized and announced the Spacemesh economic model a year or two ago. I’m extremely proud of this work, as proud as I am of anything I’ve ever done before. It wasn’t easy, and in retrospect the optimal design wasn’t at all obvious. I’m sure this design isn’t perfect. And not everyone is equally happy with it, including some of our investors. But I think it’s an excellent foundation for the Spacemesh project and community, and most importantly, it’s in line with our values and principles, which include leaving as much value as possible on the table for the community (something everyone says but no one actually does), and thinking and planning for the extremely long term.
Honestly, I thought I didn’t have much more to say about the economic model than what I already wrote when we announced our economic model, and the math and details published on Github. I thought it was pretty simple, straightforward, and mostly self-explanatory, especially since it’s based on Bitcoin’s economics and those couldn’t be simpler. However, since we launched a few months ago we keep getting questions and I’ve realized that blockchain economics is even more complex and nuanced, and less well understood, than I thought. Here’s a slightly deeper dive into some of the topics that keep coming up, and some thoughts on things I’ve learned since I originally wrote about blockchain economics a few years ago and since we designed the Spacemesh economic model.
Thing #1: Premine ⚒️
This is a sensitive topic for many blockchains and “premine” has become something of a dirty word, despite the fact that every project since Bitcoin has one. In spite of having a ginormous premine Solana, for instance, doesn’t mention it even once anywhere in its official documentation. It’s very difficult to get information today on the Ethereum premine. But the fun thing about a premine is that it’s quite literally there in the code for all to see, forever. It can be somewhat swept under the rug socially but not technically.
It shouldn’t be a sensitive topic. For all serious blockchains since Bitcoin, it’s a necessary evil (there will never be another immaculate conception) and a recognition of the fact that building something this complex requires real capital. There’s no way around it and there’s absolutely nothing wrong with a premine done right.
But not all premines are created equal. Every time I look at these graphs, they make me want to cry. Every serious blockchain that launched over the past few years gave away at least half of their coins to insiders and investors. That may seem totally arbitrary and unimportant—after all, venture-backed companies regularly sell more than half of their equity to investors before eventually exiting, right?
Except that a blockchain isn’t a company. At least, a serious, decentralized, permissionless, public blockchain isn’t like a company—and all other types of blockchains are uninteresting as far as I’m concerned. If a cryptocurrency wants any claim of being money, and if a blockchain wants any claim of being infrastructure for the public good, then it’s critically important how and when those coins are issued, and whose hands they wind up in. The problem with a premine is that it’s by definition a closed, permissioned act whereby coins are handed to a tiny group of privileged insiders. In other words, everything about a premine is diametrically opposed to the value that a public, permissionless blockchain stands for: inclusion, egalitarianism, credible neutrality.
It’s bad enough that projects do this constantly. It’s even worse that they gaslight you about it. If you read any article or listen to any interview with a founder behind a massive premine they all say the same thing: “Our first priority was to make sure that the community got a fair share,” and then proudly announce that they’ve reserved a generous 10% or 25% or, in really extreme cases, maybe 50% of coins for the community. Even then those coins are rarely if ever distributed in a credibly neutral fashion such as proof of work or proof of space time mining—they’re instead distributed in dodgy ways like airdrops, grants, and other forms of handouts to friends, or through a public sale (where insiders and the already-wealthy have an edge) and/or a treasury/foundation (which is controlled by insiders). I’m not suggesting that airdrops or grants should never happen, or that foundations and treasuries should never exist, but they’re not a credibly neutral mechanism for coin distribution to the masses and should not be confused as such. These are not the same thing.
By contrast Spacemesh reserves 93.75% of coins to distribute to the community via a meritocratic, credibly neutral mechanism. More on this in a moment.
In some respects this is the foundational lie of every blockchain after Bitcoin, and incidentally it’s one of the major reason that Bitcoin maximalists call every other coin a shitcoin and will never accept any other coins or blockchains. They have a point, but I’m a little more pragmatic than that. Bitcoin is great but I do believe that the world needs multiple chains and those chains are highly likely to have premines.
Which brings us back to my comment above: not all premines are created equal. How do you get a premine right? The most obvious and most important parameter is the size of the premine. The other parameters are the vesting schedule and how quickly the premine gets diluted.
Most projects including Ethereum and Solana didn’t impose vesting on their premined coins (some of Solana’s premine involved vesting but much did not). This is especially a problem for proof of stake chains including Solana since they require that millions of coins be staked when the protocol first launches (incidentally this is one of many reasons I seriously dislike proof of stake). And most projects including Ethereum and Solana issue coins for a few years post-genesis, then slow, halt, or even reverse issuance. The unfortunate effect is that the premine calcifies: those privileged insiders who hold a disproportionately large share of coins will maintain or increase that share through staking, and no matter how hard new ecosystem participants and new stakers try, they will probably never be able to displace those insiders. This is the opposite of a meritocracy and it’s not the world I want to live in.
Founders do this because people are afraid of inflation and because investors don’t like inflation. People don’t understand inflation. Inflation is your friend and a healthy amount of inflation is a good thing economically. Seriously, go ask a real economist (not a crypto armchair economist like me). Crypto people tend to misunderstand inflation because of a false equivalence: Bitcoin and cryptocurrency in general was created in response to mismanagement of fiat money, especially uncontrolled printing that leads to hyperinflation. Hyperinflation is bad, therefore all inflation is bad, therefore currencies that inflate over time are bad. (Wrong.)
Some people suggest that a premine isn’t an issue because coins change hands over time, early insiders tend to sell their coins to realize a profit, and new actors are always arriving. There is doubtless some truth to this, but I’ve never seen any serious research to confirm or deny it. And my gut feeling is that this effect isn’t very strong. In the ecosystems I’ve participated in, early, privileged insiders tend to become an entrenched elite in a given project or ecosystem and are still privileged, wealthy, and influential many years later regardless of merit or ongoing “proof of work.”
To be clear, as I also wrote last week, I’m not suggesting that there should be no premine or that early team and investors don’t deserve outsized compensation for their foundational work and for bearing the lion’s share of the risk. They absolutely do, and for this reason there should be a premine. But there’s a right and a wrong way to do it, and having a large premine, especially one without vesting and one that won’t be diluted over time through a healthy amount of inflation, is absolutely the wrong way.
Ultimately the question we should all ask ourselves is, who is this project for, and what world do we want to live in? Default world economics are pretty rough on every day people (which is a big part of the reason that wacky stuff like meme stonks and cryptocurrencies are so popular). Real wages aren’t growing nearly fast enough to keep up with inflation. The Cantillon Effect is in full force as governments everywhere print money in response to never-ending conflict, high inflation, and ballooning deficits and global trade imbalances, and money simply doesn’t trickle down very effectively to every day people.
What is a premine if not the purest, most extreme possible example of the same Cantillon effect dynamics at play? And why on earth would we want to recreate those same dynamics on chain any more than we must? Blockchain is quite literally a golden opportunity to opt out of the existing, broken system and build a better system—why wouldn’t we want to do better? And if we cannot, what’s the point? Why not give up the whole charade and go back to the broken default world?
A blockchain is not a company! It’s not a closed, permissioned project for a small set of private investors and insiders. A blockchain is an open, public, permissionless thing. In this respect it’s more like a country—not exactly alike, but more alike. I for one do not want to live in a country where half the money that will ever exist was handed out to a few privileged families at the founding. You choose where you want to live, and where you want to invest your time and money, and I’ll do the same.
Thing #2: Inflation 🎈
Inflation is nuanced and difficult to understand. It doesn’t help that we colloquially use the term to mean two completely different things: increase in the money supply, and decrease in purchasing power. These two phenomena are related but distinct, and they’re very easy to confuse.
In the context of a layer one blockchain inflation is more or less synonymous with issuance, emission, minting, reward, and subsidy, and I mostly use these terms interchangeably. The only way bitcoin ever comes into existence is through issuance (a.k.a. emission or minting) by the protocol of new coins as a block subsidy (a.k.a. reward). Of course as mentioned in the previous section a premine can also create new coins, and L2 applications and probably even some L1s have wacky economic mechanisms that issue coins for other reasons, but in general the block subsidy and the premine are the only way coins come into existence.
When seeking to understand a blockchain’s economics the key thing to understand is its monetary policy, i.e., the shape of the issuance curve. When it comes to economics a picture is worth a thousand words; here are the Bitcoin and Spacemesh curves including all future issuance:
As you can see the Bitcoin curve isn’t actually a curve, it’s a series of straight lines whose slope halves around every four years (the halvening cycle). Spacemesh uses a similar exponential decay model of issuance but smoothes it out so that, rather than sudden halvenings every few years, issuance declines very gradually and smoothly from one layer to the next, every few minutes. And Spacemesh issues coins for a much longer time than Bitcoin does: compared to Bitcoin’s four year half-life, the Spacemesh half-life is around 29 years. No two chains have precisely the same issuance curve: some are linear forever, some premine 100% of the coins, some depend on variables that are difficult to know ahead of time such as amount staked, transaction volume, and block time, and some are, well, weird and change constantly.
To get the full economic picture including all fluctuations in circulating coin supply you need to consider not only coins created but also coins destroyed, whether due to intentional burn or simply lost keys. Some protocols also have an enshrined burn mechanism, most notably the EIP-1559 mechanism in Ethereum whereby a portion of the transaction fee of each transaction is burned; Solana has a similar mechanism. These burn mechanisms ensure that the more active the chain, the more coins get burned, which has the net effect of reducing inflation or in some cases even making the coin deflationary, i.e., on balance more coins are destroyed than are issued.
While it’s not difficult to calculate the number of coins burnt through an enshrined mechanism like EIP-1559, calculating total burn due to all causes is much harder because, obvious burn addresses aside, there’s no way to know for certain if someone’s keys were lost or if a given address is a burn address (i.e., an address for which no one holds the spending keys). Any burn estimates will therefore be a floor, i.e., a minimum known burn amount, but not the total amount, which means that any economic calculation that factors in burn will always overcount the number of circulating coins.
The other thing to keep in mind about inflation is that it’s by definition a relative term, and one that only has meaning over a fixed period of time. Inflation is defined as new issuance over a fixed period of time divided by total prior issuance at the start of this period. This sounds pretty straightforward but the math is non intuitive. For instance, consider for a moment: what was the inflation caused by the first Bitcoin block? The answer is infinity because issuance prior to this was zero. What was the inflation caused by the second Bitcoin block? 100%. You get the gist.
In the same fashion, when Spacemesh launched there were zero circulating coins, so the inflation of the first Spacemesh block was also infinity. People often ask why Spacemesh inflation is “so high,” and this question confuses me. If you draw a straight line up starting from zero, then over any arbitrarily short period of time starting from zero inflation is going to be extraordinarily high.
What people mean by “high inflation” is usually “the protocol is issuing too many coins,” but if you do the math that’s actually not at all what high inflation means! In this case it means “many coins relative to the existing supply”, and if the existing supply is low, the relative inflation figure is going to be high. What’s more, it also depends on the period of time you’re considering. A single Spacemesh layer issues around 400 new coins, which currently represents about 0.00286% inflation. That translates into 0.823% inflation per day, or about 25% inflation per month (which makes sense since the network has been alive for about four months). Just as in how the yield on a bond or a credit card debt is meaningless on its own without a time period, inflation is meaningless without a time period. This is self-evident and axiomatic but there’s something about this math that confuses people (probably because it involves calculus, understanding relative rates of change and derivatives, etc.).
Take my word for it, there’s nothing out of the ordinary and nothing interesting about Spacemesh issuance. It’s totally unremarkable. It decays very gradually with each block, i.e., it’s disinflationary (not to be confused with deflationary: the former means that the supply is inflating at a slower and slower rate; the latter means that the total supply is decreasing). But for the first few years it might as well be linear, i.e., straight line issuance, just like Bitcoin’s first four years. The fact that people think it’s “high” speaks less about Spacemesh and more about the fact that people are used to absurdly large premines, as described above. If we had handed hundreds of millions of coins to insiders before launching the network, as everyone else does, then the denominator would be much larger in the inflation math—but your economic situation would be far worse (since the number of coins you hold relative to the total outstanding coins would be much lower).
“Inflation” is a loaded term and despite the fact that they both mean the same thing I think it’s better to use the term “issuance,” which is more neutral. And issuance isn’t always bad. The question isn’t simply how much issuance there is. As with any form of spending, the question is, what are you buying with that issuance? You’re buying chain security, for one thing. And in the case of an open, thriving ecosystem like Spacemesh you’re also buying more miners entering your ecosystem, more applications building on your platform, better infrastructure and other public goods, etc.—in other words, you’re buying a flywheel effect. If done right that spending is absolutely worthwhile and incredibly valuable, especially in the early days of a project and an ecosystem.
One final thought on issuance: it’s also important to consider where those coins go once they’re issued. Not all issuance is created equal! As mentioned above this economic phenomenon is known as the Cantillon Effect: a well-studied real world phenomenon whereby inflation affects different actors differently. It generally means that newly-created money tends to end up in the hands of the influential and already-wealthy. We need look no further than recent American stimulus spending to see this in action.
If you’re in charge of an economy the worst thing you can do is mint coins and hand them out to your friends and cronies. The best thing you can do is continually issue a steady, predictable supply of new coins through a credibly neutral mechanism such as proof of work or proof of space time, whereby any participant has an equal opportunity to earn coins by creating objective value for the protocol. That’s what Spacemesh does and it shocks and saddens me that so few other protocols do the same, especially given how simple this is to achieve.
Thing #3: Governance 🏛️
Setting the initial economic parameters is only half the battle. Actually, it’s probably around 10% of the battle. Governing those parameters over the lifetime of the network and community is the really hard part.
My thoughts on governance of cryptoeconomic systems have evolved over the years. When I was part of the Ethereum community I thought that there wasn’t enough governance: decisions were made in an extremely opaque and arbitrary way, it wasn’t clear who the decision makers were, and the near total lack of formal governance mechanisms meant that governance was obfuscated and not meritocratic. Ethereum at the time was quite literally governed by friends making decisions together in back rooms and in Telegram chats. I was part of the economic decision making process during the years I worked on Ethereum, e.g., helping determine the issuance reduction in the Constantinople upgrade. And it always felt a little bit strange because I felt unqualified. Given the size of the Ethereum economy and the amount that was at stake, I wondered, shouldn’t actual economists and people with experience governing real economies at least be part of the conversation? (I previously wrote and spoke more about my experiences in Ethereum governance.)
A couple of things have changed since then. For one, while I’m not involved anymore, as far as I can tell Ethereum governance has gotten a bit better. I’m sure decisions are still made among friends in back rooms and in Telegram chats—I doubt that will ever change—but, while we were really struggling to make big, difficult decisions while I was working on Ethereum governance, the successful roll out of EIP-1559 and the Merge suggests that’s less of a problem than it used to be. Ethereum’s economics had several bumpy years when lots of changes were made, but that seems to have stabilized and, as much as Eth isn’t money and as much as Bitcoiners like to hate on Ethereum, its economics today does seem sustainable, if a bit confusing. And there are now at least a couple of actual economists in the room.
The other thing that’s changed is that I’ve become something of a governance minimalist. The main reason is that, in the intervening years, I’ve witnessed more or less every way that governance can go wrong. I’ve been part of multiple DAOs that spent nearly all of their time and effort just figuring out how to govern themselves, only to fail and collapse under the weight of this stress without having achieved anything. I’ve heard horror stories from a number of blockchain foundations and ecosystems about all the things that can go wrong when you put professors in charge, or when the founders and executives let wealth and power go to their heads and become egotistic, or when you try to design complex on chain governance mechanisms, or when any of the thousand other things that can go wrong with governance inevitably happen.
I’m often asked if there are any positive examples of blockchain governance. Honestly, in my opinion the project that did the best job of governance, and maybe the only project that has successful governance, is Bitcoin—at least if we define successful governance as achieving its stated objectives. It’s not a coincidence that the “governance surface” in Bitcoin is tiny: in other words nearly all of the protocol parameters were fixed long ago and there’s very little scope for change today. Relative to other projects and protocols there are relatively few decisions to make and relatively few resources to govern. There’s no intellectual property, no foundation, and no treasury. Each actor in Bitcoin, each core developer and company and fund, is free to govern itself as it sees fit in proper, decentralized, self-sovereign Bitcoin fashion.
I didn’t see this at first when I was working on Ethereum as, at the time, Bitcoin seemed both chaotic and stagnant, but the more I think about Bitcoin governance and the more I understand it, the more I admire it. It’s easy to write Bitcoin off as stagnant and uninteresting—and Ethereum people do this all the time—but it simply isn’t true. You need attend only a single technical Bitcoin meetup to see all of the innovation that’s happening. Segwit and Taproot were big, interesting upgrades that unlocked all sorts of new applications and use cases, and more such changes are in the pipeline. The fact that Bitcoin governance moves slowly is by design.
All of this is on my mind as I consider what sort of governance model we want to design for Spacemesh. I very much hope that we can take the best from Bitcoin, including setting extraordinarily strong norms and Schelling fences around the economic model. Spacemesh’s 2.4 billion coin hard limit should be like Bitcoin’s 21 million: it should never change.
There are many exciting upgrades coming down the road to Spacemesh such as improvements to existing components (PoST, PoET, Hare, etc.) and brand new features (most notably the VM). Governance of all of this—which features to prioritize, which improvement proposals to implement, multiple client implementations—will be entirely in the hands of the community, along with governance of ecosystem resources such as a foundation treasury, when the time comes to set one up.
But governance of the core protocol’s economic mechanisms, such as total issuance, is special. Those mechanisms are sacrosanct. They should not be changed except in a truly extreme scenario and then only by an overwhelming majority of stakeholders. The Spacemesh company doesn’t have the authority to unilaterally change those parameters, not anymore, not even though we’re the only ones actively developing and maintaining the protocol for now. The foundation, when and if one exists, won’t have the authority to do that. This is absolutely critical for the credible neutrality of the protocol. It’s the only way that Spacemesh can stand confidently, shoulder to shoulder with giants like Bitcoin, and fulfill its promise to be a people’s coin that’s not only issued overwhelmingly to the community in a credibly neutral fashion, but that can one day be relied upon as a form of hard money with perfectly predictable, reliable issuance, if that’s a goal the community decides to pursue.
Of course Spacemesh is significantly more complex than Bitcoin and is still quite immature by comparison so Bitcoin governance won’t work out of the box for Spacemesh, and it won’t work for quite some time. Nevertheless it’s something to aspire to and a yardstick against which we can measure our governance: the less there is to govern the better in my opinion.