The economics behind blockchain networks
Blockchain networks can be thought of as sovereign digital economies.
Like sovereign nations, blockchains provide property rights to their users. These property rights are secured by a currency that blockchains issue and control, and that facilitates trade in their economy. The tax on this trade is collected in the form of transaction costs. These transaction costs finance the “military-industrial complex” of the network. More trade means more demand and higher prices for the currency. This leads to more transactions costs being paid to the security infrastructure and a stronger, safer economy. Like sovereign nations, blockchains have their own internal currency that they issue and control. This currency facilitates trade in their internal economy. Blockchains provide property rights to their users. They have a tax on commerce in the form of transaction costs. Over the long-term, these taxes finance the security infrastructure underpinning the economy. There is also a governance system that plays a role in advancing the interests of the economy.
1) Moving up the Value Chain
As national economies evolve, they tend to move up the value chain. They go from producing relatively cheap commoditized products to producing more expensive, differentiated products.
On the supply-side, countries with higher economic growth are able to invest more into their capital bases: both physical (infrastructure) and human (education). These investments create efficiencies, allowing the economy to supply higher-value-added goods. At the same time, the increasing wealth of their citizens creates a larger and larger domestic market to consumer these more expensive goods and services.
From $0.01 in 2017 to $2.00 in 2022 (Source: Etherscan)
From $0.01 in 2017 to $2.00 in 2022 (Source: Etherscan)This same dynamic seems to play out in blockchain economies. We’ve seen it play out with Ethereum over the last five years. Prior to 2020, network transaction costs were roughly ~100x lower than they are today ($100 vs. $1). The rapid increase in transaction costs means that a number of use cases with relatively low transaction sizes have become non-viable. Obvious examples include applications like play-to-earn video games (Axie Infinity), sports betting (SX.Bet), among many others. DeFi looks like the next use case to become economically non-viable on Ethereum. For example, Ethereum’s DeFi dominance fell from 95% to less than 60% in 2021 alone:
From 99% to <60% in 18 months (Source: DeFi Llama)
From 99% to <60% in 18 months (Source: DeFi Llama)This isn’t a bad thing for Ethereum. At the same time, the higher price of Ether means that the underlying consumers of the Ethereum economy are richer. Ethereum is also by far the most secure and decentralized smart contract blockchain in the world. As Ethereum layer two (L2) solutions come to market, users will increasingly move off of the main chain for the lower fees offered on L2 chains. These layer two ecosystems will in turn tap into the mainnet layer for security. As these layer two ecosystems grow, Ethereum will naturally transform into a blockchain that focuses on providing block space for ultra-high value, shared security transactions. The base layer will become prohibitively expensive for mainstream users as price inelastic shared security transactions crowd out day-to-day consumer ones. Average transaction costs will likely go to +$1,000 and Ethereum will become the de-facto security and settlement layer for the entire blockchain space.
2) Benefits of Specialization Specialization is the process by which an economic entity focuses on the production of one single good or service. Specialization enables higher production at cheaper prices. Countries that specialize in a particular area are able to then fulfill a global need at a much larger scale. This same principle holds for blockchain economies. Blockchains that focus on specialization can get an advantage over more generic networks that attempt to boil the ocean. History continues to show us that block space is a scarce and valuable commodity. This scarcity creates a fundamental economic limit to the number of applications and users that can be on any one specific chain. At the same time, there is friction in moving capital across blockchains. This therefore implies that there are huge advantages in blockchains specializing in serving specific customer segments.
New blockchains are increasingly focused on specific use cases
New blockchains are increasingly focused on specific use casesWe’re starting to see this trend play out in the blockchain space. New blockchains are increasingly targeted at specific use cases. Osmosis is focused on AMMs. SX Network is focused on prediction markets. Ronin is focused on play-to-earn. Generalized blockchain economies will be challenged by a new generation of upstart chains that are laser-focused on a specific use case.
3) Staking Rate vs. Transaction Demand The staking return in a sovereign blockchain network is functionally equivalent to the central bank interest rate in a normal economy. The higher the staking return, the more investors will choose to stake (i.e. staking rate) instead of using their crypto token for other activities. With a higher staking rate, there’s less circulating supply able to be used in network transactions. Therefore, transaction demand decreases, eventually leading to decreases in transaction costs.
Lower transaction costs incentivize people to unstake (lowering the staking rate) to use their tokens on the network for commerce (DeFi/NFT transactions). This increases transaction demand, which increases transactions costs and makes staking look more attractive, leading to a higher staking rate and less circulating supply… and the whole process starts again until it reaches an equilibrium. Higher staking rates are better than lower staking rates when it comes to the security of the network and the price of the token. However, higher staking rates also crowd out other activities that these tokens could be utilized for. For an extreme example to illustrate this point, imagine a blockchain economy with a 99.9% staking rate (i.e. 99.9% of all tokens are staked). This network has very few tokens left in circulation for liquidity provisioning, lending, or available to pay transaction costs. This, in effect, crushes the local DeFi and NFT economies. It is similar to how overly high interest rates in a traditional economy disincentive spending and private investment, hurting the economy’s long-term competitiveness.
4) Layer Twos are States, Layer Ones are Countries Layer-two scaling solutions don’t solely rely on their own security, they also rely on the base layer to settle disputes and for final settlement. In many ways then, they can be considered to be a state or province of the underlying base layer country. The layer two solution pays a portion of their transaction take rate to the host chain, similar to how citizens of states pay federal taxes. In return, the base layer provides the layer two state with enhanced security and property rights.
While layer-twos each have their own structures and designs, the underlying principle is the same: a portion of transaction fees are paid to the layer-one network supporting it.
5) Developing vs. Developed Blockchain Strategy Developing economies typically have vastly different economic strategies than developed economies. Similarly, it makes sense for developing blockchain networks to have different economic strategies than mature blockchain networks.
Developing blockchains tend to have less liquid and riskier tokens than their developed peers, meaning that validators demand a higher risk-adjusted rate of return (staking return) for their services. As the network matures and the token becomes more liquid, the risk for validators decreases and the staking return falls accordingly.
Newer, less liquid networks need to offer high staking returns to validators to secure their network
Newer, less liquid networks need to offer high staking returns to validators to secure their networkHowever, as mentioned earlier, high staking returns increase staking rates and therefore can lower available circulating token supply. This can crowd out the local DeFi economy by reducing TVL potential, and lowers the amount of tokens available to pay transaction costs on the network. To counteract this, developing networks can stimulate network demand through direct protocol-level liquidity mining (LM) campaigns. This helps stimulate the supply-side (i.e. developers) by increasing the economic returns to development.
Networks with low organic demand need to be highly aggressive with protocol liquidity mining
Networks with low organic demand need to be highly aggressive with protocol liquidity miningFinally, as the organic demand for a network’s block space continues to grow, the network gains more and more pricing power. This pricing power enables the network to charge increasingly higher transaction costs and generate organic (tax) revenue. This revenue can be directed to validators, reducing the need to pay them through inflation. It can also flow through to token holders directly through a burn mechanism.
Over time, networks with high transaction costs are better able to pass back this value to token holders with lower emission rates, or even, a deflationary supply.
SX Network combines smart contracts with an on-chain treasury and prediction market protocol. This prediction market protocol to helps govern the protocol through betting-based governance. SX Network is perfect for developers with EVM-compatibility, low-cost transactions, and PoS-based consensus. SX.Bet is the #1 prediction market dapp by betting volume across all chains. All bets are peer-to-peer and settled on chain. SX.Bet has processed +$175,000,000 in betting volume.