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Principles of Incentive Designing in Web3 That You Should Know
Introduction
"Never, ever, think about something else when you should think about the power of incentives."
Tokenomics is directly related to the psychological concept called incentives theory. Right from childhood, humans are wired in such a way that they will be rewarded for completing tasks. Hence, naturally, incentivization is within the thought of everyone, so ultimately, even a business must be operated in that way. You can even find the basics of this idea in your daily life. A kid, for instance, is being incentivized to help you with household chores such as making their bed or cleaning their room. They like to help, so they earn the incentive. In simple words, the theory claims that incentives or what we call "rewards" are likely to encourage specific activities.
In Web3 world, incentives theory works in the same way. In a token economy, incentives encourage us to take useful action and are very important to a token's ecosystem.
In this blog, we will understand, What is incentive designing in tokenomics? Why it is important? How to design an incentive system? and What if the system is not governed by incentives?. We will also look into the different incentive mechanisms across industries and how some projects succeed even without being heavily dependent on these mechanisms.
What is incentive designing in Tokenomics?
Incentives are everywhere in the blockchain platform, manifesting in a variety of ways, such as miner rewards, transaction fee-setting mechanisms, token-curated registries, and prediction markets.
From an economic perspective, it is the crux of the system. Incentive design is critical in the overall economic design of effective blockchain platforms. It builds on a platform's value proposition and structures the system for which the platform's Token will be designed. Incentives are what drive people to action within the given ecosystem. Properly designed mechanisms motivate users fairly and transparently.
As a human, your behavior depends on two main factors:
1. The ability to receive rewards.
2. The desire to receive rewards.
Just like in your day-to-day life, motivating crypto users in a token's ecosystem goes through these two actions. This means motivated users naturally will participate in critical network activities.
For example, let's say you are a user of a blockchain network. This blockchain rewards you each time you confirm transactions just because the confirmed transaction helps the blockchain to operate more securely.
If you confirm more transactions, you earn more rewards. This means better security for the network and an increased number of rewards for you. It's like a win-win situation for everyone. And this is exactly why incentives or rewards play an important role in blockchain networks.
Why is incentive design important?
MIKE GOLDEN, a lead engineer at Consensus, has noted, "Blockchain gives programmable money; when you program money, you can program incentives; when you program incentives, you can program people." By using blockchain technology, we have the capacity to build and implement large-scale structures for incentivizing human behavior at certain ends.
Adam Smith, a political economist and moral philosopher known for his foundational contribution to economics, discussed the importance of incentives in his magnum opus, "The Wealth of Nations."
"It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their interest."
How to create an incentive system that will align the entire circle of players in the ecosystem is the central issue?
Incentives could be used to encourage a variety of adaptive behaviors ranging from increased academic performance to a healthy lifestyle. The importance of a design of the incentive, what the reward is, and whether the incentive interacts with the intrinsic motivation. The prospect of obtaining a reward can motivate us to do a certain task or push ourselves to do better. Hence, it is very important to understand the network's incentive structures and design those aligned with overall desired outcomes. Incentive designing in token economics is achieved through peer-to-peer exchange of values that incentivizes the actors to operate according to the overall effective outcomes.
Having understood the importance of incentive designing, let's see how to design an incentive system and what happens when a system is not governed by incentives.
How to design an incentive system?
Economic designs are a powerful tool for designing a decentralized economy, allowing the participants to work together towards a common goal without the need for manual supervision. In a system governed by incentives, the participants' behavior is influenced by rewards and penalties.
According to a behavioral science theory called Incentive Theory in Motivation, people are more likely to act in desired ways if they are rewarded with an incentive. The reward could be a positive gift, praise, money, or a negative incentive like a penalty or participation restriction. In a system governed by incentives, the participants' behavior is influenced by rewards and penalties.
Are you looking at designing your incentive system? In the first case, you need to know what should be incentivized.
It should incentivize the good actors and disincentivize the bad actors. It encourages the desired behavior and discourages the undesired behavior. The incentive could be a financial reward, access to resources or privileges, or recognition. Financial incentives are a strong motivation for people to join the network. It recognizes and encourages users to have a community around the ecosystem, participate, and stick with the network over time. Incentivizing is critical in attracting and retaining users and building a thriving and sustainable network.
Generally, the value of the token is tied to the system's success. If the system does well, the community grows and becomes more valuable, increasing the Token's value and motivating the user to hold it. In addition, some tokens give the users voting rights, giving a sense of ownership and control over the system. Thus, thinking about the incentives of others is necessary to create a win-win relationship. Early investors, retail participants, and protocol users should push for strong and principled tokenomics.
The following approach is widely adopted to design incentives in tokenomics.
1. Identify the desired behavior
This is the first step in incentive designing to identify the behaviors that you want to incentivize. It could be holding the tokens for a certain period, participating in governance decisions, or contributing to the project development.
2. Incentivize desired behavior
Incentives can be designed to reward users who perform specific actions to encourage the desired behavior.
3. Disincentivize undesired behavior
Incentives can be designed to penalize users for engaging in undesired behavior.
4. Designing project tokenomics
Design the overall tokenomics, which includes demand, supply, and overall value of tokens.
5. Create network effects
Encourage users to participate in the ecosystem by designing incentives to create network effects. For example, it can be achieved by rewarding early adopters that increase the token value.
What happens if incentives do not govern a system?
Ignoring incentives almost never works out well. Without incentives, there will not be any motivation to work toward a common goal.
When incentives do not govern a system, the user will not have any motivation to participate, hold the token and achieve network growth. There will be no reason to participate in the system as it would be difficult to retain users over time. As a result, user turnover will be high as they will not see any compelling reason to continue participation in the system.
The developers will not be motivated to build an ecosystem without incentives, as they are drivers for any innovation and development. Hence there will not be scope for the growth and evolution of the network.
The network's security could be compromised as miners do not have any incentive to validate the transaction, spending a lot of computational power and resources to maintain the network.
Lack of incentive may lead to centralization, as some participants are motivated only to contribute to incentives. This could lead to the concentration of power among those who do. Suppose the network has no or weak incentive system; in that case, miners may need more motivation to participate, reducing the network's hash rate and making it easier for a few miners to control it. This results in only a few actors having a large amount of control over it.
Prevailing incentive design mechanism across industries
Now let's look at a few design mechanisms across industries and understand how they incentivize the participants.
1. Learn-to-Earn
This is a prevalent method followed by centralized exchanges and crypto platforms. It helps the user to earn crypto by learning in an uncompetitive way.
Teaching is an essential component of an open financial system. Learn and earn incentivize the user for learning new concepts by rewarding in crypto. It is one of the effective ways to reach new users and educate them on their blockchain project or protocol. In this model, users will be eligible for crypto tokens until the predetermined amount is exhausted.
Coinbase has a very good learn-and-earn program that allows the reader to earn in crypto. It provides a simple and interesting module with a clear framework. In this, users are rewarded with crypto for watching the video or tutorial and taking the quiz that educates the users about the token. This method incentivizes the user to learn about the project and provides knowledge to trade in any cryptocurrency. Furthermore, by introducing others to the learn and earn program, users will be rewarded with additional crypto as a part of a referral program. This model helps the user to learn about the token instead of buying it by looking at the advertisement.
However, sometimes this program is available only to those users who live in the listed geography or hold a minimum number of tokens in the wallet to get qualified for the program. Users can exchange the earned coin with other prominent tokens, hold or sell and realize it in fiat currency.
2. Move-to-Earn
These are revolutions in the fitness industry and crypto market.
In a move-to-earn application, you incentivize to move. The fitness application rewards users with gift cards, merchandise, and vouchers in exchange for their efforts to reach fitness goals. These platforms incentivize people to stay fit who are not into daily exercise. This concept dually incentivizes fitness enthusiasts. Firstly, to get them fit by walking and participating in fitness challenges, and secondly, they can make some income out of it. Walking is a routine part of everyday life; this concept incentivizes people as extra revenue by doing everyday activities and staying fit.
When it comes to move-to-earn games, STEPN is the most famous one in Web3 and the crypto world. It will reward you for completing the workouts. You will earn some GST (Green Satoshi Token) in the app for performing activities like walking, cycling, running, and many more. These tokens can be traded for other cryptocurrencies or invest in them. The more you move around, the more GST tokens you will earn. In addition, users are rewarded for referring friends and family members who are looking to stay active and healthy.
3. Play-to-Own
This is a recent concept in the gaming industry, although the community continuously expands.
Play-to-own incentivizes the players to participate in the game. Players are incentivized to have a stake in the game's success, to contribute to the platform for achieving specific tasks or reaching a milestone in a game. This motivates them to continue playing and contributing to the game's success, which drives the ecosystem's and community's growth.
An example of play-to-own incentive model is Upland, where users can start playing with an "Upland Visa." Once the uplander acquires citizen status, players can acquire any digital item that has tangible value and can be liquidated in the secondary market. This increases customer lifetime value, engagement, and retention. These games provide ownership security and benefit from long value creation. Operators will get happier and more loyal customers.
4. Play-to-Earn
These are revolutions in the gaming industry.
In the play-to-earn business model, blockchain games offer tokenized incentives to players that enable a framework for the player as an owner rather than a standard player as a consumer. In traditional gaming, the users play to win, and developers control all in-game economics. In contrast, in the play-to-earn model, they play to earn where they have ownership and control over their digital assets. It incentivizes players to play and progress within the game by offering rewards that have measurable value outside the game. The players are compensated for their efforts and time spent online with digital assets that have value outside the game that may appreciate over time. It allows players to create digital assets and trade them in the game. You make in-game currency by completing missions, winning battles, or other challenges. The money earned is in the form of crypto; you can trade it or HODL it. There are great varieties of play to games available.
An example of the play-to-earn incentive model is Metacade, which has incentive structures for engaging with its services. Content creators can earn the native token for posting game reviews, sharing alpha, and interacting with other users. Players can compete with any other player worldwide or beat solo levels and grab crypto-earning opportunities. With their governance tokens attached to gameplay, users can vote to decide which new game proposals should go into development. The vote winners will receive early-stage funding to help bring new blockchain gaming experiences to life.
5. Rent-to-Earn
This is the blockchain version of Airbnb.
Rent-to-earn is the upgraded version of play-to-earn. This reduces dependency on centralized companies from the Web2 world, and users earn tokens by renting their unused resources to other users. This would create more efficient resource use and incentivize individuals to participate in the network. In addition, this model allows the users to rent their unutilized resources to the network, which ultimately benefits the entire ecosystem. This would also help the individuals create more efficient resource use and earn tokens in exchange.
An example of the rent-to-earn model is Filecoin, which allows users to rent out their unused storage space on their computer to other users. Miners are paid in Filecoin's native currency, "FIL," to store, distribute, and retrieve data from miners' storage. It leverages unused storage spaces of electronic devices such as personal computers. The economic incentive offered by the protocol encourages storage providers to play their role reliably over time.
6. Travel-to-Earn
This concept aims to shape the new ecosystem that drives change across the aviation, travel, and tourism industries.
The users are incentivized in the form of tokens for completing travel-related activities, such as booking a trip to an unexplored area, sharing a review of their experience on the website, or even booking a trip. It provides the customer with a simple and transparent way to earn rewards, allows them to easily track their progress, and redeem tokens for a range of products and services. In addition, it rewards travelers with existing flights, accommodation, and other hospitality experiences.
An example of the travel-to-earn model is Platform; it provides customers with a level of connection and engagement that was not possible earlier. It replaces traditional loyalty points or miles with crypto tokens. By tokenizing rewards, customers enjoy a more personalized and tailored travel experience. It allows the customers to earn tokens based on a percentage of the value of their purchases within their network. These tokens are transferred directly from the partner's wallet to the customer's wallet, and the transactions are recorded in the blockchain.
7. Share-to-Earn
This incentive model is being used by any project who wants to attract new users to the project.
Users are incentivized in the form of rewards for sharing information about that project or product with others. Interested users can sign up with the platform and receive a unique referral link or code that can be shared with their wide circle of friends and acquaintances. In addition, the referrer will be eligible for rewards in the form of crypto when the link is being used for signing up.
An example of share-to-earn model is being used in Crypto.com. It offers referral and affiliate programs for users who can potentially invite more users to the platform. When an invitee joins and trades on the exchange, both you and the invitee are eligible for a reward. On top of this, the referrer will get a commission on trading fees charged to the invitee.
8. Wellness-to-Earn
This concept is shaping up the fitness and health industry.
It rewards the user for investing and improving their well-being, particularly in mental health. This is a version of move-to-earn.
Users have to do light activities such as meditation and mindfulness, mental health support, and quality sleep. These apps track the participant's progress through a smartphone, fitness tracker, or smartwatch. They incentivize the users to continue using the app and engage in mindfulness practices. It rewards the users with platform tokens and other perks, such as discounts at wellness stores. They also penalize the users for engaging in unhealthy behaviors such as smoking or consuming too much alcohol. Users are eligible for discounts if they hold a certain number of tokens. Donations can be accepted through crypto, that attracts the young and tech-savvy donor base and allows for transparent donation tracking.
An example of wellness to earn is Metatate, which promotes mental health awareness by incentivizing daily Meditation. This encourages the users to uplift their minds, body, and spirit each day. Users are incentivized with the app's native Token, which can be exchanged for rewards redeemed with merchandise partners, Meditation and wellness items, technology items, and exclusive experiences.
Pokemon has announced the release of Pokemon Sleep in the Summer of 2023. This game rewards players with a token to get a good night's sleep. To play, users need to place smartphones by their pillows, which enables the app to analyze data about the quality of their sleep time routine. The player's sleep style will be classified into snoozing, dozing, and slumbering. The longer a player sleeps, the higher their score will be, and more Pokemon will appear.
Projects without incentive design but still successful
Though incentives are an important factor for a crypto project's success, few successful projects in the crypto space, including the below-mentioned projects, did not rely heavily on incentive design.
1. Stellar (XLM)
Stellar is designed to facilitate cross-border payments and other financial transactions. There are no special incentives for using or holding Stellar except for a small transaction fee for network usage. However, the project has gained traction due to its financial inclusion and partnership with World Bank and IBM.
2. Cardano (ADA)
Cardano is the first blockchain platform that was built, focusing on research and development, academic peer review, and layer architecture. The platform's success is mainly because of the research-first approach, where new features and updates are thoroughly researched and peer-reviewed before implementing in the platform. This witnessed a well-designed and stable platform focussed on solving real-world problems.
Key Takeaway
Undoubtedly, blockchain has experienced significant expansion and appeal in recent years. As a novice investor, having understood that incentives are powerful tools in a decentralized economy, instead of asking about a token, you can critically evaluate the real incentive behind the existence of a token. The project has to encourage the desired behavior of stakeholders such as investors, users, and miners by incentive design resulting in success and growth. However, it is equally essential to be aware that creating an effective incentive system depends on the community of individuals whose behavior needs to be oriented.
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Priya M
Priya is the CFO of BlockSurvey. A year ago she made a career change and left the traditional finance world as a Chartered Accountant to work full time at BlockSurvey. She is specializing in “Tokenomics” in Web 3 space.