Tokenomics and blockchain fragmentation
Summary
Focus
Money is a coordination device underpinned by strong network effects. The decentralisation agenda of public permissionless blockchains promises to replicate this coordination function without a central authority. In this paper, I examine whether blockchain-based systems can sustain the network effects that give money its social value, or whether the economics of decentralised consensus lead to fragmentation of the monetary landscape.
Contribution
I develop a formal economic model of blockchain consensus rooted in the theory of global games. Validators face strategic uncertainty about the extent to which other validators provide governance efforts sufficient to support the chain. The model derives a unique equilibrium that determines the minimum rewards validators require, which in turn determines the capacity constraints and congestion rents borne by users. The framework yields closed-form solutions for blockchain capacity and explains the proliferation of competing chains as a structural consequence of decentralised consensus.
Findings
The cost of decentralised consensus is irreducible: the more secure the blockchain is, the higher the rewards needed to sustain validator participation and the greater the congestion costs borne by users. New blockchains with less stringent consensus thresholds enter to serve users priced out of incumbent chains, producing fragmentation rather than consolidation. The analysis provides lessons for the design of future monetary infrastructure.
Abstract
Money is a coordination device underpinned by strong network effects: the more others accept a form of money, the more I wish to adopt it too. The decentralisation agenda of public permissionless blockchains undercuts these network effects and leads to fragmentation of the monetary landscape. Validators who maintain the blockchain need to be rewarded to play their role with the necessary reward increasing in the degree of dependence on other validators' actions to sustain consensus. Since these rewards must ultimately be borne by users through congestion rents, capacity constraints are a feature, not a bug, especially for blockchains with more stringent standards for consensus. New blockchains with less stringent thresholds for consensus enter the market to serve users priced out of incumbent chains. The resulting fragmentation undercuts the very network effects that give money its social value. Stablecoins inherit this fragmentation from the blockchains on which they reside. The analysis has broader implications for the future of the monetary system.
JEL Classification: D82, E42, G23, L14, O33
Keywords: blockchain, tokenomics, network effects, stablecoins, decentralised consensus, global games, monetary system, fragmentation
