In this article, we use the word blockchain as a synonym for a global public permissionless decentralized network.

Consensus and incentives

The hearth of every blockchain is a consensus algorithm. From a technological point of view, there must be more distributed nodes in the network that are responsible for making a consensus. Network consensus serves as a means for processing new transactions or executing smart contracts. At this point, technology meets with the economic interests of participants. To consider the network as decentralized one there must be economic motivation to operate a node. The more independent entities operate a node the better for decentralization. The network needs to attract participants from all corners of the world who would be willing to perform a specific function in the desired standard. The incentive mechanism must motivate people to do so and, at the same time, motivate to honest behavior aligned with the network interests. Properly designed consensus mechanism must ensure at least the following basic requirements:

1. Economically motivate people to operate a node in the required quality. You can consider that as a reward mechanism. There might be other than just economic incentives, like idealism, morality, or desire to “do the right thing”. However, economic incentives are the most important ones.
2. Distract from dishonest behavior. You can consider that as a punishment mechanism. Public networks will always face attacks and there might be people willing to lose some money in order to destroy or discredit the network.
3. Be egalitarian as much as possible.

The node operators are rewarded by network native coins that have certain fiat value. In most cases, the reward consists of network subsidy coins and fees. Fees are paid by users for using the network. It can be a transaction fee or fee for deploying a smart contract. Thus users of the network indirectly pay to node operators for their service via a consensus mechanism. All fees are collected by the network and distributed later in a defined proportion to node operators. Some small part of fees might be kept by the network for a project treassury.

At this point, the economic model of a project gets into play since it can gradually release or generate new coins that are used by the network for rewarding. A given project might be a deflationary or inflationary monetary system. In the case of the deflationary system, there is a pre-programmed model in which a certain amount of coins is regularly created and released by protocol. The amount of newly created coins is gradually decreased (for example, by a halving process) heading towards 0. The logic behind is that at the beginning of the project existence it is expected less interest in using the network so there are fewer transactions. Thus transaction fees are not able to cover the needed amount of rewards for node operators so the significantly greater part of the reward consists of network subsidy — the newly created coins. As new users come and start using the protocol there are more and more transactions and, in some cases, more deployed smart contracts so fees are gradually able to cover the rewards. The network subsidy can be gradually decreasing as the amount of collected fees increase. You can see the example in the picture below.

In the inflation model, new coins are created forever so the network cannot rely only on utility fees. However, inflation devalues existing coins so the inflation rate must be carefully calculated if coins value are to hold or even rise.

Different projects often try to fix the economic model at the beginning. It is questionable whether that is smart doing so without the possibility to predict the future and knowing how the adoption, network usage, and coin price evolves or what level of security will be needed. As a consequence, we have already seen some changes in the economic models or hot debates about the future of projects.

Fix the monetary system in advance might not be the best idea. What if the assumptions made at the beginning proves to be wrong later? What if, after a few years of protocol existence, the adoption is unexpectedly low, the majority of coins have been released sitting on a few addresses, and it is not possible to collect an expected number of fees? The project can get into trouble since blockchain security can depend on the price of coins, collected fees, or distribution of coins among users.

Collecting a sufficient amount of fees for rewarding means that there is a high number of users. In other words, the project must be adopted by people and they have to use it on a daily basis. To achieve that the protocol must have resolved scalability and offer some interesting features that people would want to use. It is not easy and at the moment the adoption is very low and most people are just price speculators. It is not what would be healthy from the point of an incentive mechanism. The holding of coins could increase their fiat value, however, without a sufficient number of transactions the network might strive to collect enough fees.