Understanding Blockchain Economics

The blockchain economics is easy to understand if you look at it as a business. Blockchain has costs to operate and must have sufficient revenue to cover them. To do this, it needs users who pay transaction fees. In the article, we will show what market mechanisms will affect the success of Cardano, but basically, this applies to all blockchains.

Reward from Blockchain

When Bitcoin was created, anyone could mine BTC on their computer. However, miners did not get money for free, but for the resources they provided to Bitcoin. This defines for us one of the basic relationships between the blockchain and a group of volunteers who, for a financial reward, provide the necessary resources to the blockchain.

It can be said that volunteers work for the network for a reward in the form of cryptocurrencies. They cover the costs associated with operating the network, which they will only do if the activity remains profitable for them. This means that their revenue must be higher than their costs.

Let's see where the costs come from.

Blockchain networks incur costs from the consumption of computational resources, such as electricity, hardware, and bandwidth. These resources are used to process transactions, execute smart contracts, ensure the integrity and immutability of the ledger through network consensus, etc. The cost of these resources depends on the design of consensus, the number of people who use the network, and the services that people use. The more people using the network, the higher the operating costs can be.

Human capital must be added to costs. For example, in the Cardano network, there may be several hundred pool operators who invest a large amount of time in running the pools. The largest publicly traded Bitcoin mining companies have several hundred employees (the largest, Canaan, has 540 employees). These are also costs that are covered by blockchain networks.

Where does the money come from to cover the costs of blockchains?

Some networks, including Cardano and Bitcoin, have a cap on the number of coins that will ever be released into circulation. Cardano has a reserve from which new ADA coins are released every 5 days to be used for staking rewards. Bitcoin does something similar in every block mined. Reserves are shrinking in both cases and trending towards 0.

To be economically sustainable in the long term, blockchains need to have revenue.

Users pay transaction fees, which is essentially the only source of income for blockchains. Some projects have infinite coin inflation, which can provide income, but it reduces the scarcity of coins as their amount in circulation is constantly increasing.

Because we don't have long-term experience with blockchains, we don't know if it's better to have more coins with a potentially lower market value, or fewer coins with a potentially higher market value. Market value is not only influenced by scarcity but mainly by demand.

Network expenses, which blockchains currently cover largely with coins from the reserve, must gradually be replaced by transaction fees from users.

If this does not happen, the blockchain will have nothing to cover the costs of its operation. Important functions and properties of blockchains will be degraded, which may lead to their gradual demise.

Blockchain has some economic aspects that can be analyzed using the concepts of revenue, cost, users, and employees. Let's see what blockchain networks need to survive the next decades when they cannot rely on coins in reserves.

Cash Flow

Cash flow in blockchain can be defined as the difference between the total inflows and outflows of a cryptocurrency over a period of time for a given network participant.

For example, a Bitcoin miner’s cash flow can be calculated by subtracting the cost of electricity and hardware from the revenue of block rewards. In the case of Cardano, the same can be done by subtracting the cost of running the pool from staking rewards. ADA stakers have almost zero costs. By delegating ADA coins to the chosen pool, they participate in the decentralization and security of the network. By doing so, they ensure an important property of the network so they deserve a reward. Staking rewards are essentially profit for them.

It is important to realize that the participants are not only people but above all the blockchain network itself. Blockchain offers services to users and they pay for them. Blockchain protocol generates income and pays out rewards.

Cash flow in blockchain can be used to measure the profitability and sustainability of a network participant's activity and also the blockchain itself. In other words, if individual participants are not profitable in the long term, the network cannot provide quality services. If the network does not provide quality services, it cannot earn transaction fees. Do you see the cycle in this?

User fees are distributed by the network to volunteers who work for the network and provide resources to it. The more fees the network collects, the more there is for rewards. This increases the hash rate for Bitcoin (higher security) or staking rewards in the case of Cardano.

Principles of Blockchain Network Success

Blockchain is similar to a business in terms of costs and revenues. Blockchain must be attractive, efficient, and useful to people. The utility generates profit. Profit determines success and ensures longevity. Blockchain is only able to cover costs if it earns money for it. This is one of the basic principles.

Utility -> Profitability -> Longevity

Only those blockchains that will be successful, i.e. that people will actively use, will survive in the long term. What do people find useful in the context of blockchain? It is mostly based on the characteristics of decentralization, high security, global availability, etc. We can say that success depends on utilities.

Success = Utility

The success of global companies is linked to a large network effect. The more users use a given network or product, the more successful the company is (and of course also profitable). Achieving a high network effect is conditioned by utility.

A large network effect can be obtained through narrative or (and) technological dominance in a specific area. People tend to get the best services for the least fees. We can say that utilities stem from efficiency.

Utility = Narrative + Efficiency

We can measure efficiency, for example, through scalability. Blockchains fundamentally differ in how quickly, securely, for what fee, and, above all, with what decentralization they are able to process a transaction.

Efficiency = Scalability

In the blockchain industry, there is a narrative associated with the belief that blockchain will succeed in disrupting money or financial services. I personally see it as two different things. Bitcoin's mission is more related to replacing fiat currencies or gold. Smart contract platforms like Cardano are more oriented towards the disruption of financial services through DeFi. Many would add that ADA coins, however, can be seen similarly to BTC coins. It's not that important for this article.

On blockchain technology, people value decentralization, security, scalability, smart contracts, etc. We can say that these are or provide utilities.

Utility = Decentralization + Security + Scalability + DeFi + Tokens

What we don't know, and what communities disagree on, is how important individual utilities are. Some argue that the most important of all is decentralization. Others say it's security provided through PoW. Decentralization and security are rather abstract concepts for people that they do not understand very well. They perceive usefulness through direct user experience, i.e. through the speed of transactions, fees, and services (DeFi), etc.

The success of cryptocurrencies will be primarily based on adoption and network effect. Unfortunately, we do not even know for sure whether the dominant aspect is the narrative (store of value, disruptive technology, etc.) or rather the technology (transfer of value, censorship resistance, DeFi, NFTs, tokenization, etc.). However, we know for sure that no blockchain will succeed without adoption.

Success = Adoption + Network Effect

What is important is that people start to trust the systems. Disruption will only happen if people don't lose money in DeFi and have confidence that the networks are reliable and secure. Transactions must be settled fast and fees cannot be too volatile. The longer a network exists and the longer people use it, the more newcomers come to trust it. Longevity is especially important for narratives.

Trust = Security + Reliability + Longevity

Trust is important to success, so we can expand our definition of success.

Success = Utility + Trust

In the context of the article, we are mainly interested in the economic model of blockchain networks. This is mainly connected with the ability to generate revenue. As we already know, revenue is linked to utility, network effect, and adoption, as this brings transaction fees. It can also be said that profit comes from success.

Profit = Utility + Trust

Just like for companies, blockchain must have higher revenue than cost.

Revenue >= Cost

If we neglect the reserve, it must be true that the network collects more fees than what it pays out in rewards.

Fees >= Rewards

If we transfer this to what was described above, we will find that the network will be profitable in the long term, i.e. economically sustainable, if it is useful, people will trust it and it will have a great network effect.

Utility + Trust + Network Effect >= Rewards

An interesting aspect is the network effect. This can be connected to direct interaction between users on the network or to a narrative. The difference is that interaction through transactions is a service from which the blockchain earns fees. Narratives will not feed the blockchain network, but they can raise the market value of the coins, which can help temporarily while the coins are in reserve.

Blockchain networks will only survive if they (or teams) manage to constantly reduce the costs of their operation (which is a challenge, especially for Proof-of-Work networks) and deliver utilities that will be attractive enough for people to start using them on a large scale. For this to happen, blockchains need to scale well in the first place to earn fees. If there are second layers in the ecosystem that people can jump to, that can be a problem. The fees will go to the operators of the second layers at the expense of the blockchain. This can destroy blockchains economically in the long run.

For Cardano to survive in the long term, the following must apply (neglecting the reserve and the Cardano treasury).

Fees >= Cost of SPOs + staking rewards

In the case of Bitcoin, it is similar.

Fees >= Cost of miners

From the point of view of the expenses associated with the security budget, it looks like this (assuming that security expenses are not allowed to decrease). This time, let's put a reserve into the equation.

Reserve + Fees >= Security budget

It is interesting how the design of PoW and PoS networks differs. In the case of Bitcoin, rewards go to miners who do not have to operate nodes (pools). Primarily hardware and electricity costs are covered. It is an exaggeration to say that Bitcoin only pays for security. It can be difficult to ensure a sufficient number of nodes in the network whose resources could be used, as there are no economic incentives for this.

Cardano pays operators for operating nodes (pools), whose resources can be used for transaction transmission (scalability) and execution of smart contracts. Cardano pays for resources and decentralization. It is possible to incentivize the addition of nodes to the network and use their resources to achieve higher scalability. Security is largely ensured through the distribution of coins (and staking rewards).

Conclusion

Most of all, blockchain networks need adoption. I am afraid that technologically blockchains are still not ready for this. Their scalability is low, which has a direct impact on DeFi as well. Expensive fees, unreliability, and, on top of that, frequent hacks and scams discourage people from adopting. Without network adoption, they will not get fees and without them sooner or later they will disappear. We still have time, because there are still enough coins in the reserves, but we have to think about the fact that one day it has to be fees from which miners and stakers will be paid. In 10 years, it is possible to make fundamental technological progress, which is necessary for the success of blockchains.