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Understanding Digital Scarcity

Published 11.12.2023

Through mining, only 21M of BTC coins will be released into circulation by the Bitcoin protocol. BTC coins are digitally scarce. However, this feature is not unique to Bitcoin. Creating digital scarcity is an easy concept to copy. Through staking, Cardano will release only 45B of ADA coins into circulation. Also, ADA coins are digitally scarce. What about tokens and NFTs? In this article, we will explain what digital scarcity is and what it depends on.

What is digital scarcity?

Digital scarcity refers to the verifiable and enforced limitation of a digital asset’s supply through the use of blockchain technology, which relies on distributed software and decentralization. This ensures that the asset cannot be replicated or counterfeited, maintaining its value and uniqueness.

Digital scarcity can be likened to a form of monetary policy because blockchain controls the supply of native coins.

However, unlike traditional monetary policy, which is managed by central banks, digital scarcity is governed by decentralized protocols and immutable code on the blockchain. This means that the supply of digital currencies is not subject to the discretion of any single authority or institution.

The project team defined the monetary policy rules and wrote them into the source code. From the source code, a client is created that can be operated by anyone interested in the project. That is, everyone who is interested in the rules not changing.

Rules can define the maximum number of coins that will be released into circulation, conditions for release, and other details. Teams can decide if the number of coins will be capped (as in the case of Cardano and Bitcoin) or if infinite inflation will be introduced (Ethereum). Coin burning may be introduced, so the number of coins may decrease over time. It is even possible to combine several rules, for example, to have infinite inflation but to burn fees. In such a case, it can be difficult to predict what the supply will be in the following years.

Digital scarcity is not a feature that only native protocol coins (ADA, BTC, etc.) can have, but it also applies to tokens and non-fungible tokens (NFTs).

Tokens that are minted on a blockchain can also exhibit digital scarcity. The scarcity of these tokens is enforced by the blockchain's protocol and the rules defined in the smart contracts (or minting scripts) used to mint the tokens.

Cardano's native assets feature unique identifiers such as a policy ID, which ensures that each token is distinguishable and cannot be duplicated. The policy ID is attached permanently to the asset, and the policy script defines characteristics like who can mint tokens and when those actions can be made. This creates a system where the supply of tokens can be controlled and verified, contributing to their scarcity.

Additionally, NFTs on blockchains redefine digital scarcity by being verifiably unique and scarce. When an NFT is minted, it is often done in a limited quantity, and this scarcity is explicitly stated during the minting process. The history of an NFT can be authenticated, and it cannot be duplicated, which adds to its value.

How is NFT different from a common image on the Internet?

An image stored on a computer or shared over the internet can be copied multiple times without any loss of fidelity, leading to an unlimited supply.

In such a case, it is not possible to say unequivocally which image is original (the one first created by the author) and which are just copies. Without a third party overseeing copyright, it is not possible to easily determine the owner of an image (copyright owner) on the Internet, because the owner can be anyone who currently has it saved on their computer.

This is fundamentally different from blockchain-based digital assets that cannot be duplicated due to the cryptographic principles and network consensus that underpin blockchain technology.

Each digital asset on a blockchain is unique and cannot be replicated, creating a digital scarcity similar to the scarcity of physical goods.

It is important to distinguish between native coins and tokens in terms of control over rules. In the case of native coins, the rules are controlled by the team along with those community members who run the client on their computer. Changing the rules is complicated and requires the agreement of the majority.

In the case of tokens (including NFTs), the rules are defined (and often controlled) by the entity minting the tokens. Blockchain can protect tokens against the creation of duplicates and counterfeits, but the minting and burning of them can remain under the control of a single person or team.

What Does Digital Scarcity Depend On?

The existence of digitally scarce coins depends on many factors. The ability to create and sustain digital scarcity is not possible without the internet, computers, and electricity. The existence of digitally scarce coins and tokens directly depends on other technologies and resources. It is not possible to digitally create scarce coins whose existence can be guaranteed forever.

The existence of coins and tokens is based on cryptography. Keeping digital coins in your wallet (so-called self-custody) and being able to spend them requires the ability to keep a cryptographic secret (passphrase). Even if you hold the coins on a centralized exchange, someone else has to create a wallet, generate a passphrase, and hold the coins for you.

Although we are talking about the digital scarcity of coins, in essence, we are talking about a record in a distributed database (blockchain, ledger) and the ability to create a new record. Coins are just numbers associated with blockchain addresses.

The ability of the blockchain to prevent someone from creating new coins out of thin air (changing the monetary policy of the project) is based on the ability to prevent the creation of an invalid entry in the ledger (an invalid transaction). As you'll see below, another safeguard is the impossibility of forcing a change in the source code without majority approval.

One essential feature of digital scarcity follows from the above.

Digital scarcity is dependent on the ability to verify the number of coins in circulation. This verification is made possible by the blockchain's transparent and immutable ledger, which records all transactions and the creation of new coins. Anyone can audit the blockchain to confirm the total supply and circulation of coins at any given time. This transparency and verifiability are what make digital assets scarce and distinguish them from easily replicable digital files like images.

The digital scarcity of ADA coins (and all other tokens) is dependent on the ability of the Cardano protocol to mint new blocks at regular intervals, i.e. on the consensus of the network. This requires people (mainly block producers) to install clients on their computers and pay costs for internet, electricity, etc.

The digital scarcity of ADA coins is thus dependent on the long-term economic sustainability of the protocol (security budget) and the ability to withstand external (hackers, governments, etc.) and internal (teams, block producers, etc.) attacks.

The security budget phenomenon is too broad to be covered in this article. However, it is extremely important because people expect that digitally scarce coins will exist for several decades and that the rules will not change. The existence of coins is conditioned by many external factors, and the immutability of the rules is only an assumption based on decentralization and a social contract between actors (who may have different preferences and interests).

What is the difference between the digital scarcity of ADA and BTC coins? In both cases, these are only numbers. What is fundamentally different is not coins, but everything related to the Cardano and Bitcoin protocols. Projects differ in decentralization, scalability, security, and many other features. As a coin owner, you perceive the difference in the settlement of transactions, in fees, and the possibility to swap tokens with each other, or use DeFi.

Users interact with the protocol if they want to use the coins. The quality of coins (visible difference) can be perceived by users mainly through the utilities of the protocol rather than through the properties of the number in the ledger. Differences can be subjective and objective. Objectively, Cardano can transfer digital assets (coins) faster and cheaper than Bitcoin. Subjectively, however, users may perceive Bitcoin as a more secure protocol due to the PoW consensus.

Discussing the properties of protocols (network consensuses) is beyond the scope of this article. However, it is important to know that the properties of the protocol affect the perception of coins.

Network protocols are just software that is always maintained by teams. So what is the relationship between teams and holders of digital assets? It's a kind of social contract.

A social contract refers to the unwritten agreement or set of expectations that exists between the community of coin holders and the development team behind a cryptocurrency project. It encompasses the mutual understanding and trust that the team will act in the best interests of the community. In return, the community is expected to support the project through investment, promotion, and participation.

This social contract is not often a formal contract but rather a collective belief in the principles, goals, and governance of the cryptocurrency.

Unlike Bitcoin, the Cardano project seeks a formalized form of governance. The goal is to clearly define the governance structure, rights and obligations of the team, the ability to decide on governance changes, who should be a team member, etc.

The social contract includes expectations such as transparency, integrity, fairness, responsiveness, etc.

It is important to note that the source code (software) is constantly changing. The one who can change the code, but mainly ensure that the client (containing the changes) becomes dominant in the network, has enormous power over the project (thus also over digital scarcity).

In addition to the team, important stakeholders (stakers, miners) and block producers (pool operators, validators, etc.) are also important actors.

Anyone in the world can theoretically fork the source code and create an alternative client (potentially with different rules). It is much more difficult to convince people to install this version on their computers.

A team cannot arbitrarily change the rules without getting majority approval from the community. Block producer nodes and big stakeholders are especially important, as they decide on the longest chain. Cardano and Bitcoin use the Nakamoto consensus, so the chain that is the longest is the right one. Creating the longest chain requires having the most resources (ADA coins, hash rate).

In essence, the social contract is a reflection of the community's culture and the values that guide the project. It plays a crucial role in the long-term viability and growth of a cryptocurrency, as it directly influences the level of community engagement and support. The digital scarcity of coins is also largely dependent on the decentralization and governance of the project.

As you can see, digital scarcity is a property dependent on many factors. Blockchain networks are very robust and resistant to change. Still, it's just technology with all the good and bad that goes with it.

Digital Scarcity Is No Guarantee Of Demand

Digital scarcity is influenced by demand in a way that is similar to traditional scarce resources. When a digital asset is in high demand but has a limited supply, its value tends to increase. This is based on the economic principle of scarcity, which states that the rarer or more difficult it is to obtain a product, the more valuable it becomes.

If a particular cryptocurrency is highly sought after, but there is a cap on its total supply, the price of the cryptocurrency is likely to rise as more people compete to acquire it. This is because the perceived value of the digital asset increases due to its scarcity and the high demand for it.

However, the limited number of coins is not necessarily the reason for the increasing demand. All the more so when the digital scarcity of coins is easy to replicate. There are thousands of cryptocurrencies with different characteristics. People may have different preferences and interests when choosing to buy cryptocurrency.

Although the maximum supply of coins is fixed and the monetary policy (gradually decreasing amount of coins released into circulation) is immutable, the demand is very volatile.

Demand may fluctuate due to trends, financial market conditions, innovation, increasing adoption, important partnerships, real-world usage, speculation, expectations, high competition between projects, rivalry between communities, etc.

Is digital scarcity useful in itself?

This is a very complex question and it may depend on what can be done with coins or tokens and how many people will use the given utility. This topic touches on central banks, money, copyright protection, authenticity, privacy, fairness, transparency, inclusiveness, and access to financial services. The potential is huge, but utilization is still low.

If more and more people become convinced that digital coins can hold value, their value will increase because demand will increase. However, the reverse is also true. As adoption (demand) decreases, the market value of coins will decrease.

Coins in the form of money or store of value will only be useful if their value is stable or slightly increasing over time. Therefore, stability is conditioned by permanent demand.

It is important to mention that despite the great potential of digital scarcity, wider use is dependent on the technological maturity of blockchain projects. From my point of view, digital scarcity is dependent on other utilities such as fast verification, fast transfer, ease of installation of wallets, and protection against loss of coins and tokens. The utility of coins and tokens grows significantly with programmability (smart contracts). This industry is still in its infancy.

The increasing utility of protocols and the increasing network effect will very likely be reflected in the demand for coins. The utility will grow with technological innovation.

Remember, the digital scarcity of coins is not a guarantee of stability of value. This may change in the future with a higher adoption.

Conclusion

The digital scarcity of coins and tokens, along with the ability to easily verify ownership, send value, and prevent the creation of duplicates and counterfeits, is a technology that has the potential to greatly enhance the capabilities of the Internet.

The Internet has disrupted society. Blockchain is a disruptive technology with similar potential. The success of this technology is dependent on adoption, more precisely, the ability of people to learn to use self-custody wallets and take advantage of all possible financial and social applications that will motivate them to use the blockchain.

At the moment, it can be said that digital scarcity is a big innovation that we are not yet able to fully use in society (although the use is slowly growing).

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