What Charlie Munger, cobras, and cash grabs can teach us about incentives in crypto
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Before we begin, a disclaimer — nothing in this piece should be construed as financial advice. With that, let’s dive in.
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Charlie Munger, business partner to Warren Buffet, and one of the most successful businessmen of all time once said this:
“Show me the incentive and I will show you the outcome.”
What does he mean by that?
He’s saying that the things happening around you aren’t accidents. They arise from an underlying incentive mechanism. And if you understand the mechanism, you’ll understand the result.
Incentives come in many forms. Simply put, they’re things that motivate you to do, or not do, something.
Speed limits and the possibility of getting a ticket incentivize people to not drive too fast.
Bonuses at work incentivize you to work a bit harder to hit some stretch goal. Even getting paid your salary is an incentive to sit down and do your work each day.
Sometimes incentives are well designed, but oftentimes they lead to bad or unexpected outcomes.
In economics, this is called the cobra effect. The term was originally coined based on a tragic miscalculation that happened in India under British rule.
The British government was concerned about the number of venomous cobras in Delhi, so they began offering a bounty for every dead cobra. Initially, this was a successful strategy and a large number of snakes were killed for the reward. But eventually, enterprising people began to breed cobras for money. When the government finally caught on to the scheme, they shut down the reward program. This caused the cobra breeders to set their now-worthless snakes free and the wild cobra population increased significantly.
Incentives are incredibly powerful. If you deeply understand how to design them, you can generate amazing outcomes. But if you don’t, you can cause tragic ones.
Incentives in crypto
In crypto, incentives can be programmed through tokens.
In other words, someone wants to get people to do specific things to get specific outcomes and they attempt to do so by giving them tokens.
In last week’s post about why blockchains are digital countries, we wrote about how “Satoshi was the first pilgrim who ventured out to form a new country called Bitcoin.”
Satoshi wanted a decentralized digital currency to exist, but couldn’t do it alone since that would quite literally be the opposite of decentralized. In order to securely run the network, other participants needed to help. And for them to go out of their way to help, they needed to be incentivized to do so. Thus, Bitcoin mining became the first example of programmable incentives in crypto.
There are countless other examples.
Someone wants there to be a decentralized internet. If you run hardware that helps broadcast independent hotspots they’ll give you a cryptocurrency called Helium.
Someone wants there to be digital forever storage. If you help store data safely they’ll give you a cryptocurrency called Arweave.
The patterns are always similar: Someone wants a thing to exist in the world, so they distribute tokens to incentivize behaviors that lead to the desired outcome. And ultimately those tokens will have value if the market believes what they’re doing is worthwhile.
It’s a simple concept with huge implications.
You can give people digital tokens to do things you want them to do to create outcomes that you want to create, all without spending a dollar, a euro, or any traditional currency. Tokens are a new form of money essentially created out of thin air. But that money will only be valuable if the underlying activities this new type of money is incentivizing are deemed valuable.
This leads to the saying, “In web2 money buys distribution. In web3, money is distribution.”
The dark side of incentives in crypto
There’s no doubt that with the amount of money that flows within the crypto space, bad actors are incentivized to, well, act badly. If they’re technically savvy, they can create programmable incentives that take advantage of people or even exploit poorly designed systems.
One of the most common scams are Ponzi schemes.
Back in 2017, BitConnect raised billions of dollars from investors as part of an ICO (initial coin offering). The protocol was supposed to pay out annual interest earnings through its BCC token by using investors’ money to trade on the volatility of crypto exchange markets. Investors who referred others were supposed to get even more earnings. The price of BCC initially soared to a high of $500. The problem was, they weren’t doing any trading at all and the promised yield was unsustainable, requiring money from new investors to pay out earlier investors—a classic Ponzi scheme set up. Eventually, investors and lawmakers caught on to the scheme. In January 2018, the BitConnect platform was shut down, the founders disappeared, and the token price plummeted to $1.00 in a matter of days as investors attempted to salvage some of their funds. All told, the BitConnect founders walked away with approximately $2.4 billion.
It’s easy to read about stories like these and think web3 has a monopoly on scams. But scams are everywhere in our modern, connected world. You’ve probably received a call about an expired car warranty that never existed. Or been emailed by “Nigerian princes” who desperately need your money.
Identity theft scams amount to over $50 billion dollars a year. And that’s not even the biggest fraud category:
“The National Heath Care Anti-Fraud Association estimates conservatively that health care fraud costs the nation about $68 billion annually — about 3 percent of the nation's $2.26 trillion in health care spending. Other estimates range as high as 10 percent of annual health care expenditure, or $230 billion.” — source: Blue Cross Blue Shield
Scams in crypto pale by comparison. The space is messy now, but it will get better—every day we are creating better systems and technologies to protect people.
In the meantime, when you’re looking into a crypto project, think about what the programmable incentives are attempting to get you to do. This is your first step towards understanding crypto more deeply.
Other Recommended Reads and Listens
Does Crypto Have Any Good Use Cases?
Nat Eliason jumps into the use cases debate and explains how we should think about it differently than the mobile revolution
Zooko on privacy and crypto history
Cobie and Ledger host crypto OG Zooko Wilcox-O’Hearn, co-creator of Zcash and early crypto advocate, on the UpOnly podcast
Anonymous writer Aylo has been critical of Solana in the past but wrote this deep dive to reassess their bias
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