Skin in the Game
Creating alignment of incentives, usually by creating skin in the game, is a challenging task for any mechanism designer. Here, we dive into risk asymmetry and give a couple of examples of networks with skin in the game.
Risk asymmetry is the concept where the actor who bears the potential upside for an action is not the same as the actor who bears the potential downside of the same action. This is particularly nefarious when the actor with the decision making ability is the actor who bears only the upside risk.
A commonly cited example in the crypto-ecosystem is the sub-prime mortgage fiasco of the 00s. Large banks generated phenomenal profits from making risky decisions, but when the house of cards came crashing down, governments and tax payers ended up paying the downside, through bailouts. Of course, this doesn’t only apply in financial markets, it can apply in other arenas too – for example, an incentive scheme where a CEO owns share options but not shares might mean she has an incentive to take more risks, as she only bears the potential upsides.
This risk asymmetry can be seen as one of the fundamental flaws of the incumbent financial system, and one of the biggest challenges of designing decentralised networks is in creating incentive structures which network participants cannot arbitrarily unwind their upside and downside risks – the network participants are said to have skin in the game.
Skin-in-the-Game in Bitcoin
Bitcoin is a great example of how having skin in the game helps to ensure good participant behaviour. In order to efficiently mine bitcoin, a potential miners needs to invest a lot of money in specialised mining hardware – ASICs. ASICs are expensive hardware, and they’re good for only one thing; mining bitcoin (and I guess mining a few similar cryptocurrencies.) The value of the ASIC comes from the ability to mine bitcoin. If bitcoin disappeared, all the specialised ASICs would simply be expensive space heaters.
This high cost is a large part of the alignment of miners incentives. Sure, they earn bitcoin for mining, but if there were no cost to launching an attack against the network, they could do so without penalty with huge potential payoffs. At the moment, they have skin in the game as a result of their hardware purchase. Successfully launching an attack against bitcoin would massively devalue their expensive hardware. Their incentives are aligned.
Skin-in-the-Game in Juri
You can’t mine Juri tokens, and you won’t need specialised hardware to join our oracle network, so we need to take a slightly different approach to creating skin in the game. Juri tokens are work tokens, which means they give the holder the right to do work on the network (read more about work tokens on this post). In order to actually do work, you need to stake your tokens through an Ethereum smart contact, and then you can be assigned work and receive network fees. In this paradigm your skin in the game comes from the staked tokens. Bad behaviours on the network will be punished by losses in stake (for example, being offline after declaring you’ll be online to do work.) Additionally, successful network attacks will cause Juri tokens to be devalued. As the chance of a successful network attack is tied to the total stake of the attacker(s), so attempting a large scale attack requires a large upfront investment with a chance of losing the entire value, if successful.
So we can see that having an alignment of incentives is essential to ensuring good behaviour, be that in a blockchain, a major financial market, or in a corporation. Unfortunately, creating good alignment is challenging, and if it isn’t approached with the right care, can end up incentivising perverse behaviours.