Tail risk, profit models, and sustainability
Understanding how to create pricing models and resilient economies around smart contracts.
It is expensive to be delegated the consequences of a tail event. In fact, in the worst case scenario, it is boundlessly expensive. This creates the need for the delegate to play the game of profit maximization to manage this risk in order to increase the chances of prolonged sustainability.
Take traditional finance for instance. If a bank’s database gets hacked and its account balances become corrupted, chaos would unfold as the bank’s customers demand their hard earned money back in full. Due to this exceptional circumstance, the bank would suffer the consequences of this responsibility letdown, and in exchange under normal conditions they can manipulate the deposited money to optimize for their profit — a significant portion of which may be used for insurance in the case of a tail event such as a hack. Profit is also used to hire excellent employees to create systems that are highly unlikely to misbehave. Banks own the risk, and with it they have the opportunity to own the reward.
From this example, it makes sense to me that the opportunity to pursue profit should be intrinsically tied to bearing the responsibility of tail event consequences. In turn, tail events should decimate organizations that haven’t structured their systems to be resilient to them, or haven’t assembled a team of people who can build and manage these systems. Given the inevitability of tail events, profit maximization seems to me a reasonable approach to sustainability over time assuming a system where no organization is too big to fail — an assumption we’ve clearly invalidated.
Now take decentralized finance, where there are no banks and people manage their own assets via the internet under cryptographic assurances. If, for some odd reason, the underlying blockchain database became irreversibly screwed up, there’s no one to give you your money back. People therefor assume their own tail risk, and hence must manage their dealings to account for unfortunate scenarios. Under normal conditions however, they can manipulate their own assets using decentralized web applications to optimize for their own profit. The people own the risk and the reward. An expectation by folks to hold decentralized protocol developers accountable for their own tail event consequences doesn’t make much more than emotional sense.
It is nonetheless true that projects must attract contributors capable and willing to dream up, build, and maintain resilient open-source systems, and that these workers provide value to the people profiting from the protocol.
How then should decentralized communities attract and pay passionate contributors? It feels like juxtaposing the examples above leaves us with a risk/reward paradox, but I think it might be because we’re conditioned to consider solutions to the problem through the traditional lens of profit seeking, which as I’ve described above is only potentially ideal in a world where the tail risk belongs to the profit seeker.
What’s missing is an organic, built-in mechanism that people can use to fund protocol contributors, something like a Patreon for software. I think there is a way to configure the tools that decentralized technology affords us to elegantly address this dilemma, and at its core, the solution requires protocol developers, users, and investors to realize two things:
- The nature of decentralized protocols passes on risk-management responsibility traditionally owned by institutions onto users.
- The ultimate goal is sustainable growth, not profit. Profit is traditionally just a means to that end, but there might now be better ones made possible by decentralization.
Once these two ideas are internalized, it becomes easier for the imagination to recognize the potential efficacy of a sustainability seeking mechanism as opposed to a profit seeking one. Under these conditions, any surplus should go to the users who bear the tail risk.
For a project that experiments with implementations founded upon this principle, see https://juicebox.money.
Gitcoin with quadratic funding are also great experimental vehicles for supporting project development in the decentralized space.
