Incentive Compensation, Bitcoin and Beyond: same as always, just warp speed
If you tear a bank note into two and hand the other half to someone else, you have a transaction. Each half validates the other, and the whole banknote represents a promise to pay a specified sum. Nobody has any value until those two halves come back together again. Bitcoin is like that, but what Satoshi Nakamoto started on the 3rd January 2009 when he mined the genesis block will eventually transform the way we all conduct transactions. This is not just for nerds, so please read on.
For the uninitiated, which is most of us, the only way to understand Bitcoins, Block Chains, Ethereum, DeFi, Tokenisation and so forth is to use ‘old world’ analogies, and that’s what we will do here. Our purpose is to illustrate how emerging trends in the ‘crypto’ world have roots in old fashioned business practices, just like e-mail could be explained using ‘snail mail’ by way of example, and use of analogous language: “addresses”, “posting”, “tracking” and so forth. A glossary of terms relevant to the crypto-asset industry is attached, and hopefully that will answer most of your questions.
It is true that bitcoin can be mined out of thin air but there is a protocol (a peer-to-peer network) and a public transaction ledger (‘the blockchain’) which limits the total bitcoin in the world to just under 21 million in number. Most have already been created - the final coin will be “mined” by around the year 2140, according to estimates. The whole thing is far more regulated than you might have imagined, with ‘consensus rules’ and ‘proof of work algorithms’; it’s just decentralised (rather as Alcoholics Anonymous is an astonishingly successful institution, without having any centralised organisation).
Before contrasting crypto companies to their traditional counterparts, let’s consider how bitcoin ‘digitalises’ asset classes we are used to:
Stocks, Bonds and Real Estate (Capital Assets) have a source of value which provides a stream of monetary reward. The ‘value’ is the future discounted back to today.
Oil, Wheat, Cattle (Consumable Assets) have economic value and can be consumed directly or transformed into other assets (plastic, cereal, leather), but do not yield an ongoing stream of value.
Art, Collectibles, Gold (Store of Value Assets) cannot be consumed or valued through discounted cash flow, but are generally not expected to deteriorate, may even appreciate.
Bitcoin is potentially applicable to any of these asset classes, and the debate over its status as an asset class is not settled (neither by regulatory bodies nor by convention). But it is most commonly seen as a digital “store of value” asset, a durable, non-consumable, zero cash flow, low correlation alternative to traditional assets.
The Bitcoin network was a trailblazer and - by design - inherently limited. However, its limitations created problems which inevitably led many players to attempt new approaches. Ethereum (a ‘second generation’ approach to Cryptographically Secured peer-to-peer networks) was created, and later many others. These new generation networks, with their almost exponentially increased functionality, created an expansive frontier into which legions of developers and entrepreneurs have flooded, establishing the foundation for new economic sectors, new political and legal frameworks, a trusted digital identity and much more.
In this way bitcoin (the asset) and Bitcoin (the network) laid the foundation for a vast multiplication and amplification of fast-growing companies working within and around the Web3 (see Glossary below) and crypto-assets sector.
If we’ve lost you already, don’t worry. Please remember this point: digital assets are here to stay, and they will increasingly stabilise. So, get used to that fact, and come back to this page later once you have renewed energy!
Not surprisingly, our work in the area of remuneration and incentive design has therefore grown at a rapid rate. The purpose of this article is to look at the implications for the digital world of incentive compensation design: how do you design rewards in this rapidly emerging world?
It is a question of enormous importance because just as we once had a world filled with small merchant banks that each had a role in the financial world, and then they merged into the financial machine we call ‘Wall Street or The City’, so we now have a rapidly flowering world of crypto ‘players’ – companies that offer much that used to be thought of as ‘banking’, but in a digitally transformed way. These companies, just as in the City or Wall Street, are struggling to manage the resources they need: their talented, footloose, constantly disruptive, creative workforce. The winners will digest the losers, and so we have a race on our hands.
Comparing Old Fashioned Incentives with their Crypto Equivalents:
Shareholders of large financial institutions in the 80s and 90s would have felt very much like the shareholders of companies in this new digital business world. The opportunity for cross-fertilisation of creative ideas is dazzling, it's just that - for those less familiar with some of the technology - the story may be the same, but it is just happening incredibly fast.
For example, over the last four years a bitcoin’s value rose from $10,000 to a high of nearly $65,000 then fell back to $19,164 very recently. The challenge for those responsible for finding and keeping talent is to create an incentive structure that aligns individuals with their business priorities, as well as the strategy of investors seeking shareholder value creation.
Let’s consider how an old-fashioned financial services company with investment banking, asset management and wealth management divisions would incentivise their people, and why, and then compare that to the new digital world.
Investment banking: the goal is to create value through transactions, deal management, funding tactics. This division hires people who are experienced in a range of business situations and who have a wide range of skills: accounting, finance, strategy, comfort around 'owners'.
Success is measured in fees, and spreads over lending.
Incentives are largely designed with the following in mind:
- Higher salaries for more experienced ‘talent’ - these are ‘stars’ who attract clients
- Significant variable cash-based, short-term compensation - this is a cyclical business and it is expected that bonus pay-outs will ebb and flow with the economic tides
- Limited participation in long-term incentives, which are used to retain key individuals - far more weight is placed upon short-term cash (even deferred cash) pay
Although there are companies operating in the crypto market in similar ways to, let’s say, traditional Venture Capital (cataloguing good projects, investing early), the difference is the level of maturity. In the digital world, there is a need to “move fast and break things” such that risks are higher. If we look at the typical funding cycle [pre-seed, seed, then Series A, B, C] where pre-seed is often barely an idea with funds raised from close friends, seed is testing viability with the barest initial competitor analysis and the beginnings of pitch decks and series A is where the product is validated, growing but ‘early stage’, crypto projects often never make it past the first two rounds. Very few reach maturity, and few companies have fully validated business models.
What also makes investing in Crypto Businesses - and specifically crypto-currencies - different is that they often raise money through issuing new crypto-assets or tokens rather than via sale of equity. The offer of Tokens for the earliest investors means early cash out and exceptional returns when it goes well, but such ‘token sales’ and ICO’s (Initial Coin Offerings’) often do not ‘go well’.
So, incentives are largely going to be designed for crypto business in the same way as our ‘old-fashioned-financial services firm’, but with these differences:
- There may be the promise of higher salaries for more experienced ‘talent’, but cash is often in very short supply, so base pay is kept at lowest levels possible
- In the end variable rewards have to be very short-term in nature and cash-based
- There is significant scepticism about participation in long-term incentives
For those who might be regarded as ‘Founders’ (a term that is used far more widely in crypto than in almost any other sector, financial or otherwise) rewards may be in ‘native coin’, sometimes with vesting schedules attached. While it would appear to be the obvious ‘alignment’ of management with stakeholders, the realities are problematic. To begin with, the release of vested tranches onto the open market creates market volatility. But the main issue is that expending huge effort on a complex project may only leave you with a worthless bag of tokens if a market slump coincides with vesting. No wonder there is resistance to the concept of long term incentivisation!
Asset management: Success is measured in an objective manner, relative to the performance of others: higher growth, higher returns. This division hires people who are fund managers, investment professionals.
Incentives are largely designed with the following in mind:
- Modest salaries, market-based
- Capped bonus, linked to Key Performance Indicators
- Significant (particularly in the case of senior individuals) long-term incentives
The ability to buy and sell crypto assets has never been easier, so Asset Managers offer products with blended complex returns to add value. These are managed in much the same way as a classical investment portfolio offering lower risk.
Crypto is only different from traditional asset management in that it includes assets where the value has been transferred to the blockchain. The process is similar to managing any other asset class (managers track, buy and sell assets to generate returns) but - given the liquidity crunch in crypto - asset managers must find new ways to offer returns to investors, such as lending stable coins.
Bitwise, for example, offers multiple index funds consisting of different layers of token and crypto-asset, as well as blended index funds. Their fees are based on the scale of Assets under Management (‘AuM’).
Wealth Management: Clients are wealthy individuals, clients of the company, who have many types of assets.
Success is measured in fees, client quantity and quality. This division hires people who can get along, personally, with such clients, help them build their investment portfolio and consider new, innovative ideas.
Incentives are largely designed with the following in mind:
- High ‘headline’ market-based salaries for ‘known players’
- Uncapped bonus linked directly to selling
- Some long-term incentives, largely tenure based
The “Innovative Idea” here is merely investing in digital assets in the first place. Family Offices (the epicentre of a multi-generational wealth creation project) typically respond to two types of client; the ones that lack understanding, but have a significant amount of FOMO (fear of missing out) and the ones that have more understanding and are going out on their own (without an advisor). Many family office managers don’t have the access, knowledge or the tools to include digital assets as part of a client’s portfolio. Therefore, their clients don’t have any other choice but to invest in crypto or other digital assets on their own terms. This is beginning to change. There are also new companies offering wealth management advice in a specific Crypto focussed way.
In the same way that the relatively slow-moving, under-invested, union-dominated, grim ‘70s gave way to an investment banking ‘Big Bang’ in the City of London during the 80s, we are under-going a profound digital transformation today. The laptop-focused executive working from a home office, receiving home food deliveries, conducting business over video links and tearing up that precious airline ‘gold card’ is not going away. It is a permanent change, and it brings both good and bad. Less contact with colleagues, but more free time. Lower costs of shopping, lower emissions, but new suppliers expecting a minimum of digital capability.
Digital currency, and digital transactions are part of this shift. It may be volatile, but it is permanent. It is not simply a Dutch Tulip market on steroids.
The power of incentives in any business is a fact of life. An Ugly Truth, as it were. People do what they are paid to achieve, so it makes sense to line up incentives towards a few goals that make the difference. Rather as traditional car manufacturers can make e-cars, traditional incentives can be adapted in the same way.
 As of 18/10/22
 Every independent blockchain has its own native crypto; e.g. Bitcoin is BTC; Ethereum is ETH; Dogecoin is DOGE, etc
Glossary of terms:
Satoshi Nakamoto: The pseudo anonymous name of the person or group responsible for the original bitcoin white paper and heavily though anonymously contributed to the original development and implementation of the Bitcoin Network.
Blockchain: A data structure of ordered, back-linked listed blocks of transactions. It is stored as a file or in a simple database. Being ‘back-linked’ means each new block refers to the previous block. Each transaction is recorded and stored, becoming permanently positioned in the blockchain due to confirmation by multiple external entities on the same network.
“The way to think about the blockchain is like layers in a geological formation, or glacier core sample. The surface layers might change with the seasons, or even be blown away before they have time to settle. But once you go a few inches deep, geological layers become more and more stable. By the time you look a few hundred feet down, you are looking at a snapshot of the past that has remained undisturbed for millions of years. In the blockchain, the most recent few blocks might be revised if there is a chain recalculation due to a fork. The top six blocks are like a few inches of topsoil. But once you go more deeply into the blockchain, beyond six blocks, blocks are less and less likely to change. After 100 blocks back, there is so much stability that the coinbase transaction—the transaction containing newly mined bitcoin—can be spent. A few thousand blocks back (a month) and the blockchain is settled history, for all practical purposes.”
Web 3: There are almost as many opinions on what Web3 means as there are people using the term. The best way to conceptualise the difference is by directly comparing the three iterations of the Web.
Web 1.0 came first; a collection of web-sites serving up static content often from a single file system or database. There was a lack of dynamic HTML meaning very limited interactivity. Each website had a basic login directly to and from their own servers. Login details and Passwords were unique to each site.
Web 2.0: the Web in its current form - a more interactive and social web. The sites are dynamic and there is far more user involvement. Individuals can upload and share information, you do not need to be the primary developer to contribute or create on the web. Web 2.0 also represented the rise of data authority delegated by users in multiple forms to large centralised tech companies and their respective secured servers. The user has therefore little if any control over their own data and how it is stored. The delegated data has been used to drive exponentially increased targeted advertising by these larger entities, exploiting the centralization of that data. The way to think about this centralisation is to consider every time one is asked to “login with your Google / FaceBook / Apple Account'' for everything from online shopping to parking tickets.
Web 3.0: This is what is expected to come into being as a result of the rise of decentralisation. The idea is to enhance the web of today with certain specified characteristics; being Verifiable, Trustless, Self-governing, permissionless, distributed and robust, stateful and with built in payments. The idea is that Web3 applications would run on decentralised networks of peer to peer nodes (servers) &/or blockchains rather than large centralised servers. The specific mechanism for this development is the source of the discussion surrounding Web3.
Cryptocurrency and Web3 often are spoken about concurrently as Cryptocurrency is often described as the mechanism to incentivize the participants who are building, securing and otherwise contributing to these projects. However the current ideas of today may turn out to be very different from a more finalised form of Web3.
The potential for this next iteration of Web is expansive, including the possibility of Tokenization of economic effort that is currently hard or impossible to evaluate, and by providing an international market for these tokens - could be the precipitant for a new level of value and global gross product. There is much more to be said on this subject and it is very much a live field.
Tokenization: The process of transforming ownership and rights of anything of potential value into a digital form, often with the added step of creating the token in the context of a distributed network.
This process includes the transformation of indivisible assets or hard to quantify economic activity into token form. Tokenization allows fractional ownership of hard assets, like paintings for example, but also allows for value to be specified and quantified where previously it was not practicable to do so. When these tokens are placed in a global and permissionless environment such as that provided by a blockchain network, and where tokens of different forms can interact - a marketplace exists - a market where tokens will find a value, potentially unlocking huge amount of private economic product that exists but is currently unquantifiable or unrecognised by measures of global economic effort or by GDP.
DeFi: This stands for “Decentralised Finance”. A way to classify applications of smart contracts allowing for complex financial transactions, such as lending and collection of interest payments or collateral in the event of a liquidation event, gambling or creation of derivative products, all publicly viewable and confirmed by an expansive peer-peer blockchain. The decentralised nature of DeFi applications means that there is no “middleman”, like VISA or clearing houses required to complete a transaction. Each party is aware of the underlying mechanisms, and the outcomes of multiparty interactions are pre-determined, entirely dependent on the code specified in the application.
Smart Contracts: Code written into programmes of varying complexity which are designed to perform specific tasks and record the outcomes on the blockchain network. The code controls the execution of the task, and the outcomes are trackable and irreversible.
Stable Coins: A digital currency that is “pegged” to a real world asset, most commonly a global reserve fiat currency like the US dollar. The value is usually pegged to 1:1. The peg is maintained in different ways, the most popular examples such as USDC and USDT are backed by a basket of traditional currencies, precious metals and some higher order cryptocurrencies like bitcoin. With the proportion of the value of underlying backing assets owned versus the number of stableCoin tokens released a matter of some contention but usually a higher proportion is seen as preferable.
Other attempts at stable tokens have included algorithmically pegged stablecoins; where there are backing assets kept but the tokens value is maintained by a smart contract, for example where the value rises above the $1 basis - the smart contract will create a large number of the underlying token and release them thus diluting the price - and where the peg is below the $1 the backing assets are sold to purchase the token from the open market and destroy them, reducing the circulation and increasing the value.
Native Coin: A term for the Cryptocurrency or Token produced and distributed by the business in question.
ICO: “Initial Coin Offering”. The CryptoCurrency industry equivalent of an IPO - however ICO differs by being often at a much earlier stage, even as part of venture capital funding round or pre-product launch. A company seeking to raise money to create a new application, coin or service can use an ICO to allow early investors to purchase their token/currency which may have some utility related to the product, it may represent a stake in the company or it may represent only its own free-floating value divorced from the businesses underlying value creation. By their nature ICO’s are often highly speculative.
- Y. Elmandjra (Sept, 2020). “Bitcoin: A Novel Economic Institution”. [A research note authored by ARK investments and CoinMetrics]. Sept 3, 2020. https://ark-invest.com/white-papers/bitcoin-part-one/
- “What is Ethereum” - an Introduction to the book by Andreas M. Antonopoulos. The file of which can be found on his GitHub page: https://github.com/ethereumbook/ethereumbook/find/develop
- The 2018 book by Andreas M. Antonopoulos, “Mastering Bitcoin”. The ASCII file of which can be found on his GitHub page: https://github.com/bitcoinbook/bitcoinbook/find/develop