Dfinity, part 3. The economic and governance challenges for the project

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In the previous two articles in this series, we have discussed the core ambitious objectives the Dfinity project is trying to achieve and the key approaches it is using in order to do that. This article will be devoted to the potential challenges the project could face.  

It is worth emphasizing from the start that given the quality of the technical team behind Dfinity and the technical complexity of the platform under development, it is not the task of this article to try to assess the platform’s technical merits. One can only note that so far, no serious technical objections seem to have been raised.

However, an extremely ambitious project like Dfinity that aims to fundamentally transform the way software is made and managed may fail even if its technical aspect is irreproachable. This is where the economic and governance issues come in.  

Potential economic challenges. Dfinity’s economic calculation problem

A general economic objection that could be made to Dfinity’s vision is that its approach to running much of the world’s software on the Internet is completely novel and unproven in its value proposition, and this is a fair point as far as it goes. However, most innovative goods and services involve leaps of faith, hence this is not really a serious problem, unless someone can convincingly demonstrate that Dfinity’s project is a non-starter for some basic reasons.

One such reason may be that Dfinity could make a large part of the world’s software dependent on a bunch of entities, just like Bitcoin and Ethereum mining are controlled by a few pools at present.

Williams’s response to this is deserves to be quoted in full:

Each node in DFINITY has an approximately similar hardware specification, and each node in the network acts as a replica, right, for in some shard that stores some number, you know some subset of the applications hosted on the Internet Computer, and the protocol has cryptography schemes incorporated into it that enable it to apply sort of service level agreement, if you like, to each individual node, so let’s say you were running a DFINITY node, it would look something like a mid to high end server machine. It would be required to have a certain amount of storage and a certain amount of process capacity. Once that’s added to the DFINITY network, the network will fill its storage space with cryptographic junk that’s predictable that you have to encrypt in a special way, and this enables the network to interrogate you to check that indeed you have performed the role and you’ve uniquely stored this data, and economically speaking, the most efficient way of doing that is with a dedicated machine that’s designed in that way, so how could you pool it. How could you pool that?

Williams’s assurances that one cannot scale the process have to be taken for granted at this stage, however, even if they are legit, the potential risk may stem from the incentive side. Will the remuneration for the individual nodes be sufficient to incentivize them to use their machines in the desired way? Especially if there is no way to unlock the economies of scale. Only practice can probably tell.

There is, however, a more serious economic issue with the project. In the present model of cloud computing and software-as-a-service, the market determines the rates which providers charge to their customers. The providers are remunerated according to the added value they create, as with any other business in a competitive environment. This is achieved through the price system denominated in the widely used currencies.

In the Dfinity’s model, though, nodes will be remunerated in Dfinity’s native tokens, and they are supposed to be remunerated for a large part of the world’s computational load. This all but implies that in order to not introduce major distortions into price formation in such a large sector, Dfinity’s native token must quickly become a widely accepted means of exchange with low volatility. Let us call this the economic calculation problem for Dfinity.

Notice that Dfinity’s situation is different from more narrow smart-contract platforms like Ethereum. With the latter, the costs of operating smart-contracts on-chain will usually represent only a small percentage of overall costs of operating a correctly designed decentralized application (DApp) most of which will tend to run off-chain or on some second-layer solution. This means that, except during periods of massive network congestion, the native token’s nature as a means of exchange does not matter critically for the usability of DApps. Related to this is the fact that many DApps probably do not have to be significantly modified compared to what they would look like if they were not designed to be powered by smart-contract platforms.

Dfinity’s model is, however, different in two important respects. First, applications designed for it will tend to differ significantly from the way they are made at present. This means that developers for Dfinity risk not being able to run their software on another platform should the Dfinity option fail, without large modification costs at best. Secondly, they will have to be run entirely on-chain, which means that the DFN token will be responsible for governing the allocation of a large chunk of the world’s computational resources.

The latter can, of course, be used in different ways and how they are best allocated should be guided by profit signals. However, at least in the beginning, the DFN token will probably not be a mature enough means of exchange to ensure that the profit signals function correctly.

Lest this concern looks merely like arm-chair theorizing, consider a relatively realistic hypothetical example. One can imagine that Dfinity will launch its mainnet with some partners already running their software on it. Suppose that shortly after launch, they demonstrate a certain profitability based on the DFN payments the clients running their software received times the market price for DFN tokens at the time. If a major software provider uses these numbers to estimate the profitability of switching her software to Dfinity and decides to do that but then gets burned because the volatile DFN price crashes, this may deter other major software providers.

Government actions can exacerbate this problem. So far, outside countries like India, there has been no attempt by a major country to restrict the use of a cryptocurrency directly. However, this may have been just because none of them has been remotely widely used outside of speculation. However, if DFN token starts showing signs of mass adoption, some governments may change their passive stance. Even though DFN tokens’ ostensible goal is to power the Dfinity platform, nothing prevents them from being used for paying for other goods and services. Moreover, the fact that DFN can be used to pay for important services arguably makes it an even better candidate for the first genuinely money-like cryptocurrency.        

The economic calculation challenge may, of course, be mitigated if Dfinity is capable of irrefutably demonstrating major performance gains or cost reduction for a few significant projects in a purely technical sense. Then, multiple major software providers could switch to Dfinity and ensure quick transition to mass usage, which should stabilize DFN’s exchange rates.

Ultimately, however, the best way for Dfinity to address its economic calculation problem may be to start out using a stablecoin instead of DFN tokens. A switch to the mandatory usage of DFN tokens may be scheduled for a certain future date with the hope that the platform will have become sufficiently widely used by then. This will not remove the potential challenge from governments, but if Dfinity’s value proposition is really strong, the combined clout of the stakeholders may be sufficient to convince most governments to back down.     

Potential issues with the governance model

Some problems for Dfinity could also arise from its chosen governance model described in part 2. First, nothing in it appears to preclude token holders from not tying their neuron’s voting patterns to those of some authoritative neurons. Even though doing so may be somewhat less onerous than staying informed about the project and voting by oneself, it may still prove too demanding for many small token holders.

In addition to this, there seems to be a larger concern. If token holders are allowed to delegate their voting to other neuron owners and stay relatively uninformed about the project-related developments, how are they supposed to reliably attribute the potential declines in the value of their tokens to the bad votes by their delegates? Voters in modern polities already delegate the vast majority of particular decisions to parliaments and those further delegate them to bureaucracies. So far, this approach has not necessarily resulted in good governance, even though it can be claimed that it has not led to disasters, either.

However, the difference in Dfinity’s case is that here we are dealing with direct production of services, not government-like policy, and there have been no attempts to democratically direct innovative production processes in the past.

Dfinity’s supporters could respond that Dfinity’s governance is similar to that of a large corporation where shareholders can remove the management if the latter misbehave or do not deliver. Setting aside the worry that the connection between authoritative nodes’ votes and token performance is less clear for Dfinity than that between the management’s actions and share price for a traditional company, another problem rears its ugly head. It is widely recognized that crypto asset markets are not yet mature enough to reliably reflect the quality of projects in their assets’ prices. One can hardly believe that in a mature asset market a project like Bitcoin SV could have the eighth largest market capitalization. Poor quality of crypto asset markers may further weaken the link between the decision of unreliable delegates and the price performance of the token.

Also, in the present practice, even if a large company’s ownership may be widely dispersed, individual investors tend to participate through large intermediaries like mutual and pension funds and insurance companies. They may be significantly mitigating the problems with the governance participation of large numbers of shareholders  This option does not seem to be viable in Dfinity’s case.

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In sum, it appears that Dfinity will have to handle major economic and governance challenges if it were to succeed in its grandioze vision. None of these challenges is necessarily insurmountable but they need to be taken into account by anyone considering investing into or developing on Dfinity.  

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