A Beginner's Introduction to Cryptoeconomics

What is cryptoeconomics?

In simple terms, cryptoeconomics provides a way to coordinate the behavior of network participants by combining cryptography with economics.

More specifically, cryptoeconomics is an area of computer science that attempts to solve participant coordination problems in digital ecosystems through cryptography and economic incentives.

It is essential to consider cryptoeconomics when building decentralized networks because it is the mechanism that provides a way to align participants’ incentives without the need for trusted third parties.

Rather than being a subset of traditional economics, cryptoeconomics is a mix of game theory, mechanism design, mathematics, and other methodologies from the field of economics. The main goal is to understand how to fund, design, develop, and facilitate the operations of decentralized networks.

This article will dive into the origins of cryptoeconomics and its role in the design of Bitcoin and other decentralized networks.

What problem does cryptoeconomics solve?

Before the emergence of Bitcoin, it was commonly believed to be impossible to create a peer-to-peer network where consensus is achieved without significant vulnerabilities to attacks and faults.

This problem is often referred to as the Byzantine General’s Problem. It is a logical dilemma that demonstrates how, in distributed systems, it is critical for the different actors to reach agreements. The problem assumes that since some of the actors might be unreliable, agreements can never be made, and the network cannot function as intended.

With the creation of Bitcoin, Satoshi Nakamoto introduced economic incentives to a peer-to-peer network and solved this problem.

Since then, decentralized networks have continued to rely on cryptography to achieve consensus regarding the state of the network and its history. Also, most networks have been incorporating economic incentives that encourage network participants to behave in certain ways.

This synergy of cryptographic protocols with economic incentives enables an entirely new ecosystem of decentralized networks that are resilient and secure.

The role of cryptoeconomics in Bitcoin mining

The goal of Bitcoin is to create a value transfer network that accurately verifies transfers of value, and that is immutable and censorship-resistant.

This is achieved through the process of mining, in which miners who successfully validate a block of transactions are rewarded in bitcoin. Such economic incentive encourages miners to act honestly, making the network more reliable and secure.

The process of mining involves solving a difficult mathematical problem based on a cryptographic hash algorithm. In this context, hashes are used to tie each block to the next block, essentially creating a timestamped record of approved transactions called the blockchain.

Hashes are also utilized in the computational puzzles that miners are competing to solve. Additionally, one of the consensus rules that transactions have to follow is that a bitcoin can only be spent if a valid digital signature is generated from a private key.

These technological rules relating to mining are aligned with the security requirements of the Bitcoin network, including preventing malicious actors from taking control.

How does cryptoeconomics enhance Bitcoin’s security?

Bitcoin’s security model is built around the principle of majority rule. This means that malicious actors could potentially take control of the blockchain by seizing control of the majority of the network’s computing power in an attack commonly referred to as the 51% attack.

In such a scenario, the attackers would be able to prevent new transactions from gaining confirmations or even reverse transactions entirely. However, gaining control of this amount of hashing power would be hugely expensive, requiring substantial hardware and considerable amounts of electricity.

Cryptoeconomics is one of the reasons Bitcoin has been successful. Satoshi Nakamoto implemented assumptions to encourage certain incentives for the different participant classes of the network. The system’s security guarantees depend a lot on the effectiveness of these assumptions about how network participants react to certain economic incentives.

Without the hardness of its cryptographic protocol, there would be no secure unit of account with which to reward miners. Without the miners, there would be no confidence in the validity of the transaction history of the distributed ledger, unless if it was verified by a trusted third party, which would negate one of the main advantages of Bitcoin.

Based on cryptoeconomic assumptions, the symbiotic relationship between miners and the Bitcoin network provides confidence. However, this is not a guarantee that the system will persist in the future.

The cryptoeconomic circle

The cryptoeconomic circle is a holistic model of cryptoeconomics. It was published by Joel Monegro and illustrates abstract flows of value through different participant classes in such a peer-to-peer economy.

The model represents a three-sided market between miners (the supply side), users (the demand side), and investors (the capital side). Each group exchanges value between one another using a scarce cryptoeconomic resource (a token).

In the miner-user relationship in the circle, miners are compensated for their work through tokens used by the users. The network’s consensus protocol standardizes this process, while the cryptoeconomic model controls when and how miners get paid.

Creating a network architecture that is sustained by a distributed supply side (miners) is desirable as long as the benefits outweigh the disadvantages. The benefits often include censorship resistance, borderless transactions, and higher reliability. But, decentralized systems tend to have lower performance when compared to centralized models.

The role of the investor in this model is twofold: providing liquidity for the miners to sell their tokens, and capitalizing the network by supporting token prices that are above the mining costs.

The model exemplifies these two roles by dividing investors into two groups: traders (short-term investors) and hodlers (long-term investors).

Traders create liquidity for the token so miners can sell their mined tokens and cover operational costs, while holders capitalize the network for growth by supporting token prices. The miner-trader relationship works with a direct flow of value, while the miner-holder relationship works with an indirect flow of value.

This simply means that all the participants in such an economy depend on each other to reach their economic goals. Such a design creates a robust and secure network. Compliance with the incentivized ruleset is more beneficial to the individual participant than malicious activity - which in turn makes the network more resilient.

Closing thoughts

Even though a relatively new concept that emerged with the birth of Bitcoin, cryptoeconomics is a significant building block to consider when designing decentralized networks.

Isolating the different roles in cryptoeconomic models helps to analyze costs, incentives, and value flows for each participant group. It can also help to think about relative power and identify potential points of centralization, which is important to design more balanced governance and token distribution models.

The field of cryptoeconomics and the usage of cryptoeconomic models can be highly beneficial during the development of future networks. By studying cryptoeconomic models that were already tried and tested in live environments, future networks can be designed to be more efficient and sustainable, resulting in a more robust ecosystem of decentralized economies.