Content
What is cryptoeconomics?
What problem does cryptoeconomics solve?
The role of cryptoeconomics in Bitcoin mining
How does cryptoeconomics improve the security of Bitcoin?
The cryptoeconomic circle
Final thoughts
What is cryptoeconomics?
In simple terms, cryptoeconomics provides a way to coordinate the behavior of participants in a network by combining cryptography and economics.
More specifically, cryptoeconomics is an area of computer science that tries to solve the coordination problems of participants in digital ecosystems, through cryptographic and economic incentives.
It is essential to take cryptoeconomics into consideration when building decentralized networks, because it is the mechanism that provides a way to align the incentives of participants, without the need for trusted third parties.
Far from being a subset of traditional economics, cryptoeconomics is a mix of game theory, mechanism design, mathematics, and other methodologies from the area of economics. Its main objective is to understand how to finance, 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, the creation of a peer-to-peer network in which consensus could be achieved without significant vulnerabilities to attacks and failures was often considered impossible.
This problem is commonly known as the Byzantine Generals Problem. This is a logical dilemma that demonstrates how, in distributed systems, it is crucial for the different actors to reach agreements. The problem assumes that since some actors may not be trustworthy, agreements can never be reached and the network cannot function as intended.
With the creation of Bitcoin, Satoshi Nakamoto introduced economic incentives into a peer-to-peer network and solved this problem.
Since then, decentralized networks have continued to rely on cryptography to reach consensus regarding the state of the network and its history. In addition, most networks have been incorporating economic incentives that encourage certain types of behaviors in their participants.
This synergy between cryptographic protocols and economic incentives makes possible an entirely new ecosystem of decentralized networks, which are both resilient and secure.
The role of cryptoeconomics in Bitcoin mining
The goal of Bitcoin is to create a value transfer network that accurately verifies these transfers, and is immutable and resistant to censorship.
This is achieved thanks to the mining process - by which miners who successfully validate a block of transactions are rewarded in bitcoin. This economic incentive induces miners to act honestly, which makes the network more reliable and secure.
The mining process involves solving a complicated mathematical problem based on a cryptographic hash algorithm. In this context, hashes are used to link each block to the next, essentially creating a time-stamped record of approved transactions, which is called a blockchain.
Hashes are also used in the computational puzzles that miners compete to solve. Likewise, one of the consensus rules that transactions must respect is that a bitcoin can only be spent if a valid digital signature is generated from a private key.
These technological rules regarding mining are aligned with the security requirements of the Bitcoin network - which includes preventing malicious actors from taking control of it.
How does cryptoeconomics improve the security of Bitcoin?
Bitcoin's security model is built around the principle of majority rule. This means that malicious actors have the ability to potentially take control of the majority of the network's computational power through an attack popularly called the 51% attack.
In such a scenario, attackers could prevent new transactions from getting confirmations or even roll back transactions entirely. However, gaining control of this amount of hashing power would be enormously expensive, requiring substantial hardware and considerable amounts of electricity.
Cryptoeconomics is one of the reasons why Bitcoin has been successful. Satoshi Nakamoto implemented assumptions to encourage certain incentives for the different participating classes of the network. Systems security guarantees largely depend on the effectiveness of these assumptions on how network participants react to certain economic incentives.
Without the strength of their cryptographic protocol, there would be no secure unit of account to reward miners. Without miners, there would be no confidence in the validity of the distributed ledger's transaction history unless 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 trust. 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 value flows across different participating classes in 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 with each other 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 users. The network's consensus protocol standardizes this process, while the cryptoeconomic model controls when and how miners are paid.
It is desirable to create a network architecture supported by a distributed supply side (miners) as long as the benefits outweigh the disadvantages. Benefits often include censorship resistance, borderless transactions, and increased reliability. But, decentralized systems tend to have lower performance compared to centralized models.
The investor's role in this model is twofold: providing liquidity for miners to sell their tokens and capitalizing on the network by supporting token prices that are above 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 operating costs, while holders capitalize on 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 participants in such an economy depend on each other to achieve their economic goals. Such a design creates a robust and secure network. Compliance with the incentivized rule set is more beneficial to the individual participant than malicious activity, which in turn makes the network more resilient.
In conclusion
Although a relatively new concept emerged with the birth of Bitcoin, cryptoeconomics is an important component to consider when designing decentralized networks.
Isolating the different roles in cryptoeconomic models helps analyze the costs, incentives and value streams for each participating group. It can also help to think about relative power and identify potential points of centralization, which is important for designing more balanced governance and token distribution models.
The field of cryptoeconomics and the use of cryptoeconomic models can be very beneficial during the development of future networks. By studying cryptoeconomic models that have already been tested in live environments, future networks can be designed to be more efficient and sustainable, resulting in a more robust ecosystem of decentralized economies.
