What is cryptoeconomics and why we should care about it?

December 26, 2018
Darya Karatkevich

Simply put, cryptoeconomics is the underlying concept behind cryptocurrency, combining cryptography with economics. The combination of these two has formed an all-new way of storing and verifying financial data.

Cryptography describes a wide-ranging set of techniques for protecting the privacy of electronic communication through ciphering text. From scrambling messages by the military to encrypting your chats on messengers, cryptography is an important part of the security and independence we enjoy.

In its turn, economics describes an extensive range of ideas surrounding value, wealth, transactions, investment, and accounting. Because economics lacked any sort of encryption, each entity in the economic system kept a separate ledger. As a business, you wouldn’t want your competitor to see your books. Same goes for your neighbor seeing your bank statement.

The promise of cryptoeconomics is a single, shared ledger where all transactions are recorded. The big benefit here is that it virtually eliminates the possibility of fraud.

Cryptoeconomics goes beyond simply combining cryptography with economics, it also relies heavily on economic incentive and game theory to advance common goals. By incentivizing all users of the system to behave in a certain way, it upholds and reinforces the desired properties of the network.

Decentralized P2P network

p2p network

Cryptocurrency applies the concepts of cryptoeconomics through a decentralized P2P network. What that means is users who choose to participate in the system vow to contribute something to the system. Think of Napster or BitTorrent. The idea is that collectively all the users can offer more by pooling their resources.

Those resources could mean time, attention, fiat money or computing power. In the case of bitcoin, users are incentivized to ‘mine’ bitcoin by contributing computing power (and paying fiat currency for the energy costs) to help validate each new transaction.

Cryptoeconomic security models

blockchain secure

There are several different theories surrounding cryptoeconomic security. Each one makes some assumptions about human behavior to set a threshold for security protocols. Let’s take a quick look at each:

Uncoordinated choice

This model assumes that all individuals participating in the system make their decisions independently from each other. These networks tend to be smaller in size, and not very secure.

Honest majority model

A subset of the uncoordinated choice, this model assumes that even though each actor is making decisions independently, as long as no member has more than 50% of the hashing power, the output of the system can be trusted. This is a very optimistic assumption, and isn’t as secure when facing real-world security challenges.

Coordinated choice

This is the polar opposite of the uncoordinated choice model, and it assumes that all participants in the system are working together. There would have to be some agent or coalition to cause people to act in unison in this manner.

Byzantine fault tolerance

In this type of decentralized network, it is said to be able to function even under the conditions of the Byzantine Generals’ Problem, where a certain percentage of participants and assumed to be dishonest and in conflict with the system’s desired properties.

Bribing attacker model

This model assumes an uncoordinated choice model, but that each user is being bribed to act a certain way which in turn compromises overall network security. It is another type of ‘attack’ which must be considered when designing a system.

As you can see, the type of model you assume for your base design makes a big difference in how you’re going to design your final system. It’s critical to take all possible threats into account when designing a secure decentralized digital network, especially if you’re trying to create a currency with implied value.

Digital signatures

digital signature

One of the other keys to cryptoeconomics is identity. For trusted users to verify transactions on the blockchain, there must be a secure and private way for the whole ecosystem to verify their identity. Digital signatures have been around for a while, but integrating them into a blockchain architecture increases their power.

A real-world example of this is your actual signature. If there’s a centrally stored copy of your signature, say at your bank, any teller can compare a document with the stored copy to verify your identity. This doesn’t give away any of your personal data, but it can be copied. A digital signature does the same thing, but cannot be copied due to advanced encryption.

Economic incentives

incentives

What is it that drives users to participate in a system using all of the above principles? This is the economic part of cryptoeconomics. There must be some reward for people to participate. Nobody would invest in the stock market, for example, if it wasn’t possible to make money doing so.

Tokens

Simply put, tokens are the exchangeable (via crypto exchange) good within any cryptoeconomic system. By loading a system with tokens, you create an incentive for users to participate for a chance at the shared value of the sum of all tokens. Most cryptocurrencies have set a limit to the number of tokens that will ever become available to stabilize the value of the cryptocurrency.

Block rewards

To create a valuable network, you must have users who adhere to the desired properties. To do that, you can create a reward for a user to verify a certain transaction or to create a new secure block on the blockchain. Users have to expend computational power, thus contributing to the overall system. In the case of bitcoin, the reward for establishing a new block is 12.5 BTC (to be reduced to 6.25 BTC in 2020), but it takes enormous computational energy to complete that task.

Consensus mechanisms

Bitcoin uses a ‘proof of work’ consensus mechanism, meaning that the users who verify transactions and are rewarded have to prove their work. Another mechanism is ‘proof of stake,’ where users simply need to vote on a particular transaction. In a proof of stake system, users are incentivized to vote only for valid transactions by risking their ‘stake’ and votes are weighted by the size of that stake.

Transaction fees

Once all of a certain cryptocurrency has entered the market, what incentivizes users to continue to validate the blockchain when no new tokens can be mined? Transaction fees fill this need, and give future users incentive to continue to verify transactions long after the maximum amount of tokens is released.

A whole new global economic engine

economic growth

These cryptoeconomic concepts are new, but quite radical when compared to traditional economic models. By putting control over the verification of data in the hands of the users, the influence of central authorities such as banks and governments is reduced.

If you follow cryptocurrency news, you’ll often read about how transformative these new technologies will be for global financial models. The future of economics is likely to be governed by these decentralized systems, and that’s why we need to start caring about cryptoeconomics.

Post written by Darya Karatkevich
Darya is a blockchain market observer with 5+ years of experience as an author and editor for major tech blogging platforms. Her fortes are blockchain technologies and solutions, cryptocurrencies and crypto-related regulations.

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