A Beginner’s Guide To Cryptoeconomics

Cryptoeconomics is often confused for a distinctly separate branch of economics dealing specifically with cryptos. The subject has often earned flak for being a stupid and invented concept of a parallel ‘crypto version of economics.’ However, the crucial concept that cryptoeconomics truly is, has been misunderstood, generalized, and ignored. We are here to debunk these assumptions and unravel the dynamics of cryptoeconomics that impact real-world crypto scenarios. Let’s get started.

Cryptoeconomics combines cryptography with economics to provide a way for coordinating the behavior of network participants. It is an area specifically belonging to computer science that aims to solve participant coordination problems in digital ecosystems through cryptography and economic incentives.

It isn’t a subset of economics but comes under applied cryptography that takes the economic factors into account. It is a mix of game theory, mathematics, mechanism design, and other relevant methodologies pertaining to the field of economics. Bitcoin, Ethereum, and all public blockchain could be considered the products of cryptoeconomics.

Cryptoeconomics= Cryptography+Economics

We must consider cryptoeconomics while building decentralized networks. As a mechanism, cryptoeconomics aligns participants’ incentives while eliminating the need for third parties. It also helps determine how to fund, develop, design, and facilitate the operations and encourage the adoption of decentralized networks.

To explain this further, let’s take Bitcoin as an example.

Before Bitcoin came into being, a peer-to-peer network immune to vulnerabilities such as attacks and faults was considered impossible. This logical dilemma of different actors reaching a consensus as critical to a distributed system was referred to as the Byzantine General’s Problem. This implied that since not all the network participants could be reliable, no agreement can ever be made, and as such, the network cannot function in a trustless way.

Satoshi Nakamoto introduced economic incentives to a cryptographic peer-to-peer network, and thus, Bitcoin was born. Let’s understand both the aspects of cryptoeconomics relevant to the Bitcoin network.

Economics: Bitcoin blockchain uses a system of economic incentives and penalties. Each Bitcoin block is generated by the miners who have economic considerations. The miners are paid economic (Bitcoin) rewards for mining the next block on the blockchain. The miners, in exchange, contribute their hardware and electricity to keep the network running. The mining process involves solving a complex mathematical problem based on a cryptographic hash algorithm.

The economic costs or penalties are a part of Bitcoin’s security model. A hacker needs to obtain a majority of the network’s hashing power to sustain a 51% attack that would, in turn, change the past state of the blockchain and compromise with the security. But to gain hashing power, an attacker would require considerable funds for the electricity and hardware required. Bitcoin’s mining operations are deliberately made difficult and expensive for an individual to unleash any security risk.

Cryptography: Bitcoin relies on public-private cryptography to provide exclusive control to the holders. It links each block to the blockchain while creating a time-stamped record of transactions via hash functions. Cryptography guarantees the reliability of the Bitcoin network, as, without it, there would be no confidence in the authenticity of the transaction history of the blockchain.

In this way, both the cryptographic elements and economic incentive structure affect the functionality and security of Bitcoin’s design. Cryptoeconomics constitutes understanding the cryptography and economics involved and their coordination to make networks more secure and resilient. Or in other words, the symbiotic relationship between the miners and the Bitcoin network supplies confidence to the overall network.

Understanding the Cryptoeconomic Circle

The cryptoeconomic circle theory was published by Joel Monegro as a holistic model of cryptoeconomics. The model explains the abstract flow of value to and from different participant classes in a peer-to-peer economy. Let’s talk about the variables in the model first.

The model consists of three network participants:

  • The miners form the supply side of the market.
  • The investors form the capital side of the market.
  • The users form the demand side of the market.

The value is exchanged between the three groups using a scarce cryptoeconomic resource called a token.

The Cryptoeconomic Circle | Source: Binance Academy

Miner-User Relationship: Under this arrangement, the miners are compensated for the work they do via tokens used by the users. While the cryptoeconomic model controls the time and manner of compensation given to each miner, the network’s consensus protocol acts as a standard for this process. A distributed supply side, i.e., miners, is beneficial until its advantages outweigh its disadvantages. Some of the advantages include:

  • Borderless transactions
  • Resistance to censorship
  • Greater reliability of the network

Due to the consensus mechanism involved, decentralized models are less efficient than the centralized model in terms of their performance.

Investor-miner relationship: Investors carry out a dual role of supplying the miners with substantial liquidity to sell their tokens and helping to capitalize the network via supporting token prices that are well above the mining costs. The first task is executed by traders who invest in the network or token in the short term, while the capitalization task for the network is performed by hodlers who support the token prices to go higher by holding them in the long term.

It is noteworthy that the miner-trader relationship involves a direct flow of value. The miners can cover their operational costs by selling their mined tokens. While the miner-hodler relationship involves an indirect flow of value as hodlers would capitalize the network to grow further. They do this by supporting the token prices.

Investor-user relationship: Investors add both direct and indirect value to the network, which brings about the worth of the token that users use to make payments, transfer funds, or for any other transaction. At the same time, users provide the investors with capital in exchange for tokens.

The model demonstrates the interlinked motives of every network participant and how they are dependent on each other to meet their economic goals. The robustness and security accorded by such a model incentivize compliance with the standardized rule-set rather than participating in malicious activity. Thus, making the network more resilient.

When we isolate different roles in a cryptoeconomic model, we can analyze the costs incurred, incentives earned, and the value flows for each network participant group. Cryptoeconomics can also be an important tool to divulge the magnitude of relative power and potential points of centralization in a given distributed network. This assessment helps to design more balanced governance models and token distribution systems. What’s more, the cryptoeconomic study of the current distributed networks can be utilized to build more sustainable and robust networks in the future.

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A blockchain enthusiast and entrepreneur’s musings on the next big revolution since the Internet.

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Dr Vin Menon

A blockchain enthusiast and entrepreneur’s musings on the next big revolution since the Internet.