Introduction to Cryptoeconomics

Introduction

Cryptoeconomics is a special field of science intersecting economics, cryptography and information technology. Its task is to develop an effective coordination system between the individual participants of digital ecosystems, using cryptographic protections and economic incentives.

It underlies the creation, development, and effective operation of decentralised peer-to-peer networks, as it provides common interaction without the need for participants to trust one another.

Despite the name, there are not so many “economics” in it. The main role is given to game theory, mathematics, design of mechanisms and various cryptographic methods. Why does it even work?

Before the creation of the Bitcoin network, it was believed that it was impossible to create an effective peer-to-peer network. It’s too vulnerable to external influences, as well as to internal fraudulent schemes and common system errors.

This problem, however, is quite ancient, that is why it was called Byzantine generals problem, or Byzantine fault tolerance. In short, its essence boiled down to how to ensure the effective system operation if its individual elements deliberately introduce discord. It complicates the management process, as well as the interaction between individual participants.

It turned out that the problem has an original solution, consisting in a combination of cryptographic guarantees of reliability and effective economic incentives. Data is encoded in such a way that forging it becomes if not difficult, then surely economically disadvantageous. And following the rules of the network is, on the contrary, extremely simple, you can even get a reward for this. So the rational behaviour that the game theory implies just makes the participants act in the interests of the whole system.

Cryptoeconomics and mining

Let’s consider the Bitcoin situation as the simplest and most intuitive. Initially, the task was to create a payment network resistant to external changes, where each transaction is recorded on every machine connected to this network.

This was achieved thanks to the mining process. The bottom line is simple — miner machines solve a complex mathematical problem, resulting in new data blocks, in which network transaction data and other useful data are recorded. The one who first solves this problem automatically receives a reward — a small amount of bitcoins contained in the new block. Ready blocks are connected to each other using a hash, and each subsequent one is built on the basis of the hash of the previous one. This provides a chronologically consistent network — the blockchain.

It is also worth considering that each reliable transaction must contain a “digital signature” — a guarantee that the amount in bitcoins belongs to a particular person. The owner’s name doesn’t matter because anonymity is one of the competitive advantages of cryptocurrency networks.

Cryptoeconomics is introduced when the miner is tempted to “fake” the calculation results to get ahead of competitors or add a block with false data to the general chain. And this is where the problems begin because to ensure reliability, you need to change the data on all the machines on the network. At the same time, on the changing block, a new chain has time to line up, which will also have to be redone from the moment of change. So all this requires very high energy and resource costs.

Cryptoeconomics and security

When all elements are equal in the network, those who are grouped into large formations get an advantage. 51 percent of the total capacity is enough to “take control”. This is called “51% attack”.

If this can be achieved, the new majority will be able to fully control the creation of new blocks and even “reversely review” the contents of the previous ones. The problem is that the larger the network, the more resources are needed. The Bitcoin level network is resistant to such influences since in practice, it is impossible to provide such computing power, even using state-level resources. But smaller networks are more vulnerable to this.

Despite the fact that all nodes of the system are equal, they have special roles. Three are conditionally distinguished — miners, investors and users. Miners are needed to guarantee the protection of the accounting unit, the new storage blocks extraction continuity and the verification of transactions. All this happens automatically, based on the network protocols. And since this work requires a significant expenditure of resources — miners receive a reward for it. If you draw parallels with the economy — this is the production link. Other roles are even more interesting. And the interaction of these large groups forms a phenomenon called the “cryptoeconomics cycle”.

The cryptoeconomics cycle

This scheme was first described by Joel Monegro, when it was necessary to illustrate the interaction features for the individual elements of the peer-to-peer network, depending on the tasks they perform.

In simplified form, it is a primitive three-way market where miners (supply party), users (demand party) and investors (capital party) interact. Interaction is carried out through the automatic and targeted transfer of a cryptoeconomic resource — tokens or coins.

The interaction between miners and users is fully automated by existing protocols. The supply party provides a resource and automatically receives a reward for it. The demand party drives the whole process — nothing would have happened if people had not been convinced that tokens have value. And the capital party works just on this.

Although, the tasks of investors are somewhat more complicated. They provide not only the liquidity of tokens but also the maintenance of the token price at a certain level — the total capitalization of the network. And they do it because the advantages of such networks outweigh their disadvantages. The advantages are resilience to changes, a high security level and no restrictions on transaction volumes. So, it is profitable for investors to use cryptocurrency; therefore, it is necessary to create conditions so that it is profitable for other network participants.

There are two types of investors — short-term traders and long-term holders. Traders are committed to creating market liquidity, providing miners with the opportunity to sell mined tokens for real money. Holders provide the large capital necessary to maintain prices at a certain level and for overall growth. What’s important, both benefit, just at different speeds and in different volumes.

As a result, we have an interconnected system where individual participants are obliged to interact with each other but at the same time forced to act rationally in order to secure a profit. This ensures the safety and overall stability.

Conclusion

Cryptoeconomics describes not only the processes taking place in the world of cryptocurrencies, but also the work of decentralised systems in general. However, it is the cryptocurrency aspect that has been studied best so far. Especially, economic incentives for each of the categories of participants. It allows you to more effectively control the flow of finance and information, even within partially centralised networks.

We can say that the general operation concepts for such systems are broken in with the help of private economic models. So cryptoeconomics will continue to develop, which will have a very positive effect on the overall process automation and the implementation of decentralised systems in everyday life.