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What is Cryptoeconomics?

  • Ashesh Anand
  • Feb 03, 2022
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The term Crypto-economics is derived from two words: cryptography and economics. People often overlook the "economics" portion of the equation, which is what gives the blockchain its distinct powers. 


The blockchain isn't the first time a decentralized peer-to-peer system has been used to transfer files; pirate sites have been using it for years. It was, however, a failure in every sense of the word.



What is Cryptoeconomics?


The combination of incentives and cryptography to build systems, applications, and networks is known as Crypto-Economics. To put it another way, crypto economics is applied cryptography that considers economic incentives and economic theory.


Cryptography is used in both digital signatures and hash functions on blockchains.


What does it have to do with Economics in general?


Because it implies a comparison to economics as a whole, the word cryptoeconomics might be deceptive. This is one of the reasons why some people, like Parker, disregard the word. Economics is the study of decision-making: how individuals and groups respond to incentives. 


The development of bitcoin and blockchain technology does not necessitate the development of a new theory of human choice because humans have not changed. The application of macroeconomic and microeconomic theory to cryptocurrency and token markets is not cryptoeconomics.


Mechanism design, a discipline linked to game theory, has the most in common with cryptoeconomics. In game theory, we look at a specific strategic interaction (a "game") and try to figure out what the best strategies are for each player, as well as what would happen if both players adopt those strategies.


Cryptoeconomics, like mechanism design, is concerned with the creation and design of systems. We utilise economic theory to build "rules" or procedures that achieve a specific equilibrium outcome, just as we did in our auction example. 


The methods used to establish economic incentives in cryptoeconomics, on the other hand, are developed using encryption and software, and the systems we design are nearly invariably distributed or decentralised.


Watch this: Blockchain Economics


Purpose of Cryptoeconomics


Prior to the introduction of Bitcoin, it was widely assumed that establishing a peer-to-peer network capable of achieving consensus without significant vulnerabilities to attacks and faults was unachievable.


The Byzantine Generals Problem is a common name for this problem. It's a logical conundrum that highlights how, in distributed systems, reaching agreements among the various actors is crucial. Because some of the actors may be untrustworthy, the problem assumes that agreements will never be reached, and the network will not function as planned.


Satoshi Nakamoto solved this challenge by introducing economic incentives to a peer-to-peer network with the introduction of Bitcoin. Since then, decentralised networks have relied on cryptography to reach consensus on the network's current state and history. 


In addition, most networks have included financial incentives to urge network participants to act in specific ways. This combination of cryptographic protocols and economic incentives creates an entirely new ecosystem of durable and secure decentralised networks.


What role does Crypto Economics play in improving Bitcoin's security?


The security mechanism of Bitcoin is based on the notion of majority rule. This means that a 51 percent attack, in which bad actors seize control of the majority of the network's computer capacity, may theoretically gain control of the blockchain.


The attackers would be able to block fresh transactions from receiving confirmations or even reverse transactions entirely in such a scenario. Getting control of this much hashing power, on the other hand, would be prohibitively expensive, needing major hardware and large quantities of electricity.


One of the reasons Bitcoin has been so successful is because of cryptoeconomics. Satoshi Nakamoto used assumptions to support certain incentives for the network's various participant groups. The validity of these assumptions about how network participants react to various economic incentives is critical to the system's security assurances.


There would be no secure unit of account to compensate miners without the hardness of its cryptographic technology. Without the miners, there would be no way to verify the veracity of the distributed ledger's transaction history unless it was confirmed by a trusted third party, which would nullify one of Bitcoin's key benefits.


The symbiotic relationship between miners and the Bitcoin network promotes confidence, according to cryptoeconomic theories. This does not, however, guarantee that the system will continue to exist in the future.


(Here’s a Guide to Trading and Investing in Bitcoin)


Cryptoeconomic Application Design


We can design applications that sit "on top" of a blockchain like Ethereum once we've solved the core problem of blockchain consensus. The underlying blockchain provides a monetary unit for creating incentives and penalties, as well as a toolset for creating conditional logic in the form of "smart contract code." 


Cryptoeconomic design can also be found in the applications we create with these tools. 


For example, cryptoeconomic procedures are required for the prediction market Augur to work. Augur develops a system of incentives that compensates users for reporting the "truth" to the app, which is subsequently used to settle bets in the prediction market, using its native coin REP. 


This is the breakthrough that allows for the creation of a decentralised prediction market. Gnosis, a prediction market that utilises a similar strategy but also allows users to define alternative mechanisms for detecting genuine outcomes, uses a similar method (commonly called "oracles").


Token sales or ICOs are also designed using cryptoeconomics. For example, Gnosis utilised a "Dutch auction" as a model for its token sale in the hopes of achieving a more equitable distribution. 


Although this is a separate problem than developing the underlying consensus methods, there are enough parallels that both can be considered cryptoeconomic. 


Building these applications necessitates a thorough grasp of how incentives influence user behaviour as well as the careful design of economic processes that can consistently generate a specific result. They also necessitate knowledge of the capabilities and limits of the underlying blockchain on which the app is based.

Watch now: Cryptoeconomics In 30 Minutes by Vitalik Buterin (Devcon5)


Final thoughts


Cryptoeconomics is an important building component to consider when creating decentralised networks, while being a relatively new idea that developed with the launch of Bitcoin.


In cryptoeconomic models, isolating the various roles aids in the analysis of costs, incentives, and value flows for each participant group. It can also aid in the consideration of relative power and the identification of potential areas of centralization, both of which are necessary for the development of more balanced governance and token distribution schemes. 


Cryptoeconomics and the application of cryptoeconomic models can be extremely useful in the construction of future networks. Future networks can be developed to be more efficient and sustainable by analysing cryptoeconomic models that have previously been tried and tested in actual contexts, resulting in a more resilient ecosystem of decentralised economies.

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