What is Cryptoeconomics | Blockchain Through Cryptoeconomics

The term Crypto-Economics is an amalgamation of two words: cryptography and economics. People often overlook the “economics” portion of the equation, which is what gives the blockchain its distinct powers.

What’s important to note is that blockchain is actually not the world’s first decentralised peer to peer system; pirate sites have been doing that for years now! However, that system was not a success.

CryptoEconomics refers to the combination of incentives and cryptography to build systems, applications, and networks. Basically, it is applied cryptography that considers economic incentives and economic theory.

Relation with Economics

Some experts consider the term crypto-economics a bit deceptive because while economics is the study of how individuals and groups respond to incentives, cryptoeconomics refers to something else totally.

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 the best strategies for each player.

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 contrary, are developed using encryption and software, and the systems we design are nearly invariably distributed or decentralised.

Mechanisms

The Bitcoin Network and similar blockchain networks operate using the ‘Proof of work” consensus algorithm. That is a set of rules to define how multiple nodes can reach an agreement over any decision. In this setup, the miners validate transactions and compete with each other to figure out the cryptographic hash of the next block. Miners collect recent transactions, verify them, and run all the data. All miners have to perform computational work to solve the puzzle, which is the reason why this process is referred to as “Proof-of-Work.”

The first miner that solves a mathematical puzzle can write transactions to the blockchain, creating the next block. In return for their effort, they get a reward in the form of new network tokens.

Blockchain Through Cryptoeconomics

The study of economic interaction in adversarial environments is referred to as cryptoeconomics. In decentralised peer to peer networks, there is always a suspicion for malicious agents. Cryptoeconomics uses both cryptography and the political economy to produce redistributed P2P networks which thrive over time. Cryptography makes network communications secure. The political economy further incentivizes all nodes to contribute to the network for development.

Before the arrival of Bitcoin, it was considered impossible to build a fraud and attack resistant accord among nodes in a very P2P network (Byzantine Generals Problem). Satoshi Nakamoto resolved that drawback by introducing economic incentives.

Machine Consensus P2P Network

Due to the large number of faulty processes in distributed computing, achieving overall responsibility is a challenge. A number of the processes might fail or be unreliable in different ways, therefore protocols should be fault tolerant, attack and collusion resistant:

1. Fault-Tolerant

Decentralised systems are less probable to fail accidentally because they involve a number of elements.

2. Attack Resistant

Decentralised systems are harder to manipulate since they do not have a single point of failure or central servers.

3. Collusion Resistant

It is more durable for participants in localised systems to interact and act in ways which profit them at the expense of different participants. Whereas centralised organisations interact in ways which profit themselves at the cost of the people.

Rules of Consensus

Below given are the 5 major types of consensus algorithms in Cryptoeconomics:

1. Proof of Work (PoW)

The Bitcoin blockchain uses this algorithm to ensure the protection of the system. The system is such that you’ll be able to solely participate by acquisition prices – Proof of labor (PoW). One party (the prover) proves to others (the verifiers) that a certain amount of a specific computational effort has been expended. If the transaction is verified, then they are rewarded in terms of blockchain token.

The accord rules designs in an exceedingly approach that it doesn’t pay to cheat. This straightforward game theoretical equilibrium is the core of the Bitcoin accord rule. A key feature of proof-of-work schemes is their asymmetry: the work – the computation – must be moderately hard (yet feasible) on the prover or requester side but easy to check for the verifier or service provider.

2. Proof of Stake (PoS)

Is an alternate methodology by which a blockchain network aims to attain consensus. For a blockchain transaction to be recognized, it must be appended to the blockchain. Validators carry out this appending; in most protocols, they receive a reward for doing so. It is more eco friendly than POW as there is no need to sacrifice energy to mine a block. The user has to prove they own a definite quantity of the cryptocurrency to come up with a block.

The more stake you have got, the higher is the probability for you to mine. In theory, this could stop users from making forks as a result of it’ll devalue their stake. Proof of Stake seems like an honest plan, however ironically, there’s the “Nothing at Stake” drawback. Since mining Bitcoins is expensive, it’s not good to waste your energy on a fork that won’t earn you any cash, but with Proof of Stake, it’s liberated to mine a fork.

3. Delegated Proof of Stake

DPoS uses a name system and period of time option to achieve consensus. To be more specific, a panel of trustworthy parties must be established, with all of its members eligible to form blocks and stop non-trusted parties from collaborating. Delegates, the parties accountable for making blocks, are unable to manipulate group action details.

However, they will stop specific transactions from being enclosed within the next network block. This on the face of it needs a good little bit of trust, that makes the construct look so much less appealing. Any group action not enclosed within the next block – or a block failing to form – can mean a future network block is double the scale.

In a way, this prevents malicious attackers from allowing transactions or blocks being created within the assigned fundamental measure. All it will do is probably slightly delay the same group action or block, however, it’s on the face of it not possible to forestall inclusion and creation within the long-term.

4. Proof of Burn

This technique is an alternative to Proof of Work and Proof of Stake. It may be used for bootstrapping one cryptocurrency off of another. The fact that miners need to show proof that they have purchased some coins – that’s, sent them to a verifiably unspendable address. This often valuable for their individual purpose of read, rather like proof of work; however it consumes no resources however the burned underlying quality

5. Proof of Authority (PoA)

A Proof of Authority is another consensus algorithm used in blockchains that basically provides one consumer (or a selected range of clients) with one particular personal key the proper to create all of the blocks within the blockchain.

Purpose of Cryptoeconomics

Before bitcoin became mainstream, it was considered impossible to establish a peer-to-peer network capable of achieving consensus without significant vulnerabilities to attacks and faults was unachievable.

This was called the Byzantine Generals Problem. It’s a logical conundrum which 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 (author of the whitepaper that established Bitcoin) 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.

Since then, 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.

Cryptoeconomics for Bitcoin security

The bitcoin security mechanism relies on the rule of majority, hence, a 51% attack (wherein bad actors seize control of the majority of the nodes, and by extension the network’s computing capacity) would grant them control of the blockchain.

Such a case would allow attackers to block fresh transactions from receiving confirmations or even reverse transactions entirely in such a scenario. Getting control however, would be really expensive, and demand extensive hardware.

Cryptoeconomics is one of the reasons for Bitcoin’s astounding success. 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 transaction history unless 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 crypto economic theories. This does not, however, guarantee that the system will continue to exist in the future.

CryptoEconomics Application Design

We can design applications that operate on 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.”

Crypto-economic design can also be found in the applications we create with these tools.

For example, cryptoeconomic procedures are needed for the prediction market Augur to work. Augur works 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 breakthrough allows for the creation of a decentralised prediction market. Gnosis is a prediction market that utilises a similar strategy but it also allows users to define alternative mechanisms for detecting genuine outcomes, using a similar method (commonly called “oracles”).

Token sales or ICOs (INitial Coin Offerings) are also designed using cryptoeconomics. Just like 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 demands 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 require knowledge of the capabilities and limits of the underlying blockchain on which the app is based.

Conclusion

In this article we familiarise ourselves with the complex concepts of cryptoeconomics, we not only learnt how it differed from economics in general and what other relation it shares, but we also tried to understand the exact purpose of cryptoeconomics. We then, learnt how crypto economics could aide in bitcoin security and then proceeded to learn about cryptoeconomic application design