An Introduction to Cryptoeconomics

In this guide, you will be introduced to the concept of cryptoeconomics and how it has given birth to an entirely new digital multi-billion dollar industry.

What is Cryptoeconomics?

Cryptoeconomics is a concept as well as a new term and, hence, has no official definition yet.

According to Ethereum developer Vlad Zamfir, cryptoeconomics is “a formal discipline that studies protocols that govern the production, distribution and consumption of goods and services in a decentralized digital economy. Cryptoeconomics is a practical science that focuses on the design and characterization of these protocols.”

The Ethereum Wiki defines cryptoeconomics as “the combinations of cryptography, computer networks and game theory which provide secure systems exhibiting some set of economic dis/incentives.”

While the founder of TheControl, Nick Tomaino, explains cryptoeconomics as “the study of economic interaction in adversarial environments. In decentralized P2P systems that do not give control to any third party, one must assume that there will be bad actors looking to disrupt the system. Cryptoeconomic approaches combine cryptography and economics to create robust decentralized P2P networks that thrive over time despite adversaries attempting to disrupt the network.”

In simple terms, cryptoeconomics is a new field of study that analyses economic interactions in the decentralized digital economy that was pioneered by bitcoin. It is the foundation on which cryptocurrencies and digital assets are built on.

How Cryptoeconomics Changed Peer-to-Peer Networks

The Bitcoin network was not the first decentralized peer-to-peer network. Before Bitcoin, we had peer-to-peer file sharing platforms such as Morpheus, and Kazaa, where users from across the world would share files with other members of the decentralized peer-to-peer network. However, what these file sharing platforms were missing was an economic incentive. Without economic incentives, there was little reason for users to keep seeding files that take space on their computers so that other users can download them. Aside from the legal aspect of sharing copyrighted material, a lack of economic incentive is what contributed to the demise of the above-mentioned platforms.  

Satoshi Nakamoto, the anonymous creator of Bitcoin, however, managed to create an economic incentive to uphold Bitcoin’s peer-to-peer network. He introduced Bitcoin mining rewards for those who used their computing power to secure the blockchain and to process bitcoin transactions. This was the birth of cryptoeconomics.

Before bitcoin was created, it was believed that it was impossible to achieve consensus among nodes to develop a decentralized digital currency system due to the Byzantine General’s Problem. However, due to the implementation of the proof-of-work consensus mechanism that allows Bitcoin network participants to receive new bitcoins for enabling the network to function, this previously “unsolvable” challenge was resolved.

Today, the Bitcoin network has become an internationally thriving peer-to-peer payment system that has a market value of over $45 billion dollars and a single bitcoin is worth more than a troy ounce of gold.

The Evolution of Cryptoeconomics

Bitcoin was the first technology to implement a rewards system to a cryptographically secured peer-to-peer network. Due to the network’s open-source nature, many other cryptocurrencies followed that were built on top of the technology that Satoshi Nakamoto has created.

Many new “altcoins” were merely bitcoin clones while some had new features that improved on their pioneering predecessor. Litecoin, for example, provides faster transaction times than bitcoin while DASH and Monero provide complete transaction anonymity. These cryptocurrencies, however, all use a proof-of-work mechanism similar to that of their predecessor, bitcoin.

A new blockchain that has introduced new concepts into the world of cryptoeconomics is the Ethereum Project. Ethereum was developed by Vitalk Buterin and officially released on July 30, 2015.  

Ethereum differs bitcoin in three key ways, which are also helping to reshape the dynamics of cryptoeconomics.

1.Proof-of-Stake vs. Proof-of-Work

The bitcoin network uses a proof-of-work consensus mechanism, which means that participants who want to earn rewards through bitcoin mining need to use their computational power to maintain the network by validating and processing transactions. For this work, they receive financial rewards in the form of new bitcoins. However, the proof-of-work mechanism is very inefficient. Not only is it expensive to maintain bitcoin mining hardware, it also requires a substantial amount of energy to keep the bitcoin network running. According to Vice Motherboard, the bitcoin network is projected to consume as much energy as the entire country of Denmark by 2020.

Ethereum, however, is addressing this cryptoeconomic inefficiency by moving towards a proof-of-stake consensus. A proof-of-stake consensus mechanism enables users that hold the cryptocurrency ether, to receive rewards for validating transactions without the need for electricity-intensive mining hardware to be used. Ethereum still runs on proof-of-work but it is expected to switch to a proof-of-stake consensus mechanism within the next two years.

2.Monetary Policy

Bitcoin has a hard coded monetary policy built into its network, which allows for 21 million bitcoins to be created in total and, thereby, limits the supply of bitcoins. Furthermore, the rate at which bitcoin are created halves every four years. Bitcoin miners (those who enable the network by validating and processing transactions) are rewarded with the newly created coins.

Ethereum’s monetary policy does not involve a finite number of ether that can ever be created, which could be seen as a negative. However, as Ethereum moves towards proof-of-stake, the holders of ether will be the ones to receive new ether for validating transactions. This is considered a more inclusive way of distributing coins than Bitcoin’s proof-of-work approach, which favour large well-funded centralized mining operations.

3.Different Script Language

Ethereum also uses a different scripting language than bitcoin, which allows for decentralized applications and smart contracts to be developed on top of its blockchain. This makes Ethereum and much wider applicable blockchain than Bitcoin’s and adds entirely new layers to the field of cryptoeconomics.

The Future of Cryptoeconomics

It is hard to predict the future of such a new field of social science. However, the developments in cryptoeconomics in the past decade or so are suggesting that cryptoeconomics has the potential to play a major role in society.

Through the use of trustless peer-to-peer payment networks and self-executing smart contracts, intermediaries can be alleviated while payment speed and security can be increased. As technology becomes an increasingly important part of our day-to-day lives it would only make sense for economics to become part of that too.