What is cryptoeconomics and why is it a crucial element in decentralised networks?

You may be familiar with Torrent Systems, a software that allows anyone to download and share their files with a decentralised network free of cost. Torrent works on an honour system; if you download a file, you are expected to share the file with others in the network.

However, many users don’t follow this honour system as they don’t see any economic benefits for doing so, so it defeats Torrents’s very purpose.

The advent of cryptocurrency and blockchain-powered decentralisation has changed this scenario. Now, decentralisation comes with a lot of economic and other benefits for participants.

In the crypto industry, the area that deals with the economic benefits for participants in a decentralised network is called cryptoeconomics. This discipline seeks to solve user coordination problems through economic incentives and game theory.

A crucial element in decentralised networks

In a nutshell, cryptoeconomics is a discipline that studies the protocols that govern the production, distribution and consumption of goods and services in a decentralised digital economy. It combines cryptography with economics, allowing for the coordination of the behaviour of network participants. Cryptoeconomics is crucial while building decentralised networks as it eliminates the need for a trusted third party to align participants’ incentives.

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Traditionally, decentralised networks rely on cryptography to verify data transactions and provide economic incentives to encourage participants to behave in a certain way. It is achieved through a process called mining, where the miners who successfully validate a block of transactions receive bitcoins in rewards. This approach encourages miners to act honestly, making the network more secure and reliable.

Crypto mining, however, involves solving a complex mathematical problem based on a cryptographic hash algorithm.

What are hashes?

Hashes tie together blocks, creating a timestamped record of approved transactions. They are also used in the computational puzzles that miners compete to solve.

One of the consensus rules governing crypto transactions is that a Bitcoin can only be spent if a valid digital signature is generated from a private key. Bitcoin’s security model is also built around penalties and barriers to entry. These rules were introduced to prevent malicious actors from potentially taking control of the majority hashing power, a process known as a “51% attack“.

Nevertheless, gaining control of the hashing power is not easy and is prohibitively expensive; it costs nearly US$2 billion in hardware and electricity to do so.

These requirements and rules make Bitcoin immensely popular and successful even ten years after its invention by Satoshi Nakamoto. Nakamoto foresaw people’s future thought processes and made assumptions about how they would react to specific incentives.

Nakamoto also made the cryptographic protocol rigid to make it easier to reward miners. There exists a symbiotic relationship between miners and the Bitcoin network. Without miners, there would be no confidence in the blockchain records. This relationship gives us confidence about Bitcoin’s future.

Cryptoeconomic Circle theory

In cryptoeconomic, a theory emerged recently to show how value flows through different participants in a crypto network. This theory, known as cryptoeconomic circle, was published by Joel Monegro, Partner at Placeholder Capital.

The cryptoeconomic circle (see the diagram) represents the three network participants — miners (supply), users (demand), and investors (capital). Each group exchanges the flow of value via a scarce cryptoeconomic resource called tokens.

The relationship between miners and users is relatively straightforward — miners are compensated for their work via tokens used by the users. Creating a network based on a mining setup makes sense as long as the costs of a decentralised system are outweighed by the benefits of having a distributed supply side (low cost of production, higher reliability, etc.).

As per this theory, the third participant — investors — has two vital roles: funding the cost of developing new technology, and 2) supporting the network by supplying financial capital to miners.

Monegro further divides investors into two: traders (short-term investors) and holders (long-term investors). While traders create liquidity for the token so that miners could cover operational costs, holders capitalise on the network for growth by supporting token prices.

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Traders are a direct form of value transfer. On the other hand, miners sell earned tokens in the open market to cover their costs and reinvest profits. Holders is an indirect transfer of value in miners’ balance sheets rather than their income statements.

The cryptoeconomic circle focuses on understanding how networks operate and exchange or capture value.

Conclusion

As discussed above, cryptoeconomics as a discipline is crucial in decentralisation, especially in times of blockchain rage. It has broad implications, from supporting the first major cryptocurrency to forming the foundation of the next stage of digital currencies.

By educating ourselves on previous cryptoeconomic successes and pitfalls and staying up to date on the latest cryptoeconomic research, we can glimpse what the next major crypto networks may look like. However, we still have a long way to go to achieve ‘cryptoeconomic literacy’.

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Copyright: slonme

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