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Cryptoeconomics: Diving into the Definition and Workings

Weiss Ratings

Cryptoeconomics studies the design and protocols behind any system that uses economic incentives and cryptography. Cryptography proves properties of information that have occurred in the past while economic incentives, encourage people to contribute to the network.

By combining cryptography and economics, cryptoeconomics allows economic interactions to occur in adversarial environments.

An example of a system that combines economics and cryptography is Satoshi Nakamoto’s Bitcoin payment network. The network uses the blockchain system to form a decentralized digital economy where people can trade without a central control and are incentivized to follow the rules.

Cryptocurrencies like bitcoin, ether and public blockchains are all products of cryptoeconomics. These digital tokens and networks will give birth to modern systems and applications from this new practical science.

Getting to cryptoeconomics

Mechanism design is a field of economics and game theory. It engineers economic incentives to achieve specific outcomes, despite having multiple self-interested parties.

In a bitcoin payment system, for instance, individuals act in their self-interest. While the vast majority are good players, rogue actors will attempt to overpower the system. Central authorities monitor this problem by punishing actors that misbehave.

Without a central control, a computer network must be able to handle conflicting information from different parts of the system. Computer scientists call this problem the Byzantine General’s problem.

A decentralized system requires a Byzantine fault tolerance (BFT) that can tolerate the Byzantine problem even when third parties are not present. Up until 2008, a consensus among all parties was believed to be impossible in a decentralized digital cash system. Satoshi’s proof of work became the underlying data that solved the Byzantine General’s problem.

Proof of Work  

A proof of work is the validation of work that has happened and proof that it is correct.

In the bitcoin blockchain, proof of work begins with computers verifying transactions on the network. Computers validate transactions by solving challenging mathematical puzzles. The blockchain network rewards the first miner who can solve this puzzle with bitcoin, in exchange for their computational power. The transaction is transmitted and validated by other computers in the network in the form of a decentralized public ledger.

Undergoing a proof of work requires a significant amount of computational energy. Overpowering or altering the blockchain requires so much power that the cost would outweigh the financial benefits.

While the proof of work serves as an excellent BFT, it is incredibly inefficient. It costs miners hundreds of millions of dollars every year to run algorithms and secures the network. The significant use of energy limits bitcoin’s ability to scale and grow into a proper currency.

Avoiding a 51% attack

While mining bitcoin is open to everyone, the sheer amount of computing required closes the mining community to those with the hardware capabilities.

Consequently, miners can band together to create a mining pool large enough to dominate the network. A pool with more than 50% of computational power in the bitcoin blockchain network can theoretically prevent new transactions from gaining confirmations. The mining pool that controls the majority of the network’s computing power could halt payments between users, reverse transactions and double-spend coins in the system.

By having the power to invalidate valid transactions and create fraudulent blocks, this problem is a significant flaw in the system.

Proof of Stake

The proof of stake is an alternative approach to validate transactions and achieve distributed consensus.

In the proof of stake, there are no miners. Actors place a stake or lock up a designated amount of coins they own for a period. By doing so, they have a chance of being selected to produce a block. Blocks are, therefore, said to be forged rather than mined.

Unlike the proof of work, there is no block reward. Forgers take transaction fees instead. Forging has greater scalability as it uses significantly less computing power than proof of work.  

The proof of stake also avoids the potential of a 51% attack, as the system is significantly fairer.

Actors could not merely upgrade computing resources and form a mining pool to cheat the system. Actors involved can only linearly increase their wealth, as forging new blocks is limited to the individual’s current stake in the cryptocurrency. The proof of stake leads to a more democratized system.

A proof of stake has significant benefits such as increased scalability, flexibility, safety and is a significantly cheaper and a greener alternative to Satoshi’s proof of work. The ethereum blockchain network is, therefore, shifting into a hybrid state between bitcoin’s proof of work and Casper, ethereum’s proof of stake.

Looking ahead

In an increasingly digital world, the move to an online digital currency using a secure and safe blockchain network is a necessity for the future. Cryptoeconomics utilizes original economic incentives that exist. It also uses cryptography to allow transactions to occur between individuals without the need of a third party.

With cryptography, individuals can trust the technology and mathematics that drive the system. While there may be flaws in earlier blockchain models, further development on cryptoeconomics can change the way trading, and transactions occur in the future.


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