Although you may not know it, Bitcoin wasn’t the first attempt at creating a peer-to-peer cash system. Hashcash, Bit Gold, and Digicash are some early examples of digital currencies that never quite took off.

Bitcoin worked because Satoshi Nakamoto brilliantly combined incentives that encouraged different parties to sustain the network's security, decentralization, and functionality.

Nakamoto's design inspired "cryptoeconomics", a concept that combines cryptography and economics to create a functional, decentralized peer-to-peer network to secure transactions.

Cryptoeconomics can be hard to grasp, but this article is an ELI5 introduction to the concept. We’ll consider cryptoeconomics in detail and explore its applications in real-world situations.

The Meaning of Cryptoeconomics

Cryptoeconomics is a portmanteau of “cryptography” and “economics.” As defined by the MIT Cryptoeconomics Lab, cryptoeconomics “brings together the fields of economics and computer science to study the decentralized marketplaces and applications that can be built by combining cryptography with economic incentives.”

Cryptoeconomics is how we design rules that incentivize participants in a distributed system to act honestly and secure the network. Cryptoeconomics is crucial in sustaining decentralized networks like public blockchains and preserving their unique qualities—security, immutability, and censorship resistance.

Many early peer-to-peer networks failed because participants had minimal incentives to sustain the network. Without any rewards for contributing to the p2p network, there was nothing to stop people from trying to attack or game the system.

Satoshi Nakamoto was the first person to devise a system of rewards and punishments to encourage honest behavior. Called “proof-of-work”, Bitcoin’s mechanism required computer nodes called “miners” to invest a valuable resource (electricity) before participating (i.e., adding new transactions to the blockchain).

Honest miners who added valid transactions received a “block reward”, which consisted of newly generated coins and transaction fees. Conversely, dishonest miners lost the block reward but also failed to recoup gains on their investment (electricity).

We’ll dive deeper into the cryptoeconomics of Bitcoin later, but the above summarizes the main goal of cryptoeconomics: incentivizing honest behavior and punishing malicious actors. For now, let’s look at the various components of cryptoeconomics.

Components of Cryptoeconomics

It’s easy to conclude cryptoeconomics is just another field of economics. However, while cryptoeconomics borrows from classical economic concepts like game theory, it adds several elements, making it an entirely new field.

This section covers several concepts that underpin cryptoeconomic protocols, especially those found in cryptocurrencies. It’s also important to note that cryptoeconomics applies to other cases aside from cryptocurrencies.

Game Theory

Game theory is the study of the interaction between rational agents in a system with clearly defined rules and rewards. The assumption is that individuals always protect their self-interest and follow strategies that benefit them. Therefore, the role of game theory is to predict the potential actions of individuals and evaluate the results of those actions on the system.

Mechanism Design

Mechanism design combines both economics and math to create systems that produce desired outcomes. If game theorists study how different players act in a game, then mechanism designers create the game itself.

In the context of cryptoeconomics, mechanism design guides the creation of functional blockchain networks. By understanding how participants may act, we create certain rules that ensure they act how we want, i.e., honestly.

Economic Incentives

Economic incentives refer to the system of rewards that influences the behavior of individuals. Cryptoeconomic protocols use economic incentives to control the actions of nodes in a distributed network.

Here's a brief illustration of economic incentives:

Jack works for XYZ Corp. as an accountant and receives a salary (along with other benefits) as compensation. Now, Jack could use his position to steal money from XYZ Corp, but he doesn't.

That Jack doesn't steal from the company doesn't make him a saint. Heck, Jack could be the greediest person to ever work as an accountant.

However, Jack cannot plausibly steal because of the consequences. Getting caught would cost Jack his job and lead to a loss of income. Jack's employer could sue—more money to be spent on lawyer fees—and put him in jail. Also, Jack will likely find it difficult to get a job after jail, since employers may be unwilling to hire an ex-convict to secure their funds.

The summary here is: Jack has incentives to remain honest regardless of his values. In the same way, blockchain protocols attempt to design economic incentives that promote positive actions among nodes in the network.

Token Engineering

The difference between Bitcoin and other peer-to-peer systems that came before it was the existence of a financial incentive for participation. This incentive was in the form of "tokens"—digital assets that have some value attached to them.

In Bitcoin's case, miners received a certain number of tokens (bitcoins) for validating transactions and securing the chain. Other decentralized networks adopted the same method: rewarding users with tokens for sustaining the system.

But the token itself must be designed to have value, or else it'd be worthless, reducing financial incentives for network participants. This is where token engineering comes in—we must program features into tokens that make them valuable.

Here's an example:

Imagine a city issues tokens that grant the holder access to the Metro Bus. This token has value because it allows you to travel within your city. It's also valuable because other people may want that token and will pay you to use it.

The value of the token also depends on supply and demand. Suppose more people want to use the Metro Bus, but not enough tokens to go around. People will be willing to pay higher amounts to secure the token, increasing its value.

Thus, the Transport Department may deliberately limit the introduction of new tokens to avoid crashing the value of existing units. Additionally, it may raise the requirements necessary to acquire one of the tokens—for example, requiring that holders must be six-figure earners.

Cryptoeconomic protocols may implement similar measures to program value into tokens. This includes designing them for specific uses, capping supply, and raising the bar for ownership.

For example, Bitcoin has value because it's useful for storing value (inflation hedge) and settling transactions (payments). Its value also derives from scarcity (on 21 million bitcoins will ever be mined) and acquisition costs (miners must invest in specialized hardware and electricity)

Cryptography

Cryptography plays a key role in securing peer-to-peer decentralized networks. On a blockchain, "cryptographic proofs" are necessary for validating information. Without cryptographic proofs, it'd be impossible to verify the truth of transactions and determine if nodes are acting honestly.

Two important cryptographic proofs used in Bitcoin are hashes and digital signatures. Let's look at both concepts in detail:

Hashes

A hash function runs an input of any size and returns an output of fixed size. Here's an example of a hash derived from running "emmanuel" through an SHA-256 hashing algorithm:

25eaebedfb6ad2b4701c34333231755afb593792844378aebf0117c9e3ef4402

A hash is a one-way function, meaning you cannot determine the input from the output. Using the above example, there's no way you can know the text ("emmanuel") encoded in the hash just by looking at it.

While hashes help protect the confidentiality of information, their usefulness lies in their ability to verify information on a decentralized network.

Because hashes are linked to their inputs, changing the information causes the hash value to change. If I change "emmanuel" to "emmanuelle", the resulting hash looks very different from the original:

fa14cf60ee743d478f76fb1c5ee8c5f3889d58f2b8636c1a11fbdf0ca7f2c863

So, how do hashes apply to the blockchain or, specifically, cryptoeconomics?

Nodes must hash each transaction in a block and, thereafter, combine these hashes into a single hash called the "root hash." This root hash derives from all transactions contained in a block and serves as a "digital fingerprint" for the block.

If the information within a block is altered, then the block's hash will change as well. That way, other nodes can easily notice the alteration attempt and reject the transaction block.

Another use-case for hashes, commonly associated with Bitcoin, is verifying if nodes have done the "work" necessary to add new transactions. Bitcoin requires miners to find a target hash before adding blocks to the chain. Since. finding this number is incredibly difficult, anyone who does automatically has "proof of work" and can broadcast new transactions on the blockchain.

Digital Signatures

Digital signatures are used to verify the source of information in a decentralized network. Without digital signatures, it'd be difficult to determine who initiated a transaction.

Digital signatures work through a public-private key generation protocol (PGP). When a new blockchain address is created, a "public key" is generated from the address, while the private key is derived from the public key.

Think of the public key as an "ID badge" that you can share to prove your identity. However, the private key is like a bank PIN used to authorize transactions. Like the bank PIN, your private key must be kept secret.

So, how do digital signatures apply to blockchains and cryptoeconomics?

Generating a digital signature requires "signing" a transaction with your private key. Public-private cryptography is structured such that anyone can verify your signature if they know your public key.

The basic rule of any blockchain is: transactions are only valid if signed with the correct private key. With this feature, nodes can easily validate transactions that other nodes submit for addition to the blockchain. Thus, any invalid transactions submitted will be rejected and the dishonest node penalized.

Cryptoeconomics in Action: The Bitcoin Example

As with all concepts, our understanding of cryptoeconomics might benefit from analyzing its real-world applications. Bitcoin was the first successful cryptoeconomic experiment and gave birth to cryptoeconomic research, so we’ll use it in our example:

Before miners can add new transactions, they must solve complex puzzles as “proof of work.” The Bitcoin protocol is pre-programmed to increase the difficulty of those puzzles, so miners must invest in powerful computers, such as Application Specific Information Computer Systems (ASICs).

By nature, ASICs cost a lot, consume huge amounts of electricity, and require specialized cooling options, as they produce considerable heat. If we add equipment costs, electricity costs, and cooling costs, it’s obvious miners are making a considerable investment.

To recoup their investment, miners must try to secure “block rewards” by adding valid transactions to the Bitcoin blockchain. Miners can then sell bitcoins earned through the block reward, take their profit, and reinvest the rest into mining operations. With the current block reward pegged at 6.25 BTC (around $237,000), miners have every incentive to follow the rules.

Bitcoin’s cryptoeconomic design further protects it from outside attacks. To control the Bitcoin consensus mechanism, malicious actors need to control more than 51 percent of the total computing power (hash rate) dedicated to the network. A successful 51 percent attack would allow malicious actors to reverse transactions, block new transactions, and potentially double-spend bitcoins.

However, the costly nature of mining means an attack on Bitcoin requires massive investments in electricity and hardware. An estimate suggests attackers would need to spend around $34 billion on hardware and $23 million on electricity every day.

Perhaps now we see why cryptoeconomics is crucial to Bitcoin’s security and functionality. Bitcoin wouldn’t exist as a decentralized, censorship-resistant, and secure payments network without Satoshi Nakamoto’s brilliant combination of cryptography and economic incentives.

The Value of Cryptoeconomics

Cryptoeconomics is useful in designing consensus protocols, which help nodes agree on the true state of the blockchain. Bitcoin’s proof-of-work is an excellent example, but other consensus algorithms like proof-of-stake apply a similar principle.

Let’s use Ethereum’s proof-of-stake system as an example. To add new transactions, nodes (“validators”) must lock some tokens (ether) into a smart contract. This is similar to Bitcoin’s PoW system which requires miners to commit resources, however, validators are committing money, not electricity.

Ethereum’s PoS protocol is designed to select validators randomly based on the size and age of their stakes. If a validator acts dishonestly, the funds in the smart contract are automatically frozen. Dishonest validators also lose the transaction fees paid out on each valid block.

We can also apply cryptoeconomics to designing secondary applications that run on the blockchain (decentralized applications). The underlying blockchain protocol developers create tokens necessary for economic incentives and smart contracts that power these applications.

An excellent example of an application powered by cryptoeconomics is Augur, a decentralized prediction market. Typically, users bet on certain outcomes and receive profits or gain losses depending on the outcome.

Augur relies on nodes (“reporters”) to feed it the information it uses to determine if a bet is successful or not—and this is where cryptoeconomics comes into the picture. Reporters stake tokens (REP) and earn rewards for reporting truthful outcomes. However, any attempt to report false information leads to a loss of staked tokens.

Decentralized Autonomous Organizations (DAOs) are another use-case for cryptoeconomics. In a DAO, a token allows the holder to contribute work and earn rewards for their participation. To earn greater rewards and increase participation, DAO members must buy more tokens, which is just another example of economic incentives in action.

Final Thoughts

Cryptoeconomics is essential for creating self-sustaining, secure, and useful decentralized networks. By creating incentives, it’s possible to bring together unaffiliated individuals to participate in a peer-to-peer system without a central entity enforcing rules of behavior.

More importantly, the long-term sustainability of a blockchain or blockchain-based project is linked to cryptoeconomics. Without a well-designed system of rewards and penalties, participants have no incentives to keep the network functional and secure.

Cover photo by Art Rachen on Unsplash