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The term cryptoeconomics is one that creates a whole lot of confusion regarding its meaning. People often misunderstand the term for some crypto version of economics, which it definitely is not! Cryptoeconomics is a science that makes use of cryptography and incentives to design various applications, systems and networks. In more basic form, cryptoeconomics is about building things.
Considered to be a subfield of applied cryptography, cryptoeconomics takes economic theory and economic incentives into account while building applications or technologies. Cryptocurrencies like Bitcoin, Zcash and Ethereum are all built on this concept. Cryptoeconomics has led to the development of robust applications by combining the soundest technologies of economics, cryptography, networking theory and computer science.
Before we go into a detailed study of cryptoeconomics, let’s have a look at the dynamics of our current financial system and where cryptoeconomics fit into it right now.
Our financial system – the journey so far
The current financial system and economy have passed through quite an evolution to reach the stage it is in today. In the early years, our economy was based on the barter system, where some goods were exchanged for another. This led to chaos as there were no fixed values or rules for exchange. Hence a unified value system in the form of currency was introduced.
Today, our currency value is determined by boundaries. A unified value system does not exist in our global economy. Countries like Greece face huge difficulties due to an unstable currency value. This is where the idea of digital currency arose from. However, the digital currency failed to find a foothold in the economy due to its vulnerability to security attacks, mainly the double spending problem. The double spending problem refers to the safety issue where people are able to hack the digital currency, recreate it, and spend it as they please, leading to the devaluation of the currency.
Cryptocurrency is the latest addition to our financial system that is yet to be accepted worldwide. An improved version of digital currency when it comes to security, cryptocurrency is built with what is considered as the best features of networking theory and cryptoeconomics. Cryptocurrencies such as Bitcoin have managed to find success with a lot of applications being built in its context.
The value of Bitcoins is maintained by regulating its supply in the digital economy. By regulating the production of bitcoin, its value stays high.
What is cryptoeconomics?
Cryptoeconomics refers to the technology that employs both cryptography and economic incentives for the creation of robust decentralized applications or protocols. The reason for the success of Bitcoin among various other decentralized protocols is widely acknowledged as the efficiency of cryptoeconomics that worked at the core of its protocol.
Cryptoeconomics aims to replicate this success in every field including transaction, storage, computation, power and prediction. With blockchain playing an important role in various applications today, the scope of employing cryptoeconomics and its various incentives are on the rise.
The design of Bitcoin is mainly based on the penalties and economic incentives in it. The economic incentives in a Bitcoin are gained through mining or creation of a block. If the user is able to create a block, he/she will be able to produce Bitcoins.
A Penalty is a part of the Bitcoin security model. The only way that the security of a bitcoin blockchain can be compromised is when an attacker is able to access the majority of the application’s hashing power. However, the cost required for this is quite high and the process is very difficult to get through. The hash function not only offers security but integrity as well by linking the previous blocks to one another. The public-private key cryptography ensures additional security and offers the users the access and control over their bitcoins. On a deeper note, cryptoeconomics is not limited to just computer science or network theory, it is interdisciplinary.
Want to know more about cryptoeconomics-based applications?
Cryptoeconomics – the link with economics
The term cryptoeconomics is one that can misguide people to think of it as an application of some level of economics, which it is not. It is not either a microeconomic or macroeconomic application. The only link it has to mechanism design would be a type of game theory, where the best strategies are designed to obtain the best outcome. In cryptoeconomics, we employ the best economic theories to design a mechanism that would help produce an equilibrium outcome.
The theories used to design a mechanism in cryptoeconomics mainly involve software and cryptography in a decentralized and distributed system. Incentives could prove to be a good security model for some time but nothing can be said about the future. The success of a security model mainly depends on the ability to gauge how people would react to certain things.
Some applications of cryptoeconomics
Different systems in operation today employ cryptoeconomics at the heart of it. One such system is the consensus protocol. The consensus protocol in blockchain sets the platform for a reliable agreement without having to depend on a centralized trust party. In the case of Bitcoin, this is known as proof of work consensus, as the miners are required to commit the work initially in terms of electricity and hardware before being allowed to participate in the mining process and seeking rewards.
Cryptoeconomic research is still on for designing a better alternative for the proof of work consensus. Proof of stake is an alternative that is being developed to the current system with a number of improvements and variations.
State channels are another application of cryptoeconomics where small set interactions are designed between users. This helps in overcoming one of the biggest disadvantages of blockchain, the cost. Designing smaller interaction sets ensures that the blockchain is made more efficient by moving some of the processes, off-chain while maintaining the trust factor with the help of cryptoeconomic design.
State channels can be used not just for payment transactions but for any update process. However, it can be easily explained in the context of a payment transaction. Consider that A and B want to conduct a number of transactions involving small payments. If A and B perform this via a blockchain, the cost involved increases with each transaction and also, the time taken to build the blocks increases.
With the help of state channels, these small transactions can be conducted off-chain. A and B sign off the transactions in a way that can be conducted on the blockchain but is not done so. When that is done, only the last transaction is updated on the blockchain. The safety of a transaction is not compromised as it is performed in the same format as can be done on a blockchain.
The cryptoeconomic technology has been viewed in the context of Bitcoins or blockchain technology till now. It’s time to widen the scope of this promising branch of technology and use its benefits outside the scope of the finance system. The world has a lot to benefit from if cryptoeconomics stays to bring about what it promises to do!
Further reading list
Want to learn more about cryptoeconomics? Here are some links for a deeper understanding of it.
- A Crash Course in Mechanism Design for Cryptoeconomic Applications
- Understanding Crypto-Economic Security through Game Theory
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