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Crypto-economics Explained

Crypto-economics Explained

Ever since Bitcoin was unveiled in 2008, many Altcoins have been introduced. As of February 2018, there are approximately over 1,400 cryptocurrencies, and the number is growing with Bitcoin being the most popular and successful one. So far, Bitcoin controls a fair share of the total market at $170 billion out of the possible $750 billion for all the cryptocurrencies.

Notably, a significant number of banks have begun to explore the adoption of cryptos and the underlying Blockchain technology for both retail and large scale payments. Recently, the Bank of Canada and Monetary Authority of Singapore started to explore the use of Blockchain for interbank transfer of payments. 

In Germany, the Deutsche Bundesbank has already implemented a preliminary system based on Blockchain for settlement of financial assets. Many proponents are certain that cryptocurrency and its underlying Blockchain technology will have a significant impact on the future of payments and financial platforms.

Whereas policymakers are concerned about the prospects and hurdles brought about cryptocurrencies and Blockchain, there is little literature regarding crypto-economics regarding the appropriate use of these technologies and optimal design of the systems. This chapter dives deeper into the world of crypto-economics to help you understand the economic trade-offs necessary to address relevant policy issues. 

What is crypto-economics?

Economics is often regarded as the study of choice. Economics can help us explain how different groups of people respond to incentives. The unveiling of cryptocurrency and its underlying Blockchain technology doesn’t require any new theory of human choice because human beings haven’t changed. 

Therefore, crypto-economics has most to do with mechanism design which is related to game theory. Game theory allows us to examine a particular strategic interaction (a “game”) and try to understand the best strategies that each player can take. In mechanism design, we begin with an anticipated outcome and work backward to create a game that, if players were to pursue on own self-interest, the results would be desirable. 

Just like mechanism design, crypto-economics focuses on designing and creating platforms. However, in crypto-economics, the mechanisms for designing and creating economic incentives are developed using cryptography and software that is decentralized, transparent and immutable.

You can think of crypto-economics as the application of cryptography and incentives to create a whole new class of platforms, networks or applications. In other words, crypto-economics is about creating new things and has everything in common with mechanism design.

But don’t get me wrong here.

I’m not suggesting that crypto-economics is a sub-field of economics, but, rather an area that relies on cryptography to manage the creation of economic incentives through economic theory. You can think of cryptocurrencies such as Bitcoin, Ethereum, Litecoin, Zcash, etc. as products of crypto-economics.

Ideally, crypto-economics is what makes the ubiquitous Blockchain technology to be interesting and different from other existing technologies. As a result of the first application of Blockchain technology in Bitcoin, we can now combine cryptography, computer science, network theory and economic incentives to build a whole new of systems that can accomplish tasks that previous disciplines couldn’t do. 

To grasp the concept of crypto-economics in detail, we must first understand what cryptocurrencies and Blockchain mean before delving deeper into the economics side of it.  

What are cryptocurrencies?

For many years, tangible tokens such as shells and gold were used as means of exchange. Some of these tokens such as gold, coins, and banknotes are still used today to settle payments. In this environment, there must be a direct exchange of the sellers’ products/services with the buyers’ tokens which allows an immediate and final payment. The diagram below illustrates this form of payment:

Source: Chapman.edu

However, this approach may not work in instances where the 2 parties are unavailable in the same physical location such as e-commerce. If you were to settle payments in e-commerce, you’d be forced to rely on digital tokens where the payment is facilitated via a string of bits. 

However, it’s difficult to prevent a buyer from copying the bits and re-using them over and over again to make payments. This problem is often called “double-spending.” In digital currencies, the double-spending problem can be solved only where there is a trusted intermediary (third-party) such as banks and PayPal which will manage a centralized database (ledger) as shown in the diagram below:

Source: Chapman.edu

In many cases, it isn’t possible to find a single organization that we can all trust to manage the centralized ledger. Reliance on the centralized ledger can also be undesirable in instances where there’s a single point-of-failure. The financial crisis of 2008 was enough proof that the centralized approach to management of currencies isn’t feasible.

Cryptocurrencies apply cryptography to verify and secure transactions besides controlling and managing the creation of new units of a particular currency. Cryptocurrency transactions are facilitated by a Blockchain (a public ledger) where no coins are minted, or bills are printed. 

Cryptocurrencies are decentralized—meaning no regulatory body or government controls and manages how the currency is created and supplied. To understand how cryptocurrencies work, consider the example below:

Alice wants to send some coins to Bob. To do this, Alice must first alert her intention of transferring her bitcoins to Bob on the entire network (Blockchain). Once the computers—simply called nodes—have validated the data above, Alice’s transaction is included in a block and linked with the previous block, hence the name “Blockchain.” 

Once confirmed, the transactions are immutable. In other words, the transactions can’t get undone or even tampered with because doing this will mean tinkering with all the blocks that were created earlier. The diagram below illustrates the transaction:

Source: Visualcapitalist.com

It’s simple. Not so fast!

Both Alice and Bob must have a wallet. A wallet is just a software that holds both Alice’s and Bob’s private key and cryptocurrency address (public key). Alice’s wallet will contain a record of all her transactions and the account balance. Each cryptocurrency will have a corresponding private key. Whereas the public key acts a cryptocurrency address and is accessible to the entire world, the private key is only accessible to Alice (kept safe and secret). 

Alice’s transaction from her cryptocurrency address will be signed with her private key as a digital signature. To do that, Alice will put her private key and the transaction particulars such as the number of coins to send to Bob into the wallet software on her PC or smartphone which generates a digital signature that is sent across the entire network for validation.

So, how are keys generated?

Bitcoin is a decentralized system with no dedicated and centralized authority to issue out private keys. Private keys are randomly generated whenever a user creates a wallet. Essentially, a private key is a 256-bits long that contains strings (numbers and letters). Therefore, Alice’s PC will generate the private key the moment she signs up for a wallet. However, her public key will be derived from the private key using the mathematical function. 

The mathematical function that relates Alice’s private key to the public key is called Elliptic Curve Cryptography (ECC). Consider the following example that illustrates how ECC works:

Suppose elementary school pupils who have just learned multiplication but are yet to learn division. These pupils may have learned from their teacher that 2 multiplied by 3 is 6. To help them master multiplication, sometimes the teacher can hide 2 and display only 3 and 6 as follows:

To find the missing (?) number, the students may recall that their teacher once taught that 2×3=6, therefore fill in the missing number as 2. In other words, the pupils have multiplied their teacher’s special number (2) with 3 to obtain the result oblivious of the magic of division.

The same principle occurs in ECC. 

The knower of the private key (Alice) is gifted with both the powers of multiplication and division while the public key holders are limited to multiplication only. Since computers can generate large numbers, generating a private key won’t be a problem on Alice’s PC. Once the private key is formed, its corresponding public key becomes easy to compute on Alice’s PC. This is because Alice’s PC has both multiplication and division powers. 

On the other hand, other public key holders can’t guess the private key (as illustrated in the above example) because they only have the multiplication powers. Therefore, it’s difficult to reverse-engineer the public key and get the private key.

Essentially, a cryptocurrency platform in a decentralized network that should overcome 3 hurdles:

  • Establishing consensus in the decentralized network
  • Preventing double spending problem
  • Encouraging/introducing economic incentives for proper transaction validation

#1: Establishing consensus 

Because there is no centralized authority, cryptocurrency relies on distributed confirmation of transactions, their updates, and storage of transaction histories. In the above example, Alice’s transaction can only be confirmed when nodes—simply called miners—confirm that:

  • Alice owns the coins she claims she has and is transferring to Bob; and
  • She has not copied or transferred coins to another person on the network.

Obviously, the demands above require consensus between the nodes. Such a consensus must be trustworthy and maintained for correct record of transactions. This trust is established by establishing a competition-based system for updating record. This competition often takes various forms. 

In Bitcoin, the process is called mining, and miners compete to solve a cryptographically complex and costly problem using proof-of-work (PoW). 

Proof-of-Work (PoW)

PoW is the power behind Bitcoin’s consensus mechanism. Besides Bitcoin, PoW is also used by other cryptocurrencies such as Litecoin and Ethereum (for now). In PoW, miners use their GPUs (Graphical Processing Units) or ASICs (Application Specific Integrated Circuits) — high powered specialized mining hardware—to complex hash algorithms which validates the Blockchain.  

PoW is one of the most path-breaking processes in Blockchain systems. Earlier the majority of decentralized peer-to-peer (P2P) digital currency systems used to flop because of the BGP (“Byzantine General’s Problem”). To appreciate the nature of BGP, consider the following scenario:

Suppose there is a group of generals who want to attack a particular city and are facing 2 distinct problems:

  1. The generals and their armies are miles apart. Because of the distance between them, centralized authority can’t be used to help coordinate the attack; and
  2. The city has a large army. Therefore, the only way that they can successfully attack and win is if they attack at once.

To make a successful coordinated attack, the armies on one side (right) of the castle can send an emissary to the armies on the other side (left) of the castle with a secret message that says “We are attacking on Tuesday.” However, imagine the armies on the left are not prepared on Tuesday and send back the messenger with the message “No, we are attacking on Thursday.” Obviously, there will be a problem. For instance, the messenger may be compromised, get captured, killed and even replaced with another messenger by the city with one result: uncoordinated attack and eventual defeat.

The problem above bears a resemblance to Blockchain. The chain is a large network. Therefore, it’s difficult to trust one party in the network. For instance, if you’re sending someone 0.5BTC from your wallet, how sure are you that the transaction isn’t going to be tampered with?

Satoshi Nakamoto—a pseudonymous group of persons—behind the unveiling of Bitcoin was able to solve the BGP using a PoW protocol. Here is how the protocol works:

  • The sender appends a nonce—a random hexadecimal value—to the original transaction;
  • The sender hashes the transaction appended with a nonce and sees the result;
  • If the hash requirements are satisfied, the transaction is broadcasted to the network; and
  • The nodes in the network compete to solve the hash function and correlate it with the sender to validate the transaction.

The node which successfully adds a block to the Blockchain after the mining process is incentivized via bitcoins. In the case of Bitcoin, the code has been written to automatically generate a fixed amount of bitcoins as a reward to the fastest miner as an incentive in every 10-minutes period with the reward being halved after every 210,000 blocks have been successfully mined. 

Proof-of-Stake (PoS)

Enhancing the PoW systems and creating alternatives has been an active area of crypto-economic research and design. For instance, the Ethereum’s current PoW consensus algorithm is different from the original Bitcoin’s PoW that allows faster block times. It’s also more resistant to mining centralization which can result from ASICs.

As of this writing, Ethereum is planning to migrate to Proof-of-Stake (PoS) consensus algorithm that is commonly called Casper. Casper is an alternative PoW which doesn’t require specialized mining hardware such as ASICs which consume loads of electricity.

The whole point of requiring miners to purchase expensive mining hardware and spend loads of power is to impose a cost on them. For instance, the expensive ASICs in Bitcoin mining makes the so-called 51% attack expensive for miners to attempt. Casper algorithm uses deposits of cryptocurrency to generate the same level of disincentive instead of the real-world investments such as hardware and electricity in PoW. 

For instance, to mine using the Casper algorithm, you’ll be required to commit a certain sum of Ether into the smart contract to act as a “collateral” or bond. Committing a certain sum of Ether in the smart contract increases the cost of a 51% attack since the hacker would have to commit a large amount of Ether to effectively attack the platform.

#2: Double spending

Bitcoin was the first cryptocurrency to prevent double spending problem. Before Bitcoin, many attempts had been made without success. The possibility of double spending can undermine the application of a given cryptocurrency. Bitcoin and other cryptos solve the double spending hurdle by applying Blockchain and confirmation lags. 

Unlike cash, a Blockchain keeps track of all the transaction histories. Essentially, a block is just a series of transactions which have been performed by the cryptocurrency users. To maintain a chronological history between blocks, a chain is created starting with the first block (genesis block) to the current block. 

The result is a Blockchain that you can store on your PC and publicly verify as shown the figure below:

Source: Visualcapitalist.com

All the transactions that have occurred in different blocks must be dynamically consistent in a Blockchain. If you attempt to revoke a historical transaction, you to solve complex cryptographical hashes for an alternative blockchain which is consistent with the original Blockchain. Such a process is costly and lengthy which makes it impossible. 

Double spending can also be prevented by using confirmation lags into the transactions. By waiting for some blocks prior to completing the transaction such as delayed delivery of goods and services, it becomes difficult to change transactions in any sequence of blocks.

#3: Economic incentives

As it is with any concrete economic system, there must be rewards and incentives for people to get the work done. Similarly, the system should have a form of punishment for unethical miners who don’t perform good jobs. 

Participants in Blockchain systems have 2 main sets of incentives: 

Set 1

Here, the incentives can take two forms:

  • Tokens where the actors who participate and contribute towards the growth of Blockchain are given some cryptocurrencies for their efforts; and
  • Privileges where actors are assigned decision-making rights. For instance, miners who successfully mine new blocks can become temporary managers of the block and decide on how the transactions are stored. 

While venture capital investments and IPOs (Initial Public Offerings) provide dividends to the investors as compensation for shares in the company, Blockchain based projects can provide either a token or a privilege.  You can think of tokens as specific values of digital assets that you control on the Internet, and also transfer to someone else.

In Blockchain, the token is assigned to the public address of each investor and stored in a Blockchain network’s decentralized ledger. Tokens will be “owned” by the investor who holds the private key for one of those public addresses. The ownership of the token grants some rights and privileges of transferring ownership through the creation of another entry in the Blockchain. 

In the past, the properties of tokens have been continuously changing.  However, tokens have 3 main features:

  • They are digital assets which are stored on a Blockchain and can be moved from one entity to another without involving an intermediary;
  • Their supply is usually limited while their value is derived from the cryptocurrency community which accepts them as means of exchange and general speculative methods; and
  • They rely on cryptography and Blockchain for creation and transfer.

Set 2

Here, the incentives can take the form:

  • Rewards where participants who perform well are incentivized with monetary rewards or decision-making rights; and
  • Punishments where bad actors are made to pay a monetary fine or have their rights taken away

How is the value of cryptocurrencies created?

When users trust any commodity and give it value, it essentially becomes a currency, and that’s why fiat currencies and gold have value. Just like fiat currency, cryptocurrencies have value because its community of users trusts them.  And whenever a commodity is given a value that amount will change according to the rules of Supply and Demand shown below:

Source: Titaniumteddybear.net

As you can see, the demand for any commodity is always in inverse proportion with its supply. Where the two graphs meet forms, they form what is commonly called equilibrium. Consider the case of Bitcoin:

Bitcoin was fixed at 21M bitcoins which is the total market capitalization of all bitcoins. Because the number of bitcoins has been fixed, specific regulations have to be put in place to ensure progressive mining becomes extremely difficult. Otherwise, if these measures are not put in place, miners will start to mine indiscriminately generating more bitcoins and decreasing the overall value.

To help cap the supply and limit inflations in Bitcoin, the mining reward halves after every 210,000 blocks have been mined. When Bitcoin was unveiled in 2009, the reward was capped at 50 BTC for each block. In 2012, the figure was halved to 25 BTC which was subsequently halved to 12.5 BTC in 2016. It is estimated that by around 2137, all the coins will have been mined and the total market capitalization of bitcoins will be 21M.

On the other hand, the demand of any cryptocurrency depends the following factors:

  • What is the history behind it?
  • Has it been subject to attacks or hacks?
  • Does it reliably produce desirable results?
  • How good is the development team behind it?
  • Does it have potential to improve?
  • How much hype is behind it?

In May 2017, Bitcoin prices soared to a symbolic $2,000 mark for the first time since its unveiling. At the time, the reasons advanced for soaring of prices were:

  • Increased worldwide demand as a result of media attention the currency;
  • Japan unveiled new rules which treated Bitcoin with kid gloves making Bitcoin part of its banking system; and 
  • Hype and the fear of missing out (FOMO).

 

April 14, 2021
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