By Eric C. Jansen, ChFC®
The word “cryptoeconomics” is a combination of cryptography and economics, and the concept is key to making a functional blockchain. How do you get strangers to work together to create a trustworthy, decentralized network for transmitting and storing encrypted information? How do you get that distributed ledger system to function reliably without a central authority to control it? And once you’ve got those things working, how do you defend against individuals who want to game the system? You use cryptoeconomics, an infrastructure of rewards and punishments that incentivizes honesty to keep the system useful and secure.
To understand cryptoeconomics, we first need to understand how blockchain transactions are verified without the use of an intermediary.
The Cryptographic Components of Cryptoeconomics
Cryptography relies on miners using their own computing power and electricity to confirm transactions, link transactions together and keep the blockchain secure. The system rewards miners with a cryptocurrency, or token, such as Bitcoin or Ether, for doing this work.
Consensus protocols govern how blockchain transactions are verified. Common consensus protocols are proof of work and proof of stake.
Proof of work (PoW) lets miners demonstrate the computing power and electricity they put into verifying and securing transactions. It only pays people who add value to the blockchain. It’s hard for the miner to prove they have done the work, but it is easy for someone else to verify the miner has done the work once it is complete. PoW keeps bad actors from intercepting and changing transactions.
Proof of stake (PoS) does not rely on computing power and electricity. Instead, it requires validators to “stake” their own cryptocurrency tokens, similar to an escrow account, so in the event they validate a fraudulent transaction, they lose their holdings that have been staked. Validators are chosen based on the amount of tokens they stake. The system rewards their PoS with transaction fees, as opposed to the mining rewards for PoW.
The Incentive System
The economic components of the blockchain motivate participants to follow the rules, and punish participants who break them. Consider some real-world incentives: You do work for your employer, who rewards you with money. Alternatively, you could steal money from your employer, which would result in losing your job, losing the possibility of getting another job with a different employer because of your reputation and possibly being put in jail.
Because of this incentive system, even people without a strong sense of what is morally right and wrong will generally choose to receive a paycheck in exchange for honest work instead of engaging in theft. They follow the rules because that path gives them the best chance of success.
When it comes to blockchain, we also need an incentive system. Earning cryptocurrency acts as an incentive for miners and validators. Conversely, punishments discourage bad behavior. If they try to validate fraudulent transactions, the system is designed to prevent them from succeeding, and they will not earn rewards.
Tokens Drive Blockchain Technology Economics
In both proof of work and proof of stake, the promise of cryptocurrency tokens encourages miners to devote their resources to validating blockchain transactions and maintaining the integrity of the blockchain. These cryptocurrency tokens drive the economics of blockchain technology; the success of the blockchain depends on the allure of the tokens or rewards.
Tokens are valuable because they are useful and a group of people agree they have value. Suppose you need a token to take the subway from downtown to the airport for a business trip. That token is useful because it gets you where you need to go. That same token is also valuable because lots of other people want to go from downtown to the airport. If you don’t need to make that trip, you can sell your token to someone who does and receive a different type of currency instead that you do have a use for, such as Bitcoin, Ether, or U.S. dollars.
The more demand there is to go from downtown to the airport, and the fewer tokens (supply) there are, the more those tokens will be worth. The opposite is also true. To make sure those subway tokens retain their value, the transportation authority will limit the number of tokens in circulation. Any new tokens are released into circulation slowly, not all at once. Many cryptocurrencies cap the amount of coins or tokens that will ever exist, while others have no such caps. Bitcoin is capped at 21 million, while Ethereum’s Ether tokens are not.
Cryptocurrencies or tokens aren’t valuable by themselves. The material of a subway token is far less than the fare it represents; the ones and zeros that make up a cryptocurrency token are similarly valueless. What gives cryptocurrency tokens value is:
- usefulness for transactions in the present
- perceived usefulness at a projected future point
- supply and demand fluctuations
- regulatory actions
- speculative demand
Speculative demand in particular accounts for the vast majority of cryptocurrency values today. Like the dollar bill, cryptocurrency tokens have a symbolic value, not an inherent value.
Cryptoeconomics and the Imperfections of Blockchain
The idea behind blockchain is to provide a more secure, decentralized network through the efforts of unaffiliated individuals. Mechanism design allows us to figure out how to produce particular outcomes based on our assumptions by working backwards to figure out how to achieve that outcome through a system of individuals pursuing their own self-interest; the blockchain concept relies on the self-interest of miners and validators seeking cryptocurrency rewards to achieve the outcome of a secure, decentralized network.
That’s a potential weakness for a cryptoeconomic system: Its designers could make incorrect assumptions about how people will respond to their system’s incentives. They might assume their cryptocurrency tokens will incentivize people to devote their resources to ensuring the validity and integrity of the blockchain, while resisting efforts to corrupt the blockchain. If those assumptions are wrong, the system won’t be secure.
Like most economic systems, cryptoeconomics relies on supply and demand concepts to thrive. The value of cryptocurrency, its desirability to miners and validators, and its scarcity drive the security, validity and trustworthiness of a blockchain. With proper incentives, miners and validators enable a decentralized peer-to-peer network that provides a secure alternative to traditionally centralized networks.
Recent articles by Eric C. Jansen: Why You Shouldn't Ignore Cryptocurrencies
Disclaimer: Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns cryptocurrency.
This article was originally published on Investopedia.