Crypto Economics – The Art of Money & Math
Cryptoeconomics is the study of parameters that govern the relationship between price, the cryptocurrency ecosystem, and its present to future value. The words primarily consists of two words cryptography and economics. The union of these two concepts results in feasible operating protocols for distrustful decentralized networks. To break it down individually, Cryptography is the mechanism of protecting messages with the help of codes by eliminating the need for a third party. The economics part involves many things like game theory, mechanism design, and causal inference. Applying economic operations along with cryptography to achieve the desired decentralized P2P networks. One could say Crypto economics lays the base for anything occurring in P2P networks.
The practical example of crypto-economics is Bitcoin, a peer to peer network for financial transactions. Before the emergence of Bitcoin, it was considered almost impossible for digital networks to gain value, security, and longevity. It is almost impractical not to assume that the actors involved in P2P networks would reach a common agreement without a third party or without having the feeling of the other being undependable. The problems were legit before Satoshi Nakamoto found a way to solve these by providing economic incentives. Economic incentives or rewards are used to support the network while penalties back its security model. This collaboration of cryptography and economics paved a way to keep the network secure and incentivize participation. Cryptographical Tools
The vital techniques that keep these messages secure and fixed are called cryptographic tools or primitives. Some of the underlying cryptographic functions used for its performance are
- Hash Function
- Digital Signatures
- Proof of Work
- Zero-Knowledge Proofs
Hash Functions – ‘A hash function is a function that takes an input of any size x and gives an output of a fixed size H(x).’ It is collision-resistant and puzzles friendly.
Digital Signatures – It practically holds the same function as a signature holds in real life with more difficulty and reliability. Digital signatures bind an identity and are authentic. It works on Public Key Cryptography (PKC) which use two keys Private Key and Public key that is mathematically associated.
Proof of work – ‘Proof of work is a consensus mechanism for Blockchain networks.’ It is one of the most pioneering tools in Blockchain. It uses an algorithm to verify the transaction and help miners add new blocks to the Blockchain if they crack the puzzle.
Zero-Knowledge Proofs– ‘A method by which one party (prover) can prove to another party (verifier) that they know a value x, without conveying any information apart from the fact that they know the value of x.’
Crypto Economics 101
The difference between other decentralized P2P networks and a blockchain is the financial and economic incentives the user receives in the latter. There are ways economic tools are used to encourage and discourage certain conduct among the network participants. The two most common sets of incentive that the members have are:
Tokens – It constitutes as a unit of value within the decentralized P2P network. It is accepted and supported in a blockchain. Active members get cryptocurrencies for their efforts and contribution to the Blockchain. Some of the most popular tokens in the crypto world are Bitcoin and Ethereum.
Rewards – Good participants get rewards in the form of money or decision making. The block created by the node is accepted by the rest of the network only when the block is valid, thus adding the block’s hash in the next block they create. If, however, there are faulty transactions, the block won’t be accepted. Moreover, if the participants do not behave up to the required expectations, they are subjected to lose their rights or to pay monetary fines.
Crypto economics shares a common ground with mechanism design, a field related to game theory. The game theory in Blockchain keeps the unregulated and decentralized peer to peer network honest. In crypto-economics, the channel used to generate economic incentives is cryptography and software. The Blockchain in itself is a self-imposing Nash Equilibrium because if a particular set of miners try taking the malicious route for their selfish financial gains, they would be ignored. Any block that is mined on an invalid block is not regarded as a valid block so, the new block may be of no value. Since mining is an expensive process, and attacking Blockchain is infeasible as it is a huge and widely distributed network; therefore, miners prefer the way where they get a maximum pay off. Consequently, maintaining the Nash Equilibrium of the Blockchain.
Impact of Supply and Demand
Cryptocurrencies have value for the same reason money is considered a store of value, trust. The crux of microeconomics lies mainly on supply and demand, even in the case of cryptocurrency the values change in accord of demand and supply.
There are a total number of 21 million bitcoins that can be mined. Due to this, some protocols prevent miners from unlocking all the bitcoins; else they’d be exploited. To curb the miners from increasing the output from the predefined phase, the following measures are taken:
- The new blocks are added to the chain at a fixed rate. The time is determined so that miners do not add blocks to the chain with no regulation.
- With time it persistently increases the difficulty level. ‘During the mining process, the hash of the block along with the nonce needs to be less than a particular number.’ This number is called the difficulty level. There is a direct relationship between the difficulty level and the number of zeroes.
When the demand for the bitcoins increases. The price also increases, and when the demand for bitcoin falls, the price also falls. The demand must follow this level of inflation to keep the price stable because there is only a limited number of bitcoins available. Usually, when demand surges, supply shrinks.
Potential Attacks to the Network
Not literally attacking the network but trying to put the security, worth and credibility of the Blockchain by including faulty transactions. The reason someone tries to attack the Blockchain could be for their selfish gains or political stands.
The well-known type of attack on blockchains is the 51% attack. As the name suggests to attack the Blockchain, the miner would need to administer a more substantial part of the hash rate. To ensure the double-spend or faulty transaction is by upgrading the Blockchain after which transactions can be included or excluded. The nodes must build on top of the block that contains the faulty transaction and overtake the current chain by growing at a faster rate. It leads an attacker to censor transactions and alter the state of the Blockchain. This is where crypto-economics comes into the picture as the economic penalties involved would prevent an attack like the 51% attack. Attaining control over the majority of the network would be very costly.
P + Epsilon Attack
Another kind of an attack that is called as the p + ε attack which involves an attacker bribing the participant at no cost. So, if in case of a situation where the user has to prove something, voting would be the perfect way to establish if the fact is actual or not. Also, if the vote is in the majority, the user gets a reward. In a coordinated model, all the participants would vote in the majority to grab the reward say P. This is when the attacker steps in to bribe the user and asks them to vote in the minority and ensures a reward of P + ε for the same. But if the vote is in the majority, you get no reward. It is human greed to think of that little extra amount, and one might win if they change their vote.
But consequently, everyone changes their vote to the minority, and the attacker doesn’t need to pay anything. The solution to this problem is Proof of Stake, which demand the participants to own a stake in the network. By placing a stake, the user has an upper hand of being chosen to validate the blocks of the transaction and even getting rewarded for the same. This prevents the members from using or falling into malicious routes as they’d have much more to lose.
An emerging field which lays the foundation for the blockchain technology. Crypto economics gaps the bridge between networking, economics, computer science, and cryptography to provide a technology which furnishes security and to stimulate engagement in the decentralized P2P network.
Read about Smart Contracts: Here
Read about Tokenization.
Read about Bonds Issuance on Ethereum: Here
Ashni Santhosh is a forward-thinking individual with refined interpersonal and multitasking skills. She is always looking for opportunities to expand her curious mind through new experiences. She is currently pursuing B.A. in economics and mathematics.