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Cryptoeconomics is what makes blockchains exciting and different from other technologies. This element is notable through the creative combination of cryptography, computer science, networking theory, and economic incentives. Now, we can build new kinds of technologies due to Satoshi’s white paper. Blockchain is a singular product of these crypto-economic systems that can accomplish milestones that these disciplines could not achieve independently.
Bitcoin, Ethereum, Zcash, Binance coin, etc., are all crypto-economics inventions explicitly focused on building different solutions. This article aims to explain crypto-economics in clear, simple terms and its relation to economic theory in general.
What is Crypto Economics?
Crypto economics is a practical science that focuses on designing and characterizing protocols that govern the production, distribution, and consumption of goods and services in a decentralized digital economy. There are two central pillars of crypto-economics, as the name suggests:
- Cryptography: is the science of safeguarding information by converting it into a secure format. This process is also known as encryption, used repeatedly to prevent handwritten messages from being accessed by unintended recipients. Today cryptography is majorly used to secure digital data. It is a form of computer science that transforms information into formats that unauthorized users cannot recognize.
- Economics: is standardly defined as a social science aiming to satisfy needs and wants by production and quality services distribution. Three kinds of systems in this selection could be called ‘crypto-economics.’
Three Examples of Crypto-Economics
- Consensus protocol
- Crypto economic application design
- State channel
The consensus protocol is a fault-tolerant mechanism used in computer blockchain systems to achieve necessary agreements on a single network state or an available data value, such as with cryptocurrencies. Proof-of-work is the scheme through which a blockchain can reach a consensus. This popular consensus algorithm is what many popular cryptocurrency networks use, including bitcoin and litecoin.
The Proof of Stake algorithm is an alternative for PoW at a lower cost, issuing a low energy-consuming way for crypto transaction confirmations. In addition, this algorithm allows allocating responsibility for proper maintenance of all blockchain processes according to the digital currencies distributed. However, the one downside of the process is promoting crypto saving instead of spending.
Other consensus algorithms like PoC allow sharing of memory space of the contributing nodes on the blockchain network. The more hard disk or memory space a node has, the more rights it has to authorize the public ledger.
Crypto economic Application Design
Once blockchains solve the consensus problem, they can build applications that run on them comfortably. Cryptoeconomics is also usable in designing ICOs and other token sales. One application area for this mechanism design is the format of auctions and token sales.
However, many blockchain applications are not crypto-economics products, for example, Metamask and Status platforms that let users link with the Ethereum blockchain. Instead, building these applications requires a comprehensive understanding of how incentives shape users’ behaviors. In turn, they can know how to design economic mechanisms that reliably produce a particular result. Also, you require an account of the capabilities and impediments of the underlying blockchain on which the application works.
State channels are not applications but valuable techniques used by blockchain applications to become more efficient. A downside to blockchain applications is that blockchains are expensive since sending transactions requires fees. Furthermore, using ethereum to run smart-contract code is relatively costly to other kinds of computation. The main aim behind state channels is to make blockchains more efficient by advancing many processes off-chain while still keeping blockchains’ trustworthiness using crypto-economic design.
Most blockchain applications in the future will use state channels in some form; it’s almost always a rigorous improvement that requires less on the chain operation.
Looking at the blockchain space through the crypto-economic lens is helpful. Once the idea is understood, different parties can finally clarify many controversies and debates flooding the industries. We should expect that there will be crypto-economic consensus protocols that do not rely strictly on a chain of blocks. Likewise, such a technology will have something in common with blockchain technology, but labeling them as blockchains would be inaccurate.
However, the relevant organizing concept is whether such a protocol results from crypto-economics, not a blockchain. One of the most tangible signs of a token’s value is if it forms a needful component of the application to which it is connected; therefore, understanding the design mechanism of a project holding an ICO is crucial in determining that token’s usefulness and potential value.
We have moved from looking and thinking about this new field solely through the lens of one application, Bitcoin. It is the moment to think in terms of a more critical approach to solving problems of crypto-economics.