update 12 September 2021

Crypto-economics For Beginners – What You Need To Know

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 as a result of 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, Etherium, Zcash, etc. are all crypto-economics’ inventions, explicitly focused on building different solutions. This article aims to explain in clear, simple terms crypto-economics and its relation to economic theory in general.  

What is Crypto Economics?

Crypto economics is a practical science which focuses on the design and characterization of 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
  • Economics

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 focuses on transforming 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. There are three kinds of systems in this selection that could be called ‘crypto-economics.’

Three Examples of Crypto-Economics

Consensus protocol

The consensus protocol is a fault-tolerant mechanism used in computer blockchain systems to achieve necessary agreements on a single state of the network 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. This algorithm allows allocating responsibility for proper maintenance of all blockchain processes according to the digital currencies distributed. However, the one downside that comes with the process is promoting crypto saving instead of spending.

Other consensus algorithms like PoC allow the 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 authorization for the public ledger.

Crypto economic Application Design

Once blockchains solve the problem of consensus, they can build the applications that run on them comfortably. Cryptoeconomics is also usable in designing ICOs and other token sales. One area of application for this mechanism design is in 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. Building these applications requires a comprehensive understanding of how incentives shape users’ behaviors. In turn, they can have an idea of 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

State channels are not applications but rather a valuable technique 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 making 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.

Conclusion

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. 

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We have moved from looking and thinking about this new field solely through the lens of one application, which is Bitcoin. It is the moment to think in terms of a more critical approach to solving problems of crypto-economics.                                    

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