Education 101 Series: Cryptoeconomics Explained

Cryptoeconomics is concerned with the approaches to achieve consensus in decentralized networks.

Behind our discussion of blockchain, cryptocurrency, and decentralization lies a fundamental question: how do we enable people from across the world, with all of their competing interests, to collaborate and create valuable opportunities for each other?

The issues surrounding coordination in decentralized networks can be summed up using the Byzantine Generals’ Problem, which poses the question of how to achieve consensus under the following circumstances:

  1. Multiple generals must decide to attack or retreat
  2. Generals may send messages to each other; however, messages may be delayed, destroyed, lost, or even fraudulent
  3. After a decision is made, it can’t be changed
  4. Each general must agree on the same decision and execute it properly

Cryptoeconomics has emerged as the field concerned with the different approaches people take to try to solve the Byzantine Generals’ Problem as it applies to the governance of decentralized networks.

In this article, we’ll introduce cryptoeconomics, describe the flow of value in decentralized networks using The Cryptoeconomic Circle, and highlight some of the economic exploits to watch out for when using decentralized applications (dApps).

What is Cryptoeconomics?

Cryptoeconomics lies at the intersection of cryptography, economics, and computer science and provides insight into the incentives and disincentives experienced by different stakeholders in a decentralized network. All of the items we already discussed, now together.

Its practice involves applying economic methodologies like game theory, mechanism design, and econometrics to help reveal potential strengths and/or weaknesses in the architecture of decentralized technologies before being deployed.

In addition to subjecting code to security audits before deployment, many teams working on decentralized technologies have started incorporating economic audits into their development cycles.

The Cryptoeconomic Circle

First described by Joel Monegro of Placeholder VC, the Cryptoeconomic Circle provides a generalized framework for thinking about the flow of value in decentralized ecosystems.

The Cryptoeconomic Circle refers to a three-sided marketplace between miners, users, and investors. Miners supply a scarce digital resource, users consume that resource, and investors provide capital to help facilitate the process.

According to the Cryptoeconomic Circle, the way value flows through a decentralized ecosystem depends on the relationships between these key stakeholders:

  • Miners and users collaborate to regulate the use of a digital resource, with miners providing the supply and users providing the demand.
  • Miners and investors collaborate to ensure the network has enough capital to support miners until it has enough users to enable both parties to profit from their investments.
  • Users and investors compete for the supply of resources provided by miners but for different reasons: users aim to use the resource to create something of value while investors aim to use the resource to profit from speculation on its future value.

Other frameworks may consider different stakeholders or include more than three classes but the success of any decentralized network undoubtedly relies, at least to a certain degree, on its ability to facilitate interactions between these participants.

The Cryptoeconomic Circle of Bitcoin

How does value flow through the Bitcoin network? To overcome the double-spend problem (discussed in our article on Cryptocurrency), its creators leveraged a consensus algorithm relying on “proof-of-work.”

Initially described in a 1992 publication as a technique for combatting junk mail, proof-of-work enables participants in decentralized networks to achieve consensus and add transactions to a blockchain by contributing computer processing power in a process known as “mining.”

Miners create “mining rigs” that validate transactions and help secure the network. In return, miners receive freshly minted cryptocurrency in the form of mining rewards as well as the transaction fees of the transactions included in a new block.

To realize their profits and cover the ongoing costs associated with operating mining rigs, miners need to be able to sell at least some of their cryptocurrency. This is where investors and users come in.

Investors simply aim to buy Bitcoin, whether it be from miners, users, or other investors, at a low price and sell it at a higher one.

Users, on the other hand, may purchase Bitcoin to use decentralized gambling applications or make purchases while avoiding the steep transaction fees associated with centralized payment processing solutions.

As miners get closer to the total supply of 21 million Bitcoin, the network aims to have enough users generating transaction fees to sustain the support of miners but only time will tell!

Economic Exploits to Consider

It can take years of study to learn how to apply economic methodologies and effectively analyze the cryptoeconomics of decentralized protocols.

Some of the more common economic exploits found in decentralized networks include:

  • Collusion attacks

Collusion attacks occur when the mechanics of a network allow participants to form partnerships with enough power to take control of the network.

Blockchains using a delegated proof-of-stake (DPoS) consensus algorithm have historically shown themselves to be vulnerable to collusion attacks.

DPoS algorithms allow participants to vote for the delegates who get to validate transactions and secure the network, with “votes” typically being equal to staked assets.

This enables rich cartels to vote in their preferred delegates and govern the network in a less-than-decentralized manner.

  • Sybill attacks

Named after the tragic 1973 case study on the dissociative identity disorder of Sybil Dorsett, Sybill attacks happen when an attacker or attackers create multiple identities to game a system or take control of a network.

A common example of a Sybill attack would be the “sock puppet” accounts created on social media platforms to promote or attack specific types of content posted by other accounts.

Under normal conditions, most blockchains tend to be Sybill-resistant but many decentralized identity solutions and the applications leveraging them tend to be vulnerable to Sybill attacks due to the difficulty in conducting identity verification in a decentralized way.

Follow along as we add to our Binance.US Education 101 Series: Your Guide to Crypto Literacy
#1 Demystifying Digital Dollars
#2 Evolution of the Internet
#3 Finance, Rhymes with …
#4 Back that Asset Class Up
#5 What are Cryptocurrencies?
#6 Defining Decentralized Finance
#7 Cryptoeconomics Explained
#8 Intro to Consensus Algorithms

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