Best Articles On Blockchain Technology – 3 – Making Sense of Cryptoeconomics

In these series of blogs written like a tweetstorm, we are summarizing the best articles on blockchain technology (in our opinion) published on the web.



Read the first two articles here and here.

This blog will summarize third such article – about what is cryptoeconomics.

Some key points in the article are:

1. In simple terms, cryptoeconomics is the use of incentives and cryptography to design new kinds of systems, applications, and networks. Cryptoeconomics is specifically about building things, and has most in common with mechanism design – an area of mathematics and economic theory

2. Cryptoeconomics is not a subfield of economics, but rather an area of applied cryptography that takes economic incentives and economic theory into account. Bitcoin, ethereum, zcash and all other public blockchains are products of cryptoeconomics.

3. Cryptoeconomics is what makes blockchains interesting, what makes them different from other technologies. As a result of Satoshi’s white paper, we have learned that through the clever combination of cryptography, networking theory, computer science and economic incentives that we can build new kinds of technologies. These new cryptoeconomic systems can accomplish things that these disciplines could not achieve on their own. Blockchains are just one product of this new practical science

4. Bitcoin is a product of cryptoeconomics. Bitcoin’s innovation is that it allows many entities who do not know one another to reliably reach consensus about the state of the bitcoin blockchain. This is achieved using a combination of economic incentives and basic cryptographic tools.

5. Bitcoin’s design relies on economic incentives and penalties. Economic rewards are used to enlist miners to support the network. Miners contribute their hardware and electricity because if they produce new blocks, they are rewarded with amounts of bitcoin.

6. Economic costs or penalties are part of bitcoin’s security model. The most obvious way to attack the bitcoin blockchain would be to gain control of a majority of the network’s hashing power – a so-called 51 percent attack – which would let an attacker reliably censor transactions and even change the past state of the blockchain.

But gaining control of hashing power costs money, in the form of hardware and electricity. Bitcoin’s protocol intentionally makes mining difficult, meaning that gaining control of a majority of the network is extremely expensive – enough that it would be hard to profit from the attack. As of August 16, 2017, the cost of a 51 percent attack on bitcoin would be around $1.88 billion in hardware and $3.4 million in electricity every day

7. Bitcoin also relies on cryptographic protocols. Public-private key cryptography is used to give individuals safe, exclusive control of their bitcoin. Hash functions are used to “link” each block in the bitcoin blockchain, proving an order of events and the integrity of past data.

Cryptographic protocols like these give us the basic tools necessary to build reliable, secure systems like Bitcoin. Without something like public-private key infrastructure, we could not guarantee to a user that they have exclusive control over their bitcoin. Without something like hashing functions, nodes would not be able to guarantee the integrity of the history of bitcoin transactions contained in Bitcoin’s blockchain.

Without the hardness of cryptographic protocols like hashing functions or public-private key cryptography, we would have no secure unit of account with which to reward miners – no confidence that our record of past accounts was authentic and exclusively controlled by a rightful owner. Without a carefully calibrated set of incentives to reward an industry of miners, that unit of account could have no market value because there would be no confidence that the system could persist into the future.

8. One of the most common mistakes in this industry is made by those who view blockchains only through a lens of computer science or applied cryptography. In blockchain technology, this leads many people to assume or abstract away the crucial role of economic incentives. This is one reason we see meaningless phrases like “blockchains are trustless,” “bitcoin is backed only by math” or “blockchains are immutable.” These are all wrong in their own way, but all have the effect of obfuscating the essential role of a large network of people whose necessary participation in the network is maintained through economic incentives

9. Cryptoeconomics is not the application of macroeconomic and microeconomic theory to cryptocurrency or token markets. Cryptoeconomics has most in common with mechanism design, a field related to game theory. Cryptoeconomics, like mechanism design, focuses on designing and creating systems. Like in our auction example, we use economic theory to design “rules” or mechanisms that produce a certain equilibrium outcome. But in cryptoeconomics, the mechanisms used to create economic incentives are built using cryptography and software and the systems we are designing are almost always distributed or decentralized.

10. Bitcoin is a product of this approach. Satoshi wanted bitcoin to have certain properties – for instance, that it be able to reach consensus about its internal state and that it be censorship-resistant. Then, Satoshi set out to design a system that would achieve those properties, assuming people responded in rational ways to economic incentives

11. “Permissioned” blockchains that are centrally managed and do not use proof-of-work have been a source of constant controversy since they were first proposed. This area of work is often referred to as “distributed ledger technology” and is focused on financial and enterprise use cases. Many partisans of blockchain technology dislike them – they may be blockchains in the literal sense, but there is something about them that feels wrong. They seem to reject the thing that many people see as the whole point of blockchain technology: being able to produce consensus withoutrelying on a central party or traditional financial systems.

A cleaner way to make this distinction is between blockchains that are products of cryptoeconomics and blockchains that are not. Blockchains that are simply distributed ledgers and do not rely on cryptoeconomic design to produce consensus or align incentives might be useful for some applications. But they are distinct from blockchains whose whole purpose is to use cryptography and economic incentives to produce consensus that could not exist before, like bitcoin and ethereum. These are two different technologies, and the clearest way of distinguishing between them is whether or not they are products of cryptoeconomics


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