What is Cryptoeconomics? An Introduction for Beginners

Want to understand how a blockchain works? Cryptoeconomics is the place to start.

Understanding the mechanics or technical attributes of a blockchain can be challenging – especially if you don’t come from a technical background. Most people continue to struggle to comprehend how a blockchain works and that doesn’t bode well for the industry.

Having worked in the space for several years now I believe it’s fundamental to educate yourself on all the key elements that enable a decentralized blockchain network to run – particularly if you are professionally involved in the industry.

Out of all the elements you’ll need to grasp, mastering what is known as the cryptoeconomics or tokeneconomics of a network is perhaps most critical.

What is cryptoeconomics?

Cryptoeconomics = Cryptography + economics

In its simplest form, cryptoeconomics refers to the use of economics (through incentives) and cryptography (through encryption) to design a secure system or network with predefined desired properties.

– The cryptography aspect underlying these systems is what allows communications and interactions between peers in the network to be proved and secured.

– The economic incentives defined inside the system encourages all actors to behave in a way that holds desired properties and enables the network to operate smoothly and thrive over time.

Creating sound cryptoeconomics is both the genesis and the goal for a system to become a robust decentralized network that can prevail and thrive against malicious actors attempting to disrupt the network.

When Satoshi Nakamoto developed the Bitcoin blockchain, the first decentralized digital currency, and implemented a Proof of Work (PoW) protocol to the system he/she/they were doing so to secure the network through cryptography and using an incentive system for settlement.

Explaining the Proof of Work consensus algorithm demands an entire article by itself, but in a nutshell, it is what allows transactions on the blockchain to take place. Through it, members of the network with high levels of computing power (called miners) prove that a specified amount of work has been completed in order to validate transactions.

Why is cryptoeconomics so fundamental to decentralized blockchain networks?

Cryptoeconomics enables parties who do not know one another to reach consensus about the state of a blockchain. Without the application of cryptoeconomic principles, decentralized blockchain networks like Bitcoin and Ethereum simply cannot work. And so, it is the elements of cryptoeconomics – cryptography and economic incentives that allow the creation of decentralized networks and the ability of these networks to reach consensus, without the need to rely on a trusted central authority.

What are the challenges of building incentive mechanisms?

Building sound incentive mechanisms into a decentralized system that has no trusted or central authority is a complex task. The main reason for this is that cryptoeconomics attempts to combine the “perfect” world of technically implemented rules with the unpredictable behaviors of human nature.

Aleksandr Bulkin, co-founder of Coinfund expresses it very well:

“Cryptoeconomics of a token is a hybrid between rules programmatically implemented on a blockchain and the entire world of interactions real human beings have with it.” [1]

In this same line of thought, Bulkin very accurately analyzes the differences between cryptoeconomics and traditional economics. As the latter is a product of centuries of research, governance, and observations of social dynamics, he states that more appropriate than talking about designed economies is to talk about partly designed, partly discovered, partly self-evolved economies.

In contrast, thinking (or designing) the cryptoeconomics elements of a network demands that most of its characteristics be designed from inception. It requires designing predefined rules based on all the possible ways human beings can interact with the system. Accordingly, designing good rules entails understanding and predicting the way humans will interact within a decentralized system.

This is what makes cryptocurrencies so hard. We are not used to designing economic structures from scratch, and predicting all future human interactions is close to impossible. We are entering new territory and learning on the fly.

At the same time, this is the reason why cryptoeconomics is so essential. If rules are not correctly defined, a decentralized system is bound to collapse and fail. This is where proper mechanism design comes in. Mechanism design is a field in economics and game theory focused on designing mechanisms to incentivize or disincentivize behaviors within a system toward desired objectives.

What role do tokens have in a blockchain protocol?

At the core of cryptoeconomics, a token exists as the primary tool to control a protocol’s micro-economy. A well-designed system properly manages the incentives and distribution of tokens within the corresponding network of participants. When tokenized incentives are accurately aligned a decentralized system thrives.

Cryptoeconomics is helping us create systems where those who adhere to and protect the rules of the game receive rewards, while those attempting to break the rules face financial walls which disincentivize their behavior thus safeguarding the network. In Bitcoin, for example, miners who are honest and verify transactions receive block rewards (currently 12.5 new minted bitcoin plus fees) for their work, while those who are dishonest face wasting their computing power, energy, and money, making it an expensive, unprofitable and fruitless endeavor.

Lately, the evergoing ICO craze has diverted attention away from the importance of tokens within a decentralized system. ICOs are an innovative way to raise capital from a wider audience of supporters without having to give away any shares of a company. However, it is essential to understand that tokens are not just a tool for an ICO, but a vital cog in a blockchain system’s ability to function.

Tokens must be an integral element of the network in which they exist to have any value. A token’s utility should be what secures and governs the behavior of the users within the network. Failure to achieve this will ultimately result in the failure of a system. Conversely, blockchain networks that effectively utilize cryptoeconomic principles to operate can offer new and innovative decentralized systems built with internal mandates and incentives that encourage all stakeholders to act in the interest of the network.

If you want to learn more about the blockchain in a simple and easy to understand way check out our How does the Blockchain Work series:

How does the Blockchain Work? (Part 1 )
A simple and easy explanation

How does the Blockchain Work? (Part 2)
The top 5 things you need to know

How does the Blockchain Work? (Part 3)
What is Consensus and why does it matter?

How does the Blockchain Work? (Part 4)
Differences between Private, Public and Consortium Blockchains.

If you have any questions or would like to connect you can find me on Twitter or email me at [email protected] I’m always interested in meeting people working, learning, or involved with the blockchain space.

Also published on Medium.