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A Beginner's Introduction to Cryptoeconomics

A Beginner's Introduction to Cryptoeconomics

What is cryptoeconomics?

In simple terms, cryptoeconomics provides a way to coordinate the behavior of network participants by combining cryptography with economics.

More specifically, cryptoeconomics is an area of computer science that attempts to solve participant coordination problems in digital ecosystems through cryptography and economic incentives.

It is essential to consider cryptoeconomics when building decentralized networks because it is the mechanism that provides a way to align participants’ incentives without the need for trusted third parties.

Rather than being a subset of traditional economics, cryptoeconomics is a mix of game theory, mechanism design, mathematics, and other methodologies from the field of economics. The main goal is to understand how to fund, design, develop, and facilitate the operations of decentralized networks.

This article will dive into the origins of cryptoeconomics and its role in the design of Bitcoin and other decentralized networks.

What problem does cryptoeconomics solve?

Before the emergence of Bitcoin, it was commonly believed to be impossible to create a peer-to-peer network where consensus is achieved without significant vulnerabilities to attacks and faults.

This problem is often referred to as the Byzantine General’s Problem. It is a logical dilemma that demonstrates how, in distributed systems, it is critical for the different actors to reach agreements. The problem assumes that since some of the actors might be unreliable, agreements can never be made, and the network cannot function as intended.

With the creation of Bitcoin, Satoshi Nakamoto introduced economic incentives to a peer-to-peer network and solved this problem.

Since then, decentralized networks have continued to rely on cryptography to achieve consensus regarding the state of the network and its history. Also, most networks have been incorporating economic incentives that encourage network participants to behave in certain ways.

This synergy of cryptographic protocols with economic incentives enables an entirely new ecosystem of decentralized networks that are resilient and secure.

The role of cryptoeconomics in Bitcoin mining

The goal of Bitcoin is to create a value transfer network that accurately verifies transfers of value, and that is immutable and censorship-resistant.

This is achieved through the process of mining, in which miners who successfully validate a block of transactions are rewarded in bitcoin. Such economic incentive encourages miners to act honestly, making the network more reliable and secure.

The process of mining involves solving a difficult mathematical problem based on a cryptographic hash algorithm. In this context, hashes are used to tie each block to the next block, essentially creating a timestamped record of approved transactions called the blockchain.

Hashes are also utilized in the computational puzzles that miners are competing to solve. Additionally, one of the consensus rules that transactions have to follow is that a bitcoin can only be spent if a valid digital signature is generated from a private key.

These technological rules relating to mining are aligned with the security requirements of the Bitcoin network, including preventing malicious actors from taking control.

How does cryptoeconomics enhance Bitcoin’s security?

Bitcoin’s security model is built around the principle of majority rule. This means that malicious actors could potentially take control of the blockchain by seizing control of the majority of the network’s computing power in an attack commonly referred to as the 51% attack.

In such a scenario, the attackers would be able to prevent new transactions from gaining confirmations or even reverse transactions entirely. However, gaining control of this amount of hashing power would be hugely expensive, requiring substantial hardware and considerable amounts of electricity.

Cryptoeconomics is one of the reasons Bitcoin has been successful. Satoshi Nakamoto implemented assumptions to encourage certain incentives for the different participant classes of the network. The system’s security guarantees depend a lot on the effectiveness of these assumptions about how network participants react to certain economic incentives.

Without the hardness of its cryptographic protocol, there would be no secure unit of account with which to reward miners. Without the miners, there would be no confidence in the validity of the transaction history of the distributed ledger, unless if it was verified by a trusted third party, which would negate one of the main advantages of Bitcoin.

Based on cryptoeconomic assumptions, the symbiotic relationship between miners and the Bitcoin network provides confidence. However, this is not a guarantee that the system will persist in the future.

The cryptoeconomic circle

The cryptoeconomic circle is a holistic model of cryptoeconomics. It was published by Joel Monegro and illustrates abstract flows of value through different participant classes in such a peer-to-peer economy.

The cryptoeconomic circle

The model represents a three-sided market between miners (the supply side), users (the demand side), and investors (the capital side). Each group exchanges value between one another using a scarce cryptoeconomic resource (a token).

In the miner-user relationship in the circle, miners are compensated for their work through tokens used by the users. The network’s consensus protocol standardizes this process, while the cryptoeconomic model controls when and how miners get paid.

Creating a network architecture that is sustained by a distributed supply side (miners) is desirable as long as the benefits outweigh the disadvantages. The benefits often include censorship resistance, borderless transactions, and higher reliability. But, decentralized systems tend to have lower performance when compared to centralized models.

The role of the investor in this model is twofold: providing liquidity for the miners to sell their tokens, and capitalizing the network by supporting token prices that are above the mining costs.

The model exemplifies these two roles by dividing investors into two groups: traders (short-term investors) and hodlers (long-term investors).

Traders create liquidity for the token so miners can sell their mined tokens and cover operational costs, while holders capitalize the network for growth by supporting token prices. The miner-trader relationship works with a direct flow of value, while the miner-holder relationship works with an indirect flow of value.

This simply means that all the participants in such an economy depend on each other to reach their economic goals. Such a design creates a robust and secure network. Compliance with the incentivized ruleset is more beneficial to the individual participant than malicious activity - which in turn makes the network more resilient.

Closing thoughts

Even though a relatively new concept that emerged with the birth of Bitcoin, cryptoeconomics is a significant building block to consider when designing decentralized networks.

Isolating the different roles in cryptoeconomic models helps to analyze costs, incentives, and value flows for each participant group. It can also help to think about relative power and identify potential points of centralization, which is important to design more balanced governance and token distribution models.

The field of cryptoeconomics and the usage of cryptoeconomic models can be highly beneficial during the development of future networks. By studying cryptoeconomic models that were already tried and tested in live environments, future networks can be designed to be more efficient and sustainable, resulting in a more robust ecosystem of decentralized economies.

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A Beginner's Introduction to Cryptoeconomics

A Beginner's Introduction to Cryptoeconomics
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What Is Proof of Work (PoW)?

What Is Proof of Work (PoW)?
Proof of Work (commonly abbreviated to PoW) is a mechanism for preventing double-spends. Most major cryptocurrencies use this as their consensus algorithm. That’s just what we call a method for securing the cryptocurrency’s ledger.
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What Is Proof of Stake (PoS)?

What Is Proof of Stake (PoS)?
Proof of Stake is a popular, alternative consensus mechanism to Proof of Work. Instead of needing computing power to validate transactions, validators must stake coins. This fact drastically reduces the energy consumption needed. Proof of Stake also improves decentralization, security, and scalability.
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Interest Rates Explained

Interest Rates Explained
It doesn’t make much sense to lend money for free. If Alice wants to borrow $10,000 from Bob, Bob will need a financial incentive to loan it to her. That incentive comes in the form of interest – a kind of fee that gets added on top of the amount Alice borrows.
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Hards Forks and Soft Forks Explained

Hards Forks and Soft Forks Explained
When you’re prompted to update your digital banking app on your smartphone, you probably don’t even think twice. Maybe your phone auto-updates without you even noticing. It’s a necessary process, after all – if you don’t install the latest version of the software, you run the risk of being denied access to its services.
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Financial Risk Explained

Financial Risk Explained
In short, financial risk is the risk of losing money or valuable assets. In the context of financial markets, we may define risk as the amount of money one can lose when trading or investing. So, the risk is not the actual loss, but what can be eventually lost.
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Black Monday and Stock Market Crashes Explained

Black Monday is the name used to describe a sudden and severe stock market crash that occurred on October 19th, 1987. The Dow Jones Industrial Average (DJIA), an index that measures the US stock market performance, fell more than 22%. The crash was preceded by two other large drops a week before.
Black Monday is the name used to describe a sudden and severe stock market crash that occurred on October 19th, 1987. The Dow Jones Industrial Average (DJIA), an index that measures the US stock market performance, fell more than 22%. The crash was preceded by two other large drops a week before.
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Byzantine Fault Tolerance Explained

Byzantine Fault Tolerance Explained
Since the inception of Bitcoin in 2008, as a peer-to-peer electronic cash system, many other cryptocurrencies were created, each one with a particular mechanism. But one thing that nearly all cryptocurrencies have in common is the blockchain, as the core element of their architecture.
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Bitcoin ETFs Explained

Bitcoin is solidifying itself as a legitimate investment asset that anyone can invest in. Well, technically not anyone, as some institutions and individuals can only participate in a highly regulated manner. Many think a Bitcoin ETF could fulfill this purpose.
Bitcoin is solidifying itself as a legitimate investment asset that anyone can invest in. Well, technically not anyone, as some institutions and individuals can only participate in a highly regulated manner. Many think a Bitcoin ETF could fulfill this purpose.
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5 Common Cryptocurrency Scams and How to Avoid Them

5 Common Cryptocurrency Scams and How to Avoid Them
In today’s world, your cryptocurrency is an incredibly valuable asset to criminals. It’s liquid, highly portable and, once a transaction has been made, it’s almost impossible to revert it. As a result, a wave of scams (both decades-old classics and cryptocurrency-specific swindles) has flooded the digital realm.
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Как вести учет криптовалютного портфеля в Гугл Таблицах

Как вести учет криптовалютного портфеля в Гугл Таблицах
«Деньги любят счет» - это пословица, как никакая другая, очень точно описывает всю суть успешного распоряжения своими деньгами. На сегодняшний день существует множество инструментов и сторонних сервисов (Blockfolio, Coinmarketcap, Cryptocompare и т. п.) для ведения учета и контроля своего инвестиционного криптопортфеля. Также существуют инструменты для работы в Google Sheets.
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7 Common Mistakes in Technical Analysis (TA)

7 Common Mistakes in Technical Analysis (TA)
With that said, there are some trivial mistakes that almost every beginner makes when starting out. The best traders always remain open-minded, rational, calm. They understand their gameplan, and simply keep reading what the market is telling them.
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Отчет по доходности крипто портфеля за 2021 год

Отчет по доходности крипто портфеля за 2021 год
Ниже мы публикуем отчет по росту криптовалютного портфеля, а также доходности портфеля за 2021 год. Основные моменты - Поквартальная доходность составила 1829,08%, -29,33%, 217,56%, 3,32% за I, II, III и IV кварталы соответственно. Самым прибыльным оказался первый квартал, на него как раз пришелся альткойн сезон, в то время росла вся крипта, можно было покупать любую. Второй квартал оказался в минусе в результате коррекции после сезона альткойнов;Четыре месяца в году оказались минусовыми, причем прилично минусовыми, доходность же по остальным месяцам с лихвой перекрыли убытки; Доходность за первое полугодие составила 1263,25%, за второе полугодие 228,10%, как писал выше, высокая доходность в первом полугодии обусловлена сезоном альткойнов, который как раз пришелся на начало года; Итоговая доходность за весь год составила 4372,85%, даже не знаю удастся ли повторить такой рост в 2022 году, поживем увидим.
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Обвал криптовалютного рынка или же локальная коррекция?

Обвал криптовалютного рынка или же локальная коррекция?
19 марта биткойн достиг отметки 30 тысяч долларов за монету, допустив просадку чуть более чем на 50%, потянув за собой все остальный альткойны, за редким исключением.
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How to register on Binance with a mobile number

How to register on Binance with a mobile number
Регистрация на криптовалютной бирже Binance, похожа на регистрациею в других криптовалютных биржах, но всё же есть отличия.
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Клуб проводит акцию "Заработай на друзьях" и выйграй 150 тыс. рублей прямо на карту

Подробнее о клубе Crypto Fans
В преддверии роста крипто рынка мы с командой решили “поднажать” и провести акцию, дабы скорей увеличить объём портфеля, и максимально увеличить прибыль. Уверен, это будет легкая прибыль для инвесторов и команды клуба. Сейчас крайне актуальное время для вступления и инвестирования в клуб. Повторюсь, криптовалютный рынок находится внизу, все сигналы говорят о том что рынок ожил и пошел вверх. В ближайшее время, примерно до конца года рынок должен показывать бычий тренд.
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