The economics of cryptoassets, which includes cryptocurrencies and tokens, is more than simply the interaction of economically rational individuals in an adversarial environment, but extends into the intricate dynamics of finding balance in the creation of value for a digital product in a new digital marketplace. Economics of cryptoassets therefore combines the knowledge of supply and demand, scarcity, applicable game-theoretic concepts and rational human decision-making to devise an autonomous decentralized store of value protected by cryptography to secure its past and economic incentives to protect its future.
Table of Contents
1. Understanding cryptoeconomics
2. Decentralization in an adversarial environment
2.1 Tackling the Byzantine General Problem
2.2 Proof of Work to the rescue
3. Applicable game theoretic concepts
3.1 Nash Equilibrium
3.2 The Schelling (Focal) Point
3.3 Game theoretic applications in blockchain and cryptocurrencies
4. Security models as necessary foundations
4.1 The honest majority model
4.2 The uncoordinated choice model
4.3 The coordinated choice model
4.4 The briber attacker model
5. Determining the value of a cryptoasset
6. Controlling supply
7. Finding the right balance: lessons being learnt from bitcoin cash
8. Conclusion
9. References
ABSTRACT
The economics of cryptoassets, which includes cryptocurrencies and tokens, is more than simply the interaction of economically rational individuals in an adversarial environment, but extends into the intricate dynamics of finding balance in the creation of value for a digital product in a new digital marketplace. Economics of cryptoassets therefore combines the knowledge of supply and demand, scarcity, applicable game theoretic concepts and rational human decision making to devise an autonomous decentralized store of value protected by cryptography to secure its past and economic incentives to protect its future.
1. Understanding cryptoeconomics
Cryptocurrencies have dominated the conversation in the financial technology space. In this period the economic underpinnings of successful cryptocurrencies have remained largely untouched. This paper will attempt to explain the relationship between economic concepts and cryptocurrencies where bitcoin is the focal example.
Though there is no generally accepted definition of Cryptoeconomics, the definition by Vlad Zamfir of the ethereum foundation provides a clear description of what Cryptoeconomics entails. Vlad Zamfir defines Cryptoeconomics as “a formal discipline that studies protocols that govern the production, distribution and consumption of goods and services in a decentralized digital economy. [It] is a practical science that focuses on the design and characterization of these protocols”
The technology underpinning most cryptocurrencies, the blockchain, runs on Cryptoeconomics, which is an amalgam of cryptography and economics. This paper will focus on the economics of cryptocurrencies in a decentralized space. Cryptoeconomics used here is not intended as a subfield of economics, rather it refers to the application of economic concepts to design cryptographically secure financial systems. It is not the application of macro or micro-economic theory to cryptocurrency. It is the incorporation of economic incentives to determine appropriate designs of new kind of systems, applications and networks. It has more in common with mechanism design – an area of mathematics and economic theory, sometimes referred to as reverse game theory. We look at a given strategic interaction, and extrapolate the potential benefits and costs incurred in an attempt to minimize as much as possible any damage that the system may be exposed to. However, given enough time and resources any system can be disrupted, the trick therefore, is to balance rewards for appropriate activity within the network and mitigate harmful behaviour by making them increasingly infeasible as more participants join the network.
Prior to the bitcoin, there was no true application of cryptoeconomical concepts to the financial world. But with Satoshi’s design of the bitcoin protocol which incorporated cryptography, game theory, economic incentives, and networking theory, it became a reality. The combination of these distinct aspects created the blockchain as it exists today. Before bitcoin, there were other cryptocurrencies but none reached the level of popular acceptance, sustainability and reliability that bitcoin has reached. The decentralized and economic incentive model of the bitcoin has enabled it to surpass its predecessors in a short period of time through active user participation. Since its inception in 2009, more currencies have sprung up modelled on bitcoin or otherwise. This is possible because of the open source nature of its code and its decentralization. However, they have all experienced varying levels of success.
Economic governance application to technology, though a new concept in the space, is essential, the very nature of decentralization predisposes virtual economic systems to failure as a result of malevolent users. So to design an efficient cryptocurrency that will weather the storm, one has to put into consideration their inter-disciplinary nature.
2. Decentralization in an adversarial environment
Cryptocurrencies exist in a virtual space, the internet. The internet is also home to self-interested individuals like hackers, spammers and more who act to the detriment of others in so far as they stand to benefit. This kind of behaviour is detrimental in a decentralized system as it can lead to distributed denial of service attacks which can prevent legitimate users from being able to access the service due to spam overload.
Though decentralized systems existed before the bitcoin protocol, none had reached the level of bitcoin integration due to lack of incentives. A notable example is decentralized file sharing sites. Like bittorrent, these sites rely on multiple devices sending files to one another. When a single device has an original file, it sends bits of this information to different devices which then propagate the same information across the network of participants until they have a copy of the same file. At this point, the users with the complete copy file are expected to “seed” the file to the network to allow others also have it. But as rational humans, participation waned in the network as “leechers”, as users with downloaded copy files are called, did not bother to redistribute the copy files to the network as there was no economic reason to store information on their devices for others to access.
Therefore, the focus of Cryptoeconomics is the design of robust autonomous protocols that govern decentralized peer-to-peer systems. This application of game theory, economic incentives and disincentives in its design to shape behaviour leads to desired outcomes, that stabilise the network and encourage increased activity.
The design relies heavily on economic incentives and penalties. Where incentives encourage “miner” activity on the network and penalties are meted out to participants who run contrary to the default design. These incentives are in the form of block rewards awarded when a new block is found in addition to fees accumulated as a result of privileges gained as a temporary dictator of the new block. Prior to bitcoin it was assumed that it is impossible to create a stable financial system as a result of what is known as the Byzantine General Problem. Consensus was assumed to be impossible in a decentralized setting.
2.1 Tackling the Byzantine General Problem
To create a truly secure decentralized currency, the peer-to-peer network must satisfy the byzantine general problem on how to achieve consensus.
The byzantine general problem is a case of unknown traitorous generals.
The great byzantine army has laid siege to a city, they have surrounded the city on all sides. The city they intend to attack also have a great army though less than theirs, which can only be conquered if they coordinate their attack on all sides. Coordination is inherently difficult in the army because there is no central commander, rather there are generals leading different units of the army.
Among these generals there is an unknown amount of traitors. Because of the vastness of their army, to pass information among themselves, they have to use messengers. So, the generals on the left send a message to the generals on the right saying: “attack today”. The traitors among them after seeing the message from the left, decide to distribute messages that says: “attack tomorrow”. Knowing that an uncoordinated attack will lead to the byzantine army defeat.
This is the dilemma posed to the decentralized cryptocurrency network which led to earlier cryptocurrency iterations focusing on a centralized network and ultimately led to their failure. Satoshi’s 2008 paper applied the existing concept of Proof of Work (PoW) to ensure security.
2.2 Proof of Work to the rescue
The proof of work was designed as a deterrent to potential hackers or spammers who wish to send multiple requests to the network in order to destabilize it. Proof of Work as applied in the bitcoin protocol requires a hashing of blocks and use of electricity to meet the computational requirements of the set difficulty level in order to slow down potential spams.
The participants have to “mine” the loaded block of transactions to create a new block. To do this, the hash of the parent block (the previous block) is added to the new block and hashed, it is relatively easy to generate hashes of data. To make it infeasible for spammers, bitcoin has its difficulty adjustment levels. The difficulty level requires a certain amount of zeroes (currently five initial zeroes) to meet the minimum requirement of the difficulty. To arrive at this hash, multiple computations has to be done in parallel until the hash meeting the requirement is generated. A “nonce”, a random piece of data, is added at each retry until a particular nonce satisfies the minimum difficulty requirements. The successful miner is then awarded 12.5 bitcoins, which at the current value of bitcoins converts to $56,250 which in naira is about N20,531,250 in value per block. The cumulative work done to arrive at the required difficulty requirement is known as the proof of work which is appended to the block, in this way the new hash is linked to the previous block cryptographically to ensure authenticity.
This model of providing incentives for computational work done to the successful miner has kept the wheel of mining running as every 10 minutes, one block is mined and a miner or group of miners receive the reward. The difficulty level is readjusted every 2016 blocks, which roughly translates to a schedule of changes every 2 weeks to make it more difficult to mine coins as more computational power is added to the network.
Though there have been proposed alternatives to the proof of work, like the proof of stake by Vlad Zamfir and Vitalik Buterin of the ethereum foundation, or Algorand by Micali, none has been fully implemented without issues. However, ethereum intends to switch from the Proof of Work to the Proof of Stake soon.
Despite the security levels that cryptography allows, a fully autonomous self-maintaining decentralized network has to consider the appropriate environment in which to operate and this is where game theories and economic incentive come to the fore. Balancing the right amount of incentives, difficulty level (if it relies on proof of work), relative dependence and similarity to other cryptocurrencies, and the expected behaviour of participants in an adversarial environment can lead to a successful cryptocurrency.
3. Applicable game theoretic concepts
Game theory is essentially the study of strategic decision making in the context of the expected behaviour of others under assumptions of rationality. An early application of game theory was by John von Neumann and Osker Morgenstern in 1944 to oligopolistic markets. Since then it has seen more applications in other fields. Today, game theory is especially important in the design of cryptocurrency governance protocols.
A game theory has at least 3 components:
- Players: the decision makers
- Strategies: the decisions that could have the optimal benefit
- Payoff: the outcome of strategies.
In game theory, there are usually two types of games
- Zero sum game: where one player gains at the expense of the other.
- Non-zero sum game: where the gain of one player does not affect the gains of the other.
In a discussion of blockchain protocol design applicable games like the
- Nash equilibrium
- Schelling point
- Grim trigger argument
These games exemplify the expected behaviour of rational minded individuals and these give clues or directions for design. So individuals make the decisions that seems most sensible by considering the potential decisions of others.
3.1 Nash Equilibrium
The Nash equilibrium is a solution to a game where each player chooses their optimal strategy given that the same strategy was chosen by the other and they have nothing to gain by choosing otherwise. This kind of equilibrium decision making has massive implications for design of distributed systems like the blockchain. The bitcoin blockchain is “cheat free” because of this self-imposing Nash equilibrium.
Consider the “payoff” matrix below
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Table 1: A “payoff” matrix showing intersection of strategies
If A takes action:
then B has a payoff of 4 as well if it takes action and 0 payoff if it doesn’t, so the better strategy is to take action
If A does not take action:
Here, B still has 4 units of payoff for acting while it has no payoffs if it doesn’t.
It becomes clear then, that regardless of the actions of the other participant the best strategy is to act rather than not to in order to benefit maximally.
This therefore defines the Nash equilibrium as the intersection of A and B taking action.
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Table 2: a “payoff” matrix delineating the optimal strategy for both players
3.2 The Schelling (Focal) Point
During a class, the great economist Thomas Schelling decided to conduct an experiment with a group of students by asking them a simple question: “Tomorrow you have to meet a stranger in New York city. Where and when do you meet them?”. Most of his students responded that it will be at noon at the grand central terminus. This common denominating response came as a result of the fact that the terminus was a natural focal point. This came to be known as a Schelling point: a solution that people in the absence of communication will tend to default to.
A famous example of this game is “The Chicken Game”
Two individuals ride towards each other on a bike. If they collide head on they die, however the first rider to swerve out of the incoming rider’s way is a “chicken”.
In this game there are two scenarios that end in death.
- Scenario 1: both drivers ride without swerving and collide into each other
- Scenario 2: one swerves right and the other swerve left in whichever order.
The solution to this in the absence of pre-communication, according to Thomas Schelling, is not to look the other rider in the eye and simply move instinctively. For riders who were raised in an environment of left side driving, both will move left and avoid collision.
All these have applications in a blockchain.
3.3 Game theoretic applications in blockchain and cryptocurrencies
A block as used here, contains individual transactions. It functions as a store of those transactions for reference purposes. Multiple blocks are combined to form a blockchain through the interdependent hashes.
A blockchain generally has a genesis block, which is the first block in the chain. The preceding block of transactions of which is hash linked to the current block is the parent block. Then the proof of work which refers to the computational work done to create the block. The block with the optimal score, that is, the highest score is the current state of the network. The bitcoin blockchain as the focal example has two players: the users and the miners. The users of bitcoin only have to send or receive coins while the miners “mine” coins.
These users simply have their private and public key for encrypting and decrypting their transactions. Miners here have the power to authenticate and record these transactions and to “mine”: through this process new blocks are added to the chain and more coins are generated as incentives. On bitcoin, the incentives currently stand at 12.5 bitcoins. These miners as ledger keepers, therefore have a lot power in the system and can decide to misuse them, which is where game theory mechanics kick in to check behaviour. Though not explicitly stated, their incorporation ultimately checks bad behaviour.
For miners to cheat the network, they can
- Add blocks randomly without worrying about the proof of work
- Include invalid transactions and give themselves extra coins
- Mine on top of invalid blocks to get more coin
Consider the example below
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Figure 1: A simplified blockchain showing a fork in the chain
The blue blocks are the main chain while the red blocks are the forked chain which allows the miner to double spend his coins
A hypothetical double spend scenario goes like this:
A miner who is in blue block 61 wishes to use his 15 bitcoins to buy 180 bitcoin cash coins. He wants to create an alternate chain, red block 61 where his transaction never occurred. What can happen is at the end of this chain he ends up with his original 15 bitcoins in addition to the 180 bitcoin cash coins such that he can reuse them. This is what is known as double spending a cryptocurrency. Other miners could also theoretically continue mining on this forked chain so that they can benefit from the double spending trickery. This kind of behaviour can destroy the bitcoin ecosystem.
Yet, miners do not participate in this activity not because they are the most honourable men but because mining has a recursive punishment system.
Any block not on the consensus valid block becomes invalid, as such mining on invalid blocks makes anything on it invalid and any resource expended on it is wasted. Although, it is theoretically possible to encourage other miners to mine on your invalid block but this is where the Schelling point comes into play. Due to the vastness of miner activity, it is difficult if not infeasible to coordinate miners to move to the new block. The miners have an optimally scoring block (time stamped) which due to the coordination of parallel computing will run the proof of work faster and be ahead of the solo renegade miner. So at no point in time will a renegade miner be ahead of the network unless he has a 51% control of the network which becomes increasingly costly as the network increases due to proof of work requirements. So the miners as a group choose the stable state optimally scoring block and the renegade loses his invalid transaction as it is not recognised by other miners, he is therefore unable to spend any newly generated coins. The accurate transaction history remains intact.
A loophole in this arrangement is the coordinated attack on the chain. As miners pool their hashing power together to increase their chances of getting the reward, the prospect of a 51% attack may appear more likely.
4. Security models as necessary foundations
The security model on which the currency depends on the level of potential coordination. Protocol designers obsess over how coordinated attackers are, their budget and the cost they will assume in order to successfully destabilise the network. There are various assumed models
4.1 The honest majority model
This is a naïve model with the assumption that 51% of the participants on the network are honest individuals who want the best for the network. Naturally, this model doesn’t exist in reality as there is no such scenario in an adversarial environment.
4.2 The uncoordinated choice model
This assumes that due to decentralization and the vastness of distribution across geographical areas, the miners will not be able to coordinate their activities to game the network to their benefit. This model is based on individual self-interested miners who do not cooperate. This is the model on which bitcoin was built.
4.3 The coordinated choice model
This assumes that all the protocol participants are coordinated under the same agent regardless of distance and size of the network.
The realities of the bitcoin network today points to this as the base reality as more mining pools are being created increasing the likelihood of a 51% attack on the network. A mining pool is a group of miners who combine their hashing powers to maximize their potential for discovering new blocks and splitting the revenue generated among themselves. Though so far, the largest mining pools have proactively curtailed their numbers to be below the 51%, or miners voluntarily leave the pool, a combination of mining pools can still do the damage to the network since they are controlled by a handful of people. So this style of coordinated attack is quite feasible. At this time, based on the average energy requirements for the proof of work, an individual will require about $1.88bn to control 51% of the bitcoin network.
Though the attacker will not be able to rewrite past transaction or steal coins from wallets, they can prevent other miners from posting blocks and double spend on both chains since they have sufficient miners to determine what makes a chain invalid. However, this line of action of allowing a 51% coalition does not take place despite the fact that it is quite feasible even now, because of profit concerns. An attack on the blockchain devalues it and breaks the trust ascribed to the chain. Since the chain, especially bitcoin’s, is built on network acknowledgement and speculators, the value will precipitate rapidly as they move off the network due to lack of trust in the security of the systems and the expected future value of the currency. This eventuality is detrimental to profit, which underlines the major part of the reason why miners till date have actively sought to not form a 51% coalition.
4.4 The briber attacker model
This model builds on the assumption of lack of coordination in the network but acknowledges that there is an attacker which exists in the network, who is able to bribe his way through the network and achieve his aim at zero cost to himself and maximal benefit. This model brought forward by Vitalik Buterin and others assumes an attacker with enough resources to sway network participants to take certain actions through conditional bribes
The base Schellingcoin game as described by Vitalik is shown below
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Table 3: a payoff matrix of the base Schellingcoin game
This base game works on the assumption of majority and minority where the majority earns a determined amount as long as they are in the majority and any one in the minority earns nothing. Therefore, where others vote YES and you vote NO, you earn nothing, but, if you vote YES as others or NO as others you belong in the majority and as such earn the determined amount.
An attacker could in this scenario tip the scale. The attacker convinces you that you can vote independently of the majority and if you do, an earning of P + ɛ is awarded. The payoff matrix then looks like this
Abbildung in dieser Leseprobe nicht enthalten
Table 4: An altered Schellingcoin payoff matrix showing a P + epsilon potential reward
Unlike the base game, the attacker has assured the participants perhaps using a cryptographical zero knowledge proof (ZKP) that he has the resources to give anyone who votes in the minority the same amount given when in the majority plus epsilon. Given that your reward for being in the majority is fixed, there is now more incentive to vote in the minority as you benefit more, because ultimately your reasons for voting is to earn rewards. Other participants in the network driven by the same desires and conclusions decide to vote in the minority as they realise it is more lucrative to be in the minority assuming that others will vote in the majority. Since their optimal strategy is independent of others they vote for the minority. But others vote for the minority as well since they are rational beings and arrive at the same conclusions as you.
This makes the minority become the majority, thereby reverting the rewards to the original P.
Abbildung in dieser Leseprobe nicht enthalten
Table 5: the reality of the manipulated payoff matrix at zero cost to the attacker
The attacker has through the trickery of benevolence achieved his goal at zero cost since his conditions stipulate you have to be in the minority to receive the additional rewards, but the former obvious minority is now the majority, hence, the network automatically gives rewards and the attacker does not need to pay anyone. This is formally known as the P + epsilon attack. This is where Vitalik insists on the weakness of the proof of work framework and endorses the Proof of Stake (PoS). though Vitalik’s Ethereum still runs on Proof of Work, it is expected to be switched out in the short term. Summarily, the proof of stake intends to require proof of ownership of stakes in the network, its base currency, in lieu of computational requirements to enable harsher punishments for malevolent participants. Where proof of work merely recognises the attacker and thwarts them, then punishes with a mere “tap on the knuckle”, proof of stake intends to make the endeavour as costly as possible, by requiring substantial deposits by forgers who risk losing all their deposit if a trace of malfeasance is found.
5. Determining the value of a cryptoasset
Generally, cryptocurrencies have value because they are trusted as a store of value and speculators balancing out expected demand, supply and anticipating others purchases increases its valuation. Despite the fact that bitcoin was invented 9 years ago, it has only seen massive adoption this year, it therefore is still at the mercy of regulations around the globe to determine whether or not it may become the next disruptor in the financial technology space or just a novelty.
The potential to overtake the traditional finance industry has spurned several copies of the currency, as its code is open source.
Many people assume that simply as a result of creating a cryptocurrency people will ascribe value to it and participate in it. The reality has often been far from this.
To illustrate:
You live in a country where individuals like meeting in large spaces, yet all large spaces are owned by the government of the day. The government doesn’t stifle competition but because of costs of creating such places and expected participation, the government has maintained a monopoly over large spaces where individuals meet to commune.
After some time, an individual or group creates a similar sized space relative to government controlled spaces. At first individuals pass by and ignore the new space as they reason within themselves that they are likely to be the only individuals within the new spaces. Despite the added features and conveniences of your similarly sized space, at first no one participates in the new communal space.
After a while, an individual, an early adopter, who believes in your idea comes along and decides to spend time in your place. He invites friends and those friends do the same, soon enough there are plenty of people in your space enjoying community in the first privately owned space.
Others see your success and decide to copy your arrangement, they do so successfully, but they receive incrementally lower participation because they are simply following your design. The aura and mystique surrounding your initial establishment as the first and its obvious differentiating value morphs it into a class of its own.
So to determine value we must analyse through 3 basic principles
Principle 1
A cryptoasset value is determined by an expectation of what participants can do with it.
If one can exchange a bitcoin for something valuable, a dollar, then the bitcoin has the same value as its dollar price. Other assets are valued based on the service they render like access to a cloud service or their values are tied to physical assets like gold.
Expectation of value most often refers to some speculated future, and this is what plays a major part in determining what value speculators ascribe to it and are willing to pay for it. A cryptoasset needs to be useful beyond just its inherent nature of enabling exchange as we expect individuals to pay for them. For someone to exchange something of value for an obscure currency there has to be a reason beyond just being able to enable exchange of value like the bitcoin. That model already exists as a viable method and makes any other verbatim copy all the more likely to fail.
Principle 2
If you issue or pre-mine all your cryptoasset, you have created something with zero value.
This is a clear and obvious principle as there is no way around it. If this were valuable, then anyone could simply mine theirs and expect people to ascribe value to it. This is the operating principle until principle 1 kicks in. That is, people ascribe value to it because it is tied to the value of a service, good or product it provides.
Principle 3
The only meaning of the price of a cryptoasset is to compare its value with that of the asset with which it is being priced. Absolute value does not exist. Value is relative.
Some coins often referred to as stable coins can lead one to infer that the coin has an absolute or constant value. No coin has a stable value they fluctuate with the movement in the coin, currency or product which they are tied. One can programme value into a coin, by controlling how much people want the coin (principle 1). There are examples of assets tied to gold and some to other fiat currencies like the yen (following relaxed regulation). These cryptoassets fluctuate with the prices of their base anchor. Though they often don’t have the same value as their anchor product but their prices move with them.
6. Controlling supply
“A fixed money supply, or a supply altered only in accord with objective and calculable criteria, is a necessary condition to a meaningful just price of money” – Fr. Bernard W. Dempsey
Over the years in centralized economies, governments have devised means of making sure they curtail inflation through monetary and fiscal policies. This has checked the circulation of currency within the populace and keeps the economy in a particular state of balance when applied efficiently.
Bitcoins as well, are designed such that there is a fixed supply of 21 million units of coins over its lifetime. Which is expected to end in the year 2140 at the depreciating rate of bitcoin generation. Through mining, 12.5 bitcoins are currently generated every 10 minutes on average. This change kicked in on the 9th of July 2016 (previously, it was 25). Subsequently, assuming that the blocks being mined maintain an average of 10 minutes per block then we can expect another halving to occur in 2020 to 6.25 bitcoins per block mined. With an issuance rate currently at 4% with further reductions as time passes, the amount of coins to be mined clearly has a long way to go. Though the number of bitcoins in existence will never exceed 21 million, the money supply of bitcoins could exceed that fixed value (it is divisible to a millionth) with the growth of exchanges which offer marginal trading and other services.
Other cryptoasset like ethereum have a nebulous supply, currently at a 14.75 % issuance rate and a circulating supply of over 300 million units. This design could be because of the upcoming Proof of Stake protocol which requires large stakes to qualify as a validator. The price of ethereum fluctuates between $290 and $350 while bitcoin has found stable demand in the $4000 to $5000 range at the time of writing.
It could be argued then, that the fixed supply and relatively constant generation rates makes bitcoin the more valuable currency, which is evident in its price and value relative to other cryptoasset. It will be interesting to see how bitcoin performs in the long run as it issuance rate deflates to 0%.
7. Finding the right balance: lessons being learnt from bitcoin cash
U sing the case of bitcoin cash as a clear example of the need to find an appropriate relative balance.
On August 1, 2017, the bitcoin blockchain experienced a hard fork that created the bitcoin cash, thereby doubling coins. Ordinarily on paper, the bitcoin cash was supposed to be a better alternative to the bitcoin, but in reality it has faced circumstances that have made it stagnate and decline in value.
- Limited exchanges liquidity
- Relatively unrealistic difficulty levels
- Miner apathy
- Miner manipulation
These problems came together to create the perfect storm against it. Due to its relatively lower incentive and unbalanced relative to bitcoin difficulty level, the long term viability of the currency is threatened as miners’ game the network. The bitcoin cash can be mined by the same ASICs as bitcoin, but miners are not sufficiently incentivized to leave the more profitable bitcoin to mine it. This has led to a coordinated attack, perhaps not as direct as the type specified in the security models but attacking within the rules that is also damaging to the currency.
According to the protocol rules, the difficulty levels will adjust downwards if only 6 blocks are mined within 12 hours. As a result, coordinating miners have sought to increase profitability by mining only 6 blocks within the 12-hour limit. Subsequently, the difficulty levels drop making it easier to mine, still not satisfied, they progressively mine 5 blocks at the next phase making the relative cost of proof of work reduce further, thereby increasing their payoffs. Relative block difficulty increases profitability from 0.267BTC cost to 0.068BTC. Since block difficulty changes every 2016 blocks every difficulty level change allows miners to generate more coins faster since the current hardware relative to the difficulty level is superior. They repeat this process, over and again. This has led to the generation of more bitcoin cash than bitcoin as at the time of writing, with more bitcoin cash in circulation but at steadily depreciating values. This naturally has led to mass disposal of the coins as their value precipitate. Though attempts have been made by altruistic supporters to sabotage the coordinated miners 12-hour limited plan, consistency has been lacking as due to the proof of work required they ultimately have failed as more miners become apathetic to the currency. Though bitcoin has seen its value rise within the last quarter, the value of bitcoin cash has seen massive falls in value as miners and users leave the currency in its own continuing wreckage. Perhaps it may yet restore confidence in the future when all these issues cease.
8. Conclusion
Though Cryptoeconomics is a relatively new concept with more practical applications being developed daily, the far reaching effects of being able to create a viable currency goes beyond what most might assume to be the rudimentary design of virtual currencies. It involves balancing good cryptographical protection, understanding that humans are always incentive driven rational beings. A good application of strong peer-to-peer networks, game theory, and appropriate economic incentives will create value to sustain the cryptocurrencies future. Incentivizing decentralization however as can be seen in bitcoin cash can also have negative effects when not balanced. For now, bitcoin remains a role model in striking the right balance between networking, game theory and appropriate incentives. Though useful, verbatim replication of its protocol will not ultimately lead to success for other cryptocurrencies as it has a first-mover advantage.
9. References
[1] Josh Stark. Making sense of cryptoeconomics. www.coindesk.com/making-sense-cryptoeconomics/ August 2017
[2] Wikipedia. Game theory https://en.m.wikipedia.org/wiki/game_theory/
[3] Blockgeeks. What is cryptoeconomics? The ultimate beginners guide www.blockgeeks.com/guides/what-is-cryptoeconomics/
[4] Kyle Wang. Cryptoeconomics: Paving the future of blockchain technology www.hackernoon.com/cryptoeconomics-paving-the-future-of-blockchain-technology-13b04dab971 July 2017
[5] Juice. The myth of Bitcoin cash: Understanding Game theory www.medium.com/@rextar4444/the-myth-of-bitcoin-cash-understanding-game-theory-f87858bf8791
Frequently asked questions
What is Cryptoeconomics?
Cryptoeconomics is the study of protocols that govern the production, distribution, and consumption of goods and services in a decentralized digital economy. It's a combination of cryptography and economics, applying economic incentives to design cryptographically secure financial systems. Think of it as mechanism design – reverse game theory – applied to digital systems.
How does Cryptoeconomics relate to Blockchain and Cryptocurrencies?
The blockchain technology underpinning most cryptocurrencies relies on cryptoeconomics. Cryptoeconomics provides the incentives (and disincentives) to ensure the network operates securely and as intended. It addresses issues like preventing malicious actors from disrupting the system and ensuring miners are rewarded for their work.
What is the Byzantine General Problem, and how does it relate to Decentralization?
The Byzantine General Problem describes the challenge of achieving consensus in a distributed system when some participants (generals) may be traitorous. In a decentralized cryptocurrency network, this translates to the difficulty of ensuring all nodes agree on the state of the blockchain when some nodes might be trying to manipulate the system. Bitcoin solves this problem with Proof of Work.
What is Proof of Work (PoW), and how does it secure Bitcoin?
Proof of Work is a mechanism requiring participants (miners) to expend computational effort to solve a complex mathematical problem to add new blocks to the blockchain. This process makes it costly for attackers to spam the network or manipulate the blockchain's history. Successfully finding a valid block earns the miner a reward (currently 12.5 bitcoins).
What is the Nash Equilibrium, and how does it apply to Cryptocurrencies?
The Nash Equilibrium is a game theory concept where each player chooses their optimal strategy, given that the other players have chosen their optimal strategy, and no one has anything to gain by changing their strategy. In the context of Bitcoin, it means that it's in the best interest of miners to act honestly and follow the protocol rules because any deviation would ultimately be detrimental to them.
What is the Schelling (Focal) Point, and how does it apply to Cryptocurrencies?
The Schelling point is a solution that people, in the absence of communication, will tend to default to. In a blockchain context, it explains why miners generally choose to mine on the longest, valid chain; it's the most obvious and logical choice for everyone, ensuring network stability.
What are the different Security Models in Cryptoeconomics?
Several security models are used, each assuming different levels of attacker coordination and capability:
- Honest Majority Model: Assumes 51% of participants are honest, which isn't realistic.
- Uncoordinated Choice Model: Assumes miners act independently without coordination. Bitcoin's original design was based on this.
- Coordinated Choice Model: Assumes participants are coordinated under a single agent, increasing the possibility of attacks like a 51% attack.
- Briber Attacker Model: Assumes an attacker can bribe participants to act maliciously.
How is the value of a Cryptoasset determined?
The value of a cryptoasset depends on:
- Expectation of what participants can do with it: Its utility in exchange for something valuable.
- Supply: Issuing or pre-mining all the cryptoasset can result in zero value if it lacks intrinsic utility.
- Relative Value: Comparing its value with that of the asset with which it is being priced. Absolute value does not exist; value is relative.
How does controlling the supply affect the value of a Cryptocurrency?
A fixed or predictably altered supply (like Bitcoin's 21 million cap) can contribute to a more stable and predictable value. Currencies with a nebulous or inflationary supply might experience price volatility.
What lessons can be learned from Bitcoin Cash?
Bitcoin Cash demonstrates the importance of finding the right balance in a cryptocurrency ecosystem. Issues like limited exchange liquidity, unrealistic difficulty levels, miner apathy, and miner manipulation can negatively impact a currency's long-term viability, leading to depreciating values.
What is a P + Epsilon Attack?
A P + Epsilon Attack is a bribery attack where an attacker uses a zero-knowledge proof to convince network participants that they will be rewarded with P + Epsilon if they vote for the minority outcome. However, because rational actors all select the minority outcome (as they all believe they will be rewarded more if in the minority), they become the majority, meaning the original conditions of the bribe are no longer met. The attacker spends nothing, and the network consensus is achieved at zero cost to the attacker.
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- Quote paper
- Toochukwu Obasi (Author), 2017, The Economics of Cryptocurrency. Incentivizing Decentralisation, Munich, GRIN Verlag, https://www.grin.com/document/435228
