Cryptoeconomics refers to the study of economic interaction in adversarial environments. The underlying challenge is that in decentralized P2P systems, that do not give control to any centralized party, one must assume that there will be bad actors looking to disrupt the system.

The cryptography underlying these systems is what makes the P2P communication within the networks secure, and the economics is what incentivizes all actors to contribute to the network so that it continues to develop over time.

Before the advent of Bitcoin, it was commonly believed to be impossible to achieve fault-tolerant and attack resistant consensus among nodes in a P2P network (Byzantine General’s Problem).

Satoshi Nakamoto introduced economic incentives to a P2P Network and solved that problem in the Bitcoin White Paper published in 2008. While decentralized P2P systems based on cryptography were nothing new – see Kazaa and BitTorrent – what these P2P systems before Bitcoin lacked was the economic incentive layer for coordination of the network of participants. Satoshi’s implementation of a Proof of Work (POW) consensus mechanism introduced a new field of an economic coordination game, now referred to as cryptoeconomics.

P2P networks

The underlying challenge of P2P networks of untrusted actors is how to deal with malicious network nodes in the absence of centralized parties securing the system. This is referred to as the “Byzantine Generals Problem”. A malicious node, also called a Byzantine node, can lie and intentionally mislead other nodes involved in the consensus process. One must always assume that there will be bad actors trying to disrupt any open and public network.

Advantages of Decentralized Systems

Collusion Resistant

It is much harder for participants in decentralized systems to collude and act in ways that benefit them at the expense of other participants, whereas the leadership of corporations and governments collude in ways that benefit themselves but harm less well-coordinated citizens, customers, employees and the general public all the time.

For the first time in the history of distributed computing, Bitcoin introduced a mathematical solution to this problem with the introduction of a consensus mechanism called “Proof-of-Work.” Bitcoin’s “Proof-of-Work” showed how a resilient consensus protocol can be designed in a way that the economic cost of attacking a system is disproportionate to the benefit of doing so. This makes counterfeiting or censorship economically unprofitable. “Proof-of-Work” sparked a new field of science around economic coordination games using cryptographic tools, also referred to as “cryptoeconomics.” It can be described as the study of economic interaction in untrusted environments, where every actor could be potentially corrupt. The Bitcoin blockchain is the first practical instance of cryptoeconomics. It produces “trust by math” rather than “trust by human discretion” or “trust by default of a legal contract.”

Public-private key infrastructure hereby guarantees attack-resistant access control of one’s token. Hashing functions allow nodes to verify transactions that are done over the network. Both hashing functions and public-private key cryptography are also required for the economic coordination game called “Proof-of-Work,” to reward miners for adding truthful transaction blocks to the ledger. Cryptoeconomic mechanisms can provide a security equilibrium such that a distributed system is safe against attacks.

However, security very much depends on the strength of its assumptions about how people react to economic incentives. How people react to incentives has been a field of study in economics. Cryptoeconomics, therefore, has much in common with mechanism design, a field of economics related to game theory. Game theory analyzes strategic interactions, which are referred to as games. It tries to understand the best strategies for each player, and the likely outcome if both players follow those strategies according to the players’ utilities. Mechanism design defines desirable outcomes and works backwards to create a game that incentivizes players toward that desired outcome. While cryptoeconomics is interdisciplinary, it is a discipline that was predominantly developed in the computer science community. It seems that there is still much room to incorporate methods from various economic disciplines.

This competition is driven by a cryptographic puzzle where all miners compete to be the first to find a solution to a mathematical problem, where they have to find an input that gives a specific hash value. Miners hereby have to collect recent transactions and some metadata, verify the transactions, and run all the data through a SHA-256 algorithm. They must find a hash value which begins with a consecutive number of zeros. This means that they have to perform computational work to solve the puzzle, which is the reason why this process is referred to as “Proof-of-Work.”

The first miner that solves a mathematical puzzle can write transactions to the blockchain, creating the next block, and in return, they get a “block reward” for the costs incurred in the form of new network tokens. In the case of the Bitcoin Network, it would be Bitcoin (BTC); in the Ethereum Network, it is Ether (ETH).

This means that all network participants that work toward adding blocks of transactions to the ledger can potentially earn network tokens (block reward plus potential transaction fees). At the time of writing this book, the reward for successful block creation in the Bitcoin Network is 12.5 BTC per block. The block reward gets reduced by 50 percent every 210.000 blocks, around every four years. The next “halving” of block rewards is in 2020. By participating in this race, miners collectively make sure that all transactions included in a block are valid.

To get a better understanding of how high economic costs of attacking or manipulating a network would be, it is helpful to check these websites, because they provide real-time information about how much it currently costs to attack blockchains and similar networks:

Online tool to check what it would cost to attack Bitcoin:
https://gobitcoin.io/tools/cost-51-attack/

Online tool to check what it would cost to attack different blockchains:
https://www.crypto51.app/

A successful 51-percent attack could have the following impact:

1. Change blocks by adding or removing transactions. It requires additional PoW, which means the older a transaction is, the harder an attack gets;
2. Censor participants and therefore blocks;
3. Send transactions and then reverse them; and
4. Change protocol rules.

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