Cryptoeconomics refers to as 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. Cryptoeconomic approaches combine cryptography and economics to create robust decentralized P2P networks that thrive over time despite adversaries attempting to disrupt them. 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 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 economic coordination game, now referred to as cryptoeconomics.


Machine Consensus in a P2P Network

A fundamental problem in distributed computing is to achieve overall system reliability in the presence of a number of faulty or potentially corrupted processes. This often requires entities to agree on some data value that is needed during computation. The consensus problem requires agreement among a number of network participants for a single data value. Some of the processes may fail or be unreliable in other ways, so consensus protocols must be fault tolerant, attack and collusion resistant: (Source)

  • Fault-Tolerant
    Decentralized systems are less likely to fail accidentally because they rely on many separate components.
  • Attack Resistant
    Decentralized systems are more expensive to attack and destroy or manipulate because they lack sensitive central points that can be attacked at much lower cost than the economic size of the surrounding system.
  • 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 harmless well-coordinated citizens, customers, employees and the general public all the time.


Consensus Rules

In a crypto economic setup, economic incentives are designed to be fault tolerant, attack and collude resistant. These economic incentives are tied around a cryptographic token. The token is considered to be the least common denominator to align interests in a multi-stakeholder network like a (permissionless) Blockchain. Bitcoin is only the first example for how token governance rulesets align stakeholder interests around economic incentives. While Satoshi tied Bitcoin’s token governance rulesets to PoW incentive mechanisms, other Blockchains that followed have experimented with alternative consensus mechanisms.

  • Proof of Work (PoW)
    The Bitcoin blockchain uses electricity to ensure the security of the system. It creates an economic system where you can only participate by incurring costs – Proof of Work (PoW). You do that for the possibility of reward – in this case, Bitcoin tokens. If you spend money, and you play fair by the rules, you get money back. If you cheat, you lose money. The consensus rules are designed in a way that it doesn’t pay to cheat. This simple game theoretical equilibrium is the core of the Bitcoin consensus algorithm. Currently, the majority of Altcoins are software forks of the Bitcoin protocol with usually minor changes to the proof of work (PoW) algorithm of the Bitcoin blockchain. Some people argue that Bitcoin’s current consensus system is more a Delegated PoW and not a pure PoW as designed by Satoshi, since most miners have formed cartels in form of mining pools.
    History: Proof of work is an economic measure to deter denial of service attacks and other service abuses such as spam on a network by requiring some work from the service requester, usually meaning processing time by a computer. The concept may have been first presented by Cynthia Dwork and Moni Naor in a 1993 journal. The term “Proof of Work” was first coined and formalized in a 1999 paper by Markus Jakobsson and Ari Juels. A key feature of these schemes is their asymmetry: the work must be moderately hard (but feasible) on the requester side but easy to check for the service provider. This idea is also known as a CPU cost function, client puzzle, computational puzzle or CPU pricing function.
  • Proof of Stake (PoS)
    is an alternative method by which a cryptocurrency blockchain network aims to achieve distributed consensus. While the proof-of-work (PoW) method asks users to repeatedly run hashing algorithms or other client puzzles, to validate electronic transactions, proof-of-stake asks users to prove ownership of a certain amount of currency (their “stake” in the currency). Peercoin was the first cryptocurrency to launch using Proof-of-Stake. Other prominent implementations are found in BitShares, Nxt, BlackCoin, NuShares/NuBits and Qora. Ethereum has planned a hard fork transition from PoW to PoS consensus. Decred hybridizes PoW with PoS and combines elements of both in an attempt to garner the benefits of the two systems and create a more robust notion of consensus. With Proof of Work, the probability of mining a block depends on the work done by the miner (e.g. CPU/GPU cycles spent checking hashes). In the case of Bitcoin, with Proof of Stake, the resource that’s compared is the amount of Bitcoin a miner holds – someone holding 1% of the Bitcoin can mine 1% of the “Proof of Stake blocks”. Instead of sacrificing energy to mine a block, a user must prove they own a certain amount of the cryptocurrency to generate a block. The higher stake you have, the more likely you are to generate a block. In theory, this should prevent users from creating forks because it will devalue their stake. Proof of Stake sounds like a good idea, but ironically, there is the “Nothing at Stake” problem. Since mining Bitcoins is costly, it is not smart to waste your energy on a fork that won’t earn you any money, however with Proof of Stake, it is free to mine a fork.
  • Delegated Proof of Stake
    DPoS uses a reputation system and real-time voting to achieve consensus. To be more specific, a panel of trusted parties has to be established, with all of its members eligible to create blocks and prevent non-trusted parties from participating. Delegates, the parties responsible for creating blocks, are unable to change transaction details. However, they can prevent specific transactions from being included in the next network block. This seemingly requires a fair bit of trust, which makes the concept look far less appealing. However, there is a caveat. Any transaction not included in the next block – or a block failing to create – will mean the next network block is twice the size. In a way, this prevents malicious intent to block certain transactions or blocks being created in the allotted time period. All it does is perhaps slightly delay said transaction or block, but it is seemingly impossible to prevent inclusion and creation in the long run. Moreover, anyone who behaves in a nefarious way will have their behavior exposed to the public. Community members of the DPoS-capable currencies can vote to have said person removed as a delegate altogether. It appears as if cheating under DPoS rules is not only impossible, but it is not in anybody’s best interest to do so either. It is equally possible to have more or fewer delegates as part of the network, although that may not necessarily be beneficial either. It is always possible to change the number of delegates, though, which is an important factor to keep in mind.
  • Proof of Burn
    “is a method for distributed consensus and an alternative to Proof of Work and Proof of Stake. It can also be used for bootstrapping one cryptocurrency off of another. The idea is that miners should show proof that they burned some coins – that is, sent them to a verifiably unspendable address. This is expensive from their individual point of view, just like proof of work; but it consumes no resources other than the burned underlying asset. To date, all proof of burn cryptocurrencies work by burning proof-of-work-mined cryptocurrencies, so the ultimate source of scarcity remains the proof-of-work-mined fuel” (Bitcoin Wiki).
  • Proof of Authority (PoA)
    A Proof of authority is a consensus mechanism in a private blockchain which essentially gives one client (or a specific number of clients) with one particular private key the right to make all of the blocks in the blockchain.


Upgrading/Changing Consensus Rules

Blockchain protocols are a powerful tool to auto-enforce predefined consensus rules in distributed networks without centralized management. Network members know the transparent and open source ruleset and can opt in and out anytime. Blockchain Protocols are powerful governance tools, as long as the protocol does not need modification.

Over time, as circumstances change, there might be a need for a system upgrade. These upgrades (forks) need majority consensus by all stakeholders in the network. While the protocol can be upgraded through a hard fork or a soft fork and these forks can be highly controversial as we have seen in the Bitcoin blocksize debate or Ethereum post TheDAO hard fork.

Example: In the Bitcoin network, developers suggest bitcoin improvements/modifications, small or big, proposals on Github, Bitcointalk, Reddit, mailing lists, etc. Discussion on this level is critical to enable smooth runtime consensus transitions. Modifications with reference implementations get tested on the testnet. After successful testing developers implement the changes into the Bitcoin software. Who has a say in the consensus process? (1) Software Developers (do the reference implementations); (2) Miners (Runtime consensus for mining blocks); (3) Exchanges (They run nodes that validate transactions); (4) Wallet companies (create transactions run on nodes); (5) Merchants (Merchant processing also through nodes).


Further Reading

Cryptoeconomics 101Nick Tomaino
The meaning of Decentraization, Vitalik Buterin
Understanding Crypto-Economic Security through Game Theory,
Delegated Proof of Stake, Bitshares
Fat Protocols, Joel Menegro
Tokens, Tokens and More Tokens, Nick Tomaino
Crypto Tokens and the Coming Age of Protocol Innovation, Albert Wenger
Crypto Tokens: A Breakthrough in Open Network Design, podcast with Vitalik Buterin, podcast with Olaf Carlson-Wee
Regulatory discussions , Coincenter
A gentle Introduction to Digital Tokens

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Blockchain Handbook