Cryptoeconomics 101
Much has been discussed about blockchain-based tokens lately. We hosted the inaugural Token Summit in New York on May 25th. Prices of tokens have soared, startups are raising millions in token sales within seconds, mainstream media outlets like Bloomberg, Forbes and CNBC are talking about token models and every venture fund in the world is now discussing what to make of tokens internally.
In recent discussions with people newly interested in the burgeoning token economy, one thing I’ve noticed is that the concept of cryptoeconomics is largely foreign to people. Cryptoeconomics is the fundamental catalyst for this whole movement, so I think that needs to change.
The goal of this piece is to shine a light on cryptoeconomics and encourage more people to start thinking about it. If you know a young (or old) person interested in math, science, or economics, please share with them!
What is cryptoeconomics?
Cryptoeconomics is the study of economic interaction in adversarial environments. In decentralized P2P systems that do not give control to any third 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 the network. 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 thrives over time.
Satoshi Nakamoto birthed the field of cryptoeconomics when he created Bitcoin in 2009. Just like Galileo is known as the founding father of physics, Satoshi will forever be known as the founding father of cryptoeconomics. I believe in 50 years, cryptoeconomics may be a discipline as widely studied as physics and Satoshi may be as widely revered as Galileo.
Some history on decentralized systems
Decentralized P2P systems based on cryptography were not new in 2009 (you probably heard of Kazaa and Bittorrent prior). What these earlier decentralized systems lacked was economic incentives, and the lack of baked in economic incentives is arguably what stifled these early P2P systems from persisting and thriving over time.
Satoshi added economic incentives to P2P systems when he created Bitcoin in 2009. It was actually previously believed to be impossible to achieve consensus among nodes (the Byzantine General’s Problem) to create a decentralized digital cash system, but Satoshi’s implementation of a proof-of-work consensus mechanism + incentives solved this previously unsolvable problem (see here for his own explanation). Satoshi’s combination of crypto and incentives resulted in a robust, thriving p2p payment network that today stores over $40B worth of value and processes over $600M worth of transactions daily.
The forefront of cryptoeconomics today
If Satoshi is the Galileo of cryptoeconomics, Vitalik may be the Einstein. To understand Vitalik’s thinking about cryptoeconomics, start by watching his intro presentation:
From a cryptoeconomic perspective, Vitalik has designed Ethereum to be different from Bitcoin in a few key ways:
- More expressive scripting language: Satoshi built Bitcoin with a simple scripting language that is not designed to facilitate complex transaction types. Ethereum is built from the ground up to be a general purpose, decentralized computing platform and the team implemented some clever techniques like a flexible fee structure for running more complex contracts (aka gas).
- Proof-of-stake consensus: This is where things get interesting from a cryptoeconomic perspective. Proof-of-work in Bitcoin is inefficient — costing miners hundreds of millions of dollars per year in the hardware and electricity required to secure the network. Proof-of-stake is a consensus mechanism that seeks to solve the inefficiency problem by allowing the stake holders in the token to validate the network. This approach has historically been thought of as insecure (the nothing at stake problem and the long-range attack have been two of the major unsolved vulnerabilities), but Vitalik and team have been diligently working on solutions to these problems. Ethereum now runs on proof-of-work, but the expectation is to switch to proof-of-stake in the next 12–18 months.
- Economics: Bitcoin has a clear monetary policy: 21M BTC will ever be created and the rate at which BTC is created decreases by half every four years. Miners running hardware earn tokens for expending electricity. Ethereum has a more flexible monetary policy that is not yet set in stone at this time. Many cite the fixed supply of BTC and the nebulous supply of ETH as a negative; we’ll see. What is clear is that when the switch to PoS occurs, holders of coins will act as the validators of the network and earn more coins. This is a more inclusive approach to coin distribution than Bitcoin’s current ASIC mining approach.
Ethereum is such an exciting project to me because Vitalik and his team don’t come from academia or existing industry and they have a new and fresh perspective on building cryptoeconomic systems. Their approach flies directly against what a lot of the traditional academic and crypto communities have thought to be possible (the popular belief is that it’s impossible to build a secure decentralized platform that has a Turing complete scripting language and uses proof-of-stake as the consensus mechanism).
Learn more
Diversity of perspectives is incredibly important to build robust systems that persist over time, and the hope is that the Ethereum team’s work inspires new minds to enter the field and start solving problems in new ways just like they did. There are many projects beyond Bitcoin and Ethereum that are interesting from a cryptoeconomic perspective as well, including Sia, Augur, and Zcash. I expect the number of cryptoeconomic projects to proliferate in the coming years.
Today, there are probably less than 100 people in the world who are experts in cryptoeconomics. I don’t think there’s a better field for a young person to be studying right now and you don’t need formal education for it either — all the tools are at your disposal now, for free (Reddit, Slack, Twitter, Github, Coursera & Youtube among others).
If interested in learning more, start by checking out the following:
About the author: Nick Tomaino runs The Control and is an investor at Runa Capital, an early stage venture fund. Previously, Nick worked on business development and marketing at Coinbase. Follow him on Twitter, sign up for our newsletter, and support The Control by becoming a member:
