Cryptocurrency: Economic Perspective

Introduction:

Historians estimate that metal objects were first used as currency as early as 5,000 B.C (Wonderopolis). The first known currency was created in Lydia, presently Turkey, in 600 BC by King Alyattes. Paper money was introduced in 1661 AD. In the 1800’s the gold standard was implemented, but was soon abolished by Nixon in 1971. One of the most recent changes in currency was the introduction of the euro in 1999, which was fully legalized and circulated in 2002 (Callander). The implementation of paper money and extensive development of financial institutions over the past century have had severe economic advantages that are now trying to be improved with cryptographic and block chain technology. It was only On January, 4th, 2009, that the bitcoin network came into existence, it was the first purely digital asset with no corresponding physical asset backing it.

Image by: Noah Mac Millan; source: www.noahmacmillan.wordpress.com

This paper attempts to provide a general understanding of the principles of crypto-economics, followed by an examination of the properties of Bitcoin to provide an insightful lens to crypto-economics designs. The article attempts to cover properties such as Proof-of-Work, Proof-of-Stake, inflation and the current economic environment to provide an understanding of this emerging asset class.

Principles of Cryptoeconomics’:

Cryptoeconomics can be defined as a discipline that studies protocols that govern the production, distribution, and consumption of goods and services in a decentralized digital economy (Lielacher). Cryptoeconomics is a practical science that focuses on the design and characterization of these protocols (Rosic).

The term “Cryptoeconomics” is derived from the disciplines of Cryptography and Economics. Cryptography is a science of secure communication, that has been used as a method of storing and transmitting data in varying forms so that, only the intended parties can process or access it. A scientific approach towards cryptography focuses upon the designs of cryptographic algorithms around computational hardness assumption that are theoretically undecryptable by an advisory (Vahed). In addition to protecting data from theft or alteration, it can also be used for authentication purposes.

Another important aspect of Cryptoeconomics is the Blockchain. At its essence, Blockchain is a ledger of records of transactions. These transactions can include but are not limited to fiat money, secure digital data, government identification information, and many other kinds of goods and services.

Blockchain technology combined with Cryptography allowed the creation of a Blockchain Ledger.

People tend to leave out the “economic” aspects of Cryptoeconomics, the part which gives the blockchain its unique capabilities (Rosic). Cryptoeconomics uses incentives and cryptography to design systems, applications and networks (Stark). It has a lot in common with mechanism design which is closely related to the fields of mathematics and economic theory. It is not justified to subset crypto-economics as a part of economics. Cryptoeconomics should be categorized as economic incentives that are applied cryptography and blockchain technology. The public imagination towards cryptocurrencies and blockchains technologies is in a positive light, where they envision it as a key piece of technology that will dramatically influence how finance and trade are conducted in the future. The implementation of bitcoin and other virtual currencies forces us to reassess, how we perceive money. Instead of money being backed by commodities or legal tenders by large organizations, one could think of money in terms of design or engineering problems.

Virtual Currencies Fundamentals and Properties through the lens of Bitcoin:

At its fundamental level Virtual Currencies (VC) are big public ledger and track records of transactions. Satoshi Nakamoto is the renowned creator of Bitcoin, he initially laid the foundation whitepaper for the technology in October 2008. Bitcoin was the first successful implementation for something based in crypto-economics.

Bitcoin possesses several common aspects with current currencies. It improves on basic priorities such as its durability, divisibility and verifiability. Bitcoin is intangible in nature, hence it is highly durable. Furthermore, one bitcoin is divisible down to eight decimal points, with the smallest unit of donation 1 Satoshi (0.00000001 BTC). Payments made on the network are verifiable and one is unable to counterfeit the virtual currency.

Two properties that make it even more popular are its portability and fungibility. Since Bitcoin are stored online and are intangible in nature, it possesses the same fungibility and portability across the globe and therefore is recognized globally. One must appreciate Bitcoin’s impact on reducing the necessity of third parties and escrow services. This combined with its relatively quick transaction speed compared to the modern banking system, allow it to retain low transaction cost and remain highly frictionless (Vaidya).

Bitcoin technology is based on blockchain where each block contains a hash of the previous block and forms a continuous chain, each of these blocks include a transaction and time stamp (Rosic). Blocks maintain a state of the following property “(UTXO set) s’ = STF (s, TX)” which changes according to the transaction. If individual A has 100 BTC and transfers 40 BTC to individual B, the new state would be with A left with 60 BTC and B with 40 BTC. Furthermore, the blockchain is immutable, only new entries can be made into the blockchain and altercation of previous blocks can’t be performed. In addition, the blockchain can be downloadable quickly by anyone to check a transaction, additional transactions can be made in the blockchain for a fee.

The identification component of blockchain technology is carried out with the assistance of cryptographic keys and hashes. Signatures are used to prove the identity of the sender of a message (prove TX sender authenticity) and prove topological order of messages respectively.

Hashes are used to ensure a consistent total ordering and linking of the blockchain and guaranteeing the integrity of the history of bitcoin transactions on the blockchain. A system of public-private key cryptography is used to allow individuals exclusive rights and control over their Bitcoin (Stark). Since, a certain block on the blockchain is accessible by an individual, Private Keys are essential, without which one cannot guarantee individual exclusive rights over their Bitcoin or cryptocurrency.

Incentives:

The essential economic design of Bitcoin relies on the principles of incentives and penalties. Mining is the process of securely adding transaction records to the Bitcoin public ledger of past transactions, making it computationally impractical to modify any one entry. The blockchain is decentral, it can be downloaded and the integrity of the blockchain is ensured through this decentralized system. This allows a consensus about the ordering of transactions. Miners are economically rewarded to support the Bitcoin network. Miners contribute computational processing power and electricity and are rewarded with Bitcoin tokens.

Cryptographic puzzles and hashing are solved to mine new block. Mining is the mechanism that introduces new Bitcoin tokens in the economy. Miners are paid a transaction fee or “subsidy” for their efforts. Upon the successful mining of a block, a miner is rewarded a set number of tokens (12.5 Bitcoin). Random progressive difficulty levels are set which helps ensure the system fairly distributes rewards and prevents the same miners from obtaining new blocks and acquiring multiple rewards. The system of rewarding tokens for contributing resources incentivizes actors by assigning they units of a protocol-defined currency ,Bitcoin.

Incentives to participate in the blockchain include tokens, privileges and rewards. Tokens are assigned to actors to actively participate in the blockchain by contributing resources to maintain the blockchain. Upon the successful mining of a block, miners are awarded temporary privileges that give them decision-making rights and the ability to charge rent. The miner who mines the new block has the power to decide which transactions go into the new block.

Good participants are rewarded with monetary rewards whereas bad participants are punished by either having to pay a monetary fine or having their rights taken away. Over the long run, mining is a zero-sum gain, the reason for this is that eventually the profits that a miner would receive would slowly get adjusted to the cost of mining (hardware and electricity) when enough individuals enter the market.

Copies of the blockchain ledger are present all over the world and the systems are designed to distribute in a decentralized fashion with no centralized authority issuing Bitcoin. These Virtual currencies are Open Source Protocols that allow people to make their own entries in a decentralized way. Similar properties of such decentralized peer-to-peer networks have existed in the past.

The Torrent Clients were introduced in early 2001, the allowed peer-to-peer sharing of files on a decentralized network. But even if we ignore all the issues associated with copyrights and integrity rights, the entire concept remains flawed. The network to function efficiently requires peers to seed files which utilize storage and network bandwidth. Since the network worked on an honor system and the network failed to provide an economic incentive for individuals to seed files to others to access.

As mentioned earlier, blockchain differs from other decentralized peer-to-peer networks as it can successfully incentivize actors to dedicate resources to support the network. This is the foundation of any economic system, incentivize to yield greater productivity and efficiency. But at the same time, it doesn’t forget to punish bad participants not playing according to the rules, which will be discussed ahead.

Carrot and Stick: Proof-of-Work and Proof-of-Stake:

One should be concerned with the authenticity, security and distribution of these decentralized ledgers. In day-to-day financial banking institutions who offer online banking services or an online payment gateway like PayPal; money is moved only within the centralized financial institutions accounts. Also, these service providers are legally responsible to hold up their terms of the deal by governments regulating their activities.

Satoshi Nakamoto thought of this highlight. In addition to virtual currencies being decentralized, they incorporate two extremely important properties that help resolves several potential security and vulnerability threats.

The two concepts that make our cryptocurrency secure are Proof-of-Work and “Proof-of-Stake” for which the “Carrot and Stick” analogy may be appropriate. As Proof-of-Work could be compared to a carrot (incentive) and Proof-of-Stake as the stick (punishment).

Proof of work:

The mining of cryptocurrencies is designed to intentionally be resource intensive. This, in addition to the progressively random difficulty, limit the number of blocks mined. There is a steady relationship the number of blocks mined and the computational processing power of current technology. The ever-increasing difficulty of cryptographic protocols, allow cryptocurrencies to retain their unit of account.

This helps the blockchain to become more secure and by doing so they increase confidence that past records are authentic and allow miners to hold onto this secure unit of account. Without these carefully calibrated incentives and security protocols no one would have confidence in the system and it may not persist into the future.

New blocks are mined to add to the blockchain, a consensus system called “Proof-of-Work”. Proof-of-Work validates and then adds these blocks to the new public ledger. For blocks to be considered valid it must contain a “Proof-of-Work” which is verified by Bitcoin nodes every time a block is received. Bitcoin uses the “Hash cash” proof of work function.

The “Proof-of-Work” consensus system was added to solve a long-standing problem of earlier decentralized peer to peer systems called the “Byzantine Generals Problem”. The Byzantine Generals Problem illustrates the difficulty of reaching a consensus in a distributed system (Vaidya). The system needs to agree upon the valid transactions of the ledger that should be included in the block and the appropriate distribution of nodes in the network.

But the system has difficulty distinguishing good players from bad players. By implementing Proof-of-Work the system can reach consensus. Improving Proof-of-Work and designing alternatives is one of the most active fields of research in crypto-economics.

P+ Epsilon Attack or 51% Attack:

Since bitcoin is decentralized in nature and the majority needs to agree on the correct ledger, Proof-of-Work is theoretically vulnerable to a P + epsilon attack or a so-called 51 percent attack. It is possible to gain control and reliably censor transactions as well as alter past transactions of the blockchain. This could be done by gaining a majority of greater than fifty percent in the network’s hashing power.

But gaining control of such a large magnitude of hashing power, electricity, resources and difficulty in coordination limit this from occurring to a certain extent, but do not remove the possibility altogether. As of March 2018, the approximate cost of implementing a “P + Epsilon” or “51%” attack would be approximately $ 7,324,473,094 in the most efficient price-to-performance ratio hardware and approximately 261,814,195 kWh electricity per day (approximately worth $ 13,090,709$ per day).

But humans are prone to “bad” behavior, the fundamental concepts of Game Theory and Nash Equilibrium help keep this decentralized system honest. Looking at the graph below, we observe a malicious miner attempting to alter the ledger (hard-forking) from “Block Two” to “Block Two B”. The malicious miners’ attempt in hard-forking the ledger is for financial gain. There are two models that are possible an “Uncoordinated Choice Model” and a “Bribing Attack Model”.

Figure 1: An Hard-Forking Attempt by a Malicious Miner
Figure 2: Uncoordinated Choice Model: Nash Equilibrium Matrix

In an uncoordinated choice, model participants don’t have the incentive to work with one another. The participants could form groups but no one group holds the majority at any particular time. In an uncoordinated choice, it is in one’s best interest to vote the truth about the integrity of the blockchain and if you agree with the majority you are rewarded with a payoff of P. If a malicious individual decides to alter the blockchain (hard-forking) for financial gain, they would be unsuccessful to do so. The currency mined by the malicious miner would have no value as it would not be considered a valid block because other miners voted the truth. Other miners simply ignore the invalid block and continue to mine on the old chain. Since all currencies work on trust and mining utilizes resources, it is not in the best interest of an individual to lie on the blockchain. Miners choose the maximum payoff, that is derived from them following the Nash Equilibrium and voting the truth to maintain the chain. In an uncoordinated choice, model actors coordinate because of a common interest. By coordinated voting for the correct consensus of the ledger the currency retains its value and authenticity.

Bribing-Attack-Model:

It is assumed that the block chain is an uncoordinated model, but the “Bribing-Attack-Model” goes against the integrity of the block chain and incentives others to take an action by bribing them.

In an uncoordinated model, if a malicious user attempts to incentives miners to coordinate with one another by allocating a bribe, this system would be vulnerable to a Bribing-Attack-Model that can be observed in the matrix below:

Figure 3: Bribing Attack Model: Nash Equilibrium Matrix

In the case with no bribe above in “Figure 2,” the Nash Equilibrium was to vote with the majority. But with the implementation of the bribe, things change. Upon voting and agreeing with the malicious user one is rewarded with a higher payout of P +E (bribe). If others don’t agree with the bribe their payoff remains P.

With the implementation of the bribe by the malicious user; the Nash Equilibrium shifts to everyone voting Y or whatever the malicious users set up the bribe for. What’s even more interesting is that the malicious miner does not even need to pay the bribe and is able to convince a group to vote a certain way. This leaves the Proof-of-Work system vulnerable to a certain extent.

Proof-Of-Stake:

The solution to “P + Epsilon Attack” lies in Proof-of-Stake. The concept relies on a consensus algorithm Casper that is signed by bonded validators. Proof-of-Stake is used to deposit cryptocurrencies that must be staked to be able to invest them in further blocks.

Proof-of-Stake creates a disincentive for not following the rules of the network, rather than incentivizing miners for their contribution of hardware or electricity for mining. Proof-of-Stake is implemented upon Proof-of-Work and this raises the cost of the “P + Epsilon Attack”. A potentially malicious user would have additional costs as they are staking their currency to alter the blockchain. Miners would face a dilemma and the possibility of their fortunes being taken away, for not agreeing with the consensus of the network. This improves the overall economic system, as it incorporates a punishment component to the equation.

Users would be less likely persuaded by a briber as the extra payoff would not be worth the risk of staking their entire invested savings. Also, as we observed earlier, even the successful implementation of the “P + Epsilon” Attack does not guarantee one enjoys they extra payoff from the bribe. Therefore, it is best for one not to get involved in such malicious activities. The implementation of simple game theory rules incorporated through Proof-of-Work and Proof-of-Stake ensure that mining of illegal block is punished and ledgers are authentic.

Inflation and Value of Bitcoin:

The gold standard set a fixed exchange value for a country’s currency and the price of gold. Under the gold standards, gold was redeemable at an individual’s discretion from financial institutions. Britain stopped using the Gold Standard far back in 1931 the United States followed this trend in 1971 under the Nixon administration. The gold standard was popular as gold’s physical quantity limited the evils of inflation.

With the introduction of paper money and implementation of Fractional Reserve Banking, the government was successful in controlling the supply of money. Under Fractional reserve banking, banks are only asked to hold a certain fraction of deposits reserves and have the right to lend out the other section. As seen historically, without strict regulations, the Fractional Reserve Banking system is very likely to fail (Lioudis).

Since the central bank can change overnight lending rate to other institutions, it is able to control the supply of money in the economy. Politics and lobbying power come into this equation as people vote for people aligning with their goals. With Fractional Reserve Banking the government can give injections into the economy if it wishes, but by the time the trickle-down effects of these are observed, most people are at the same economic status if not worse.

A primary goal for virtual currency was to eliminate inflation caused by governmental institutions who could control the supply of money in the economy. Cryptocurrencies are finite in nature. In the case of Bitcoin, the program is designed to only allow the mining of 21 million Bitcoin by the year 2140. Out of the total of 21 million 17 million have currently been mined. Due to this fixed supply, the price relative to other fiat currencies is predicted to rise.

The supply of Bitcoin is set by the program and currently, the demand is limited to speculation. Currently, virtual currencies are extremely volatile, due to the relatively small size and early stages of development. Countries suffering from hyperinflation such as Venezuela and Zimbabwe could still consider these as secure payment methods even in their current form compared to their local currency. Inflation could be deduced down to functions of supply and demand, skeptics doubt it would be a reliable store of value because of its very decentralized nature.

Figure 4: Bitcoin Monetary Inflation (Inflation=Coin Base*Blocks Per Year/ Existing Supply), source: https://cointelegraph.com/news/worlds-best-performing-currency-bitcoin-inflation-rate-drops-to-4

Theoretically, in the long run when the process of mining would be a zero-sum-gain the true value of Bitcoin could be determined. Currently, as more miners enter the market and make the entire process more efficient the supply increases and authenticity and credibility of Bitcoin would also increase. Furthermore, increasing real-world uses and wider acceptability of digital currencies would likely increase demand and hence increase the price.

What is worrying some is that in a digital forensic study conducted by “Chain Analysis” in 2017; an estimated 2.78 million to 3.79 million Bitcoin is lost or unaccounted for from the current supply of 17 million. As much as 22% of the existing supply is non-existent. It is estimated that only around 13.21 million bitcoins are currently in circulation (Robert).

Given the fact that the supply is finite, no mechanism exists to control inflation and a significant portion of the existing supply is missing or unaccounted for, Bitcoin suffers from stride deflation. As the demand for the virtual currencies would increase, this limited supply would need to be distributed throughout society forcing a higher price. Bitcoin attempts to counter inflation with a worse deflationary practice. In this economy, it is best to accumulate capital as prices would increase in the long run. This would cause less spending in the economy, as people would want to hold on to their currency in hopes of its appreciation and them being able to purchase more in the future. This would hurt the economy.

Current Environment and Conclusion:

This technology has gained popularity amongst millennials and they are the ones driving this change and making cryptocurrencies an asset-class. The current social groups are highly interested in the back-end technology at present just like the initial days of the internet where people were obsessed with protocols such as “SMTP” or “FTP” compared to the potential implementations of the technology in a wide scale economy. The fields of blockchain and cryptography technology are in a similar state. One would be able to make well educated predictions about possible implementations of the technology, but one was not able to predict the emergence of information technology goliaths such as Apple, Google and Intel in the past. These technologies have significant wide-scale application if implemented correctly.

But that said, the current trend in this asset-class has shown huge speculation bubbles. Individuals have compared these bubbles to events in the past such as the “Dot-Com” bubble from 1997 to 2001 and the “Tulip Mania” in 17th century Holland. Blind investment merely based on speculation without understanding the underlying technology is the biggest downfall of the industry. Several people are extremely likely to suffer substantial financial losses. Then again, there is significant requirement for investments in the correct companies and teams that would be able to develop these technologies.

Our current understanding and practices of crypto-economics still suffer from several problems such as reaching optimal properties of consensus algorithms, scalability is another significant issue as the transaction time for network tends to increase with additional nodes. Also, there is a censorship resistance that exists. These are just a few of the current issues that currently exist and are being actively being researched upon. Improving and fairly implementing such crypto-economic systems would allow the creation of dynamic applications that consider the basic economic principles of a coherent economy. One can now proceed to view the term crypto-economics as an economy that prompts solving problems and providing economic incentives for participating according to the rules of the system.

We have moved, in the past few years, from looking at this field only through one application, Bitcoin, to looking at it in terms of various other underlying technologies like block chain, cryptography and economics. Crypto-economics should be viewed as a unifying approach to solving problems. One cannot accurately forecast the best uses of this new crypto-technology. Even at its current state of development the potentials and implementation gains of this technology are revolutionary.

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Student, University of British Columbia

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