How the Bitcoin Network is Secured by Cryptoeconomics
An introduction on the concept of cryptoeconomics
This is the second part of our new educational series on the latest trends and facts in crypto.
Table of Contents
Introduction
A glance into the past
Bitcoin as the birth of cryptoeconomics
Consensus mechanism
Economic incentives and losses
Conclusion
Introduction
In simple terms, cryptoeconomics examines the effects of economic incentives and economic laws on the governance and security of a decentral network.
The importance of cryptoeconomics is showcased by the nature of a decentral network: There cannot be a single authority with exclusive rights. All participants of the network have equal rights.
However, inevitably certain questions inevitably come up without such an authority: Who decides on the operating rules of the networks? Who organizes it and how? How is the network secured against malicious actors?
The inherent dilemma of decentralized networks can be sustainably solved by the use of cryptoeconomic principles. Its objective is to create robust and independent networks in conjunction with cryptography and economic principles. Cryptography secures the processes of the network on a technical level, whilst economic principles manage the behaviour of the participants.
A brief glance into the past
Decentral networks have existed for a long time — Kazaa and BitTorent as file sharing networks, for example. Here, users can download files via other users’ computers and, in return, offer disk space for other users to download files.
What’s problematic is that there are actually no rational reasons for users to do so. Users are not rewarded for providing disk space, nor is it a requirement to be able to download files from other participants. How do you, therefore, motivate users to provide memory?
Bitcoin as the birth of cryptoeconomics
In 2008, a whitepaper had been published which solved this issue of decentral networks in a sustainable manner. The author’s name is Satoshi Nakamoto.
Satoshi not only provided a solution to the longstanding double spending problem, but also combined economic incentives with cryptographical functions to secure the bitcoin network. With great success: The network, which has been in existence since 12 years, administers bitcoins worth more than 250 billion US dollar and has not, thus far, been compromised.
If you are wondering, why there are so many “bitcoin hacks” news out there — that has nothing to do with the network itself. Rather, these news are about centralized crypto exchanges, where you can trade fiat currency for cryptocurrencies. They are not supported by the technology behind bitcoin, blockchain, and thus fall victim to cyber attacks many times.
Consensus mechanism
An essential role for the bitcoin network and basically all decentralized networks, that administer digital assets, is the so-called consensus mechanism. The majority of the network agrees on a status of the network, determining how much of an asset every participant owns within the network. By comparing the copies of all transactions between every participant, double spendings and wrong bookings can be prevented. If everyone agrees on a status quo of the network, it cannot be revoked.
It’s a standardized process of consensus finding, which takes place periodically and updates the digital assets within the network.
In which way this consensus happens, is defined by a protocol. Bitcoin, for example, uses the proof of work mechanism, while Ethereum, one of the most advanced decentral networks, uses a type of proof of stake mechanism. There are many shapes of consensus mechanisms out there — proof of elapsed time, proof of activity, delegated proof of stake, etc.
What all consensus mechanisms have in common is that: they use economic incentives to foster “honest” (rule-consistent) behaviour and economic losses to penalize “wrong”, harmful behaviour on the network.
Economic incentives and losses
What do these incentives and losses look like? Let’s take a look at bitcoin: Participants, who validate transactions and maintain the network, are called “miners” and receive bitcoins and transaction fees. However, bitcoins will only be distributed, if the consensus finding follows the rules defined by Satoshi.
For that, miners have to put in economic value in the form of computing power (hardware and energy). If one of the miners tries to spend the same bitcoin twice or doesn’t validate some transactions, other participants notice it and reject the suggested block (status quo of the network) from the “dishonest” miner. This implies two things for this miner: No bitcoins, no transactions fees in addition to the costs of the used energy and hardware. Unlawful actions in the bitcoin network are punished by the loss of economic value and, therefore, miners have an incentive to play by the rules.
Another interesting aspect is the competition between miners. They compete for the next distribution of bitcoins and transaction fees. In order to increase their chances to receive the next payout, they maximize their input of computing power. On one side, this makes it much less worthwhile to not follow the rules (as they put in more value that could be lost). On the other side, external attacks, such as the infamous 51% attack, are less likely to happen as the attackers have to mobilize more computing power to provide more than half of it in the bitcoin network. This would be, in theory, necessary to spend the same bitcoin twice.
The reason a 51% attack didn’t happen in the last eleven years is simple: the economic costs greatly exceed the economic advantages. The attacker has to put in a massive amount of hardware and energy just to spend a couple of bitcoins twice. And since the network has been compromised, bitcoin’s price will crash in any case — leaving the attacker with bitcoins that are worth nothing or much less.
Conclusion
By means of cryptography and economics, it is possible to create decentral economic systems which are highly resilient to attacks. Every public blockchain network leverages the effects of crpytoeconomics in some way. Nowadays, we see a flourishing ecosystem of networks which are all autonomous and secure. All thanks to the combination of two concepts that exist for a long time. Satoshi showed us that true innovation doesn’t have to reinvent the wheel.
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