Decrypting Cryptoeconomics

The Cryptoexchange and Cryptoeconomics

Ruhani Walia
Dec 29, 2019 · 11 min read

When I first started getting into cryptocurrency and blockchain, all I ever really knew about the economics, was that it was “volatile.”

I didn’t even really know what “volatile” meant.

Let’s break it down today, shall we? It’ll be fun 😎

You know that street, where those people work, who trade those things?

  1. Wall Street
  2. Stockbrokers
  3. Stocks

Yeah — that 🔼

Those are the components most associate with the word “exchange.” The cryptoexchange has a similar structure but also has many key differences. For starters, the analogous components would be:

  1. Distributed P2P Network
  2. Fees and Miners
  3. Digital Assets

The main difference between a cryptoexchange and the stock exchange is the underlying asset. Bitcoin and Ethereum, the two most popular assets traded, don’t have the same valuation properties as fiat currencies.

We’ll get into how cryptocurrencies are valued later.

A cryptocurrency exchange, also called a Digital Currency Exchange (DCE) allows users to buy, sell, hold or exchange their crypto.

It is essentially where someone can trade one type of digital asset for another.

The crypto market never closes, unlike the stock market. This means that there aren’t any opening or closing prices. To substitute for this, most calculate the 24-hour price change of a cryptocurrency between its current market price to the market price of the day before.

In addition to just being faster at making transactions, trading bots don’t sleep as their human counterparts would. For these reasons, they’ve become a widely used tool among traders and investors.

I created a trading bot that uses a volume-based trading strategy. Check out the video here 🔽

There are different types of cryptoexchanges.

A trading platform, at its most basic, is just a website that connects buyers and sellers. These sites take a fee from each transaction. The most popular trading platforms right now are Binance, Kraken, Poloniex, and Coinbase. Coinbase offers insurance. Because it is a CEX (covered later) this is a benefit of using the site.

A crypto fund is a pool of assets that are managed professionally. Any user may buy and hold crypto through the fund. Using it, they may invest without directly purchasing or storing the crypto on a trading platform. An example of a crypto fund that is quite popular is GBTC — Grayscale Bitcoin Trust.

Crypto brokers are similar to fiat foreign exchange dealers. These are websites where anyone may buy crypto at a price set by the broker. The exchange is between buyers or sellers and the broker — not between buyers and sellers. An example of a popular crypto broker is Shapeshift.

Direct trading is trading directly from person to person without the interference of a trading site. This means that there isn’t a fixed market price, so sellers set their own exchange rates.

These exchanges are called Over the Counter Exchanges (OTC). Most DEXs follow this format.

This leads me to the two subcategories of exchanges. Cryptoexchanges are either centralized (CEXs) or decentralized (DEXs).

CEXs take custody of a client’s digital assets that are used on the platform. They require lots of information to create accounts.

DEXs mimic traditional exchanges. Unlike CEXs, DEXs do not support fiat trading (trading fiat for crypto) but require much less information. For example, IDEX trades based on a smart contract structure rather than a centralized third-party software.

There are a few key aspects you should note before choosing a platform.

  • Reputation — How widely used is the platform? What do the reviews say? The reputation of a trading platform determines its validity.
  • Fees — Does the platform ask for transaction fees? Deposit fees? Withdrawal fees?
  • Payment Methods — Does the exchange allow fiat to crypto exchange? Does it only accept credit cards? Digital wallet funds?
  • Verification — Does the platform ask for your id? Most platforms do ask in order for you to create an account, though some allow anonymity.
  • Lastly, check Market Price — a good website for this is coinmarketcap

An important distinction needs to be made before we continue — a lot of people confused cryptoexchanges as being synonymous to wallets or wallet brokerages. These do not provide the same services nor do they have the same function.

Wallets and wallet brokerages allow you to buy/sell a small range of digital assets — the most widely used crypto like BTC and ETH, for example, which you may then send to an actual cryptoexchange to trade for other digital assets, like altcoins.

This is if the digital wallet doesn’t let you buy and sell altcoins like Ripple or Monero. In this case, you must set up a cryptoexchange account on a platform like Binance. Once you have an account on a cryptoexchange, you can send coins to the account and exchange BTC and ETH for the altcoins.

Now that we’ve looked at how various cryptoexchanges work, its time to take a look at cryptoeconomics.

If you have a decent understanding of cryptocurrencies and the blockchain, then you likely know most of the basics of the technology’s structure. What you might be missing, is the economic why behind these functions.

But first — why do we need to understand cryptoeconomics? Well, the cryptoeconomy is what makes blockchain so interesting and unique. Satoshi Nakamoto’s white paper for Bitcoin introduced the use of cryptography, economic incentive and computer network in conjunction to build a new form of technology. This combined use is the kicker.

P2P is not new — torrent websites have used this structure for many years to share files. These sites would allow anyone to download files but in return, expected people to sow (sharing a file with the network so others could download it too). This is an honours system.

Surprise.

Humans aren’t honourable.

So, eventually, it didn’t make economic sense for people to sow files that took up space on their computers if they didn’t have to. A hugely underrated genius of Blockchain is that it allowed honesty to equate to economic sense and benefit.

We all know that adding monetary benefit to things is a great source of motivation for humans, so of course, the consensus system worked, and still works, really well.

Blockchain is just one outcome of the combined elements of cryptography, economic incentive, and computer networks. After understanding the why behind its structure, what if we could create other groundbreaking technologies?

Blockchain uses a decentralized P2P network ▶️ cryptography keeps network secure ▶️ economic incentives makes actors contribute and remain honest

The genius is this: Bitcoin created economic and financial incentive to follow the rules. Any functioning economy system requires incentive for actors to do their part — let’s look at how cryptocurrency and blockchain have incorporated these basic economies.

The Byzantine Fault Tolerance debate has existed for quite some time. It essentially questions if it is possible to achieve consensus among corrupt or attacked nodes in a P2P system — and its original proclamation was “no”.

When Nakamoto introduced the consensus mechanism called Proof of Work, he created an economic incentive to remove bad actors, more specifically named, Byzantine nodes.

The consensus mechanism made it so that the economic cost of attacking the system was disproportionate to the benefit of literally even trying.

The current cost of a successful 51% attack on the blockchain network would cost upwards of $17 billion.

And that’s just the hardware you would need.

Cryptoeconomics at its most basic is just the interactions occurring within an untrusted environment in which any actor might be corrupt. Assuming you have a basic understanding of PoW, it really does allow for trust by math.

Spend Money + Play by the Rules = Profit

Surprise.

The key to forcing humans to be honourable, is money.

Cryptoeconomics mechanisms within PoW like the hash system and truthful transaction blocks lead to security equilibrium for a distributed system without making it centralized.

Another economic concept of cryptocurrencies that most are confused about is how they are valued. The answer is, the same way that money, in general, is valued; trust.

It just depends on it more.

The decentralized nature of cryptocurrencies creates one major stakeholder; the users. There is no government, no international currency, etc. to which the crypto’s value can be pegged and determined. This means the only ones with the power to determine its value are the users.

And boy are they confused.

When a commodity has trust it gains value and becomes a currency. Basic stuff. This value will change based on the oldest economic principle: supply and demand. This is where the basic stuff becomes a little varied.

Cryptocurrencies have a set supply, i.e. Bitcoin will only ever produce 21 million coins. This set supply is what caused a need for the progressive difficulty in the hashing process (explained in this article). If it didn’t become harder for miners to mine, the market value would decrease given the limitation.

Of course, fiat currencies don’t work the same way. Therefore, supply and demand for crypto don’t work the same way either. Instead, it’s kind of similar to the valuation of gold; crypto is a commodity with a value that is contingent on the miner’s activity.

It’s all coming together now, isn’t it? Why the tech is built the way it is.

Ah. Lovely.

Let’s dig a little deeper now- with game theory — this is likely the largest contributing factor to how crypto maintains a decentralized system of honest actors.

Woah, woah, woah — what’s game theory?

Game Theory is the study of strategic decision making. In cryptocurrency, it revolves around incentives and consequences.

Asymmetrical design dictates that there must be a consequence that outweighs the benefit of bad acting in the system. This goes back to the idea of a 51% attack being unreasonable that I mentioned earlier.

Instead, miners are financially incentivized to be good actors. This is the essence of internal game theory. This idea doesn’t just apply to Bitcoin’s PoW blockchain — it could also apply to Ethereum’s PoS system.

Let’s end this article off with a BANG. Why is the cryptocurrency market so volatile?

We ask the big questions here.

This was literally the first thing I was told when I started looking into cryptoeconomics. No explanation of how or why — just that it is.

I won’t do unto you the same injustice 😉 Here we go.

Okay, let’s start slow. What is volatility in economics?

It is the numerical and statistical measure of an asset’s variance in price — basically, how much the value fluctuates over time. An asset or investment is considered volatile when it’s price regularly changes to different extremes (both up and down).

This is the case with cryptocurrencies. Here’s why.

Remember what I said about their valuation depending on just the users? Condensed, this means that the popularity of the coin determines its validity as a currency.

An economic bubble is a quick increase in an asset’s price that is followed by a severe contraction. Because of exuberant market behaviour, and really just, like, hype, the asset price increases unwarranted by its actual fundamental value. Eventually, when investors refuse to purchase at an extremely high price, a huge sell-off happens. This is the drop. The bursting of the bubble.

This is what happened with Bitcoin.

Contrary to common belief, this “pop” takes quite some time to actually reach market bottom. Sometimes years. Here’s the cycle broken down:

  • Displacement: Investors begin noticing a new paradigm — something grabs their attention
  • Boom: Prices begin to escalate, the market is quickly populated — more start to buy the asset
  • Euphoria: Caution is dismissed, asset prices skyrocket, more continue to drive the price up
  • Profit Speculation: People begin to speculate when the bubble will burst
  • Panic: People begin to sell off, the value drops rapidly, supply overrides demand

Basically, economic bubbles happen as a result of a change in investor behaviour 🤷

This is what happened with cryptocurrencies. Nouriel Roubini, the economist who predicted the 2008 crash, calls Bitcoin’s bubble the biggest in history.

Bitcoin doesn’t have any intrinsic value; no fundamentals. This means that the coin doesn’t generate a return because it’s just a token used to transfer money. Cryptocurrencies don’t sell products, employ people or earn revenue or even return dividends. The only way to profit, economically, would be for an increase in the cryptocurrency’s value in the future because of user demand.

Without fundamentals, users rely on market sentiment. If no one knows what the value of a cryptocurrency should be then no one knows if they are overpaying or underpaying. This creates high volatility.

Any asset without a basic value is a perfect target for scams — another huge issue conflicting with the potential stability of the cryptoeconomy. It’s purely speculation; nothing external impacts the value besides if other users believe the value is going up or down.

Volatility is, ultimately, the enemy of functionality

One of the most hyped features of crypto is that is immune to inflation — which means it could potentially store value against inflation. However, because they are so volatile, many lack trust in it. No one wants to store value in something that fluctuates in value up to 10% daily.

Now, the cryptocurrency market is void of speculative investing for the most part. Instead, people are trying to assign functionality and use cases for the technology.

This is where the idea of “stable coins” came from.

These are payment tokens that act as a store of value. They aim to achieve stability through value pegging.

A popular way that people have tried to avoid volatility is by pegging digital assets to a commodity. JP Morgan introduced the JPM Coin which is tied to the dollar on a permissioned blockchain (networks that require granted access to join). The Venezuelan government issued Petro cryptocurrency to try and peg crypto to barrels of oil.

To sum this all up — the cryptoeconomy is so cool. The potential implications of more people working on implementing the innovative economic incentives and mechanisms used by this technology could be huge and have many use cases.

A big issue that I’m working on right now, is figuring out how we can leverage the cryptoecononomy and cryptocurrencies to grant women financial liberty and economic autonomy around the world.

Check out this article and slide deck to learn more 😄

TLDR;

  • There are various types of cryptoexchanges
  • The basics of blockchain have reasoning embedded in economic incentive
  • Cryptoeconomics created Bitcoin — by understanding it, we can expect even more forms of ground-breaking technology

If you enjoyed this article and are interested in learning more about cryptocurrencies and blockchain, check out my other articles, give this one some👏s and follow me on Medium!

Connect with me on LinkedIn here.

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