Fundamentals Of Cryptoeconomics: Guide To The Token Economy
December 13, 2018
Welcome To This Cryptoeconomics Guide
Before we dive into the world of cryptoeconomics you can be sure you’re getting the best guide here, having helped over 100,000 students achieve their cryptocurrency & blockchain goals.
My goal with this guide is to help you understand how this whole new ecosystem of tokeneconomics has arisen, bringing cryptoeconomics to the forefront as an economic model.
If you’re aware of Bitcoin, you’ll know how this digital asset has created a whole new economy of tokens. Which at the time of creating this is collectively worth above $200 Billion! Which is a mere dent in the all time high value, which was once at approximately $800 Billion.
In this guide we’re going to mention many resources, as is the nature with this ecosystem.Therefore as well as linking to them throughout this guide, you can also find an organised list oft hem on our perks page should you wish to refer to a specific resource we mention.
One more thing before we move on, having helped over 100,000 students I found what most people crave is community. Moreover a safe community where questions can be asked, and a generous answer is given.
So should you wish to be apart of our Facebook community head over to this link here: facebook.com/groups/b21block.
That’s everything for the introduction! I look forward to guiding you through this entire guide,helping you to become proficient on the topic of cryptoeconomics.
Fundamentals Of Economics
Introduction To Economics
Let me introduce you to the term ‘economics’. I’m sure you’ve come across it before, but due to it being such a fundamental building block of cryptoeconomics it’s something we must discuss.
As defined by Wikipedia; “economics is the social science that studies the production,distribution, and consumption of goods and services.”
Diving deeper than that now, economics is often split into two camps.
Microeconomics, and macroeconomics.
Microeconomics tends to concern itself with economic decisions of individuals, so understanding the economy at a grassroots level. Whereas macroeconomics looks at the economy at a more national and international level, examining the gross domestic product.
Some areas macroeconomics concerns itself with, which microeconomics doesn’t are; national fiscal and monetary policies, inflation and interest rates. Those are just some differences between what is examined when it comes to microeconomics, and macroeconomics.
Even though there are differences with what is measured between microeconomics, and macroeconomics they are inherently intertwined. As there wouldn’t truly be much macroeconomic data, without microeconomic data.
It’s important I share three fundamental principles of economics with you:
1. Opportunity Cost
This principle describes the value of something you’ve given up, in order to get the other thing in question. It’s used in a monetary aspect, but it can also be used in a non-monetary aspect.
A simple non-monetary example would be, the cost of going to work today would make you miss your child's graduation. As you’ll be able grasp from that, opportunity costs are benefits you could potentially receive from taking another decision.
Linked to supply and demand, there are simply not enough resources for everybody's wants.However, everybody has unlimited wants hence they try to get them as much as possible.
This is where price hikes tend to come in, when there is a lack of resource yet the demand is still there if not growing. Hence scarcity being another fundamental principle of economics.
3. Trade Offs
This is something which is intertwined with opportunity cost and scarcity, as people are forced to make a trade off for a scarce resource. An example is whether you should spend an extra $1 for a potential improvement in taste, because the item you want is limited in supply.
As you’ll notice, many similarities of trade-offs can be taken from opportunity cost, and scarcity
What Is Money?
As we’re covering the fundamentals of economics in this section of the guide we have to discuss what money is, otherwise this section of the guide would simply not be complete.
When many initially ask themselves the question; ‘what is money?’ it confuses them. Reason being even to this day, we don’t really have a unified definition of money. That in itself is extremely bizarre, considering it is half of every trade we participate in day to day.
It’s likely if you asked ten friends, and/or family members that they’d all give you a different response as to what money is. Therein lies the confusion many people have over money, it’s something so common yet people are confused as to what it really stands for.
However by breaking down the three main uses for money, it’ll help shine a spotlight on the foundations money is built upon in this era.
This is what helps to facilitate a transaction, more specifically it’s something that allows value to transfer from one person to another. Without a medium of exchange we would end up with a bartering system, where it’d only be possible to trade with someone if they wanted what you were trading. You can imagine the issues this could cause! Let me give you an example.
Imagine if you grow potatoes, and want to buy fertiliser. Without a medium of exchange you would have to go out and find someone that sells fertiliser whom wants potatoes. That would severely limit the amount of options to trade, and wouldn’t help an economy thrive!
This is what allows us to place a price upon our products in a universally measured way, therefore allowing us to compare between them. If there was no unit of account, it’d be extremely difficult for us to assess the value we should trade in return for the product.
As an example, how many potatoes should be given for ten kilograms of fertiliser? We just don’t know, and this is where bartering comes into play. Therefore a unit of account has positives,because we are able to understand exactly how much the fertiliser is, then go forth to purchase it with the intermediary exchange unit in this case, dollars, euros, and so on.
This is what allows us to have future security! By future security I mean knowing that our money,assets or even produce will be worthy in the future of good value. Money doesn’t decompose in the same way potatoes do, so money is seen as a better store of value.
Without such store of value, we would constantly be worrying about the future. Having a reliable store of value allows us to save, over the alternative which would be living trade by trade which isn’t suitable for a fruitful financial future.
All the three characteristics mentioned are as important as each other, when it comes to understanding what money is truly about. They enable a stagnated society to become a trade enabling society, and this is the reason why every civilisation in human history has been found to use a form of money. Whether that form was precious metals, tobacco or something else.
What Is Value?
Let's move onto discussing what value is, more specifically economic value. It’s something that doesn’t need to be over complicated, regardless of how easy it is to over complicate.
To really define economic value in the most simplest way, it’s whatever you’re willing to give up to get something else. It could be the case you’re giving up time to get what you desire.
On top of that, economic value is also correlated in many ways to the value that a marketplace in question places upon an item. Whether it would be a vehicle, or window frame.
It’s important to note that economic value of consumer goods is a moving figure not static. It changes as the price of similar items change for example, if the price of petrol increased we could see people buying less petrol and new vehicles.
As a result it would lead to corporations rebalancing the pricing to get customers back through the doors spending. Corporations have to toe the line between competitive pricing, and ensuring they don’t turn people away who inevitably choose how to spend their income.
When it comes to placing that price upon something it’s not solely a mathematical formula that is followed, intangible and tangibles of the product are also applied to come to a correct price. By tangible I mean the products functionality, and by intangible I mean customer sentiment.So remember (as summarised by Investopedia); “the economic value of a good or service is determined by the preferences of a given population and the trade-offs its members make given their resources.”
What Is Cryptoeconomics?
Welcome to this part of the guide where I want to introduce you to the term ‘cryptoeconomics’,and help you to understand what it means before diving further.
If you weren’t already aware the term cryptoeconomics is a mashup of the words cryptography,and economics. Hence you were provided a foundational introduction to economics previously,and as we move forward you’ll see just how it plays a part.
Cryptoeconomics as defined by Ethereum developer Vlad Zamfir is:
“A formal discipline that studies protocols that govern the production, distribution, and consumption of goods and services in a decentralised digital economy. Cryptoeconomics is a practical science that focuses on the design and characterisation of these protocols.”
However broken down to its simplest form cryptoeconomics is simply the use of economics, and cryptography to create a system with predefined properties that are desired. The economics side powers the incentive, and the cryptography powers the encryption.
It’s cryptoeconomics which makes blockchain technology stand out. Naturally, it’s as a result of Bitcoins anonymous founder Satoshi Nakamoto that we came to this finding of cryptoeconomics. As the combination had never successfully been explored before Bitcoins conception. Now we have this theory of cryptoeconomics which can be successfully applied, we’re able to accomplish things which were otherwise considered unachievable.
To give you an example of cryptoeconomics in play, lets bring Bitcoin into the spotlight. This way the theory will come together providing you a solid example of how it works in practice.
The proof of work system (which we will discuss later in this guide) is apart of Bitcoin, and it is the first successful example of a cryptocurrency. Hence it became the first successful working example of cryptoeconomics in play.
The incentive developed into Bitcoin utilising the blockchain makes miners use computing power to solve extremely complex mathematical puzzles, if they succeed in solving that puzzle they are rewarded with 12.5 Bitcoin as it stands today. This is the incentive for investing in mining equipment and running these machines, and competing with miners around the world.
On the other hand should someone come in with bad faith to try and manipulate the protocol,they would need to control over 50% of the computing power on the network. Which of course means an extensive investment, especially as the difficulty of mining increases. This monstrous increase in cost would make it unprofitable for such an attack to take place.
But just for the sake of it, let's say someone did gain over 51% of the computing power on the Bitcoin network. Then what? Well it would be self sabotage, as the value of Bitcoin would inevitably decrease. As a result the attackers would haemorrhage money!
The cryptoeconomic incentives of Bitcoin make it a true self fulfilling ecosystem, best of all the rules of the system are transparent and immutable.That’s how a cryptoeconomic system works practically, in this case with Bitcoin. We’ll be diving further into fringe aspects of cryptoeconomics as we move through this guide, ensuring you get a full picture of how revolutionary this ecosystem is.
The Blockchain Economy
Now you have a primer understanding of cryptoeconomics, let me move onto introducing you to the blockchain, and blockchain technology as a whole.
As has been previously mentioned in this guide already, Bitcoin was the catalyst to bring cryptoeconomics and blockchain technology to the forefront. As Bitcoin become more popular, sodid the actual revolutionary technology behind it along with a new economic theory.
Blockchain technology specifically in Bitcoins case with its immutable ledger, has shined a spotlight on a revolutionary way to track finances which has never been witnessed before. By revolutionary we mean that the blockchain in Bitcoins case provides a transparent, and immutable way to trace Bitcoin transactions.
Going beyond Bitcoin, blockchain technology is helping forge a new era of financial tracking. Blockchain technology is being used to track a variety of assets which include financial assets, all of which takes the ambiguity out of auditing these transactions. In many ways by implementing blockchain technology corruption is far more difficult!
The reason corruption on such a scale would be difficult with a blockchain implemented, is because any transactions that happen on the blockchain are publicly recorded. However in the case of Bitcoin, you wouldn’t know who the exact person is making that transaction (well not unless you got into blockchain forensics). But that isn’t the case for all blockchains.
There are three common types of blockchains apart of this ecosystem, all of which are created and managed in different ways. Remember the best way to look upon a blockchain is as a ledger,an immutable one. Let me share the three variations of a blockchain with you.
1. Public Blockchains
These blockchains are most commonly known to the masses due to the rise of Bitcoin. With Bitcoin as it is based on a public blockchain, anyone in the world can download the entireblockchain and essentially read the data. With Bitcoin you can see the amount sent to and fromcertain addresses and more. What I’m trying to get across is that with public blockchains they’re fully public, though that doesn’t mean insecure as it’s secured by the power of cryptography. It’s part of the fully decentralised nature of blockchain technology.
2. Consortium Blockchains
This sort of blockchain isn’t fully public, so me you or anybody can’t just get involved. Aconsortium blockchain is controlled by a pre-selected set of nodes i.e. computers.The best way to visualise a consortium blockchain is to imagine ten banks that run that blockchain. All of them have been pre-approved unlike with a public blockchain. Then for any block to be processed by the chain, a minimum of say six banks must sign that transaction off. It can then be added to the chain.But remember only those ten banks can sign the transaction, no others. With regards to viewing the transactions, it is up to the consortium to decide the level of access and transparency to offer outsiders. A good example of a potential use case for consortium blockchains could be medicalrecords, or voter records which would only be available to a select group of verified computers.Consortium blockchains are considered partially decentralised, not fully decentralised as public blockchains are.
3. Private Blockchains
This is actually sort of a taboo topic, as many don’t feel these are actually legitimate blockchains. Private blockchains are as the name suggests, private. All permissions for the blockchain are kept centralised, so let’s do the bank example again. All permissions would be kept to that one bank and it’s own computers around the world.Now blockchain technology is typically decentralised, so centralising it definitely brings out the critics. For the most part, these are the sort of blockchains banks are experimenting with.The most likely applications for private blockchains include the likes of; database management,auditing, and basically anything that is internal to the company in question. So when the critics come out on the topic of private blockchains, the opposing party generally express their view of it being necessary to be private.So those are the three types of blockchains you need to be aware of. Public blockchains,consortium blockchains, and private blockchains. You’ll definitely see each of these be expanded upon and implemented in unique and interesting ways as this ecosystem moves forward, let me now share four current examples with you.
A blockchain startup named Chain has joined forces with NASDAQ to test trading shares that are listed upon the NASDAQ exchange in a private market. From what has been gathered so far,blockchain technology has increased the accuracy of trading while reducing the settlement process.
2. Supply Chain Management
Blockchain technology has a great chance to impact the supply chain management of businesses, it’ll allow transparency throughout the chain resulting in fewer losses. A range of things that could be recorded upon a blockchain built purposely for supply chain management include; date, location, producer, certification, product and more. Being able to have audited access to an entire chain on-demand would only improve efficiency.
Linking to supply chains a blockchain within the healthcare sector could potentially help improve efficiency. By no means would this need to be a public blockchain, rather consortium. Hospitals could exchange data in real time between each other on patients, ensuring no admin issues stop a patient from receiving the care they need.
The Cryptoeconomics Of Bitcoin
In this part of the guide we’re going to be discussing the cryptoeconomics of Bitcoin.
Without a question of a doubt Bitcoin is the most successful example of cryptoeconomics in play so far, it was in fact the anonymous founder of Bitcoin Satoshi Nakamoto that crafted this cryptoeconomic ecosystem in 2009, by combining economic incentives with peer to peer systems.
Bitcoin includes all the fundamentals required in order to have a successfully functioning cryptoeconomic ecosystem, those are the following:
1. Blockchain based.
2. Allows valid transactions only.
3. Transactions can be fast tracked if a higher transaction fee is paid.
4. The blockchain is downloadable and immutable.
5. Each of the blocks include a transaction.
The cryptoeconomics of Bitcoin is structured based upon incentives and penalties, where by miners are incentivised with economic rewards (Bitcoin) to join the ecosystem.
Once a miner has joined the ecosystem they are essentially offering their hardware and electricity to the network, in order to solve and produce blocks. Only once a block has been solved, is the miner rewarded with 12.5 Bitcoins (this decreases on average every 4 years).
That’s the incentive side, let's switch to the penalty side of Bitcoins cryptoeconomic protocol.
The most common threat to Bitcoin due to it being a decentralised network is that a 51% attack could occur, which is where an attacker gains control of the majority of the networks hashing power. As a result they could potentially change the previous state of the blockchain.
However, Satoshi was extremely clever in his invention to avoid such issue as much as possible.As to pull off a successful 51% attack would cost an extremely large amount of money, let alone electricity. As of creating this guide an estimate for a one hour attack would be $504,839. Even if successfully done, it would drop the price of Bitcoin potentially wiping out any financial gain for the attackers.
It’s important to note that without cryptoeconomics in play, Bitcoin wouldn’t work! The same can be said for other cryptocurrencies, the structure of a cryptoeconomic system is very similar with other tokens as they follow the same formula mentioned previously:
1. Blockchain based.
2. Allows valid transactions only.
3. Transactions can be fast tracked if a higher transaction fee is paid.
4. The blockchain is downloadable and immutable.5. Each of the blocks include a transaction.
Technical Aspects Of Cryptoeconomics
Game Theory In Blockchain
Welcome to this part of the guide where we’re going to dive deeper into the technicalities of cryptoeconomics, helping you understand the inner workings of this word - cryptoeconomics.
At its core game theory studies how people make decisions in various situations, and something to note with game theory is that it’s based on only mathematics. Due to it being based on mathematics, it can be applied in any situation where people must compete with each other. You can see how this would benefit blockchain projects!
Getting a bit more specific on the blockchain (well, cryptoeconomics) side of game theory, its purpose is to incentivise participants within the ecosystem to behave in a positive way.Let me give you an example of game theory in action, highlighting Bitcoin.
Miners on the Bitcoin network are incentivised to use their hardwares hashing power (most commonly ASIC machines) to secure the network, the incentivisation are Bitcoins which is an economic incentive in the truest sense of the word.
Consensus among nodes connected to the network is achieved via the Proof Of Work algorithm,and it’s that algorithm that reflects the quantifiable resources it took to get there.
Remember the likes of Bitcoin is public for all to get involved in, therefore there must be something implemented to ensure users joining act according to the protocol. This is where the creator or creators of Bitcoin were smart to program in rewards and punishments. It’s not as easy as saying it, as it takes a lot of foresight to think ahead of potential behaviour.
With Bitcoin specifically it intentionally makes mining more difficult over a period of time, and reduces the reward for solving a block (theory that the price per Bitcoin will increase). Therefore making it more expensive for a party to try and take over the network (known as a 51% attack), as a result nodes connected to the ecosystem work within the parameters.
That’s just one example of how game theory is implemented into Bitcoin, and the cryptoeconomic ecosystem in general. But it’s not just the cryptoeconomic ecosystem where we see game theory in action, we see it take place in our day to day activities. Civilisations are built to reward good behaviour, and deter bad behaviour in the form of a punishment.
In this part of the guide I want to move onto the topic of cryptography sharing three crucial methods with you, over just explaining what the term actually means. This way you’ll gain further depth as to what the word means, allowing you to visualise its connection in cryptoeconomics.
Before we do that, many assume cryptography is just used to enable private communication through encryption. But that is only one of the four pillars of cryptography, the four pillars which make up cryptography are; encryption, authentication, integrity, and non-repudiation.Let’s now go forth to discuss three methods of cryptography which are actively used in the cryptocurrency ecosystem.
To begin with let me ask a question; have you heard of the term hash or SHA-256? If you haven’t,not to worry as I’ll be going into everything, and if you have do you know what it actually means? Either way, you’ll be fully aware of it all very soon.
Let's take this from the top, so envisage the blockchain. In order to decide which block of transactions will be entered next on the blockchain all the miners compete, they all essentially have to solve a very complex cryptographic puzzle. Now this isn’t done by the actual individuals it’s done by the mining equipment, and it’s pure guesses until it gets the right, wait for it, hash.
So a hash is simply a method used to guess the cryptographic equation in order to add a new block onto the blockchain, and the more miners that join the network the more competitive it will inevitably get. Then the SHA-256 is just a specific way of hashing, it’s otherwise referred to assecure hash algorithm 256.
Now if you’re thinking what the incentive for the miner is, it’s the reward they get for solving a block which currently stands at 12.5 Bitcoins, it halves every four years. The rule of thumb is the more computing power you have, the quicker you’ll be able solve the hash and be the one to add a new block to the chain, hence why ASIC mining machines dominate in this space.
Remember, utilising hashing helps the the Bitcoin network stay immune to alteration & fraud.
Starting with asymmetric encryption. I must say right away that this sort of encryption ensures the upmost confidentiality, it’s extremely secure. As well as being known by the term asymmetric encryption it’s also known as public key encryption, simply because it utilises a pair of keys not just one. If you already have a Bitcoin wallet you’ll know the keys are the public and private key.
Touching back on the point where we mentioned asymmetric encryption has the up most confidentiality, let me explain further. So if you encrypt data with the public key, only the person who has the correct corresponding private key can decrypt the data ensuring confidentiality.
Let me give you an example. Have you ever visited a website, and it displays an SSL certificate in the address bar? Well that uses asymmetric encryption to build that secure channel. You’ll more than likely see this on ecommerce sites. It allows the security of communication on the internet. Now just to finish on asymmetric encryption these aren't lightweight in terms of there performance, hence why they are used often.
Now lets move onto symmetric encryption. So with symmetric encryption one key is used for both encryption and decryption operations. In terms of the algorithms that exist for symmetric encryption the most popular ones are; AES, DES, Blowfish, and Skipjack. You won’t need to know the details of these algorithms, but it’s useful to know the names as they will be useful.
Just to sum up symmetric encryption, it’s most often used over asymmetric encryption for bulk data uses because of how more efficient it is.
Before moving forward lets go over the positives for both symmetric-key cryptography, and asymmetric-key cryptography. Starting with the positives for symmetric-key cryptography:
• Symmetric-key cryptography is efficient, it can handle processing large amounts of data.
• Symmetric-keys are shorter when compared with public key algorithms.
• A stronger crypto-system can be created with the use of symmetric-key cryptography.Lets now move onto the advantages of asymmetric-key cryptography:
• Asymmetric key cryptosystems are very good for digital signature use cases.
• Asymmetric-key cryptosystems can stay secure for years without exposing security flaws.
Lets now discuss how digital signatures work with Bitcoin, because this as well as the whole verification process is one of the main factors in play which make the Bitcoin protocol work.
Let me give you a brief overview of digital signature before we detail how they work, so what the bitcoin digital signature allows is non-repudiable transactions. Essentially meaning the person who sent the transaction was in possession of the private key, hence being the owner of the Bitcoins in that wallet. Then on top of that anyone on the network can verify the transactions, as it’s all recorded on the blockchain.
But how does this actually work? Well let me explain for you now.
As you’ll be aware or as you should be, Bitcoin wallets have two keys; private and public key. It’s the private key which creates the public key, which then helps to create the Bitcoin address. Then elliptic curves and modular arithmetic infinite fields help to achieve the processes completion.
So the sender generates a private and public key, then goes forth to sign the message with the signature and send their public key, the signature and the message to the network. The node then checks using the verification algorithm that the message has been signed by the sender, which can only be done by the holder of the private key to the public key that is sent.
Remember that Bitcoin uses digital signatures as a way of proving I own my Bitcoins, you own your Bitcoins and so on. So when I send Bitcoins to someone I essentially have to digitally sign that transaction in order for the transfer to happen, then that transaction is processed by nodes connected to the network and stored on the Blockchain as a record.
Network effects are inherently apart of cryptocurrencies, and cryptoeconomics in general.Therefore in this part of the guide we’ll be discussing how network effects play apart in this ecosystem. As described by Wikipedia, a network effect is the following:“It is the positive effect described in economics and business that an additional user of a good or service has on the value of that product to others. When a network effect is present, the value of a product or service increases according to the number of others using it.”
A practical example of the network effect in play would be Facebook, a perfect example!
If everyone created accounts on Facebook but didn’t post, it wouldn’t be as valuable to the users let alone the business as a whole. There has to be participation for the value to exist.
For a network effect to exist, usage and interaction must be present!
For this reason many believe Bitcoin has an issue going forward, as the network effect isn’t as prominent due to the fact many people buy Bitcoin to speculate on the price, rather than spend. If you compare that to Facebook, people are actively engaged with it.
One of the main ways to increase the network effect is to get more large merchants accepting it as a form of payment. This is the key! Just think, the telephone would be pointless if nobody else had a telephone.
So when we discuss network effect it relates to how the usage and interaction works, it’s something cryptoeconomics refers a lot to. There has to be others joining in to using andinteracting with the cryptocurrency in question.
Steem is a good example of a cryptocurrency with a network effect. In many ways it’s the decentralised Reddit, but is now forging its own path. Users get paid in their native cryptocurrency when the content they post gets up voted, shared and more. This incentivises people to post, and comment on other posts.
Proof Of Work
In this part of the guide we’re going to be learning more about the protocols at play with cryptoeconomics, powering the core of the ecosystem.
We’ll be starting with perhaps the most popular, proof of work. The goal with proof of work is to deter attacks to a centralised system, such as DDoS attacks (otherwise known as denial of service attacks).
Many believe it was due to Bitcoin that the proof of work concept was invented, however the proof of work concept existed before Bitcoin came into existence. The concept was actually published by Cynthia D work and Moni Naor back in 1993, and it allowed a trust-less and distributed consensus to exist.
The beneficial factor when it comes to proof of work is that you can send and receive anything,(not just money) without needing to trust any third party person or service.Providing the example of money you need to trust a third party payment processor to do most transactions, Pay Pal is the perfect example when it comes to online transactions. These services keep a register of transactions for your account privately.
Whereas with blockchain technology intertwined giving the example of Bitcoin, everyone has a copy of the same records therefore no third party is needed as all can verify the information.
On the flip-side when it comes to mining upon a proof of work consensus, it can get very expensive as the computer calculations which need to be made are very complex.
The miners are there to audit transaction which are being pushed through the network, all in the aim of keeping users honest to avoid any double spending issues. Verifying and solving these blocks of transactions is a race, as the first to do so wins 12.5 Bitcoins.
In essence it’s an arms race as those with the most powerful machines (also known as ASIC machines), are in the best position to solve the mathematical equation presented (which gets more difficult). Therefore winning the 12.5 Bitcoins on offer, this is the economic incentive.
It’s not just Bitcoin that implements this proof of work consensus, Ethereum also does as well as many other blockchains. However, Ethereum is in talks to switch to proof of stake which we will be discussing in another part of this guide.
Proof Of Stake
Lets now switch over and talk about POS, otherwise known as Proof Of Stake.This form of protocol is different to POW (Proof Of Work), as users are required to have a stake in the form of owning cryptocurrencies within that specific project and/or ecosystem.
In a proof of stake system when new blocks are created (otherwise referred to as forged), the creator of that specific block is chosen in a pseudo-random way dependent on the users stake in that ecosystem (another way to look at stake is as wealth an individual has). Hence it’s fair to say that it’s not the fairest of protocols out there!
Now when looking at proof of work the miners are rewarded with that specific cryptocurrency, but with the majority of proof of stake systems the coins are already pre-mined hence miners (known as forgers) are provided the transaction fees as a reward.
One of the more interesting things with proof of stake is that when users forge they must stake their own coins, therefore should they process an illegitimate transaction they will lose their stake and any chance to participate in the future. So the incentivisation exists in the form that they have the chance to claim all the transaction fees, but also avoid processing illegitimate transactions through the network.
In general compared to proof of work, proof of stake is far less energy consuming. On top of that,it tends to not need as powerful machines as the proof of work protocol.
Popular cryptocurrencies that run proof of stake include; Blackcoin, Lisk, and Peercoin.
It’s important to note that cryptocurrencies that follow a proof of stake protocol tend to launch via an ICO, or switch from proof of work at a later stage. Reason being there is no way for them to truly handle the initial distribution of their token.
Delegated Byzantine Fault Intolerance
Lets briefly discuss another protocol which has come along, however this protocol isn’t as common as proof of work or proof of stake hence many struggle to wrap their heads around this.
Having already discussed proof of stake and proof of work, we’re aware that many feel proof of work is the fairest protocol so far. But that comes with drawbacks such as the huge amounts of electricity it uses, as well as the expensive specialised hardware required. On the other hand with proof of stake this does require far less electricity, but it isn’t the fairest protocol in the land as those who own more of the chosen coin earn more rewards.
If you’re aware of the consensus protocols in existent, you’ll know that byzantine tends to have problems when it comes to game theory in computer science. As achieving a consensus in a decentralised ecosystem is not easy at all, especially in the case of the crypto ecosystem where nodes don’t know each other let alone trust each other. However by using delegated byzantine fault intolerance, the relationship between different blockchain nodes is rearranged.
So to summarise on this brief introduction about delegated byzantine fault intolerance, the consensus happens through a gamified form of block verification. The blocks are verified by the node operators, and with nodes we generally have those who are looking to make some extra cash, as well as those who are seeking to embrace the entire ecosystem. However with delegated byzantine fault intolerance there is a strong focus on professional nodes.
Then in order to achieve a consensus 66% of the nodes must agree with the version of the blockchain which has been broadcast by a professional node, only then can a consensus be achieved. If that threshold is not met, a different professional node will be chose to broadcast its version. That will continue to happen until a consensus can be made.
Token Economics Demystified
What Is Tokenomics?
As we move onto this part of the guide I want to start discussing more about the token economy with you, as it’s the layer which sits perfectly upon cryptoeconomics in this ecosystem. Albeit,they are different not the same just so you’re aware.
Token economics concerns itself with essentially the economy of tokens in the ecosystem; cryptocurrencies, initial coin offerings, security token offerings and so on.
To recap when we talk about cryptoeconomics we are referring to the structure of incentives embedded to ensure the creation, transaction, and overall validation of a cryptocurrency is successful. In the case of Bitcoin, the cryptoeconomics of this is crafted in a way which ensures miners have an incentive to mine even once all coins have been created.
Whereas if we flip this and look at tokennomics we would just focus on the layer above the token,so the application of it. Therefore ensuring the token in question can and is used within its ecosystem as intended. So from that you can gather how cryptoeconomics and tokenomics differ,yet have similarities in many ways as well. Let's dive deeper into tokenomics now!
So to begin with tokenomics doesn’t have one clear definition as it’s such a new area, if you speak to three different people I’m sure all three would give you a different definition. Therefore in this part of the guide, we’re going to explain each aspect of tokenomics.
1. Purpose Of Token
In the very initial stages of the whole ICO boom projects were raising millions of dollars with no actual product to show for it, but even in this short space of time the landscape has changed.People who pre-purchase tokens i.e. invest, want to know the use for it.
2. Utility Of Your Token
When the first step is clear with the purpose of your token, this point links in perfectly which is all about the utility of your token. The token of a project needs to be clearly defined in regards to its use; when will it be used, how will it be used, who will use it and so on.
Even if you go to great lengths to define the utility, people may not use it if the demand to use it isn’t strong enough. If that happens you’ll then have a large amount of speculators holding your coin in the hopes it increases in value, and the utilisation will suffer hurting adoption.
3. Function Of Your Token
Many believe the only use case for crypto’s is money famously due to Bitcoin, but there is a vast amount of uses available for crypto’s. Whether that is security tokens, voting rights, micro payments and much more. However in order for this to succeed, the tokenomics must be thoroughly studied beforehand to ensure it suits the use case.
4. Distribution Of Tokens
Due to the way many projects approach ICOs (basically as a cash cow), they tend to ruin the distribution of their tokens from the get go devaluing their project.
So many projects ignore this aspect as they don’t truly understand tokenomics. Much more thought should go into this such as; when will tokens be put into circulation, how many tokens will be initially released, how does distribution of tokens impact utilisation and so on.
Remember that fiat currencies aren’t capped in their supply and released at once, tokens should look at this as an example when exploring the tokenomic theory for their project.
5. Value Of Tokens
This is the sole thing most projects tend to focus on, rather than everything surrounding it. Now in a traditional offering placing a value upon shares is pretty straightforward, as there’s an underlying value there which can be assessed.
However in the crypto world things aren’t so straightforward. A lot of the value comes from the intangibles rather than tangibles such as; how good the team is, past successes etc. This is something I’ll be diving further into later within this guide.
But on your introduction to tokenomics, that is what defines this whole term as a project owner if you were to put together an ICO; purpose of token, utility of your token, function of your token,distribution of your tokens, and value of tokens.
Token Sales Models
We’ll now be diving into the sales model undertaken by the majority of projects when it comes to selling their tokens. We’ll be discussing the most common methods these projects have used.
1. Uncapped Sales At A Fixed Rate
With these types of token offerings buyers (we can also call them investors) purchase the token in question at a predetermined rate. The purchase is more commonly done with another cryptocurrency, however some token sales have been known to accept fiat currency.
In order to add that fear of missing out element in early investors tend to get a better rate, which decreases as the token sale draws to a close. This isn’t the same with all token sales!
2. Soft Caps
Now rather than being a type of sales model, it can be best looked upon as something incorporated into a token sales model. So a project may not deem the sale successful until this soft cap is reached (and some may return funds if this isn’t achieved).
As an example a project may advertise their soft cap is $2 Million, then once this is reached the rate of which you get the coins will increase as they work towards a hard cap. Soft caps work in conjunction with hard caps in many ways which I’ll get into next.
3. Hard Caps
Following on from soft caps, hard caps are the max limit projects deem to raise. Using the $2 Million soft cap example again, that specific project called Zapaygo set their hard cap to $8.5 Million. However post soft cap on route to hard cap, the amount of tokens for your contribution would have decreased but it still would be a generous discount on the token.
So those are three key components that make up a token sales model, and it’s most projects which run this sort of formula when running their sale of tokens. It’s this initial public facing showcase of the project that plays a huge role in the distribution of tokens.
Before sharing some examples of token sales it’s important to know that the terms ICO and token sale blur. However, they are different when they’re truly defined side by side. At surface level an ICO generally refers to a technology product, and a token sale refers to a financial service.
Lets now share some examples of token sales with you:
The ethereum project ran an uncapped sale, which raised approximately $18 Million over a 42 day period. The actual ICO these guys ran was uncapped, which nowadays is seen as being rather greedy. But more than that, it doesn’t give investors much certainty about valuation.
BAT used the capped sale model for it’s ICO, which in fact worked out extremely well and brought the popularity of these sales out. In fact, the BAT token sale was massively oversubscribed which helped build that fear of missing out in. The FOMO for this project was so big that they raised $35 Million Dollars in just 30 seconds.
The popularity of this token sale shed spotlight on the capacity of the Ethereum blockchain if more projects went down this route, as the capacity of the chain was full for three hours after the sale had begun. In fact over 10,000 transactions failed!
Valuing cryptoassets is a tricky topic! In a traditional market it’s far easier as there are costs,revenues, profits, losses and so much more. But how is it managed in the crypto-markets? Well in this part of the guide we’re going to share our thoughts with you, as to the three fundamentals which can help you place value upon cryptoassets.
The general rule of thumb is that the cryptocurrencies which are restricted in their creation(basically those which are capped) tend to achieve higher values. As is the case with Bitcoin, in essence there is a race for accumulation with Bitcoin to own as many as you can. So scarcity tends to equal higher values, as it does with any other scarce goods like gold.
Now this point of scarcity may contradict the last point, and it’s about how much demand the coin actually has which can impact the value positively or negatively. In the case of Ethereum it would be positive, as the Ethereum blockchain is generally the blockchain of choice for ICO’s. It’s this demand which is helping to increase the value of Ether drastically.
This plays a huge role in the value of tokens, there has to be a purpose in order for the token to attain any value. Now purpose is pretty subjective, as what you may find a worthy purpose others may not. But many tokens are built with niches in mind as an example; Monero is created for the privacy conscious. So when investing in ICOs it’s important to be aware of this!
These are the three fundamental factors that must be analysed when fundamentally assessing a coins valuation.
Utility Token VS Security Token
Lets now discuss what utility tokens and security tokens are, as well as the differences between them. As the differences between them are very important!
1. Utility Tokens
These are tokens which promise use within the projects future product. Generally utility tokens are free from financial legal restrictions, because they are not designed as investments. Rather as a digital product with a use case within a product.
A good example to showcase here is Filecoin which raised $257 Million via their ICO, for which the tokens will be able to be used within its decentralised cloud storage platform.
Many times throughout this guide I’ve referred to ICOs, but to avoid any legal implications many projects do say crowd-sale instead. As they generally don’t want to come under any scrutiny as to be offering a security as such.
2. Security Tokens
When a token is defined as a security, it comes under scrutiny from the jurisdictions financial authorities. In the United States that would be the SEC. Failure to comply with such regulations would result in heavy penalties. On the other hand should a company comply with all securities laws, the use cases can have very positive effects. As an example, a company could tokenise their entire shareholding making trading their shares much more frictionless.
Key differences to be aware of when it comes to utility and security tokens are the following.
Starting with utility tokens:
- Utility tokens provide a utility.
- Utility tokens promise no return i.e. profit.
- Utility tokens are unregulated in their sales.Flipping that over to security tokens now:
- Security tokens represent ownership of an asset of some sort whether it’s shares.
- Security token investors expect a return on their investment.
- Security token offerings are regulated and comply with KYC (know your customer) regs.
We’ve now guided you through the process of understanding everything about cryptoeconomics without becoming overwhelmed. Helping you to get involved in this ecosystem even further as a knowledgeable individual, understanding the inner workings.
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