Skip links

Crypto Economy: Decrypted Decrypting The Cryptocurrency

“To the naïve mind that can conceive of order only as of the product of deliberate arrangement, it may seem absurd that in complex conditions order and adaptation to the unknown, can be achieved more effectively by decentralizing decisions and that a division of authority will actually extend the possibility of overall order. Yet that decentralization actually leads to more information being taken into account.” – Friedrich Hayek

With that in consideration, the concept of decentralization plays a very important role in the efficient functioning of our economy. Perhaps a bigger phenomenon that is entirely based on this principle is often left ignored and out of reach. Yes, I’m talking about the revolution in the monetary world made possible by the introduction of cryptocurrency. Stating that a revolution is about to take place is itself an understatement considering the myriad of possible implications it holds for the nation at large.

Cryptocurrency is essentially an internet-based medium of exchange which uses cryptographic functions to conduct financial transactions. Its basic purpose lies in eliminating the use of a middleman and establishing a peer-to-peer network that solely operates without charging any fees at all for the conduct of the transaction. A fact that most people are not quite aware of is that cryptocurrency, like many other inventions, was made purely by accident. In fact, it was formed as a side product when Bitcoin was being developed. It is perhaps the most widely known form of cryptocurrency which came into existence in 2009. The use of Bitcoin spread when people began to understand the benefits of an easy transaction without the inclusion of any third party in the process. They also heavily invested in the technology considering its increasing usage and exponential growth in terms of value over the years which they could cash in on any given date in future. Currently, there are several cryptocurrencies in existence like Litecoin, Dash, Ethereum, etc. Despite the existence of so many players in the market Bitcoin still stands as a dominant force in the market.

In order for the cryptocurrencies to function efficiently, they require an infallible system that indisputably seeks to provide a strong framework for its operations and functioning. This is where the blockchain system comes into existence. Simply put, the blockchain is a system of data records that facilitate transactions between two or more parties and then store the data for further processing the transactions. The public ledger system that it seeks to emulate serves as a great way to enhance transparency and security within the crypto-space. Each transaction in the system is considered as a block and each block is then granted access as a legal transaction by millions of miners globally, who act as a verifier for each transaction. The verified blocks are then added to the public ledger which is then processed to the appropriate parties.

Thus, cryptocurrency serves the dual purpose of being transparent and secure. We could go to the length of saying that it is more secure than the safest bank in the world (if there exists any). Hacking a bank server to alter your balances is tough, but not exactly impossible if the resources were available and used artfully. Now consider the case for cryptocurrency in which transactions are assembled in blocks and are seamlessly transmitted in a chain that facilitates easy storage and record of data. This stored data is checked and verified by miners in the crypto-space whose primary job is to identify transactions and add them to the public ledger of the system. To be selected as a miner, one needs to invest a huge deal in the cryptographic platform and as a measure of security also needs to solve a computational problem. The difficulty of this problem increases exponentially as the number of miners attempting it increases. As an added incentive to promote the miners to work more they are given a fair share of currency to trade. Even if one of the miners dealing with this set piece of data tends to default by altering or changing the values therein, the amount of currency that they have invested in the system would then be confiscated and he would be bereft of the title of a miner. Moreover, if a single person intends to successfully commit a fraud he would first have to convince millions of others in the network to do the same which is technically impossible to speak of.

Now for the efficient functioning of the system, there is a need for an inherent network which enables a smooth transition between transactions. The peer-to-peer (P2P) network that runs through the crypto-world seeks to provide the much-needed connectivity between traders and sellers to execute trades without the need for intermediaries, who cause unnecessary intervention. In essence, a P2P system is represented by a congregation of connected devices that collectively store and share files. There isn’t a centralized system that facilitates the downloads to take place since the peers in the network send and receive the files instantaneously. The marvel of this system is that it is entirely fool-proof in every manner without a single loophole to point out.

It is this aspect of cryptocurrency that entices people to act honestly and has prompted people from all over the world to consider it as a separate field of study, and hence the coinage of the term ‘crypto-economics’. It combines the fields of both economics and computer science to study the decentralized marketplaces and their applications that can be built by combining cryptography with economic incentives. The fundamental role that classical and contemporary game theory models play in it is vital to understand the primary dynamics of interactions between players in cryptocurrency platforms. The concept of crypto-economics is very new, but when you become familiar with the functionality of cryptocurrency platforms, you will see how it is extremely crucial for eliminating malicious actors from the economy and promoting honest behaviour across the network. In this case, the incentive provided to the miners has induced them to provide their inputs for verifying the transactions. They actively spend resources (electricity) to have a chance to verify a transaction and thus, their efforts will be a sunk cost if they use malicious actions to attack the network and jeopardize the value of the reward. It becomes increasingly more costly to act dishonestly than it does to act honestly within the system. This creates a positive feedback loop where miners constantly have a positive incentive to maintain valid transactions and curb malicious actors from corrupting the system, thus resulting in a secure network.

The rationale that comes into play here can be linked to game theory since the motive of the miners to gain profit through illegal means has been disrupted due to the existence of a punishment system that inhibits them from doing so. The ‘crypto-algorithm’ is designed so that the consequences of illegal activities will far outweigh the profit that the miners could gain from it. The concept of ‘Proof of Stake’ has a major role to play in this line of work. The reason why such activities are strictly discouraged is that if a miner attempts to do this he may lose his ‘stake’ in the system. In effect, he loses his mined currency and isn’t rewarded for his mining work. Therefore, his most rational decision would be to act honestly and keep the network secure, that is, he is incentivized to behave virtuously on the network, which forms the basic essence of game theory.

The question that arises here would be that if a miner cannot profit through illegal means then what is his incentive in the first place for joining the game. The entry of the miners to get into the game is through verifying their investment through the ‘Proof of Work’ consensus. The huge amount they had initially invested and the possibility of a greater reward, in the end, incentivizes the miners into joining the mining network and providing their inputs. Also, there is no risk involved in joining the network and their investment is safe and sound. The invisible hand of the game theory mechanics comes into play once again.

Nevertheless, there exists a first-hand problem that critics have often discussed and debated. Game theory models can’t be relied upon and are only perfected over time with practice. The assumptions made in these models are primarily based upon separate individual decisions which could often wayward into a variety of possibilities. The decisions made by the players in the system are heavily influenced by the actions of the people they interact with. Considering the case of miners, the concept of Nash equilibrium is what induces them to maximize their payoffs by taking into account the decisions of others.

Game theory dynamics in cryptocurrencies will continue to develop and should become one of the most fascinating concepts within the industry. Their role in security, validity, and viability cannot be understated and their eventual success or demise within decentralized networks will unfold in real-time as novel platforms go live and incorporate larger numbers of users. The field of crypto-economics is just beginning, with implications not solely limited to cryptocurrency platforms, but the larger development of game theory mechanics themselves.

Aadithya Sumod Second Year Undergraduate Student
This website uses cookies to improve your web experience.