As I wrote about previously, if you’re going to buy any crypto, you should understand what you’re buying, how it works and why it has value. And key to comprehending that last bit is a subject called ”cryptoeconomics” or ”tokenomics.” This is the game theoretic system of incentives that produces the goods and services in a decentralized digital economy.
I realize that sounds a bit overwhelming, but basically, it’s how to design tokens in order to incentivize people to provide certain services to a crypto network that lacks a C-suite and managers that will hire people and pay them salaries to offer those services as employees.
Another way to think about it is, if you were to try to set up a decentralized network to offer the kind of service that’s popular online now — let’s say file storage, like a decentralized Dropbox — then how would you design a coin to get people to offer up spare storage space and get the quality of service high enough that people would actually use it?
It sounds complex and esoteric, but actually, cryptoeconomics or tokenomics can be pretty easy to grasp. It’s also immensely helpful for evaluating whether or not a coin is valuable, and whether or not its price may go up.
I’ll walk you through the cryptoeconomics of the original crypto asset, bitcoin (currently worth more than $50,000, at a $1.1 trillion market cap) now, and later, I’ll walk you through the tokenomics of the second biggest crypto network, Ethereum.
The Problem Satoshi Was Trying to Solve
Since a blockchain is a ledger of every transaction in that network, keeping it reliable and trustworthy is the most important goal.
What creates trust in the blockchain is knowing that it is decentralized, and that no single entity can tamper with it and either counterfeit transactions or change the historical record.
This means keeping the network safe from attacks — from a centralized entity taking it over. The most well-known of all the attacks is called a 51% attack, in which a single entity or a group colluding obtain more than 50% of the computer power on the network, giving them the power to delete recent transactions, reverse their own transactions, and, most importantly, slash confidence in the blockchain itself.
The way pseudonymous Bitcoin creator Satoshi Nakamoto designed Bitcoin the network, often written with a capital B, to help prevent these types of attacks was pretty ingenious. He/she/they designed the coin, often written with a lower case b, to bolster the network’s security so that those ”security providers” are incentivized to act honestly.
Mining + Proof of Work + Block Reward
The way to keep Bitcoin secure is to keep it decentralized and have a lot of computing power on it, because then it becomes more expensive to wage a 51% attack. The costs of doing that would be to obtain a bit more computer equipment than what is currently being used to run Bitcoin, plus the electricity costs of running it. But when Satoshi Nakamoto went to launch Bitcoin, it’s not like a bunch of people were eager to help him/her/them create this obscure digital currency, so the amount of computing power it could initially attract was low.
What Satoshi needed to do was incentivize a lot of people to run the software, to keep allowing new transactions to be executed and added to the ledger. These people (and/or the equipment they use) are called miners.
Satoshi’s solution was to create a competition. In order for an entity to have the privilege of attaching the latest block of transactions to the ledger, a miner would have to compete to solve a mathematical puzzle. (The technical term for this mathematical computation requirement is proof of work.) Whoever solved it first would win not only the ability to add the new block to the blockchain, broadcasting it out to the entire network, but also would be rewarded with what is known as the “block reward,” “coinbase reward,” or "block subsidy," which is some number of new bitcoins that the software mints with that block. (This is what the crypto exchange Coinbase is named after.) Additionally, they receive all the transaction fees, which people pay to make each transaction so the network isn’t clogged with spam.
To many miners, it feels like what they’re doing is attempting to win new bitcoins. But to the Bitcoin network, what the miners are doing is keeping it secure. Because the more computer power there is — the more computers there are competing to solve the math problem to add the next block — the harder it is to commandeer the network.
21 Million Supply Cap
When launching Bitcoin, Satoshi faced a dilemma of trying to get many people to run the software at a time when no one cared about it. Even though Satoshi had set up this competition and people had the opportunity to win bitcoins, these digital coins were worthless, so again, Bitcoin’s creator had to come up with additional enticements.
One of the main incentives was a cap on the total supply of bitcoins, set to 21 million. After all the bitcoins are mined, there will never be more than 21 million of them. This is why Bitcoin is often called “digital gold,” since gold is also a finite precious resource.
Having a cap on a non-government issued coin helped it become seen as a hedge against inflation. It was like creating a digital version of Manhattan — it was a way of signaling to people interested that if they bought early, then they would get a piece of this scarce space, and as more people wanted in, demand would push up the value of each unit.
The highest hurdle was at the very beginning to get people to join back when no one knew what it was. For this reason, Satoshi started the block reward at the highest amount, and over time, ratcheted it down. At launch in January 2009, the Bitcoin software was minting 50 new bitcoins on average every 10 minutes.
Every four years, the number of new bitcoins being minted for the block reward is halved, in an event called “the halving,” and sometimes nicknamed, “the halvening.” There have been three halvings so far, so the current block reward is 6.25 bitcoins. After the next halving, the amount of new bitcoins being minted every 10 minutes will drop to 3.125.
These halvings incentivize people to get in early, to be able to win a greater number of bitcoins per unit of effort than they would after the next halving. It also has the effect of slowing the inflation rate of bitcoin, so that as newcomers want to buy in, there are fewer new bitcoins being created by the software and sold by miners, thus decreasing the downward selling pressure on the market. This may help drive the bitcoin exchange rate up, meaning that even if miners are winning fewer bitcoins with each successful attempt, they are not winning less money in dollar terms.
The increased price then draws more newcomers, creating a positive feedback loop — attracting more miners, which makes the network more secure, etc.
The last piece of Satoshi’s brilliant creation is that the mathematical puzzle each miner races to solve every 10 minutes needs to be set to a difficulty such that it will be solved, on average, every 10 minutes. However, as more computing power and more powerful mining machines get added to the network, that results in the puzzle being solved more quickly than every 10 minutes. If the difficulty of the puzzle had remained the same as at the beginning, all the 21 million bitcoins would have been mined a long time ago.
For this reason, Satoshi has a “difficulty adjustment” trigger every 2016 blocks, or roughly every two weeks. This calibrates the difficulty of the new mathematical puzzle to the amount of mining power on the network, again pushing the issuance of new bitcoins back to every 10 minutes.
And those are the basic features of Bitcoin’s cryptoeconomics. At the moment, almost 18.9 million BTC have so far been issued using this scheme, which has worked for what will soon be 13 years. Assuming this system continues to hold up, Bitcoin will likely asymptotically reach its 21 million limit sometime around the year 2140.
If you'd like to get into crypto and understand what you're buying: