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Understanding Cryptoeconomics: A Beginner’s Guide

As the world comes to grip with the changed reality the introduction of cryptocurrency has brought, there are those that are confused by the new rules of engagement. Typical questions include: what is peer-to-peer money? Is it like peer-to-peer file sharing? If that model failed (ie. Napster), why would peer-to-peer money work?

Cryptocurrency and cryptoeconomics require a new understanding and a new relationship with money, where the user – instead of a bank – is the guarantor of the money’s worth. This new system looks at how we trust each other, how our better instincts may be a hindrance, and how a balanced demand and supply system should look like and creates controls to automate what previously a select few got to see, let alone control.

This article will give you a crash course in cryptoeconomics and help to explain how virtual money has and will revolutionized the financial world.


Peer-to Peer Sharing

As mentioned above, cryptocurrency was not the first experiment in information sharing. Starting with Freenet in 2000, peer-to-peer file sharing sought to break the problems inherent with client-server file hosting, such as the need for large storage drives, the allocation of administrative privileges to a single person or group, and the risk to that single person should the shared files be illicit in any way. By creating an exclusive two-party connection, the risk and control are quarantined to only the parties involved.

The largest attempt at establishing a peer-to-peer commercial sharing network was Napster. The original incarnation ran from 1999 to 2001 and allowed for per-to-peer sharing of music MP3 files. Prior to the popularization of iTunes and other music download sites, Napster presented one of the few viable options for those that sought music in a digital format. After losing infringement cases to Metallica, Dr. Dre, and A&M Records, Napster closed in 2001 and sold off all assets.

Napster illustrates the primary problem with peer-to-peer file sharing or torrenting. While downloading or obtaining the file is usually ignored, uploading or sharing the file is increasingly being prosecuted by intellectual property owners. It is not uncommon for agents of IP owners to pose as downloaders on torrents sites to learn which uploaders are illegally sharing content. As while not every downloader allows their torrents to be uploaded – as is expected in a peer-to-peer environment as an unspoken rule – the legal risks with sharing is not necessarily equitably shared.

This is known in cryptology circles as a “Byzantine failure.” This concept takes its name from the Byzantine generals’ problem and refers to the idea that to an outsider, a system node can both fail and appear to be operational per the system’s failure detection systems. Using the torrent example, a Byzantine failure is a downloader that pulls his/her torrent before allowing uploading. The original uploader expected the downloader to upload, taking demand pressure off him, and is unaware that the downloader failed to meet expectations.

In a low-value system such as peer-to-peer file sharing, Byzantine failures can be tolerated. After all, resending a file is not necessarily a critical choice. But, what if you are sharing something more substantial, like money?


A Question of Trust

The Byzantine generals’ problem is a mental exercise on how to avoid bad agents in a situation where all the actors are anonymous or semi-anonymous. The problem asks the answerer to imagine a city besieged by several Byzantine armies. The armies are spread out so that conventional lines of sight and communication are unavailable. One of the generals feel that the time is right to launch an assault on the city, but he needs all the armies to act at the same time. If it is unknown if there are spies on the field waiting to intercept and imitate responses from the generals, or – worse – if any of the generals have decided to align with the city.

There are a multitude of ways the generals could share messages with each other in this trustless environment. The idea of how to reach consensus in such an environment is known as Byzantine fault tolerance. Byzantine fault tolerance is at the heart of cryptocurrency.

“Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments,” Satoshi Nakamoto, the creator of bitcoin, wrote in his paper, “Bitcoin: A Peer-to-Peer Electronic Cash System.” “While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.”

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. [We] propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.”

Peer-to-peer money differs from peer-to-peer file sharing because it utilizes cryptography to replace the lack of trust that would normally exist in a peer-to-peer situation. This allows strangers to form a consensus without having to worry about bad actors.


How Does Cryptocurrency Works

A cryptocurrency is a system of money that is backed by its security framework instead of any centralized authority or bank. A cryptocurrency – within itself – is just a data file with no inherent value (typically, although there are cryptocurrencies pegged to fiat currencies). Its value is determined by the demand on that file when traded either through the initial offering or on the secondary coin market.

The theory behind cryptocurrency is that – at least for proof-of work cryptocurrencies – it is significantly harder to create or fake a cryptocurrency than it is to prove or disprove its validity. To create a proof-of-work coin, one must “mine” a block or record group for coin transactions. The successful mining of a block result in coins being offered as a reward. These blocks are stored together in a record chain called a “blockchain,” where network nodes keep and maintained an active ledger of the connected blocks.

When a coin transaction is recorded by the network, it is transmitted to the various nodes for verification and recording. Upon accepting a transaction to be valid, it is recorded to the active block. A transaction requires most of all nodes on the network to verify it as true for it to be considered valid.

The nodes, in exchange for agreeing to verify transactions, can compete in a competition to guess the address of the next block to win that block’s coins. To win, the node must guess a valid address that is less than the current target. The guess must be a calculation based on the cryptocurrency’s proof-of-work hash function, where any set of data – regardless of size – is converted into a hash. For bitcoin, the hash function is double SHA-256, where the content of a block is hashed using a nonce (random number used once) into a 256-bit (32 digit) hexadecimal hash that is hashed again. As the order of the information in the hashed block does not affect the hash, another node can easily check the validity of the hash. The hash must meet suitability requirements, including having the right number of zeros (currently 13) leading. A node can guess again as often as it likes until a node reports that it found a winning hash.

In the case of a likely tie, where two nodes or more find a valid hash below the target at the same time, the block reward goes to the node that did the most transaction calculations or work for the block. Block rewards are awarded after 99 consecutive blocks have been mined.

As the current block address is a hash of the previous block, changing a block in the blockchain requires changing every block that is a successor to it. Since there is a 100-block waiting period for coins, attempts to double-spend coins or to maliciously fork the blockchain requires recalculating a minimum of 100 blocks in less time that it would take for a legitimate miner to calculate just one. Additionally, the malicious miner would need to get most of the nodes to accept his/her changed blocks. Due to this, cryptocurrency is secure, although incidents of miner fraud (i.e. 51 percent attacks) have been on the rise with less-valued coins as of late.


The New World

With such a secure money system, functions once thought to be impossible are now possible. For example, it is now possible to start a currency without bank involvement. This means that banking products can now be offered to the unbanked and underbanked, that new lines of credit can be created on the fly, and fundraising methodologies can be innovated. One way this innovation has manifested itself is the initial coin offering, a version of the initial public offering that creates and publicly offers a new cryptocurrency to fund the seed funding of a new venture. This methodology is being replaced with security tokens or cryptocurrency backed by and treated like traditional securities.

The more impressive capabilities, however, for cryptocurrencies are what they can do for fiat currencies. For example, a cryptocurrency on an interbank network can be used to facilitate real-time gross payment and settlements. The current cross-border payment system is flawed and can take hours or days to get a payment from one part of the world to another, with each bank-to-bank hand-off requiring new fees and handling requirements.

This use of cryptocurrency for non-monetary reasons offer the potential to provide collaborative, cloud-based databasing. This technology, known as distributed ledgers, has been successfully integrated into the processes of companies such as Wal-Mart and Kroger’s. Wal-Mart, for example, used distributed ledgers to simplify its farmer-to-store produce tracking and to bring into compliance its duck meat sourcing in China. Distributed ledgering bears the potential of creating instantaneous inventory systems over multiple systems, which can make product tampering, theft prevention, and shipment tracking a simpler process regarding manpower and needed equipment.

This is possible using smart contracts or autonomous pieces of software capable of enforcing a contract without third party interference. The smart contract acts on the blockchain’s coin or token, activating a function specific to the contract. It is like an automatic, virtual vending machine.

The same process, using smart contracts, can be used to make system-to-system querying easier. This can create dynamic databases that can automate and safeguard complex logistical problems, such as remote voting, real property registry access, and filing taxes. A blockchain-enabled agent can theoretically replace any administrative process, potentially saving countless manhours.

Cryptocurrencies are risky. They are relatively new and prone to the foibles of human greed. However, there are few technologies that offer the potential than cryptocurrencies. Not only with banking, but with information sourcing and storage, retail, business funding, and property management, cryptocurrencies offer a new way to think about and handle the realities of decentralized control and flow.

“Virtual currencies might just give existing currencies and monetary policy a run for their money,” International Monetary Fund director Christine Lagarde predicted, per Investor’s Business Daily. “Citizens may one day prefer virtual currencies, since they potentially offer the same cost and convenience as cash — no settlement risks, no clearing delays, no central registration, no intermediary to check accounts and identities,” she said.

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