P2P – Forex Academy

Introduction

Cryptoeconomics is a gentle combination of both cryptography and economics, i.e. incentives, as the name suggests. Cryptoeconomics ensures the decentralized peer to peer (P2P) network is viable and dependable for the proposed transactions on a P2P network. A general misconception when people come across the word Cryptoeconomics is that it is a field in economics, but it isn’t true. The use of cryptography and economic incentives to run a decentralized network without malicious attacks as it isn’t governed by anyone is Cryptoeconomics.

Why Cryptoeconomics?

The P2P networks are not new with the invention of blockchain and cryptocurrencies in our lives. Torrents sites have been using decentralized P2P networks for decades to share files. The general principle is that whenever you download a file from torrents, you are supposed to seed a file which can be useful for anyone else to download. In general, that is how we are creating content in the torrents for others to download.

This is not hard and fast rule but depends on the honor code. Human Beings are, in general, not honorary; hence most of the people don’t even know that a file should be seeded in return for a download, and hence the system has been a big failure. Hence incentives have been introduced in the cryptocurrency platforms, including cryptographic has functions for security purposes.

How does it work?

Let us see how Cryptoeconomics work using the example of Bitcoin. In 2008 bitcoin white paper was released, showing a first-ever way to use Cryptoeconomics with a practical and live example by minting a bitcoin by January 2009. Not only does the incentive concept evolved, but Bitcoin successfully overcomes the concept of the Byzantine Generals problem to create a perfect consensus mechanism called Proof of Work. Let us see in detail how cryptography and economics play a role in the bitcoin platform.

Properties of Bitcoin that have come due to cryptographic hash functions

₿ Bitcoin works on blockchain technology, which is a continuous chain of blocks linked together with cryptographic hash functions.

₿ Each block contains a predefined number of transactions with a hash of all the transactions combined.

₿ The platform is immutable, i.e., already added, and sealed blocks are not subject to any change, but new blocks can be added.

₿ Only valid transactions are allowed and added to a block using a consensus mechanism; in the case of bitcoin, it is PoW.

₿ The blockchain is accessible by anyone in the world, as this is a permissionless system.

₿ If a high transaction fee is paid, the transaction can be verified and committed to the blockchain quickly. We had seen many examples in 2017 when the bitcoin price zoomed to be highest ever.

₿ It should be easy to retrieve information on any transaction confirmed in the blockchain. This is possible using the concept of the Merkle tree.

Some of the main functions which run the bitcoin blockchain platform are

Hashing
Digital Signatures
Mining
Proof of Work

Economics

As we discussed before, the fundamental difference between blockchain P2P networks and other P2P networks is the incentive model. For getting any work done, the work should be rewarded using appropriate incentives as motivation. At the same time, the tone should be punished if the work is not adequately done or done in a malicious way to create a loss in the network.

How are the participants rewarded in the network?

The participants are paid in native cryptocurrency of the network for actively participating in running the network and confirming the transactions as required.
The most recent winner of the block is incentivized with local cryptocurrency. Some privileges like what transactions should be added in the block and charge transaction fees to add the transaction in the block kind of decision-making rights are also given.
Simultaneously, wrong participants are fined, or their decision-making rights are snatched away as required.

Now a question might be raised like how does cryptocurrency have a value? The answer is simple: how a fiat currency or gold has value, supply, and demand. A whole lot of other factors like the network integrity, number of coins in circulation, is the network affected by a hack recently, history and purpose of the coin in the first place, and a lot of stuff. To determine all these parameters and how the miners maintain their integrity without being malicious is based on the concept of Game Theory and Nash Equilibrium, which we will be delving into in our further articles.

In the previous articles, we have learned the definition, properties, and purpose of cryptocurrency. But it is vital for us to know how cryptocurrencies work. In this article, let us find out that by taking the example of Bitcoin.

Below are some of the important terminologies you should know before going further.

Peer to Peer Network (P2P) – The networks where computational devices are joined together with the internet instead of using a central server are called peer to peer networks. Hence there is less chance of a network failure than the standard server model to form a network.

Miners – Miners are the participants in the network who validate transactions. Thus, the creation of new Bitcoins is often referred to as the mining of bitcoins.

Nodes – The individual computational devices in the network are called nodes. The nodes are joined to form a P2P network.

Consensus algorithms – To validate the transactions, the miners in the network should agree whether a transaction is valid or not. The blockchain network uses consensus algorithms to get this job done.

How does the Bitcoin network work?

The blockchain network is set up in a peer to peer way, enabling decentralization of the network effectively, removing the server model. Bitcoin network bundles a certain number of transactions into a block, and these blocks are linked using cryptographic hashing techniques. The miner should validate these blocks for the authenticity of the transactions. To confirm them, the system proposes a challenge to the miners, and the first miner to solve the problem, propagates the message throughout the network. The solution to the challenge is called ‘nonce.’ The complexity of finding this nonce increase as the number of blocks keeps increasing in the system. The other miners validate and approve the transactions if the transactions are not fraudulent.

Bitcoin as reward

The miner who achieves the solution first gets rewarded in the network in the form of Bitcoins. This is how and why the Bitcoins are generated in the network. The miners should be rewarded to keep them motivated and committed to the network. Without miners, the network wouldn’t be sustainable.

To transact Bitcoins in the network, users must pay transaction fees as well. These transaction fees are also in Bitcoin. Hence these transaction fees and Bitcoins generated are paid as a reward to the miners for validating the transactions.

POW as a consensus algorithm

Bitcoin uses Proof of Work (POW) as a consensus algorithm. POW proposes a challenge to the network, which is to be solved to validate the transactions. But why is it necessary? Because POW discourages denial of service. Below are the steps involved in POW in general.

The service requester requests service from the service provider.
The service provider gives a challenge that should be a bit complex for the service requester to resolve but easy enough for the service provider to check.
The service provider proposes this challenge to avoid the exploitation of the service from the service requester.

The exact same concept is used in the Bitcoin network, as well. The miner must expend a considerable amount of computational energy and electricity to solve the challenge. Because by doing this, he/she will not validate fraudulent transactions to be accurate. If they do validate fake transactions, they will lose all the time and computational power they spent and also the chance of gaining a reward. POW is the most efficient consensus algorithm so far, and it makes the Bitcoin network efficient.

We hope you understood the working of Bitcoin. Cryptocurrencies other than Bitcoin with different blockchains and consensus work in a different way. You will know about each of them in the upcoming articles. Let us know if you have any questions in the comments below. Cheers!