What did Satoshi Nakamoto invent?
Is it the first digital currency?
If you are a newcomer to Bitcoin, you can give the first answer as digital money to this question, but it is not. The Cypherpunks began to doubt the monetary policies of central banks after the end of Bretton Woods. With the Bretton Woods system, it was decided that the only currency that could be converted to gold would be the American dollar, and the values of other currencies would be adjusted according to the dollar.
The fact that all currencies are indexed to the US dollar has created an imbalance in the markets over time. The financial system underwent an adverse change when the US announced that it gave up the gold index system in 1971, opening the door to the global inflation period.
Today, the world’s struggle with inflation, as well as the fact that the role of central banks is being questioned by an increasing number of people, may signal that we have reached the end of the centralized monetary system.
According to the cypherpunk, to create a free internet environment, they had to have an economic system or internet-specific currency that no one could manipulate. (Who these cypherpunks or crypto-anarchists are is a topic for another article, but I highly recommend reading the 1988 crypto-anarchist manifesto and 1993 cypherpunk’s manifesto.) With cryptological developments, currencies such as digicash (David Chaum), e-gold, and B-money emerged over time, and Satoshi Nakamoto referred to the B-money system in the white paper. So the first digital currency is not Bitcoin.
Does it solve the Byzantine Generals’ Problem?
So what did Satoshi do differently? To build a decentralized money system, the trust relationship between distributed computers needs to be resolved, so we need to make sure that no one will be fickle. We call this Byzantine Generals Problem. It is often thought that Satoshi solved this problem, but Leslie Lamport solved it in 1982, after which many articles were written until 2008. We call them Paxos consensus algorithms in general.
Is blockchain a new distributed ledger technology?
David Chaum first proposed a blockchain-like protocol in his 1982 dissertation “Computer Systems Established, Maintained, and Trusted by Mutually Suspicious Groups.” Also, Tim May mentioned tamper-proof boxes in his crypto-anarchist manifesto in 1988, I think what he refers to is blocks. Thus, Nakamoto is not the first person to use blocks.
Is it the invention of Proof of Work?
If you say Nakamoto invented PoW, he did not. The concept was invented by Moni Naor and Cynthia Dwork in 1993 and was adapted to digital tokens by Hal Finney in 2004 through the idea of “reusable proof of work” using the 160-bit secure hash algorithm 1 (SHA-1).
The first transaction in Bitcoin is 10 BTC from Satoshi to Finney, and it is he who downloads the first node after Satoshi. Hal Finney was one of the first Bitcoin advocates.
Satoshi’s Invention of Cryptoeconomics
While we can guarantee the past of a system with the cryptological knowledge we have, the real issue is how to secure the system’s future. Satoshi achieved this with an economic incentive by using game theory. By combining the fields of cryptology and economics, a new discipline was born: cryptoeconomics.
Before coming to what cryptoeconomics, I would like to explain the relationship between game theory and bitcoin through the scene where John Nash was enlightened in the movie A Beautiful Mind.
Consider that picking up the blonde woman is equivalent to owning the whole system in Bitcoin, so let’s say hacking Bitcoin is getting closer to the blonde woman. In this case, if everyone focuses on the best result for himself and gets closer to the blonde woman, other women do not want to be the second choice, so at the end of the day, a woman and a man will be happy, while other men and women in the group lose their chance.
At this point, Adam Smith says that “to get the best results, everyone in the group should do what is best for them.” But in this case, a game where only two people win and the rest lose is not the best outcome.
According to Nash, “To get the best results, everyone in the group must do what is best for themselves and for the others in the group.” So ignoring the blonde woman ensures that the game ends in the best way for everyone.
To solve this situation, Satoshi designed a mechanism based on proof-of-work that gives a reward every 10 minutes to miners who use the processing power in favor of the system. So hacking Bitcoin (matching with the blonde woman) is something everyone wants, so the chances of winning are very low, and a lot of processing power is needed because of the competition. Considering the cost and the possibility of winning, it is more advantageous to work in favor of the system. In this way, the system pays for itself and ensures its sustainability without needing a central authority.
Satoshi Nakamoto added economics to the corpus of cryptology and created a new discipline: cryptoeconomics.
“Just like Galileo is known as the founding father of physics, Satoshi will forever be known as the founding father of cryptoeconomics. I believe in 50 years, cryptoeconomics may be a discipline as widely studied as physics and Satoshi may be as widely revered as Galileo.” Nick Tomaino
I believe cryptoeconomics will form the basis of the economic models and even ideologies of the 21st century. A Nobel Prize will go to the cryptoeconomics field in 30–50 years if there is still a Nobel Prize.
The first definitions in this field were made by Vitalik Buterin and Vlad Zamfir.
Zamfir’s view of cryptoeconomics is relatively broad and academic:
“… a formal discipline that studies protocols that govern the production, distribution, and consumption of goods and services in a decentralized digital economy. Cryptoeconomics is a practical science that focuses on the design and characterization of these protocols”.
In 2017, Buterin’s view is more narrow and pragmatic:
“… a methodology for building systems that try to guarantee certain kinds of information security properties”.
Voshmgir & Zargham showed the relationship between cryptoeconomic systems and eight areas in their article titled “Foundations of Cryptoeconomic Systems” published in 2020.
We will look at cryproeconomics at two different levels: micro-foundational (relating to agent-level behaviors) and meso-institutional, (relating to policy setting and governance). In this article, I will discuss the subject at the micro-foundation level. In Part 2, we will look at the subject at the meso-institutional level and share what I understand from Institutional Cryptoeconomics.
When designing a system, algorithmic game theory (CS) and mechanism design (economics) are commonly used. Mechanism design is also called reverse game theory. It has broad applications, from economics and politics in such fields as market design, auction theory, and social choice theory to networked systems.
(If you want to improve yourself on this subject, Tim Roughgarden’s CS364A: Algorithmic Game Theory (Fall 2013) is the best.)
Mechanism design is like programming human behavior for engineers.
Humans are goal-oriented machines that respond to incentives. In an economic game designed with the right incentives, we can force selfish humans to exhibit useful behavior.
If I explain by giving an example; think of bottle pick-up machines. The state or county cleaning company offers a default task that anyone can do: you get 30 cents per bottle you bring (incentive). Thanks to this mechanism, we not only push people toward beneficial behaviors but also significantly reduce costs compared to the previous system. It is obvious how this very simple mechanism makes distributed human resources more useful.
We can talk about two sub-disciplines when designing a mechanism.
- Token engineering: By utilizing system theory and control theory methods in designing an autonomous mechanism; it aims to tokenize the system in the most efficient and secure way.
- Token economics focuses on the economic aspects of token-based systems. It involves analyzing the supply and demand dynamics of tokens, token distribution mechanisms, token utility, and the broader economic implications of the ecosystem.
These two disciplines are completely interrelated. The need for professions in these fields is increasing rapidly. Soon, we will start to see departments in these fields at universities.
Trent McConaghy was the first person to come up with the concept of token engineering.
(If these topics are of interest to you or if you are thinking of becoming a token engineer, you should definitely read his two articles.)
Cryptoeconomics is, in a way, a tool for decentralizing systems. But why decentralization matters? In the next article, we will examine cryptoeconomics at the institutional level and get closer to the answer to this question.
