Cryptocurrency is not controlled by any central authority or backed by any entity. Because of this, certain principles are inherent in the cryptocurrency market that maintain integrity in transactions. Without these principles, the currency itself would have no value. In order for cryptocurrency to maintain its value, blockchains are used as an accountability system. They’re essentially a public record, like a digital ledger, of all transactions made on any given day with new transactions added in sequence. Each transaction is a block and a blockchain puts them in sequential order. Through blockchains, cryptocurrency can be followed from one transaction to another. The cryptocurrency market has to grapple with maintaining integrity in the system for it to be trustworthy. Here are some important economic principles at play in the cryptocurrency market.
Byzantine Generals Problem
The Byzantine Generals Problem is an allegory for a situation where information in a system could be so unreliable it prevents operators in the system from reaching a common goal. In the allegory, two generals (working together) are positioned on opposite sides of a city. They only achieve victory by attacking at the same time. Their only method of communication is by sending messengers through the city to the other side. However, the messenger could be ambushed or the actual message could be switched with a fake. The generals need a way to authenticate the message. When applied to cryptocurrency, this allegory describes the need for a system that reliably validates transactions.
Byzantine’s Fault Theory
Byzantine’s Fault Theory proposes a solution to the Byzantine Generals Problem. Messages sent by the generals must be reliable, unforgeable, and impervious to disloyalty. To achieve that, a message is sent with an attached code based on the content of the message. The code is relatively easy to decipher but very difficult to re-generate. If the message was replaced, the code would no longer be valid and it would be easy to realize that the message was falsified.
To prevent invalid transactions in the blockchain, a “trustless” system (validation can be proven without needing to personally trust the other party) is needed to authenticate each transaction. Miners calculate complex code components to make sure a transaction is authentic and the blockchain is validated. Anyone in the system can see the validation record and trust the authenticity of a transaction.
Blockchain has to account for the possibility of deceptive practices, nefarious-intent, and fraud and take steps to prevent it. This is because the game theory is always at play. Safeguards that exist consider the many ways people can circumvent rules or change their behavior, based on the behavior of others in the system.
The game theory takes into account how nefarious users can undermine the integrity of a blockchain. For example, there is an automatic lag put in place from the time a transaction is made until the time it is validated. This prevents the sender from secretly editing the transaction before the blockchain is validated. Because transaction blocks are validated with proof of work, there is no way for the sender to edit an individual transaction. The entire blockchain is “locked” in a sense. Even if the sender attempts to be the miner for their own transaction, the lag would make their transaction already validated by another miner. Currency senders cannot delete other transactions that come after theirs because of digital signatures that are unique to each sender.
Law of Supply and Demand
In general economic theory, the law of supply and demand means that the value of a commodity is determined by how much it’s in demand and how plentiful the supply. The bigger the supply and the lower the demand, the lower the price will be and vice versa. With all of these checks and balances put into place, the cryptocurrency market can function as any other economic system. Market values are determined by supply and demand. With no worries of cryptocurrency losing its value, some owners wait until the currency rises in value before selling—similar to traders in the stock market. In this way, cryptocurrency itself is bought and sold as a commodity or used as a medium of exchange for goods and services.
Within the validation system itself, the reward in currency miners receive cannot be so great that it adds too much circulation to the market and lowers the value of cryptocurrency in general. It also can’t be so low that miners are not incentivized to expend the computing power necessary to validate blockchains. The law of supply and demand determines the reward miners receive for their work to maintain the integrity of the market.
Mises Regression Theory
Austrian economist Ludwig von Mises proposed a theory about how people assign value to money. He states that people determine the value of money today by the purchasing power it will have tomorrow. One can argue that the value of money held yesterday is determined by the purchasing power it has today. For most societies, the first currencies had their own value because they were based on precious metals. Mises Regression Theory puts into question whether cryptocurrency is real money because it can’t be traced back to a commodity like gold. Although cryptocurrency has purchasing power tomorrow, it traces back to basically appearing out of thin air. Despite this economic argument, it is recognized as a legitimate medium of exchange because it does have purchasing power.
People unfamiliar with the cryptocurrency market may believe that it isn’t “real” money. That may be true in the technical sense, but the systems put in place to safeguard the integrity of the cryptocurrency market have resulted in people and institutions recognizing cryptocurrency as a valid form of digital payment.