How to Assess Cryptocurrencies’ Economic Model and Incentives

Along with Bitcoin’s invention, a new economic system that doesn’t require governments’ approval or traditional rules of the law came out. Bitcoin’s as well as other cryptocurrencies’ economic models rely on two essential elements: open access and incentives as a form of reward.

Yet, some cryptocurrencies have more robust and sustainable economic models and incentives than others. 

Here are some of the key factors when it comes to analyzing a crypto project’s economic and incentivization model.

Understanding Cryptocurrencies’ Economic Models

Cryptos’ economies center on crafting resilient autonomous protocols governing decentralized peer-to-peer systems. By integrating game theory, economic incentives, and disincentives, the cryptocurrency’s design aims to influence behavior, yielding desired outcomes that enhance network stability and foster heightened engagement.

The framework heavily relies on economic incentives and penalties, where rewards motivate participants, and penalties are imposed when deviating from the default design. 

As far as the game theory, it’s directly linked with the cryptocurrency governance protocols’ inner workings.  A typical game theory model comprises three key components: 

1. players (decision-makers)
2. strategies (optimal decisions)
3. payoff (outcomes of strategies)

Examining the Bitcoin blockchain as a prime illustration reveals two primary players: users, engaged in sending or receiving coins, and miners, responsible for "mining" coins.

The strategy is to solve the cryptographic hash puzzle, and the payoff is none other than bitcoins.

1. What Influences Cryptocurrencies’ Supply and Demand

One of the most basic aspects of any economy is the balance between supply and demand. Supply refers to the amount of a good or service that is available, while demand refers to the amount that people want to buy or use. 

In the context of cryptocurrencies, supply can be influenced by factors like:

• the total number of coins or tokens that can ever be created (also known as the maximum supply or hard cap)
• the rate at which new coins or tokens are generated (also known as the inflation rate or issuance rate)
• the mechanism by which new coins or tokens are distributed (also known as the consensus algorithm or mining algorithm)
• the rules or conditions that govern how coins or tokens can be spent, transferred, or burned (also known as the monetary policy or governance model)

Demand, on the other hand, can be influenced by the following elements:

• the utility or functionality that the coin or token provides (also known as the use case or value proposition)
• the network effect or network size that the coin or token enjoys (also known as the adoption rate or user base)
• the reputation or credibility that the coin or token has (also known as the brand awareness or social proof)
• the liquidity or ease of exchange that the coin or token has (also known as the market depth or trading volume)

A healthy cryptocurrency should have aligned and balanced supply and demand. If the supply is too high relative to the demand, the price will drop and the value will erode. If the supply is too low relative to the demand, the price will rise and the scarcity will increase.  

2. Incentives and Participants’ Alignment – Crucial Factors in Crypto Economy

Another important aspect of any economy is the incentives and alignment of the participants. Incentives refer to the rewards or benefits that motivate people to act in a certain way, while alignment refers to the degree of harmony or agreement among the participants. 

Incentives and alignment depend on several aspects, such as:

• the distribution or allocation of coins or tokens among the stakeholders (also known as the tokenomics or token economy)
• the governance or decision-making process of the project (also known as the voting system or consensus mechanism)
• the security or robustness of the network against attacks (also known as the attack resistance or game theory)
• the innovation or development of the project (also known as the roadmap or vision)

A successful cryptocurrency should have incentives and alignment that are fair and efficient. If the incentives are too skewed or unequal, some participants may gain an unfair advantage over others, leading to conflicts of interest, corruption, or exploitation. 

If the incentives are too weak or ineffective, some participants may lose interest or motivation, leading to apathy, stagnation, or abandonment. Both scenarios can have negative consequences for the long-term growth and stability of the project.

3. Punishments for Cheater Validators

On a proof-of-stake (PoS) network, slashing is a mechanism that punishes validators who break the rules of the network or act maliciously. Slashing in crypto networks is all about predefined rules that node operators should follow. These rules are embedded into the blockchain protocol and enforced by the network’s consensus algorithm. The penalty is automatically triggered each time a validator or staker violates the rules.

The penalty usually involves losing a portion of the staked tokens, which reduces the validator's rewards and reputation. 

In proof-of-authority, validators are authorized nodes that are restricted to a fixed set of n authorized nodes called sealers. Validators are incentivized with reputation which lets them keep their authority as a node. If a validator is caught cheating, they’ll lose their staked coins and may be subject to fines. If a validator is found to have double-spent coins, they may be subject to a permanent ban from the network.

Here’s an overview of Ethereum’s slashing system:

Source: RockX

Examples of Different Incentivization Models in Cryptocurrencies

There are many different types of cryptocurrencies, each with its own tokenomics and incentivization model. Here are some examples:

Bitcoin – both miners and users get incentives

Bitcoin is the first and most popular cryptocurrency, which aims to create a peer-to-peer electronic cash system that is decentralized, censorship-resistant, and deflationary. Bitcoin has a fixed supply of 21 million bitcoins, which are distributed through a halving process that reduces the block reward every four years. This creates a scarcity effect that increases the value of bitcoins over time. 

Bitcoin also has a difficulty adjustment mechanism that ensures that blocks are added to the blockchain at a constant rate of one every 10 minutes, regardless of the number and power of miners. This creates a balance between security and efficiency in the network.

Ethereum – all actions on the network require gas fees

Ethereum is a second-generation cryptocurrency, which aims to create a decentralized platform for smart contracts and decentralized applications (DApps) that can run on its blockchain. 

Ethereum has an unlimited supply of ethers, which are distributed through a constant block reward that does not decrease over time. This creates an inflationary effect that decreases the value of ethers over time. 

Ethereum also has a gas fee mechanism that adjusts the cost of transactions based on the demand and supply of computational resources in the network. This creates an incentive for developers to optimize their code and users to pay fair prices for their transactions.

Anatha – incentives for all ecosystem participants

Anatha is a third-generation cryptocurrency that aims to create a human-centric platform for data spaces that empowers individuals with data sovereignty and economic inclusion. 

Anatha has two types of tokens: 

1. ANATHA (native token) – used as a medium of exchange, store of value, unit of account, reward mechanism, and governance mechanism within the Anatha network
2. HRA (human-readable address) – used as identifiers for users' digital identities and data assets within the network

Anatha has an innovative token distribution model that rewards users for creating and sharing data, as well as for participating in the governance and development of the network. Anatha also has a token-burning mechanism that reduces the supply of ANATHA tokens over time, creating a deflationary effect that increases the value of ANATHA tokens over time.

Conclusion

Cryptocurrencies are complex and dynamic systems that require careful analysis and evaluation. By considering factors like supply and demand, incentives and alignment, you can gain a better understanding of their economic model and viability. 

However, these factors are not exhaustive or definitive. Other aspects may be relevant or important for a specific project. Therefore, you should always do your own research and due diligence before investing in any cryptocurrency.