Crypto FAQ: What is cryptoeconomics? What is DeFi?

• Alt. Phrasing: What is a digital economy?; What is a cryptoeconomy?; What is Decentralized Finance (DeFi)?

Stated succinctly as an analogy:

cryptoeconomics : Decentralized Finance (DeFi) :: [traditional] economics : Centralized Finance (CeFi)

• Goals: see FAQ: What are the goals of cryptoeconomics?

• Contributions from Cross-disciplines: Selected major contributions from the four cross-disciplines of cryptoeconomics are listed below:
  • Economics
    • Law of Supply & Demand
    • Law of Self Interest
    • Law of Competition
    • Fiat Money Theory
    • Modern Monetary Theory (MMT)
  • Cryptography
    • cryptographic keys
    • hash functions
    • asymmetric (public key) encryption
    • Multi-Factor Authentication (MFA)
    • End-to-End Encryption (E2EE)
    • Zero Knowledge Proofs (ZKP)
  • Computer Science
    • peer-to-peer (P2P) network architectures
    • Distributed Ledger Technology (DLT)
    • DLT data structures, blockchains, Directed Acyclic Graphs, Merkel Trees
    • single (central) point of failure
    • Byzantine Fault Tolerance (BFT)
    • consensus algorithms
    • digital signatures
  • Mathematical Game Theory
    • Nash equilibrium
    • Byzantine Generals Problem
    • Prisoner's Dilemma
    • Markov Decision Process
    • Schelling game
    • P + epsilon Attack

* How It works: see How [Cryptoeconomics] Works section of this web

• Example Applications:
  Various examples exist of the practical adoption of cryptoeconomic and DeFi principles, with mixed results. On one hand, the potential adoption of blockchain-based ID (identification) through Cardano in Ethiopa could radically accelerate the country's economic development, though the project faces backlash for its "crypto-colonial" nature. Less successful were attempts in El Salvado and Puerto Rico: the former has remained vastly in debt despite efforts to use Bitcoin to circumvent this, while the latter's attempt to use cryptocurrencies to reverse the damages of Hurricane Maria ultimately proved to be futile. This being said, the potential of DeFi platforms to promote greater financial inclusion within developing nations, thereby helping to decrease poverty in these nations, cannot be ignored.

• References:
  
  • Brekke, Jaya Klara and Wassim Zuhair Alsindi. Cryptoeconomics, Internet Policy Review 10.2, 2021.
    
  • Chris Berg, Sinclair Davidson, Jason Potts. Understanding the Blockchain Economy: An Introduction to Institutional Cryptoeconomics. Edward Elgar Publishing, 2019.
  • Jian Gong, Wei Xu. Cryptoeconomics: Igniting a New Era of Blockchain. CRC Press, 2020.
  • Ziyao Liu, et al. A Survey on Applications of Game Theory in Blockchain. IEEE, 2019.
  • Vitalik Buterin. The P + epsilon Attack. Ethereum Foundation Blog, 2015.
• See also:
  
  • FAQ: What are the goals of cryptoeconomics?
  • How [Cryptoeconomics] Works section of this web
  • Game Theory Blockchain Mechanisms Explained, Moralis Academy Blog.

The goals of cryptoeconomic systems include the following:

• Funding DeFi systems via cryptocurrencies, tokens, and other digital assets;

• Designing DeFi systems' that are reliable (fault tolerant) and cybersecure, using proven techniques and best practices of cryptography and computer science;

• Developing and implementing Defi systems that are based on sound designs* (see above), such as Decentralized Autonomous Organizations (DAO) and Decentralized Exchanges (DEX);

• Facilitating the operations of DeFi systems by applying rigorous software maintenance techniques and best practices; and

• Applying economic incentives and penalties to regulate the distribution of goods and services in emerging digital economies.

• See also:
  
  • FAQ: What is cryptoeconomics and how does it work?
  • How Cryptoeconomics Works section of this web

• Alt. Phrasing: What is Decentralized Finance (DeFi)?; What is Centralized Finance (CeFi)? How do DeFi and CeFi compare?*

• Defn: Decentralized Finance (DeFi)
  [compound noun: "decentralized" + "finance"]
  Decentralized Finance (DeFi) refers to a financial system that is not built on a centralized institution but on blockchains and/or smart contracts, which provide software programs with instructions on what to do under certain circumstances. As DeFi systems are built on smart contracts, the transaction processing that is traditionally done by different parties is instead done with code. Therefore, transactions should, if done correctly, be processed without involving any intermediaries (e.g. banks), and can be done without needing to make an account.

• Defn: Centralized Finance (CeFi)
  [compound noun: "centralized" + "finance"]
  Centralized Finance (CeFi) refers to a financial system that is built on a centralized institution, such as the Federal Reserve. CeFi is generally more secure than DeFi, since it is not anonymous and is processed by multiple different actors, but is therefore slower than DeFi. Additionally, funds are managed and controlled by the centralized institution the system was built around, meaning users do not have direct control over their money.

• Alt. Phrasing: What is crypto-macroeconomics?; What is crypto-microeconomics? What is macro-cryptoeconomics?; What is micro-cryptoeconomics?; How do crypto-macroeconomics and crypto-microeconomics compare?

In a manner similar to how traditional economics is divided into macroeconomics (regional, national, and international economics) and microeconomics (individual and enterprise economics) subdisciplines, cryptoeconomics can be divided into crypto-macreconomic and crypto-microeconomic subdisciplines as defined below:

• Defn: crypto-macroeconomics (DeFi)
  [compound noun: "cryptocurrency" + "macro" + "economics"]
  Crypto-macroeconomics is concerned with the regional, national and international regulation of cryptocurrencies and DeFi transactions.

• Defn: crypto-microeconomics (DeFi)
  [compound noun: "cryptocurrency" + "micro" + "economics"]
  Crypto-microeconomics is concerned with the individual and enterprise (business, corporate) usages of cryptocurrencies and DeFi transactions.

• Defn: tokenomics
  [portmanteau: noun "token" + noun "economics"]
  Tokenomics refers to the study of the economic properties of a particular cryptocurrency coin or token. These properties—including its distribution, supply, market capitalization, and token model—are generally discussed in the token project's whitepaper, and can be used to determine the value and potential future value of a particular token. The main aspects of tokenomics are further explained below:

Distribution - cryptocurrency tokens can be generated through either pre-mining or a fair launch. If tokens are pre-mined, this means that some tokens are distributed to an exclusive group (e.g. early investors and project members) before the token project is publicly launched. In contrast, a fair launch means that no early access to a token is given before it goes public. In most cases, some pre-allocation of tokens occurs before the project is publicly released, so it is essentially unavoidable. However, as a general rule, the more diversely a token is distributed at launch, the safer it is to invest in; if there are any whales, for example, there is a possibility that these wallets will sell all of their tokens at once and cause prices to drop substantially.

Supply - the supply of a token refers to its circulating supply, its total supply, and its maximum supply—in other words, the amount of usable tokens, the amount of both usable and unusable tokens, and the amount of tokens that can ever be minted. In the case of the maximum supply of tokens, some projects, especially those that operate under a proof-of-stake (PoS) consensus algorithm, have no maximum amount and can therefore be generated indefinitely. However, some tokens—such as Bitcoin, which has a maximum supply of 21 million—have a set amount that can ever exist, after which no new tokens can be generated. As with fiat currencies, if a large amount of tokens is being created at once, inflation may occur and resultingly lower that token's value.

Market capitalization (a.k.a. market cap) - refers to the total amount of investment in a cryptocurrency so far. Generally, the higher the market cap and the lower the total supply is for a particular cryptocurrency, the more valuable it is per coin or token. Additionally, the fully diluted market cap—the theoretical market cap if the maximum supply of a token is in circulation—can provide insight into the value of an individual token.

Token model - cryptocurrencies can either have inflationary or deflationary models—the former means that there is no maximum supply of that cryptocurrency, and the latter means that there is a maximum supply and that new coins or tokens will eventually stop being created. With the deflationary model, prices will increase over time as long as the demand for the cryptocurrency remains consistent. On the other hand, with the inflationary model, the opposite is true.

Of the 20K+ Decentralized Finance (DeFi) cryptocurrencies and tokens listed on CoinMarketCap.com, from a traditional Centralized Finance (CeFi) regulatory perspective (e.g., US Treasury, US SEC, US Federal Reserve) relatively few of them would qualify as traditional currencies. While the Group of Seven (G7) economic powers sort out the regulatory issues associated with classifying DeFi financial assets vs. CeFi financial assets, the following draft table indicates "work-in-progress"—there is yet no emerging consensus among the G7!

Bitcoin is often referred to as “digital gold” by its advocates, who maintain that bitcoin can provide a stable store-of-value, similar to gold, whose value is uncorrelated with more volatile financial assets, such as stocks. Bitcoin maximalists also see the cryptocurrency as a “safe haven” asset that can serve as a hedge against global economic uncertainty and inflation, which reduce the purchasing power of sovereign currencies (e.g., USD, EUR, GBP).

A Central Bank Digital Currency, or CBDC, is a form of digital currency that is issued by a central bank. The value of the CBDC is tethered to the country's fiat currency, so it is essentially the digital version of a country's fiat currency. CBDCs are centralized, unlike cryptocurrencies that run on a distributed ledger, meaning that they are issued by a Central Bank. However, because of this, the Central Bank would have the sole power to change the amount of money in any account at will; on the other hand, at least 51% of the users of a distributed ledger would need to be in agreement for this to occur with a decentralized currency.

Due to its centralization, however, CBDCs could be a more efficient and secure alternative to fiat currencies that can also more easily prevent illicit activity (due to the Central Bank's ability to keep track of the location of every unit of the CBDC, it would be more difficult to launder money or evade taxes, and it would be easier to detect criminal activity).