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By Zain Jaffer
Over the past few years, much has been said about blockchains and crypto, and how these will revolutionize the financial sector if they become widely adopted. Less discussed however is how economic security protects these things.
Essentially, blockchains and crypto are a way to do financial transactions (or other types of transactions) without the need for a third-party intermediary run by people. These third parties could be banks, wirehouses, law firms or lawyers, and others that facilitate transactions especially when the two parties are not face-to-face.Â
When two parties (e.g. people) are face to face, such as for a personal payment, the buyer simply gives the money to the seller. Human third parties generally come in when these two cannot be face to face, such as if they live in different towns, cities, or countries. While you can pay the cashier directly for your coffee, you cannot do the same without a third-party trusted intermediary if the cashier or seller is some distance from you.
Until blockchains arrived. Public blockchains are synchronized ledgers of transactions generally run by different parties. Different parties keep synchronized copies of updated transaction ledgers and are incentivized to do the right thing, or else they may get kicked out of the system.Â
One desirable property of a blockchain is decentralization. It is the opposite of a monopoly, where an entire network could be run by one person or corporation. A decentralized blockchain is more akin to a network run by a community, where there are financial incentives for each independent operator not to engage in fraud or illegal activity.
The blockchain is there to replace that human third-party intermediary. Instead, automated software programs called smart contracts ensure that payment is remitted when conditions are met by the buyer or person making the payment. Likewise, if the intended recipient has fulfilled the criteria set forth, the payment must be made.
How exactly does economic security play a part?
First of all, there are always people with malicious intent to defraud the system. These criminals could be cyberthieves, scammers, fraudsters, and the like. In computer science, there is something called Byzantine fault tolerance, which measures how much the system is immune to some of its participant servers getting hacked.
One example is if Bob pays Susan $100, and their blockchain wallet transactions and balance reflect this. If Bob’s balance becomes zero, obviously he cannot pay Cathy another $100, because he already spent or paid his initial $100 balance. That is an example of the double spending problem that blockchains solve and was actually the main hurdle that Bitcoin had to fix before it could work. Prior attempts at electronic money could not solve this issue.
If all (or a majority) of the participating validator node servers get hacked, then the entire network is hacked. Generally, if 51% of the blockchain network validators are hacked, the system becomes compromised. Anything less than 51% can be dealt with because the assumption is that the majority of the servers are only approving legitimate transactions. This is where economic security comes in to secure the network.
Economic security in a blockchain, particularly in what’s called Proof of Stake (PoS) blockchains like Ethereum, asks the node validator operators to stake something of value that can be forfeited if they participate in illegal activity. This works somewhat like a returnable bond which might get forfeited if you violate the terms of an agreement, such as a construction bond.Â
In the case of Ethereum, the independent node validator operators agree to operate the common software and stake 32 ETH, which is worth a lot of money. This amount gets slashed if they cannot operate their node validator correctly. The economic security of staking then acts as a behavior influence, since no one wants to lose money especially if they are making money from transactions paid to their validator.
Bitcoin operates differently because it runs on Proof of Work (PoW). However, if a node cannot approve a transaction properly, it will not get any Bitcoin from the system. So Bitcoin farm operators know this and they are incentivized to keep their systems running properly.
In PoW, the miners earn Bitcoin (or some other PoW crypto) in exchange for the work they do. Normally they want to keep their right to mine since they are earning a good amount, so this disincentivizes them from doing anything illegal or fraudulent.
Economic security is not the only thing that secures a blockchain. There can be technological fixes as well. However, the incentive not to lose money and to continue making money from blockchain transactions appears to be effective in securing these chains from hackers and other criminals.
Author Bio
Zain Jaffer is an accomplished entrepreneur and investor, actively involved in a range of investments including real estate, technology start-ups, private equity, and digital assets through his family office, Zain Ventures. He also supports underrepresented causes and underserved communities through the Zain Jaffer Foundation.
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Disclaimer
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