The History of Cryptoeconomics
Key Takeaways
Cryptoeconomics began with Bitcoin and its unique design in 2009 but has roots in earlier developments.
Ethereum's 2015 launch was a turning point for the field. It enabled more complex systems and applications, broadening cryptoeconomics beyond digital money.
The DAO hack (2016) and Bitcoin's scaling debate (2015-17) highlighted critical challenges in governance and security, shaping the field's development.
The 2016-2018 ICO boom exposed issues in token design and regulation, leading to a market downturn and a shift towards equity fundraising.
Recent DeFi experimentation has explored new models for tokens and governance, but incidents like Terra Luna's collapse (2022) underscore ongoing challenges in designing robust systems.
Introduction
In 2009, a truly novel idea, intersecting economics and technology, was introduced. This transformation was not initiated by academics, governments, or financial institutions but rather through the introduction of the Bitcoin whitepaper and its accompanying codebase, authored by a figure known as Satoshi Nakamoto. Bitcoin's launch marked the inception of what is now recognised as cryptoeconomics, a field that has continuously evolved since its foundation. The publication of the Bitcoin whitepaper was a pivotal moment that would result in the reevaluation of existing notions about financial instruments, societal organisation, and distributed economic cooperation.
So far, this series has made the case for why cryptoeconomics' development profoundly matters to civilisation and society at large and defined it as a field in a two-part article here and here. The development of cryptoeconomics is crucial because it enables new forms of digital cooperation and value transfer that could reshape economic and social structures. As lofty as such discourse is, it is important to ground the discipline in its history so we can understand how it has developed the way it has, how it came to be where it is today, and perhaps most importantly, what challenges remain unanswered and where we hope the field can progress over the next five years and more.
This article provides an analytical overview of the development of cryptoeconomics, from the release of that seminal Bitcoin whitepaper to its current state. It highlights critical milestones in the field's evolution, including the prehistory of cryptoeconomics, the launch of smart contract platforms, key events like The DAO hack and Bitcoin's scaling debate, the ICO era, DeFi experimentation, and the Terra Luna collapse. Complemented by two subsequent articles, it examines the industry's current state, addressing the unresolved challenges and potential avenues for progression. We acknowledge, however, that no historical account can be entirely comprehensive, and certain events and themes are excluded from this narrative primarily to maintain clarity and conciseness.
Prehistory & Genesis
A historian can often trace the beginnings of an era ever further back, and the same is true for cryptoeconomics. While the discipline was born with Bitcoin's particular technological and economic design, critical foundational breakthroughs in the preceding decades proved essential to its success. Understanding this prehistory is important for appreciating the fields from which cryptoeconomics draws and continues to be influenced.
Although a thorough historical account is beyond the scope of this article, the following key developments warrant recognition:
Public-Key Cryptography (1970s): This innovation enabled secure communication without a trusted channel for key exchange, laying the groundwork for trustless transactions within distributed systems. [Further Reading]
David Chaum & DigiCash (1980s-90s): An early deployment of cryptographically-secured digital currency, DigiCash was limited by its centralised reliance on a trusted third party. [Further Reading]
Cypherpunk mailing list (late 1980s-90s): This mailing list fostered a community focused on achieving privacy and decentralisation through cryptography, the ideological underpinning of Bitcoin. [Further Reading]
Hashcash (1997): An email anti-spam mechanism that popularised proof of work, influential in Bitcoin's design. [Further Reading]
b-money (1998): Early pseudonymous, decentralised currency concept by Wei Dai that never launched. [Further Reading]
Bit Gold (1998): Nick Szabo's theoretical digital currency, emphasising decentralisation. [Further Reading]
RPOW (2004): Introduced by Hal Finney, this system facilitated the exchange of proof of work tokens, later influencing Bitcoin's security and verification methods. [Further Reading]
While these developments were crucial, it was Satoshi Nakamoto's synthesis of these concepts into the unique technological and economic design of Bitcoin, as detailed in the whitepaper and initial software release in 2008, that marked the true beginning of cryptoeconomics. Bitcoin stood apart from its predecessors not only by solving the double-spend problem without centralised control but also by introducing a robust cryptoeconomic incentive system. Bitcoin combined proof of work mining with economic rewards, simultaneously securing the network and incentivising participation. Miners contribute computational power to validate transactions and create new blocks, receiving newly minted bitcoins and transaction fees as rewards. This alignment of incentives with network security and transaction processing set Bitcoin apart from earlier efforts.
Bitcoin's breakthrough set the stage for a new era of cryptoeconomic innovation as others began to explore how blockchain technology and incentive structures could be applied to more complex challenges beyond simple value transfer, leading to the next major developments in the field.
Development and Launch of Smart Contract Platforms
In the years following Bitcoin's launch, there was a growing recognition of blockchain technology's potential beyond facilitating monetary transfers. It became increasingly evident that blockchain systems could reach consensus on more complex logic, enabling a wider range of applications that required moving beyond Bitcoin's simple transfer functionality. Early attempts at achieving this goal came in the form of two tokenisation systems built on Bitcoin: the Omni Layer (2012-13), formerly Mastercoin, and Coloured Coins (2012-13). The latter, initially proposed by eToro CEO Yoni Assia in March 2012, aimed to allow Bitcoin to represent off-chain assets and support non-fungible tokens (NFTs), as outlined in the Coloured Coins whitepaper co-authored by Assia and Vitalik Buterin, among others.
Ultimately, Coloured Coins failed to gain significant traction. Recognising the need for a blockchain with more expansive capabilities, Vitalik Buterin and several others launched Ethereum in July 2015, a blockchain designed to support a much broader set of decentralised applications (dApps). Around the same time and in the following years, other smart contract platforms, such as Cosmos, Polkadot, and Cardano, emerged, each with their own approach to enabling distributed economic systems and applications. Ethereum's launch, in particular, marked a turning point for cryptoeconomics, ushering in a new era of possibilities for the field.
If cryptoeconomics was born by Bitcoin, it had its inflexion point in the immediate months and years following Ethereum's launch. Ethereum enabled the creation of cryptoeconomic systems without the necessity of creating an underlying blockchain each time. The clearest example of this was the ability to issue tokens as versatile, programmable assets that could support applications. Unlike its precursors, it allowed for intricate logic and interactions within its ecosystem, supported by standards such as ERC20, enhancing interoperability and broadening the scope of possible applications and digital representations on the blockchain. This evolution marked a significant leap in the complexity and utility of cryptoeconomics. It would lead to the development of financial protocols, NFT markets, decentralised autonomous organisations (DAOs), and other economic systems. This turning point marked the shift of cryptoeconomics from a field narrowly focused on Internet-native money to one encompassing a broad range of systems.
The DAO
The DAO, launched in May 2016, marked an attempt to create a decentralised, automated investment fund without the need for centralised control. It enabled participants to exchange ETH for DAO tokens, granting them voting rights proportional to their holdings. At one point the DAO contained nearly 15% of all circulating ETH. However, just one month after its launch, in June 2016, it suffered a catastrophic hack due to vulnerabilities in its smart contract code, resulting in the theft of a significant portion of its funds.
This incident not only exposed the technical challenges, security risks, and economic implications inherent in smart contract design but also ignited a heated debate about governance and decision-making in decentralised systems. The Ethereum community was faced with a dilemma: adhere to the principle of blockchain immutability or intervene to recover the stolen funds and reimburse affected investors. This situation raised fundamental questions about the nature of blockchains, the effectiveness of token-based voting systems, the risks of token concentration, the challenges of informed decision-making for token holders, and the use of forking as a dispute resolution mechanism.
Ultimately, the Ethereum community opted for a hard fork, essentially creating two distinct blockchains: Ethereum, which implemented the fork to reverse the hack, and Ethereum Classic, which maintained the original, unaltered chain. This controversial decision highlighted the tension between the principle of immutability and the perceived need for intervention in exceptional circumstances.
The DAO's collapse had far-reaching consequences for the industry. It underscored the need for more robust smart contract auditing, better governance mechanisms, and increased awareness of the potential risks associated with decentralised systems. It also sparked ongoing discussions about the role of immutability and the social consensus layer in blockchain networks.
Despite its ultimate failure, The DAO's fundamental concept of decentralised, incentive-aligned organisations remains relevant and promising. As trust in centralised systems and institutions continues to erode, the underlying principles behind The DAO continue to inspire experimentation and innovation with decentralised governance in the context of cryptoeconomic systems.
Bitcoin Block Size Wars
Concurrently with Ethereum's swift response to the DAO crisis, Bitcoin was navigating its own governance challenges. While Ethereum's predicament demanded immediate action, Bitcoin's dilemma evolved more gradually, stemming from a fundamental debate over its future design.
The 'Block Size Wars' arose from differing views among Bitcoin participants and stakeholders regarding the optimal maximum size for Bitcoin's blocks, which directly impacts transaction throughput and fees. Satoshi had implemented a 1 MB block limit in 2010. As Bitcoin's popularity grew, this limit led to increased transaction fees and slower transaction times, raising concerns about Bitcoin's scalability and usability as a digital currency. Some advocated for increasing the limit, while others proposed maintaining it and, instead, implementing SegWit and focusing on layer two systems such as the Lightning Network.
At its core, the debate reflected a philosophical divide over how to advance Bitcoin as a monetary system. Proponents of the 1 MB limit argued it was essential for maintaining decentralisation and censorship resistance, while the opposition believed increasing the limit was necessary to preserve Bitcoin's utility for payments. This tension, among other frictions, underscored the tradeoff between Bitcoin's role as a store of value versus a medium of exchange.
The contention peaked in 2017 with the introduction of SegWit via a user-activated soft fork (UASF). Perceiving this as a final rejection of a block size increase, a group triggered a hard fork, creating Bitcoin Cash (BCH) with an increased block size limit.
This episode resulted in an ossification of the Bitcoin system and arguably greater consensus regarding its design priorities. It demonstrated the powerful influence of social dynamics and prevailing philosophies in shaping the evolution of cryptoeconomic systems, often outweighing purely economic or technical considerations. Furthermore, it highlighted the challenges of managing stakeholder tensions in a decentralised environment and the potential tradeoffs of less formalised governance structures.
Although the Block Size Wars ostensibly concluded in 2017, the core questions it raised about Bitcoin's identity and trajectory continued to shape its development in the ensuing years, cementing its primary value proposition as a store of value and censorship-resistant monetary system.
ICO Era
As the Bitcoin community was navigating the complexities of the Block Size Wars, another important cryptoeconomic trend was emerging in what would become known as the ‘ICO era’. The ICO era marked a particular phase in the development of token allocation and distribution practices, preceded by a period mostly characterised by 'fair launches' and 'pre-mines'. Assigning precise dates to this period is challenging since a small number of token sales took place earlier, but it generally spanned the period of early 2016, with the DAO token sale, to late 2018.
Although tokens offered a rich array of economic design options for product owners, the simplest and most immediately rewarding path was to issue tokens before a product existed and, in some cases, before one had even been theorised. Despite the term 'utility token' entering industry parlance around this time, far too many of these instruments lacked meaningful utility, purpose or value, with issuers instead using them as placeholders for which they could raise capital in the short term and determine their design later. If a token did confer some utility, it was usually in the form of payments, whereby users would be expected to pay for the system's service with the native token or receive some benefit, such as a discount for doing so; a utility that rarely makes sense in early stage projects where little to no network effect exists and users face significant friction acquiring and spending the token, versus fiat currency or a more common token, such as ETH or a stablecoin.
While prior token allocation and distribution decisions had centred around the aforementioned 'fair launches' and 'pre mines', whereby participants would have to mine a blockchain's native token via a proof of work mechanism, the ICO era was characterised by tokens issued on top of Ethereum. This meant that token issuers could exchange their tokens, minted via a token generation event, for another token or currency, typically ETH. The programmability of Ethereum, in tandem with broadly adopted and easy-to-adopt token standards such as ERC20, made token generation exceptionally easy, reducing the barrier considerably relative to prior sale mechanisms.
This period entered a hyperbolic phase in late 2017 and mid-2018, with several multi-billion dollar raises. However, as 2018 progressed, capital began withdrawing from the market. This exodus was not merely a reaction to the profits reaped but also a consequence of broader macroeconomic factors and a realisation that price action had diverged from the fundamental growth of the respective projects. This withdrawal led to the remaining capital moving between sale events against a backdrop of overall deflation in the market's capitalisation and a clear bear market taking effect in the latter half of the year. By this point, those who had participated in many of these sales realised they held instruments with little reason to exist and source of value accrual, in turn leading to broad dissatisfaction, which, combined with scandals, helped contribute to heightened regulatory scrutiny and significant cooling in sales and token issuance. Instead of introspection and working towards improved token design, though, the industry largely pivoted to focusing on equity raises.
The ICO era marked a particular phase in the development of token issuance practices, preceded by the previously discussed period of ‘fair launches’ and ‘pre-mines’. Since the ICO period, practices have continued to evolve. For a more detailed account of token issuance developments, please see here.
DeFi Cryptoeconomic Experimentation
The fallout of the ICO era was rather severe and certainly contributed to the extent of the resulting bear market from 2018 to early 2020. Cryptoeconomic innovation in these years was relatively thin. It was not until early 2020, near the bottom of the market cycle, that a period of cryptoeconomic experimentation began, born out of the DeFi sector. In February, the lending and borrowing project Compound announced a new governance system that heavily relied on its native token, COMP. This system allowed holders to vote directly on decisions while also supporting delegation. Notably, the announcement explicitly stated COMP was not a fundraising or investment vehicle, aiming to address some of the criticisms of prior token models.
However, it was Compound's approach to token rewards that garnered significant attention. Departing from industry norms, COMP was awarded to both lenders and borrowers, not just supply-side participants, as seen in proof of work and proof of stake-based systems. This aimed to foster a balanced ecosystem where all active participants were incentivised and marked a significant shift in reward and distribution strategies.
Compound's experimentation led to an increase in the system’s asset base (TVL) and usage, inspiring other DeFi projects to follow suit. However, many encountered two primary challenges in sustaining this adoption. The first was the limited utility and rights associated with these newly minted tokens, which, combined with high emission rates, resulted in insufficient market demand to absorb the newly minted tokens without significant price declines. Consequently, maintaining high emission rates became unsustainable, especially as token prices fell. In cases where projects persisted with high emission rates, the net reward for recipients diminished proportionally with the token's declining value, undermining the strategy's effectiveness. Secondly, projects struggled to motivate new token holders to actively engage in governance, with voter apathy proving a stubborn obstacle.
Moreover, the liquidity farming concept risked concentrating token ownership, as wealthier participants could outearn smaller ones, which was problematic for projects aiming to decentralise their governance.
To address these issues, projects began introducing mechanisms like time-locked rewards and vote-escrowing to encourage long-term engagement and mitigate voter apathy and disproportionate wealth accumulation.
EIP-1559
As DeFi projects experimented with token design, typically iterating quickly, Ethereum, upon which most of these projects were operating, faced its own economic redesign. Its core model had been relatively similar to Bitcoin, with miners generating new ETH through the proof of work process and ETH used for network payments, functioning as a general-purpose currency, including by projects for fundraising through token sales. Ethereum also had a bidding-based gas market where participants would bid to have their transactions processed, which could lead to rapidly spiking and unpredictable gas fees when network activity was high.
EIP-1559, first proposed in April 2019 and activated in August 2021, aimed to address this unpredictability. It implemented an algorithmically adjusted base fee based on the previous block's gas usage, with users having the option to include a priority fee. Instead of accruing to miners, the base fee, expected to be the majority of the total, would be burned, introducing a deflationary mechanism to improve ETH's value accrual, while miners would receive the priority fee.
This change, arguably the most significant 'hot-swap' to a major system's cryptoeconomic design at the time, took years to implement following extensive debate and testing, given Ethereum's complexity and the importance of stability for its ecosystem. It inspired similar changes in other blockchains and sparked broader discussions about token value accrual without compromising system utility, highlighting the challenges and tradeoffs in modifying live systems.
Terra Luna - A Parable
In May 2022, the Terra Luna ecosystem, known for its algorithmic stablecoin UST, experienced a catastrophic collapse that had a major impact on the industry. Terra had created UST to maintain a peg to the US Dollar through a mechanism involving its native token, LUNA. If UST's price fell below $1.00, participants could profit by buying UST at a discount and burning it to mint $1.00 worth of LUNA. Conversely, if UST's price rose above $1.00, users could burn $1.00 worth of LUNA to mint more than $1.00 of UST. This mechanism was supposed to ensure UST's price stability.
However, when extreme market conditions and a loss of confidence in the system coincided, a vicious cycle took hold. As UST began to lose its peg, participants panicked and sold, flooding the market with newly minted LUNA. The oversupply caused LUNA's price to plummet, further eroding faith in the ecosystem. Despite being partially collateralised with BTC in the latter part of its existence, this was insufficient to effectively backstop the system due to BTC’s high correlation with the rest of the market.
The incident wiped out billions in value and had severe second-order effects on systems and businesses that depended on LUNA and UST. It highlighted the need for robust risk analysis and a better understanding of contagion risks arising from cross-system dependencies in cryptoeconomic systems. The collapse also raised questions about the viability of algorithmic stablecoins.
As the dust settled, the Terra Luna debacle served as a cautionary tale, emphasising the need for more rigorous stress testing and risk management in the industry. It demonstrated that even seemingly stable systems can unravel quickly under the right circumstances and that the industry still has much to learn about building resilient, antifragile systems that can withstand extreme market conditions.
Terra’s collapse would ultimately foreshadow, if not precipitate, another bear market, with yet again similar effects to that of the ICO Era, with regulatory scrutiny and action increasing, and token issuance declining, as well as arethguably a retreat with cryptoeconomic experimentation and innovation.
Conclusion
This article traces the evolution of cryptoeconomics from its inception with Bitcoin to its current state, highlighting key periods of experimentation. While these periods have at times contributed to market volatility and industry cycles, such as with Terra Luna, they have also been responsible for shaping many of today's industry practices. However, the discipline has suffered from insufficient collaboration between designers, inadequate testing of ideas and mechanisms, and a lack of incorporation of learnings from established related fields, including economic theories and governance practices.
The next article will provide a detailed analysis of the current state of cryptoeconomics, identifying its most critical deficiencies and areas for improvement. The final piece in this introductory series will offer a forward-looking perspective on the field's development and how it can be shaped to create a more robust and sustainable future for the industry.
