Many people see staking as an alternative to mining which requires technical knowledge. It is an activity where you don't have to own and look after complex equipment, but only store funds in a specific cryptocurrency wallet. This ensures the safety and smooth operation of a given blockchain network. Staking crypto is to put it simply, blocking cryptocurrencies, in order to receive awards and many benefits in the form of units of a given cryptocurrency. Most projects allow for staking of digital assets directly from a cryptocurrency portfolio. There are also exchanges that provide a staking service to users as part of their business offer. One such exchange is, for example, Binance. In order to fully understand staking wee need to understand how Proof of Stake (PoS) and Delegated Proof of Stake (DPoS) work.

What is Proof of Stake system (PoS)?

The Proof of Stake systemand staking crypto is a consensus mechanism which allows blockchains to save energy while maintaining proper decentralization. This consensus mechanism is designed to address the vulnerabilities and problems that exist in the Bitcoin network algorithm.

In the Bitcoin network, miners compete for who will be the fastest to solve a mathematical puzzle. The entity that is able to do so in the shortest time adds the block and receives remuneration in the form of BTC. The problem itself is related to the multiplicity of arbitrary calculations and the electricity required to do this, which is considered to be a major cost-negative.

It is worth stressing that there is a way to maintain network decentralization without incurring the high computing costs connected with solving puzzles. The solution is the Proof Stake, whose primary purpose is to validate blocks and use an "internal" investment (own cryptocurrency) instead of "external" investments (energy, crypto mining machines). Network users may “block” their coins. Afterwards, at different intervals, the protocol randomly assigns the right to approve the block to one of the users. The chance to be chosen doesn't depend on who creates a block or how quickly puzzles are solved. However, it depends on how many coins we are blocking. That is, the more wecapital we devote to this, the higher the chance we will be chosen. Another benefit of POS is that attacking a blockchain network is much more expensive because an effective attack would require owning at least 51% of all existing cryptocurrencies of a given blockchain. Of course, the cheaper and more accessible a given cryptocurrency is, the easier such an attack becomes. Hacking also has a greater impact on PoS management models than on PoW (proof of work). When a given network is hacked, miners lose more than just their cryptocurrency; they lose their place on the platform. This is a major problem that has led to the creation of the Delegated Proof of Stake (DPoS).

What is Delegated Proof of Stake (DPoS)?

Proof of Stake model also has an alternative option that was created in 2014 by Daniel Larimer. The method is referred to as Delegated Proof of Stake (DPoS). It was first tested as part of the BitShares blockchain, but shortly thereafter other networks started using this model as well.

The DPoS activity can be compared to shares held in a company. This method allows users to treat their cryptocurrency as votes whose force is proportional to their number. These votes are used to select delegates whose jobis to manage a blockchain on behalf of their constituents, which ensures consensus and security.

The strength of each stakeholder (cryptocurrency owner) is determined by the amount of cryptocurrency held. The advantage of the DPoS is, for example, that consensus can be reached with a small number of validation nodes. This improves overall network performance.

How does crypto staking work?

How does crypto staking works? Remember that the Proof of Stake model (PoS) and Delegated Proof of Stake (DPoS) algorithms require staking to function properly. Participants who block larger amounts increase the likelihood that they will be selected as the next validator in the block. This behavior allows blocks to be produced without the need for complex and expensive mining equipment, such as the ASIC system.

It should be noted that mining cryptocurrencies by means of ASIC systems requires large investments in equipment and that staking has only one requirement, which is investing in a given cryptocurrency and freezing one’s capital. Staking may at first glance remind you of depositing money in a bank, but in this case, frozen assets ensure that the blockchain network functions properly and interest is calculated in cryptocurrencies.

In addition, you should be aware that every PoS blockchain has a specific staking currency. There are networks that use a two-token system where prizes are paid out using a separate token (for example, you are freezing cryptocurrency "x", receiving the cryptocurrency "y" as a prize).

Staking rewards

How are rewards for cryptocurrency staking calculated? Several elements need to be analyzed in order to answer this question. Remember that a blockchain network is not uniform and therefore each part of it can use different methods for calculating rewards. Individual projects offer a variety of rewards. The factors that influence the rewards for staking are:

Time of active staking by validator
Amount of „frozen” coins
Inflation rate of assets
Total number of coins staked in the network

Interestingly, some networks reward staking using percentages. Such awards are given to validators as a form of compensation for inflation, which in turn encourages network users to spend coins rather than to store them. How much can You earn from this?

For example, staking of LUNA cryptocurrency offered users only 1,5% per year, and the pledged assets are subject to a 21-day unlock period. Another project that has generated greater interest was Cosmos (ATOM), which offered an annual return on investment of around 8%.

What is a staking pool?

The staking pool is a place where a group of individuals who possess given cryptocurrencies combine them with others to maximize the odds of being selected to review blocks and receive rewards funds (crypto holdings). Simply put, the staking pools are a place where group staking takes place. By combining stakes, users of a staking pool share rewards in proportion to their contribution.

Both knowledge and time are necessary to create and maintain a staking pool. Such mining pools are most effective in networks where the entry threshold is sufficiently high. With this in mind, many pool suppliers charge fees on the prizes that the participants receive. Let us remember that there is a safeguard – a minimum balance is always required and is set up to deter malicious stakers.

A significant part of the staking pool requires a low, minimum balance, but this often does not go hand in hand with the extra time in which we could cash out. As a result, joining a pool rather than ‘playing solo’ can be an very attractive solution for those who are just starting to become involved in this form of making money.

What is cold staking?

Cold staking is a process in a wallet that runs without Internet access, just like the ‘cold wallet’. When you stake crypto coins, they are frozen in your wallet. If your wallet is connected to a blockchain network, it is called a hot wallet because it is connected to the internet and becomes vulnerable to attacks. The cold staking process can be done by, i.e using a hardware wallet. It is interesting to note that you can get this effect when when using an air gap wallet. The average reward you can expect with this method is around 2%.

Networks that support "cold staking" provide the opportunity to stake crypto while ensuring that your funds are safely stored offline, howerver it should be noted that this pertains only to users working in cold staking mode. If the stakeholder transfers their assets from their wallet, the reward will automatically be waived. Cold staking is a beneficial method for big players who not only wish to focus on protecting their assets as much as possible, but also want to support the network.

Which cryptocurrencies can be staked?

At present, half of the thousands of cryptocurrencies are based on the Proof of stake algorithm. The most popular of these are listed below:

XLM
DASH
NOW
NEO
BNB
ADA
ALGO
DOT
XLM
CELO
BTS
TRON
PIVX
NEBL

The DPoS consensus algorithm was developed by Daniel Larimer and the main cryptocurrencies that are based on this technology are:

TRX,
LUNA
EOS,
XTZ
ICX
LISK
BAND

Given that blockchain and cryptocurrencies are an extremely original and diverse ecosystem, it should be noted that cryptocurrencies have a high potential to become a stable source of income. Staking is a cheaper and simpler method than mining and the staking pool makes the investment process even easier. For this reason, it is useful to know the above-mentioned terms.

Why is crypto staking worthwhile? Because thanks to it crypto investors can obtain particular digital asset. Moreover, crypto staking is also worth looking into, as it builds passive income. It is also worth noting that anyone can stake cryptocurrency and thus acquire potentially more lucrative staking rewards than any bank deposit can offer – and all that at a low minimum amount. Crypto staking is currently one of the most interesting financial solutions in the new technologies sector.

Applying Game Theory in Token Design

Kajetan Olas

16 Apr 2024

Blockchain technology allows for aligning incentives among network participants by rewarding desired behaviors with tokens.
But there is more to it than simply fostering cooperation. Game theory allows for designing incentive-machines that can't be turned-off and resemble artificial life.

Emergent Optimization

Game theory provides a robust framework for analyzing strategic interactions with mathematical models, which is particularly useful in blockchain environments where multiple stakeholders interact within a set of predefined rules. By applying this framework to token systems, developers can design systems that influence the emergent behaviors of network participants. This ensures the stability and effectiveness of the ecosystem.

Bonding Curves

Bonding curves are tool used in token design to manage the relationship between price and token supply predictably. Essentially, a bonding curve is a mathematical curve that defines the price of a token based on its supply. The more tokens that are bought, the higher the price climbs, and vice versa. This model incentivizes early adoption and can help stabilize a token’s economy over time.

For example, a bonding curve could be designed to slow down price increases after certain milestones are reached, thus preventing speculative bubbles and encouraging steadier, more organic growth.

The Case of Bitcoin

Bitcoin’s design incorporates game theory, most notably through its consensus mechanism of proof-of-work (PoW). Its reward function optimizes for security (hashrate) by optimizing for maximum electricity usage. Therefore, optimizing for its legitimate goal of being secure also inadvertently optimizes for corrupting natural environment. Another emergent outcome of PoW is the creation of mining pools, that increase centralization.

The Paperclip Maximizer and the dangers of blockchain economy

What’s the connection between AI from the story and decentralized economies? Blockchain-based incentive systems also can’t be turned off. This means that if we design an incentive system that optimizes towards a wrong objective, we might be unable to change it. Bitcoin critics argue that the PoW consensus mechanism optimizes toward destroying planet Earth.

Layer 2 Solutions

Layer 2 solutions are built on the understanding that the security provided by this core kernel of certainty can be used as an anchor. This anchor then supports additional economic mechanisms that operate off the blockchain, extending the utility of public blockchains like Ethereum. These mechanisms include state channels, sidechains, or plasma, each offering a way to conduct transactions off-chain while still being able to refer back to the anchored security of the main chain if necessary.

Conceptual Example of State Channels

State channels allow participants to perform numerous transactions off-chain, with the blockchain serving as a backstop in case of disputes or malfeasance.

Consider two players, Alice and Bob, who want to play a game of tic-tac-toe with stakes in Ethereum. The naive approach would be to interact directly with a smart contract for every move, which would be slow and costly. Instead, they can use a state channel for their game.

Opening the Channel: They start by deploying a "Judge" smart contract on Ethereum, which holds the 1 ETH wager. The contract knows the rules of the game and the identities of the players.
Playing the Game: Alice and Bob play the game off-chain by signing each move as transactions, which are exchanged directly between them but not broadcast to the blockchain. Each transaction includes a nonce to ensure moves are kept in order.
Closing the Channel: When the game ends, the final state (i.e., the sequence of moves) is sent to the Judge contract, which pays out the wager to the winner after confirming both parties agree on the outcome.

A threat stronger than the execution

If Bob tries to cheat by submitting an old state where he was winning, Alice can challenge this during a dispute period by submitting a newer signed state. The Judge contract can verify the authenticity and order of these states due to the nonces, ensuring the integrity of the game. Thus, the mere threat of execution (submitting the state to the blockchain and having the fraud exposed) secures the off-chain interactions.

Game Theory in Practice

Understanding the application of game theory within blockchain and token ecosystems requires a structured approach to analyzing how stakeholders interact, defining possible actions they can take, and understanding the causal relationships within the system. This structured analysis helps in creating effective strategies that ensure the system operates as intended.

Stakeholder Analysis

Identifying Stakeholders

The first step in applying game theory effectively is identifying all relevant stakeholders within the ecosystem. This includes direct participants such as users, miners, and developers but also external entities like regulators, potential attackers, and partner organizations. Understanding who the stakeholders are and what their interests and capabilities are is crucial for predicting how they might interact within the system.

_{Stakeholders in blockchain development for systems engineering}

Assessing Incentives and Capabilities

Each stakeholder has different motivations and resources at their disposal. For instance, miners are motivated by block rewards and transaction fees, while users seek fast, secure, and cheap transactions. Clearly defining these incentives helps in predicting how changes to the system’s rules and parameters might influence their behaviors.

Defining Action Space

Possible Actions

The action space encompasses all possible decisions or strategies stakeholders can employ in response to the ecosystem's dynamics. For example, a miner might choose to increase computational power, a user might decide to hold or sell tokens, and a developer might propose changes to the protocol.

Constraints and Opportunities

Understanding the constraints (such as economic costs, technological limitations, and regulatory frameworks) and opportunities (such as new technological advancements or changes in market demand) within which these actions take place is vital. This helps in modeling potential strategies stakeholders might adopt.

Causal Relationships Diagram

Mapping Interactions

Creating a diagram that represents the causal relationships between different actions and outcomes within the ecosystem can illuminate how complex interactions unfold. This diagram helps in identifying which variables influence others and how they do so, making it easier to predict the outcomes of certain actions.

Analyzing Impact

By examining the causal relationships, developers and system designers can identify critical leverage points where small changes could have significant impacts. This analysis is crucial for enhancing system stability and ensuring its efficiency.

Feedback Loops

Understanding feedback loops within a blockchain ecosystem is critical as they can significantly amplify or mitigate the effects of changes within the system. These loops can reinforce or counteract trends, leading to rapid growth or decline.

Reinforcing Loops

Reinforcing loops are feedback mechanisms that amplify the effects of a trend or action. For example, increased adoption of a blockchain platform can lead to more developers creating applications on it, which in turn leads to further adoption. This positive feedback loop can drive rapid growth and success.

Death Spiral

Conversely, a death spiral is a type of reinforcing loop that leads to negative outcomes. An example might be the increasing cost of transaction fees leading to decreased usage of the blockchain, which reduces the incentive for miners to secure the network, further decreasing system performance and user adoption. Identifying potential death spirals early is crucial for maintaining the ecosystem's health.

Conclusion

The fundamental advantage of token-based systems is being able to reward desired behavior. To capitalize on that possibility, token engineers put careful attention into optimization and designing incentives for long-term growth.

FAQ

What does game theory contribute to blockchain token design?
- Game theory optimizes blockchain ecosystems by structuring incentives that reward desired behavior.
How do bonding curves apply game theory to improve token economics?
- Bonding curves set token pricing that adjusts with supply changes, strategically incentivizing early purchases and penalizing speculation.
What benefits do Layer 2 solutions provide in the context of game theory?
- Layer 2 solutions leverage game theory, by creating systems where the threat of reporting fraudulent behavior ensures honest participation.

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Token Engineering Process

Kajetan Olas

13 Apr 2024

Token Engineering is an emerging field that addresses the systematic design and engineering of blockchain-based tokens. It applies rigorous mathematical methods from the Complex Systems Engineering discipline to tokenomics design.

In this article, we will walk through the Token Engineering Process and break it down into three key stages. Discovery Phase, Design Phase, and Deployment Phase.

Table of Contents

Discovery Phase of Token Engineering Process
Design Phase of Token Engineering Process
- Objective Function
Deployment Phase of Token Engineering Process
Time Duration
Required Skills for Token Engineering
Summary
FAQ

Discovery Phase of Token Engineering Process

The first stage of the token engineering process is the Discovery Phase. It focuses on constructing high-level business plans, defining objectives, and identifying problems to be solved. That phase is also the time when token engineers first define key stakeholders in the project.

Defining the Problem

This may seem counterintuitive. Why would we start with the problem when designing tokenomics? Shouldn’t we start with more down-to-earth matters like token supply? The answer is No. Tokens are a medium for creating and exchanging value within a project’s ecosystem. Since crypto projects draw their value from solving problems that can’t be solved through TradFi mechanisms, their tokenomics should reflect that.

The industry standard, developed by McKinsey & Co. and adapted to token engineering purposes by Outlier Ventures, is structuring the problem through a logic tree, following MECE.
MECE stands for Mutually Exclusive, Collectively Exhaustive. Mutually Exclusive means that problems in the tree should not overlap. Collectively Exhaustive means that the tree should cover all issues.

In practice, the “Problem” should be replaced by a whole problem statement worksheet. The same will hold for some of the boxes.
A commonly used tool for designing these kinds of diagrams is the Miro whiteboard.

Identifying Stakeholders and Value Flows in Token Engineering

This part is about identifying all relevant actors in the ecosystem and how value flows between them. To illustrate what we mean let’s consider an example of NFT marketplace. In its case, relevant actors might be sellers, buyers, NFT creators, and a marketplace owner. Possible value flow when conducting a transaction might be: buyer gets rid of his tokens, seller gets some of them, marketplace owner gets some of them as fees, and NFT creators get some of them as royalties.

Incentive Mechanisms Canvas

The last part of what we consider to be in the Discovery Phase is filling the Incentive Mechanisms Canvas. After successfully identifying value flows in the previous stage, token engineers search for frictions to desired behaviors and point out the undesired behaviors. For example, friction to activity on an NFT marketplace might be respecting royalty fees by marketplace owners since it reduces value flowing to the seller.

_{source: https://www.canva.com/design/DAFDTNKsIJs/8Ky9EoJJI7p98qKLIu2XNw/view#7}

Design Phase of Token Engineering Process

The second stage of the Token Engineering Process is the Design Phase in which you make use of high-level descriptions from the previous step to come up with a specific design of the project. This will include everything that can be usually found in crypto whitepapers (e.g. governance mechanisms, incentive mechanisms, token supply, etc). After finishing the design, token engineers should represent the whole value flow and transactional logic on detailed visual diagrams. These diagrams will be a basis for creating mathematical models in the Deployment Phase.

Token Engineering Artonomous Design Diagram — _{Artonomous design diagram, source: Artonomous GitHub}

Objective Function

Every crypto project has some objective. The objective can consist of many goals, such as decentralization or token price. The objective function is a mathematical function assigning weights to different factors that influence the main objective in the order of their importance. This function will be a reference for machine learning algorithms in the next steps. They will try to find quantitative parameters (e.g. network fees) that maximize the output of this function.
Modified Metcalfe’s Law can serve as an inspiration during that step. It’s a framework for valuing crypto projects, but we believe that after adjustments it can also be used in this context.

Deployment Phase of Token Engineering Process

The Deployment Phase is final, but also the most demanding step in the process. It involves the implementation of machine learning algorithms that test our assumptions and optimize quantitative parameters. Token Engineering draws from Nassim Taleb’s concept of Antifragility and extensively uses feedback loops to make a system that gains from arising shocks.

Agent-based Modelling

In agent-based modeling, we describe a set of behaviors and goals displayed by each agent participating in the system (this is why previous steps focused so much on describing stakeholders). Each agent is controlled by an autonomous AI and continuously optimizes his strategy. He learns from his experience and can mimic the behavior of other agents if he finds it effective (Reinforced Learning). This approach allows for mimicking real users, who adapt their strategies with time. An example adaptive agent would be a cryptocurrency trader, who changes his trading strategy in response to experiencing a loss of money.

Monte Carlo Simulations

Token Engineers use the Monte Carlo method to simulate the consequences of various possible interactions while taking into account the probability of their occurrence. By running a large number of simulations it’s possible to stress-test the project in multiple scenarios and identify emergent risks.

Testnet Deployment

If possible, it's highly beneficial for projects to extend the testing phase even further by letting real users use the network. Idea is the same as in agent-based testing - continuous optimization based on provided metrics. Furthermore, in case the project considers airdropping its tokens, giving them to early users is a great strategy. Even though part of the activity will be disingenuine and airdrop-oriented, such strategy still works better than most.

Time Duration

Token engineering process may take from as little as 2 weeks to as much as 5 months. It depends on the project category (Layer 1 protocol will require more time, than a simple DApp), and security requirements. For example, a bank issuing its digital token will have a very low risk tolerance.

Required Skills for Token Engineering

Token engineering is a multidisciplinary field and requires a great amount of specialized knowledge. Key knowledge areas are:

Systems Engineering
Machine Learning
Market Research
Capital Markets
Current trends in Web3
Blockchain Engineering
Statistics

Summary

The token engineering process consists of 3 steps: Discovery Phase, Design Phase, and Deployment Phase. It’s utilized mostly by established blockchain projects, and financial institutions like the International Monetary Fund. Even though it’s a very resource-consuming process, we believe it’s worth it. Projects that went through scrupulous design and testing before launch are much more likely to receive VC funding and be in the 10% of crypto projects that survive the bear market. Going through that process also has a symbolic meaning - it shows that the project is long-term oriented.

If you're looking to create a robust tokenomics model and go through institutional-grade testing please reach out to contact@nextrope.com. Our team is ready to help you with the token engineering process and ensure your project’s resilience in the long term.

FAQ

What does token engineering process look like?

Token engineering process is conducted in a 3-step methodical fashion. This includes Discovery Phase, Design Phase, and Deployment Phase. Each of these stages should be tailored to the specific needs of a project.

Is token engineering meant only for big projects?

We recommend that even small projects go through a simplified design and optimization process. This increases community's trust and makes sure that the tokenomics doesn't have any obvious flaws.

How long does the token engineering process take?

It depends on the project and may range from 2 weeks to 5 months.