How economics applies to cryptocurrency
Humans dominate the animal kingdom because of our ability to meme. Our culture allows us to cooperate and do awesome human stuff while dogs just smell each other (bless their hearts). To form a cohesive culture, people use meme networks to share ideas about what is true and good in the world. These ideas about the human experience can help large groups of people achieve a common goal.
Memes enjoy network effects — as more people “like” a meme, its underlying idea grows stronger. But which ideas should become established cultural beliefs? It’s very rare that an idea about what is true and good pleases everybody.
Traditionally, people rely on a central authority like a king or priest to dictate culture. And while a centralized network like this is extremely efficient, it’s not very resilient. A corrupt king can destroy the kingdom. Since a single entity manages all activity on the network, they represent a single point of failure, as the operation of the network depends on them. Because of this, traditional client-server networks (Facebook, Google, central banking, etc) can fail due to hacks, corruption, or plain incompetence.
Cryptocurrency protocols like Bitcoin don’t rely on a single party to operate; they use built-in rules to manage the network. The rules allow users to transfer digital bits of data to other people on the network, but block (make highly infeasible) actions like counterfeiting and stealing.
Cryptoeconomics describes how economic principles apply to peer-to-peer networks. It is an inquiry into the rules that govern cryptocurrencies, allowing people to transact without needing to trust a third party or even each other.
Let’s begin with a classic: The Prisoner’s Dilemma. Two detained criminals are in custody for a drug bust. They are kept separate and brought into the interrogation room one at a time. Each prisoner can either testify against the supplier or deny guilt. The Police Chief explains the rules: If a criminal denies and his partner testifies, then the dissenter serves ten years in prison while the compliant criminal is free to go. If both testify, then they each serve six years in prison. If both deny, then they can only be charged with misdemeanors and each serves one year in prison.
What would you do? Game theory explores how and why people make decisions under certain constraints.
This chart, called a payoff matrix, shows each strategy’s payoff for both players — given the other’s strategy. Criminal 1 anxiously considers his options: “If Criminal 2 testifies (left column), then I can either testify and serve six years or deny and serve ten years. If Criminal 2 denies (right column), then I can either testify and go free or deny and serve one year.” In both cases, Criminal 1 is better off testifying against the supplier (blue circles). The same logic applies to Criminal 2 (green circles). The convergence of these dominant strategies is called the Nash Equilibrium (top left).
Notice that the Nash Equilibrium, in this case, is not the best outcome for both parties. The criminals in custody could have dissented and each only serve one year instead of six (bottom right). A rational criminal should choose to testify, but the criminal could just as easily make an emotional decision and deny guilt to achieve an optimal outcome. In the Prisoners Dilemma, the optimal outcome is detrimental to society as the criminals avoid conviction.
Let’s see how game theory applies to the strategy of miners. In Bitcoin, there are two types of nodes: users and miners. Users can submit transactions to the network. Miners then choose which transactions to add to the blockchain. They effectively manage the ledger. But, how can we ensure that they only add valid transactions (no double spends, counterfeits, or theft) and mine on valid blocks? Why would I trust random computer geeks to manage my money?
The miners’ incentives are aligned with the integrity of the network. Bitcoin currently rewards a miner 12.5 BTC (>$125,000) plus transaction fees for solving the hash puzzle to add a new block of transactions to the chain. This requires an immense amount of work. And, these rewards are only spendable if other miners choose to mine on top of that block. By mining on top of a certain block, a miner expresses his approval of that block’s transactions and puzzle solution by including it in the ledger. Each block tacked on is another layer of confirmation on that block’s validity. Ultimately, a miner’s revenue depends on the approval of the network. Bitcoin ensures that the most profitable strategy for miners is to act honestly.
Users also keep miners in check. Full nodes can refuse to update their ledger or relay blocks and transactions if they don’t appear valid. Because of this, a miner must achieve consensus from users to get rewarded too. A robust consensus is possible with a large participation of full nodes — the users and direct stakeholders of the currency. Anyone can participate in this consensus process by downloading a copy of the blockchain and joining the network.
Finally, unlike in the Prisoner’s Dilemma, the Nash Equilibrium and optimal outcome for Bitcoin miners coincide, strongly reinforcing the goal of the network — a valid sequence of transactions.
Imagine I place you and a friend in separate rooms and show both of you this panel of squares:
I say, “Pick a square. If both of you choose the same square, you’ll each receive $100.” Which square would you pick? Most people will choose the red square since it seems special relative to the other blue squares. A Schelling Point is defined as a solution people tend to use in the absence of information because it seems natural, special, or relevant to them.
Without a central authority, nodes need a way to agree on the current state of the ledger at any point in time. A fork in the chain introduces two competing versions of the truth — different and parallel transaction histories. So why do Bitcoin users only assign value to the longest chain, rather than other branches? After all, this is what discourages miners from deviating from the rules and earning fraudulent rewards.
The longest chain, or main chain, is the version of the ledger with the most amount of “work” securing it. Miners have sacrificed the most amount of hash power (and have risked the most block rewards) attesting to that version of the ledger. The longest chain acts as a Schelling Point for users. It’s a focal point that seems the most natural sequence of transactions to adhere to, especially considering the choices of others.
Finally, money is a tool we use to communicate value. And communication tends to be a winner-take-all market. Think English, TCP/IP Internet, Facebook, and the US dollar. At some point, it becomes easier to just say “soda”, instead of trying to convince everyone it’s “pop”. The more people are using a communication protocol, the more valuable it becomes. Since money inherits these deep network effects, the popularity of Bitcoin strengthens its legacy as the Schelling Point of the cryptocurrency market.
Imagine an ancient kingdom ruled by a king through divine right. Noble dissenters choose to cooperate with the king’s rule, not because they believe in the divinity of the king, but because they are in a Grim Trigger equilibrium. They realize the king is mortal, but killing the king would destroy the veil of divinity and cause chaos in the kingdom. Every new king would be rejected as a false prophet and murdered, as the order instilled through divine rule crumbles. A Grim Trigger describes a game where players always cooperate unless a player defects, whereby the players then always opt to defect.
Mining enforces a Grim Trigger equilibrium. This further discourages miners from including invalid transactions or censoring the ledger in any way. The miners are heavily incentivized to maintain the integrity of the ledger. Most mining operations are run like businesses with a bottom-line profit goal to meet. Jeopardizing the integrity of the blockchain by colluding would shatter trust and crash the value, rendering their stake in the system (capital, electricity, & labor) worthless.
But, this incentive is weakened when miners are not bound to a single currency. With general purpose computing, miners can jump around and mine on different blockchains. And the more hash power a miner contributes to a particular network, the bigger the chance he finds the next block. If a group of miners is able to collude and control 51% of a network’s total hash power, they can bury invalid transactions in the longest chain since they are likely to find multiple blocks in a row.
ASICs work to enforce a Grim Trigger equilibrium among miners. ASIC miners are ultra-efficient computers designed to perform one specific algorithm, like Bitcoin’s SHA-256 hash function. This is how most Bitcoin mining is done today. While powerful, ASICs can increase barriers to entry and can lead to centralization, as readily accessible GPUs and CPUs are no longer profitable for small miners. However, ASICs bind miners to a single cryptocurrency. Due to their specialized function, ASICs increase a miner’s skin in the game, since that equipment can’t be used for anything else but mining that specific cryptocurrency. Their entire capital value becomes tied to the health of the network, and miners are less likely to jeopardize a system in which they’ve invested heavily. ASICs also increase the cost of a 51% attack by boosting the total network hash rate. In all, ASICs decrease miners’ payoff to collude and increase network security, but they can lead to the centralization of large miners if monopolized.
Cryptoeconomic Security Margin
Economic rules secure the network against faulty or malicious actors. A network’s cryptoeconomic security margin is defined as amount Y, such that either message X is true or sender loses amount Y. The message X can be a block of transactions while the amount Y can be the cost of mining. This amount Y should be maximized to discourage miners/validators from acting dishonestly.
Rewards and penalties encourage a certain desired property. In Bitcoin, the desired property is a single sequence of transaction history agreed upon by the network. A fork in the chain represents a dispute over the state of the ledger at a certain point in time. To penalize malicious actors, we must first identify who is at fault. Someone is to blame for disrupting the integrity of the ledger. Who caused this fault in consensus?
There are five possible scenarios for the occurrence of a fork. The miners of both blocks A and D are exempt from blame since they haven’t yet raised any disputes over their proposed addition to the ledger.
Miners can ignore other blocks if they are invalid. In this example, the miner of block B or C could have ignored the other to mine on block A. Since block C is on the longest chain, we’ll consider it valid. It has achieved one confirmation from block D. The miner of block C probably saw invalid block B and, not willing to risk his rewards, decided to mine on the last valid block A. On the other hand, the miners of blocks C and D could have colluded to overtake valid block B and censor the ledger. This is the danger of mining centralization and a 51% attack. Hash power should be distributed enough so that each block is a confirmation by independent miners.
Instead of ignoring other blocks, miners can also deviate by not relaying a block to their peers on the network. With a strategy called selfish mining, a successful miner will withhold their solved block and begin working on it in an attempt to find two blocks before the rest of the network. He effectively has a head start by working on a withheld version of the longest chain. The miner of block C could have delayed sharing his block with the network and began mining for block D. Then, even though someone added block B within that time, the selfish miner is able to add both blocks C and D to block A and seize the longest chain.
Finally, the miners of block B and C could have solved their blocks at roughly the same time. As the blocks must be passed along to all nodes, network bandwidth and latency time can cause competing versions of the ledger. In that case, the miner of block D chooses which block to mine on and include in the main chain.
In Bitcoin, miners are only rewarded if they achieve consensus on their block by getting in the longest chain. Mining is a simple game that rewards people for telling the truth. What if there was a game that asked, “Who won the Spurs vs. Warriors game last night?”. First, everyone votes Spurs or Warriors, with the majority answer being taken as correct. Everyone who voted with the majority gets rewarded, while the others get nothing. Would you tell the truth? You probably expect other players to tell the truth, because they expect you to tell the truth, and you must vote with the majority to get the reward. However upsetting the outcome, the truth is a Schelling Point and you expect other players to reason the same as you. Nobody’s trying to risk free money, or better yet their compensation for cryptographically hard work.
However, the game can be corrupted by a bribing attacker. Imagine an attacker announcing, “If you vote Warriors, and they don’t end up winning the majority vote, I’ll pay you the reward plus a little extra as compensation.” This way, your dominant strategy is to vote Warriors regardless of what other people vote.
If the majority of people trust that the bribing attacker is good for his money, then the game is corrupted as people are incentivized to vote Warriors — regardless of the truth. Even worse, the attacker ends up paying nothing if successful, since he only promises payout if Warriors lose the vote.
This attack shows the importance of economic incentives in open protocols. Cryptocurrency uses rewards and penalties to encourage certain behavior.
Supply and Demand
Imagine a commodity impossible to mass produce. The ancient science of Alchemy was dedicated to reproducing gold, but it couldn’t be done. This property made gold awesome as money.
Public cryptocurrency protocols compete to provide an alternative economy. They provide parameters for how new supply is introduced into the system. This property is especially important. If supply distribution is unfair or too easy, people can’t trust that money to store value. Early spenders of newly printed money gain a purchasing power advantage at the expense of savers. The spenders bid up prices, which decreases the money’s purchasing power.
Scarcity is measured using a stock-to-flow ratio. Stock = circulating supply. Flow = annual production. It considers the size of the swimming pool that you’re dropping water into. Gold has the highest stock-to-flow ratio on Earth, about 70, meaning only 1.5% of gold’s circulating supply is produced each year. Among competing forms of money, and competing individuals for scarce resources, gold became the best option to build wealth with because it was the most resistant to inflation.
Cryptocurrencies enforce a predictable supply emission schedule, instead of fiat money’s arbitrary and inflationary strategy. The flow of Bitcoin started at 50 BTC per block (1 block per 10 min), and the rate is cut in half every 4 years. The stock of Bitcoin is growing but limited in supply to 21 million BTC to be reached in the year 2140. We know the supply of Bitcoin at any given time. A predictable supply can reduce friction in commerce by eliminating inflation risk for investors.
But, how is this digital scarcity enforced?
Bitcoin gets harder to produce as demand rises. New bitcoins are released to miners for solving blocks — the block reward. But, as more miners join the network, blocks will be found faster and dilute the supply of Bitcoin. So to avoid inflation, Bitcoin dynamically adjusts the difficulty of the mining algorithm to target a new block found every 10 minutes on average. This difficulty adjustment mechanism calculates a target difficulty for miners based on the total network hash rate. Blocks without a hash satisfying this difficulty are considered invalid. Each bitcoin can be traced back to its block reward origin, where users can validate that the miner had found a solution to a puzzle of a certain difficulty.
As demand increases and supply remains steady, Bitcoin’s price continues to rise. By the year 2023, Bitcoin’s stock-to-flow ratio will surpass gold. It will then effectively be the rarest thing on the planet — a digital collectible. Bitcoin is like gold, but rarer and can be sent around at the speed of e-mail.
- The Nash Equilibrium of Bitcoin miners is also the optimal outcome for the network — a single, shared ledger of valid transactions.
- Adherence to the longest chain relies partly on its behavior as a Schelling Point, signaling to users the most amount of mining “work” has been devoted to that version of the ledger.
- ASIC mining increases skin in the game and reinforces a Grim Trigger among miners, who invest a large amount of specialized capital into the integrity of the system.
- Rewards and penalties make the system expensive to break. If miners stay profitable and diverse, the system may survive and operate without relying on a central authority.
- Cryptocurrencies have predictable supply emission schedules. Since Bitcoin is resistant to supply increases, it can store value well over time.
- Karl Kreder — Money vs. Cryptocurrency, The Real Costs (https://blog.gridplus.io/money-vs-cryptocurrency-the-real-costs-part-1-33c09dfea671)
- Vitalik Buterin — Introduction to Cryptoeconomics (https://www.youtube.com/watch?v=pKqdjaH1dRo)
- Saifedean Ammous — The Bitcoin Standard (https://github.com/darkwarshadow/The-Bitcoin-Standard-Bits)
- Jim Brysland — Bitcoin: Stock-to-Flow Ratio (https://medium.com/@jimbryz/bitcoin-stock-to-flow-ratio-256d3e71adbd)