Weak, Dumb, or Evil
How economics applies to crypto-networks
How can humans read books and build skyscrapers while dogs just smell each other and pant? Richard Dawkins argued that humans dominate the animal kingdom because of our ability to meme. Professor Dawkins coined the term “meme” to refer to shared ideas that compete to form culture. Memes transmit cultural information, just like genes transmit biological information. In short, people tell stories about what is true and good in the world. These stories, or memes, drive large groups of people to action.
But, which memes become social norms? It’s very rare that an idea about what is true and good in the world pleases everybody.
Traditionally, a king dictated culture for people. A king ruling over society creates a single point of failure, since the entire culture of the kingdom depends on them. A weak, dumb, or evil king can destroy the kingdom. In the same way, a traditional client-server system — used in networks like Facebook and central banking — can fail due to hacks, incompetence, or plain corruption.
In the late 1700s, a group of individuals under the British crown recognized the failure of a central authority to represent its people. These rebels, called Americans, created a decentralized system of checks and balances to govern their culture.
Bitcoin is a decentralized system of transactions to govern money. Users can transfer digital bits of data to other users. However, encoded rules prevent actions like counterfeiting and stealing. Users enforce the rules by validating each transaction. Bitcoin uses economic incentives to encourage users to act honestly.
“Cryptoeconomics” describes how economic principles can apply to cryptocurrency. It tries to explain the incentives that govern a token economy and enable the buy-in of all users.
Game Theory
Two criminals are in custody for selling drugs. 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 denies and B testifies, then A serves ten years in prison while B is free to go. If both testify, then both serve six years in prison. If both deny, then they can only be charged with misdemeanors and both serve one year in prison.
What would you do? Game theory models how and why people make decisions given certain constraints.
This chart shows each strategy’s payoff for both players. 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 could have denied and only serve one year instead of six (bottom right). While a rational criminal should choose to testify, the criminal could also make an emotional decision and deny guilt.
Let’s see how game theory applies to the strategy of miners. In Bitcoin, there are two types of nodes: users and miners. Users submit transactions to the network. Miners then choose which transactions to add to the ledger. But, how can we trust that they only add valid transactions? What is stopping a miner from including a transaction that creates 100 BTC and pays it to himself?
Bitcoin incentivizes miners to act in the interest of the network. Currently, Bitcoin rewards a miner 12.5 BTC ($100,000 at $8K per BTC), plus any transaction fees, for solving a hash puzzle that proves an immense amount of work was done in creating a block. However… the BTC rewards are only spendable if users include the new block in their version of the ledger. A node can refuse to update their ledger and relay the block if it doesn’t appear valid. Each transaction can be verified, and hash puzzles provide a method to prevent spam by miners. You see, Bitcoin is not like a Google Doc, but several Microsoft Word docs that users constantly reconcile with each other.
Over time, other miners approve the block by choosing to mine on top of it. Every tacked-on block is another confirmation of that block’s validity. In fact, a miner can’t even spend their block reward until 100 other blocks are built on top of their block.
Given these constraints, a miner’s revenue depends on a consensus from the network. With a robust network of users to enforce consensus rules, the most profitable strategy for miners is to act honestly.
Schelling Point
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 would choose the red square. 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, users 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 users only assign value to the longest chain, and not other branches? After all, dedication to a single chain 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. Rewriting the main chain would require solving a sequence of hash puzzles faster than the rest of the network. These censorship-resistant properties make the longest chain appear special to users. It’s the most natural sequence of transactions to adhere to, especially when considering the choices of others.
Finally, money is a tool we use to communicate value. 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.
Grim Trigger
Imagine an ancient kingdom ruled by a king through divine right. Noble dissenters choose to cooperate with the king’s rule, not because they actually 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 bring chaos to 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 discourages miners from censoring the ledger in any way. Most mining operations are businesses with a bottom-line profit goal to meet. Jeopardizing the integrity of the ledger by colluding would shatter trust and crash the token’s value, rendering their stake in the system (capital, electricity, & labor) worthless.
But, this profit incentive is weakened when miners are not bound to a single currency. With general purpose computing, miners can redirect energy and join different networks. The more hash power a miner contributes to a network, the better chance of finding 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 strengthen the 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 lead to centralization, as readily accessible GPUs are no longer profitable for small miners.
However, ASICs bind miners to a single network. Due to their specialized function, ASICs can’t be used for anything else but mining a specific cryptocurrency. So, a miner’s entire capital value becomes tied to the health of that network, and rational miners are less likely to jeopardize a system in which they’re invested heavily. ASICs also increase the total network hash rate, raising the cost of a 51% attack.
Summary
- The Nash Equilibrium of miners is the optimal outcome for the network — a single sequence of valid transactions
- The longest chain is a Schelling Point, which signals the most aggregated consensus among users
- Enforced by ASIC chips, a Grim Trigger incentivizes miners to maintain the integrity of the ledger
References
- Vitalik Buterin — Introduction to Cryptoeconomics (https://www.youtube.com/watch?v=pKqdjaH1dRo)
- Stop and Decrypt — Bitcoin Miners Beware: Invalid Blocks Need Not Apply ( https://hackernoon.com/bitcoin-miners-beware-invalid-blocks-need-not-apply-51c293ee278b)
