Estimated reading time: 5 minutes, 25 seconds
To understand a system like Bitcoin as a whole you need to consider not just computer science, but monetary theory, economics, and game theory.
Quick sidebar for those who are not familiar with game theory, you can think of it as the science of strategy, or the study of optimal decision-making of individuals in a competitive setting.
Bitcoin works because it’s a system that takes into account how real humans behave. It creates a situation the where the best deal for the individual is to participate in the system, rather than attack it.
Bitcoin isn’t a business, no one entity is running it, it’s an open decentralized network and no one at all has to be a part of it. People choose to be a part of bitcoin and to play different roles in this system because there are incentives to do so. The network and ecosystem survive because of the incentive structure.
Bitcoin Mining as an Example
As we’ve discussed in previous videos, Bitcoin is just software running on people’s computers which creates a network. One potential way to attack the network is to control a majority of the computers on the network.
To do some things, like trying to spend a coin twice, a “double spend” attack, you’d have to control at least 51% of the mining computers on the network. We won’t get into the specifics of mining here, but what you need to know is that mining requires expensive equipment and a lot of electricity, it’s a big investment.
Estimates on pulling off a 51% attack on Bitcoin vary, but you’re looking at many millions of dollars, perhaps a billion dollars. But if you’re thinking about attacking a well-designed cryptocurrency network, you might find that it’s a much better deal to just play along and mine some coins.
Miners are rewarded for their efforts. When a miner finds a valid block and that block joins the chain, they get all the transaction fees in that block and a mining reward. Currently, bitcoin’s mining reward is 12.5 BTC.
If you actually managed to control 51% of bitcoin’s mining nodes, you could make over 900 bitcoin a day! At about $6k that’s about 5 million… a day!
5 million reasons, every day, to not destroy the system and to keep it healthy and working.
Or if you just really hate Bitcoin and want to destroy it, well then you could cause a bit of damage. But it wouldn’t be long before nodes on the network would disconnect from you and in the process, you would have lost your ~1 billion investment and an opportunity at 5 million a day!!
It’s just not worth it, it doesn’t make sense…which is why it hasn’t happened.
Bitcoin survives not just by dis-incentivizing attacks but also by being set up in such a fashion that no one group of people can gain control of the system.
When analyzing incentives and game theory in the Bitcoin ecosystem you’ll want to consider 5 different types of participants.
All of these groups have power… but not that much power. If any one group pisses off the others too much they are going to be in trouble. A really fascinating thing happened last year in the bitcoin community. There was a big disagreement revolving around scaling solutions. A group of powerful miners wanted to go one way, but a plan called UASF or “user activated soft fork” became very popular among the other groups of participants. They basically said, hey you can do that but none of us will be following you, only a lot more complicated. It was a fascinating round of game theory!
Links on that below. But the take away here is that bitcoin works because it’s managed to maintain this balance of power where no one group can buy its way into control.
Clever game theory, mixed with convincing a whole hell of a lot of people that you’re right is really the only way to effect change in the system. Which makes change difficult but also makes the system incredibly resilient.
Incentive Structure and Prediction Markets
But let’s take a look at one more example. There are some really interesting projects out there called prediction markets, specifically Augur and Gnosis. These projects are built on top of Ethereum which is also an open blockchain system like bitcoin. The idea behind these prediction projects is to crowdsource data about the likelihood of certain events. But again, this is an open system, so how do you get people to participate? And how do you get people to participate in a way that actually produces useful results??
The simplified description is that you can use these platforms to place bets on future events. If you bet correctly you will win some money, if you bet incorrectly you will lose your funds and those funds will go to those who did bet correctly.
So if you have information about specific events, it’s a great deal for you to go this market, place a bet on this topic that you are familiar with and make some money. And this doesn’t just help you, it helps anyone who is interested in that event gain insight into what might happen. It helps the community get a more accurate picture of the world. That’s pretty neat. And it’s likely that the data gathered from these prediction markets will be used in other projects.
Now, these prediction markets are very new, and we’ll have to wait and see if these platforms got their incentive structure correct.
Take game theory into consideration
When you have an entirely open an voluntary system, you can’t force people to do what you think they should do, you can only incentivize them to do so. The only way to build an open system and prevent it from being taken over by a nefarious party is with a solid understanding of incentives and game theory.
So when analyzing a crypto-currency project… or any system for that matter, ask yourself, ‘does the incentive structure support the system’?? What is the game theory here? Is there incentive to cheat? This will tell you a LOT about the long-term prospects of a project.