What Is Game Theory And Why Is It Relevant To Cryptocurrency?

Many different aspects contribute to the development of existing and new cryptocurrencies. Game theory is a vital aspect of this development, as it has contributed to Bitcoin’s overall success over the years. It has also allowed the world’s largest cryptocurrency to maintain its dominant position despite multiple efforts to disrupt the ecosystem.

The Idea Behind Game Theory

To many people, the idea of game theory may seem a bit unusual. The name doesn’t necessarily do it justice. Game theory applies to using particular mathematics to study human behavior based on a rational decision-making process. The “Game” part of game theory pertains to creating an interactive environment nudging players to act rationally as they engage with the game rules and other players. 

At its core, this approach was designed to gauge the behavioral patterns of markets, consumers, and businesses in various economic settings. Today, game theory is found in many other industries, as the concept is rather versatile. Leveraging game theory can give rise to behavioral analysis under specific circumstances. It has also proven helpful in sociology, politics, philosophy, psychology, and even cryptocurrencies. 

The Prisoner’s Dilemma Example

Talking about game theory doesn’t necessarily explain why this concept became so popular over time. It is often better to look at an example of a model. The most commonly used one is known as the “prisoner’s dilemma”. 

In this scenario, two criminals face interrogation after being arrested by law enforcement. Every criminal is interrogated in a separate room and cannot communicate with the other culprit in any way. 

As one often sees in police shows, there will be attempts to make one criminal testify against the other to achieve a reduced jail sentence. However, this creates a few different outcomes that need to be considered carefully. 

If one testifies against the other, they have a reduced sentence or may even have all charges dropped. However, if both testify against one another, they both receive a slightly reduced jail sentence. Not answering the questions during the interrogation can yield a low jail sentence due to insufficient evidence. 

Which Option To Pick?

All three options are very appealing in their own way, yet remaining quiet may not be the most promising approach. In fact, betraying the other party may be the best option to get away without spending time in jail, but it is not a foolproof option. That scenario hinges primarily on the other party staying quiet. There is no way to guarantee that outcome, as the other criminal faces a similar reward structure. Self-interest will often take the upper hand when opportunities like these present themselves. 

Although there are different variations of the Prisoner’s dilemma, the concept will often remain the same for the most part. It is a useful way of investigating how other humans would behave while facing this particular set of circumstances. Moreover, it helps analyze the possible outcomes based on how different people try to rationalize their decision-making. 

Game Theory In A Cryptocurrency World

Translating the idea behind game theory to develop a new financial paradigm has proven worthwhile. Bitcoin developer Satoshi Nakamoto has introduced some unique variants of the game theory model in this decentralized ecosystem. Building a secure, trustless, and decentralized system requires a lot more effort than most people may give it credit for. To combine the best of game theory and cryptography, Bitcoin is built as a Byzantine fault-tolerant system. 

The use of game theory in the cryptocurrency industry is what gave birth to the idea of crypto-economics. It is – in normal terms – the study of blockchain protocols and which risks/rewards these models can bring to the table depending on user behavior. Similar to any technology, there will be those who behave properly and others who will try to abuse the system. It is essential to “reward” those who behave normally and come up with a punishment for those who take the contrarian approach.

Moreover, a blockchain ecosystem needs to evaluate the behavior of external agents that can join the network at any given time. Whether those agents will help strengthen the network or attempt to disrupt operations is never certain ahead of time.

The distributed nature of Bitcoin’s blockchain makes it reliant on thousands of nodes globally. However, these nodes need to agree on consensus rules to validate transactions and blocks on the network. That is much easier said than done, as nodes cannot trust one another. A very problematic situation that makes it challenging to avoid nefarious behavior. The consensus algorithms of cryptocurrency networks play an essential role in this regard.

How Bitcoin Handles it

The way Bitcoin is built prevents the network from having to deal with nefarious attacks, most of the time. The use of Proof-of-Work as a consensus algorithm has benefits. Mining cryptocurrencies is a very demanding and costly process. Moreover, there is significant competition among miners who want to protect the network. Anyone trying to perform nefarious acts will face strong competition and will have to spend ample amounts of money and effort to make a meaningful impact. 

In a Proof-of-Work environment, mining nodes have an incentive to act honestly. Failing to do so will waste their resources and nullify any potential resources the miners may earn. Nefarious actors, on the other hand, will have a callous time to perform any criminal activities. Not only is doing so discouraged, but it is also punished quickly by the remainder of the network. There is no real incentive to pull off an attack of any kind as attackers cannot control the network long enough to make a lasting impression. 

It is not uncommon for the network to kick out nodes that show an inkling of nefarious behavior. As nodes need to achieve consensus on the network, anyone who does not meet the consensus requirements will put a “target” on their back. There is no reason to keep badly behaving nodes as part of the network, and they will eventually be blacklisted if the behavior continues.

As Bitcoin mining involves the use of electricity, expensive hardware, and maintenance costs, it is crucial to put this to good use. There is already a small chance to find a network block to earn rewards. Negating that chance even further is counterproductive to everything the Bitcoin network stands for. Spending a lot of money and missing out on potential rewards is a double incentive not to attack the network.

A Successful Attack Isn’t Worth Much

Even though anyone could – in theory – pull off an attack against the network and break the game theory aspect of Bitcoin, a successful attack will not necessarily prove worthwhile. Gaining control over the network can allow attackers to roll back recent transactions or even perform a double-spend. However, the financial incentive of that “success” is much lower than the overall cost of attempting an attack. 

In a game theory network on the scale of Bitcoin, it is often better to play by the rules and earn rewards by normal means. The economic incentive to pull off an attack and the associated “benefits” are not worth it to most culprits. Mining Bitcoin the normal way is equally expensive, yet miners still have a chance to earn rewards and incentives. This attributes to the strength of Bitcoin’s game theory implementation by Satoshi Nakamoto.

Game Theory and Proof-of-Stake

While the example of Bitcoin is a valid one, there are other consensus mechanisms beyond Proof-of-Work to contend with. Various blockchains rely on proof-of-Stake to secure the network and achieve consensus. Rather than relying on miners, these networks often use validator nodes, masternodes, or nominators that will maximize the efficiency of the network and punish bad behavior. 

Validators’ behavior will follow classic game theory rules and can affect how many coins to stake to run a node or other parameters requested by the blockchain ecosystem. As a nominator, it is possible to nominate validators capable of overseeing the entire network. Most Proof-of-Stake networks will require dozens of validators to keep everything in check. In exchange for doing so, validators and nominators will receive payouts depending on their behavior and whether they succeeded in keeping the network safe from harm.

It is equally important to remember the list of current validators may change every so often. Some networks have a “rotating cycle” for validators or nominators. As anyone can opt for that role if they meet the necessary requirements, it creates an incentive to keep up the good behavior. It is a viable system that creates a somewhat level playing field for people who want to protect the network and earn incentives the normal way. 

Closing Thoughts

There are different ways to implement game theory in a cryptocurrency and blockchain setting. Analyzing human behavior under strict rules is essential to keep the network safe and to operate as normal. When dealing with distributed systems, it is nigh impossible to ensure any degree of security without exploring game theory models, regardless of whether one prefers Proof-of-Work or Proof-of-Stake.

Finding the right balance between game theory and cryptography has given rise to innovative projects such as Bitcoin. The world’s leading cryptocurrency serves as a valid example of resisting attacks in a meaningful manner and still offers incentives to those who behave normally. However, the current implementation found in most Proof-of-stake blockchains is equally valid, even if it requires a slightly different approach.

In the end, there will always be a certain security “bias” depending on the network’s size. A bigger ecosystem with more participants can successfully implement game theory and not run into any issues. Smaller distributed networks are less reliable and may be more prone to attacks and interference. . 

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