Three Bitcoin coins are lined up on an office desk with stationery around it. Above the coins is a red arrow that is pointing diagonally upwards to signify economic growth.

Cryptoeconomics: Game Theory and Cryptocurrency

The list of innovations that blockchains and cryptocurrency have brought to the world, especially in the financial technology sphere, is pretty long. There is, however, one area of concern that trumps all and which makes digital ledgers a game-changing innovation: decentralised security. 

Cryptocurrency’s history is marked by several major attempts from malicious parties to compromise its reliability and ecosystem, and by the community’s reactions to those. The cryptosphere’s ability to continue to develop a market guided by a sense of shared purpose and common good has been key to its recent adoption boom and is seen by many as essential for its survival. 

It’s no wonder then that this community’s members saw the need to develop and explore a new area of financial knowledge, that of cryptoeconomics. And within that field, the best way to project a potential path forward for such a complex and vast hivemind is the study of game theory.

By this point you might be getting overloaded with technicalities, so let’s take a step back. 

Defining a New Frontier 

A close-up of several types of crypto coins.

Cryptoeconomics is a concept born from the combination of cryptography (the science of creating secure and private connections, be they verbal or financial) and economics. It represents an attempt to develop the tools for designing economic guidelines and incentives to produce systems with predictable and convenient dynamics. 

How can that be done? Through the study of game theory. Despite what the name suggests, this has very little to do with amusement – it is rather an observational approach to financial strategy formation, and a vehicle to influence the behavior of market participants. 

A Serious Game

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In a wider sense, game theory can be used to model and predict behavioral approaches within a dynamic and evolving landscape. Usually, this is linked to a specific desired outcome that the observers want the system to spontaneously reach via their carefully designed incentives and rewards. 

These ‘games’ are anything but exclusive to the world of finance, mathematics, and crypto. There are game-like dynamics happening daily in all fragments of our world, from evolutionary biology to politics. 

The most famous example of game theory is perhaps the ‘Prisoner’s Dilemma. In this model, two outlaws are captured by the police for a crime they committed together, and are interviewed separately. During the interview, they are given varying incentives to provide a confession incriminating their partner – with varying rewards – whilst not being able to communicate with them at all. 

The scenario’s incentives and rewards are designed so that if the criminals seek to protect their own freedom and disregard their partner, they will be rewarded with no prison time while condemning the other party to a harsh sentence. However, if they choose to cooperate and deny responsibility, they will both be punished but to a much minor degree. 

Game theory is the observational approach that allows us to determine that despite the chance to minimize sentencing for both arrested felons being made available, most rational individuals would still choose the option that allows them to walk off scott-free and betray their accomplice. 

This dilemma model can be applied to many scenarios in finance, politics, commerce and even sports where the fine balance between cooperation and competition is one of the defining characteristics of success. 

Autoregulated Systems 

A man is holding a phone in front of a laptop. Both screens are showing economic graphs.

In the case of blockchain and digital ledgers in particular, game theory is an essential building block – allowing developers, investors and market participators of all kinds to cooperate in a trustless dominion and to develop tools that predict system user behavioural patterns. 

A great example of this is the core of cryptocurrency accountability, the consensus mechanisms such as PoW (Proof of Work) and PoS (Proof of Stake) which regulate token mining operations and its rewards. 

Due to the competitive nature of mining and staking, game theory-based resources are needed to incentivize and promote fair use and honesty without the need to appeal to a fickle sense of morality – rather, these incentives are based on very immediate and material sanctions that adapt dynamically thanks to the clever nature of tools such as smart contracts and decentralised financial processes. 

Sometimes these features might even appear as bugs or drawbacks, and that’s because the incentives identified as successful by game theory modelling might need to be negative. For example, Bitcoin mining’s energy intensive and inefficient nature was designed as such intentionally to require a certain degree of commitment to the network in order to guarantee rewards and financial profits – thus ensuring market participants have the whole blockchain’s interests at heart. 

In a broader sense, Bitcoin’s Grim Trigger equilibrium is another great example of game theory at play: there is no incentive to form a large group of malicious miners and overtake the network, despite the short term financial gain this would produce. This type of action would collapse the security and credibility of the network, exposing it to further attacks and destroying its value as a functioning financial product adopted by millions. 

If this type of reasoning feels familiar, it’s because it’s what allowed humanity to reach the year of 2022 without a devastating nuclear conflict. The theory of ‘mutually assured destruction’ repeatedly led to the US and USSR choosing not to act maliciously as their potential victory within the ‘game’ would be made senseless due to requiring complete destruction of the game system in question (in this case, humanity and everything alive on this planet). 

Ethereum, on the other hand, goes a step further: rather than just removing rewards for bad actors within its user base, it also has a great system of positive incentives to dispense to those who uphold its core functions.

All of these measures and their efficacy can be measured through a metric called ‘cryptoeconomic security margin’ – a figure, often in cryptocurrency, which essentially summarises the cost to a potential bad actor to sabotage the system. As is obvious, the higher this figure, the higher the security of a certain network. 

An Expanding Field 

a graphic of some coins around a phone

Having touched on all the above, it becomes clear how game theory is so central to cryptocurrency that it’s almost impossible to separate the two at times. 

In a world where power and process are being democratised and decentralised, predicting crowd behaviour and human decisional tendencies becomes essential for a proactive and preventive internal regulamentation that can keep the system healthy. 

With the growth experienced by all type of blockchain solutions and decentralised services, it’s hard to imagine game theory and the newly established field of cryptoeconomics won’t keep playing an important and growing part in understanding this promising new technology. 

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