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What Is Game Theory?
The science of strategy, game theory is the theoretical framework that explains how competing players act in social situations. Game theory explores the use of pure mathematics for explaining human reasoning and how people make strategic decisions, from politics and business to war and evolutionary biology.
Human Nature and Decentralized Networks
Given that the goal of a blockchain network is to be completely decentralized, requiring no human oversight for decision making, game theory is necessary for developing intuitive platforms and use cases.
A core concept of game theory is Nash equilibrium – a scenario where players enjoy equal access to information and compete on an even playing field. Reliant on the assumed rationality of the people involved, Nash equilibrium enables competition and is advantageous to all players who adhere to a rules-based system.
Take big tech, for example. The recent political uproar that triggered the antitrust movement, lobbying against the monopolization of the tech industry by behemoths like Facebook and Google, shows a situation where Nash equilibrium does not exist. The imbalance of power and breach of trust by a few actors, in this case, Facebook and Google, has a negative impact on the entire tech industry and damages smaller companies’ ability to grow.
In an ideal world, Facebook and Google would operate according to the same ethical standards as smaller companies, allowing the most innovative to thrive. In this scenario, all companies would benefit from equal access to information and access to market, thus creating a Nash equilibrium.
Blockchain is based on the same basis that a Nash equilibrium benefits everyone. Removing this imbalance of power, decentralized ledger technology (DLT) offers a shared, trusted, public ledger of transactions, that everyone can inspect, but which no single user controls. As game theory places a central focus on co-operative, rational actors over the single-user it can be applied to understanding consensus in blockchain protocols.
Nash equilibrium is reached by the interaction of different participants, in which no participant can gain by a unilateral change of strategy if the strategies of the others remain unchanged. As blockchain protocols are based on consensus algorithms with no central authority, Nash equilibrium gives us a clear insight into the consensus framework of blockchain. Blockchain networks, therefore, rely on the viability of a Nash equilibrium to achieve agreement across the board on the most desired outcome. Assuming the rationality of participants in a sufficiently decentralized blockchain, Nash equilibrium assures that consensus will be reached for the best decision.
Reaching consensus is paramount for blockchain, although to create an environment where consensus in decision making is effective you need a substantial number of participants contributing to the network. The more people who agree, in theory, will result in the most socially desirable outcome. Currently, however, blockchain networks are not sufficiently decentralized and companies and governments around the globe are focusing their efforts on bringing this transformative technology into the mainstream in order to widen the net. Here is where incentivization as an element of game theory comes into play.
P2P networks are based on the premise of rational actors interacting with one another to optimize their utility. Game theory incentivizes rational actors to behave in a certain way that maximizes their utility/profits.
Proof Mechanisms: The Prisoner’s Dilemma
Incentivization has become a core characteristic of many successful blockchain projects in encouraging good behavior. Bitcoin mining is the most obvious example of this incentivization at work, rewarding miners for consensus among nodes and in turn benefiting the whole network through advanced security.
Game theory is evident in mining but operates differently depending on the proof system. For example, proof of work (PoW) relies on rewarding, whereas proof of stake (PoS) uses punishment to deter bad behavior and keep the network in check. It is the combination of these methods that create the most secure networks.
In game theory, the prisoner’s dilemma is used to demonstrate strategies that reward cooperation or punish defection. Actors who defect will find themselves in a worse situation than those who cooperated. As consensus and cooperation is a key cornerstone to understanding the contract system in blockchain protocols, we can apply the prisoner’s dilemma to evaluate the risk-reward framework in blockchain protocols.
In both models, the potential deviating parties are limited by a threshold. The main difference is that in the malicious model the deviating parties can act completely arbitrarily, while in the game-theoretic model we often assume the deviating coalitions act rationally while attempting to maximize their utility. Blockchain P2P networks help avoid the double-spending problem, without the need for intermediaries guaranteeing value exchange.
Smart contracts are a design feature of blockchain protocols that involve two or more parties trading digital assets, which are then redistributed automatically. This works according to a formula based on a defined set of data that is not known at the time the contract is initiated. Smart contracts are optimized when rational actors work together to solve problems and puzzles.
Game Theory in Action: Financial Prediction Markets
In many respects, the derivatives market bears little resemblance to the rational actor model in game theory, due to the dominance of large financial institutions that are locked in a centralized trading environment. With significant barriers to entry for the average retail investor, due to high fees and regulation, it is unsurprising that the industry has been accused of benefiting only the most wealthy and powerful institutions.
Despite the derivatives industry ballooning in size to approximately $1,200 trillion USD in recent years, the centralized, high-fee characteristic of the sector has precluded many rational actors from tapping into this enormous, lucrative market.
Zero-sum game is the theory that for every person who gains on a contract, there is a counterparty who loses. Options and futures are examples of zero-sum games. Some derivative products, including collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), have been blamed for triggering the global financial crisis in 2008. These products masked risks, resulting in banks losing track of their exposure to the underlying assets.
Given the higher degree of risk and complexity in trading certain derivative products (CLOs/CDOs) than other assets like stocks and bonds, exploring the opportunity costs for rational actors to trade derivatives and mitigate these risks is vital. What are the wider risks and benefits of zero-sum games in trading?
Given the centralized nature of the outdated derivatives trading environment and the inherent lack of transparency for both the investor and the trader, there is little incentive for retail investors to participate.
Decentralization, in the form of blockchain technology, could change the entire derivatives trading landscape. By introducing DLT to record and verify all transactions, blockchain technology has the ability to open up the sector to both accredited and amateur derivative traders.
Under game theory, common knowledge (openness) is based on the principle that each player will be fully rational with complete information – a Nash equilibrium. Therefore, transparency is key to equal access to information for all participants in a democratized derivatives market, allowing traders to make rational, informed decisions.
A decentralized derivatives market will help ensure increased security, access to scalable resources and a massive reduction in the cost of transacting. As the derivatives market has been centered on a centralized system to-date, decentralized networks built with real human decision making in mind, according to game theory, would imply better outcomes, offering fair opportunities from wealth generation to traders.
Human Decision Making and DLT
Be it reward and punishment, zero-sum games or Nash equilibrium, the truly decentralized networks that future generations will use will be based on game theory. As this theory stands on the pillar of human rationality, in tandem with the vast irrationality of many, it is no surprise that the majority of blockchain projects will fail. Building the infrastructure of blockchain on the human mind as game theory suggests will ultimately result in the most socially desirable outcome and the mainstream adoption of the technology. This is technological and societal evolution in action.
Vaibhav Kadikar, founder and CEO of CloseCross, a decentralized prediction markets platform