Game theory of cryptocurrencies
A look at how the prisoners dilemma will play out in the cryptocurrency industry.
The prisoner’s dilemma is a concept of game theory that describes how two rational actors when put in a difficult scenario may not cooperate even though it is in their best interest to do so. Two prisoners when separated have the choice to cooperate with the authorities or defect. One may decide to defect but if the other on doesn’t then the one who cooperated is worse off. They both can also cooperate and defect together but they do not know whether to trust the other individual. This is a type of game that you can see when it comes to the adoption of cryptocurrencies and for the sake of simplicity I will refer only to the most popular cryptocurrency in Bitcoin.
In the game of bitcoin, instead of 2 players you have 7 billion players due to the borderless and international nature of bitcoin and all of them have two choices. Choice #1 is to adopt/cooperate and choice #2 is not adopt/defect. The risk at stake here is to miss an opportunity of financial gain and owning bitcoin rather than time in jail.
If everyone cooperates then bitcoin will see a tremendous increase in demand which will be matched by an appreciation in its price. If everyone defects, then there will be no adoption and no appreciation in price and bitcoin would eventually die out purely due to irrelevancy. However, there is a third scenario and that is the scenario we are currently living in. It is where some defect and some cooperate creating a scenario where the early adopters getting a significant first movers advantage and as more people switch from defect to cooperate the price one has to pay to become an adopter/owner will only increase. This third scenario creates an interesting game-theoretic standoff that I like to compare to musical chairs. We can call it the monetary musical chairs.
In the game of monetary musical chairs, we have 21 million chairs because the supply of bitcoin is limited to 21 million coins. Anyone can fill any number of chairs but it’s important to note that players come in all shapes and sizes and with varying interests. There can be investment firms and hedge funds who see it purely from a profit stand point and fill up a few chairs knowing that a few years down the line someone else will pay a lot more to take those chairs. You can have individuals or governments who may want to fill a chair and keep it for the rest of their lives regardless of price. Due to the limited number of chairs, the demand for filling a chair will continually increase over time and it’s up to you whether you want the music to stop and vacate your chair or you want the music to keep on playing in the hopes that you can vacate your chair at a later stage for a better price.
The game described above is also being played out in the real world as we speak. Recently, El-Salvador announced that it is adopting bitcoin as a legal tender for the country and every citizen of the country will be given a certain amount of bitcoin each. However, Its neighbouring country Guatemala has not done so. Both of these countries can be described as developing nations or even underdeveloped nations who are not in the best monetary situation. With El-Salvador choosing to cooperate and fill up a few chairs it puts pressure on its neighbour now that El-Salvador has made its move and may reap the benefits of being earlier. Guatemala now has the tough choice to either follow suit and not miss out on the growth its neighbour may see or defect and stick to its guns by trying to solve their monetary issues through traditional financial means. Now we are seeing the Russian president Vladmir Putin openly stating that cryptocurrencies should be considered as a legitimate payment system. The game described above will now be played on a much bigger scale with every country trying to capture the first movers advantage.
The creation of a new financial system is something that was completely unprecedented and the open nature of this new system has created fascinating opportunities that were never conceived before. It has taken the power that traditional institutions have over our finances and by giving power to the people it has left the choice to us. Should we defect or cooperate? The choice is yours.