Bitcoin Game Theory
Hans Hauge | 6/9/2021
Hans Hauge is Head of Quantitative Strategy at Ikigai Asset Management, a third party investment firm independent of Clearblock. This article was sourced through Kana and Katana - Ikigai’s education arm. The below is his opinion and should not be taken as investment advice.
If you’re familiar with the case for hyperbitcoinization, then you may have heard some game theory arguments on how this could play out if indeed it does. Today I’d like to talk about what just happened with El Salvador and why we may indeed be moving towards a world that is at least “hypercoinified” even if it’s not hyperbitcoinized just yet.
Hyperbitcoinization is the idea that Bitcoin’s success could be viewed as a chain reaction. The inputs to the reaction are time, labor, technology, money and other assets. The output is a new global reserve system powering a free and open monetary system that doesn’t exclude anyone and can’t be debased by any government or organization. But how exactly does this chain reaction work, if it does work at all?
To understand this process, we need to establish a multi-dimensional spectrum of participants. First, let’s label the spectrums.
Rich on one side, and poor on the other
Tech savvy on one side, and less so on the other (or young and old if you prefer)
Institutions on one side, and individual actors on the other
Each participant has a certain motivation level to join the Bitcoin network (by running a full node, by buying some Bitcoin, by writing some code that connects to the network, etc). In general, we can make the observation that the more people participate in the network, the more valuable it becomes which brings in more people, etc. On some level this relation maps out to something that looks like Metcalfe’s Law, where the value of the entire network is roughly equivalent to the number of participants squared.
But if we combine this observation with the knowledge that participation tends to be “sticky,” (think about falling down the rabbit hole) that is to say that people who do a certain amount of research and spend a certain amount of time in the space end up staying more often than not. These people who stay in the network through cycles form an ever-expanding base that is a critical part of the feedback loop. These long-term participants have the deepest understanding and appreciation for Bitcoin and are a valuable resource for newcomers into the space.
Now let’s consider the first of the spectrums, rich vs. poor. If you’re rich, you might be involved in Bitcoin and crypto because you see the potential as an investment. In this case, let’s say being “rich” just means you live in the west and you are at least middle class. The majority of the poor live in places with less developed economies, more oppressive regimes, and generally places without a stable national currency of their own. For the poor, there is actually a need for financial services. El Salvador for example, has an unbanked population of 70%. That’s an overwhelming majority of people with no access to a checking account or many of the other things we take for granted. Using the game theory framework, we can say that people who are either very rich, or very poor are more likely to be interested in Bitcoin. It’s actually the people in the middle of the spectrum who are somewhat comfortable who may not see a need, or an opportunity, and therefore are less likely to act.
Now let’s consider the tech savvy versus those that are not so much. In general being tech savvy tends to be highly correlated with age. And as we’re probably all aware, Bitcoin participation (and crypto in general) tends towards the younger generation.
Moving onto the last category, we have institutions versus individuals. The dividing line here comes into play because of course all institutions are defined by groups of humans. And very few individuals exist in isolation. It’s much easier for an individual to get involved with Bitcoin than it is for an entire institution, so this spectrum will tend towards the individual. Now, let’s summarize this data in the following table.
Now this is where it gets interesting. Notice that the old institutions are the cross-section of actors that we’ve defined which are the least likely to participate in Bitcoin. However, younger institutions are in the “maybe” bucket. Also, institutions that are either rich or poor are classified as “maybe.” So what does it take to tilt the playing field?
I am going to suggest that network effects have a role to play here as well. For example, at first there was no way to participate with Bitcoin in traditional markets. But then we got GBTC, then we got COIN (Coinbase), eventually we’ll have other instruments like an ETF. What if this continues? Well then you’ll have crypto ETFs in baskets of other portfolios, and eventually there would even be Bitcoin companies in the S&P 500.
Now let’s revisit the likelihood of participation under a scenario where Bitcoin survives and continues to grow. Old institutions would switch from “No” to “Yes.” Why? It’s actually in the definition of the market. All employees with 401k plans participate in the market by default and Bitcoin is just another part of the stock market. Fed buys corporate bonds? Good for Bitcoin. GDP grows? Good for Bitcoin.
Recall that before El Salvador announced their plans to make Bitcoin legal tender, US tech companies were leading the charge (Square, PayPal, Microstrategy). Now think about the domino effect that could happen here, and ask yourself what you think Paraguay, Panama and Brazil will do? If these trends continue (and all it takes is for the entity closest to the edge to cross over) then the price of Bitcoin will be pushed up higher. This will attract the next closest entity, and so on. The options of a country or corporation are as follows.
Do nothing.
Put BTC on the balance sheet.
If you do nothing, and all your neighbors or competitors act, then you will be left behind. If you do act, then you force your neighbors and competitors to follow you, ensuring that your action was the correct one. See how this works?
This game of “value chicken” only stops when the last participants are forced to follow suit and nobody wants to be left holding the hat when the music stops. Ironically, this situation could lead to a very rapid redistribution of wealth from the laggards to the proactive. In other words, the early-adopting rich will get richer, the poor could move up into the middle class, but it’s the people in the middle of the pile who are complacent that might fare the worst.
But this is the way of the world in the “Age of Turbulence.”
While game theory can help us understand why “widget company A” has to cut prices to compete with “widget company B,” and why mutually assured nuclear destruction is a powerful deterrent to nuclear war, the implications of the game theory framework are far more wide-reaching. Consider one final example.
Will country A debase their currency? What happens if they don’t? Well someone else will gain office promising to give away free stuff and here comes the printing press. If they do debase their currency, people get used to the free stuff and some of them enjoy getting paid not to work so the debasement continues. What about country B? Well if country B was an export economy and now their currency is appreciating against country A due to their debasement, they have to debase as well or they will see their GDP growth decline. This trivial example helps to explain why as long as ANY country has people who want free stuff, as long as politicians can get elected for providing it, and as long as ANY export economy wants to maintain their GDP growth, debasement will continue.
You know what they say, “bullish a hard-capped supply, global, immutable, non sovereign store of value.”
Thank you,
Hans Hauge | Head of Quantitative Strategy @ Ikigai Asset Management
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The views above are the opinions of the author and Ikigai Asset Management’s Head of Quantitative Strategy, a third-party research entity not affiliated with Clearblock Insights. This article was sourced through Kana and Katana - Ikigai’s education arm. They are not to be taken as investment advice.
