The cryptocurrency industry is a collision of ideas and a game of wisdom!

introduction

With the development of the times, game theory has now become a basic analytical tool in the mainstream of modern economics and financial markets, and covers almost all aspects of human interaction research, and has a significant impact on disciplines such as policy science and international relations, artificial intelligence, computers and communications, and biological evolution. In the field of crypto-finance, we can still see the presence of game theory. In this article, BiB Exchange will reveal the game phenomenon in the cryptocurrency industry.

1. Game Theory

Game theory, also known as countermeasure theory, is a theory that uses rigorous mathematical models to study optimal decision-making problems under conflict and confrontation conditions in the real world. Its inventor, John Forbes Nash Jr. (1928-2015), was born in 1928 in a middle-class family in West Virginia, USA. He showed great mathematical talent since childhood. As a famous American mathematician, he received a doctorate in mathematics from Princeton University at the age of 21. In his doctoral thesis, he established an axiomatic framework for non-cooperative games, laying the foundation for modern game theory.

However, he soon began to suffer from severe schizophrenia and lived in a fantasy world of his own creation for decades. Despite his illness, he continued to make significant contributions to mathematics and won the Nobel Prize in Economics with two others in 1994. In the movie "A Beautiful Mind", Russell Crowe created an Oscar-winning biographical film based on Nash's true story, making his deeds widely known.

There is a very classic case in game theory, the Prisoner's Dilemma: Suppose two people are arrested by the police on suspicion of joint theft and they are detained and interrogated separately. The police provide them with the following options:

1. If you admit to the crime and your accomplice does not, you will be acquitted and your accomplice will be sentenced to 10 years in prison;

2. If you do not admit it, but your accomplice does, you will be sentenced to 10 years in prison, while your accomplice will be acquitted;

3. If you both confess, each of you will be sentenced to 5 years;

4. If neither of you admits, you will each only be imprisoned for 6 months due to insufficient evidence.

In this regard, they face a dilemma: either confess and betray their accomplices in order to reduce their sentences, or remain silent and do not confess to each other. This reflects many dilemmas in the real world. In this game case, if both parties remain silent, that is the most ideal result. However, since the other party's choice is unknown, participants usually tend to confess, which is the "prisoner's dilemma."

The prisoner's dilemma shows a specific model of a competitive dilemma, highlighting the contradiction between individual rational choice and collective rational choice. However, the theoretical and methodological framework of game theory is far more than the prisoner's dilemma, which is only a representative content in the field of game theory.

Game theory studies how players make optimal decisions in competitive or adversarial situations. Its main concept is the "Nash equilibrium". This is a stable state in which each player chooses the optimal strategy when the decisions of other players are fixed. Game theory has a wide range of applications in economics, political science, computer science and other fields, such as analyzing market competition, formulating bidding strategies, network security, etc. It can help decision makers find the optimal solution. Its applications in traditional finance include:

(1) The pricing strategy game between Procter & Gamble (PG) and Unilever (UL) in the field of cleaning products among similar domestic and foreign stocks in the A-share and US stock markets;

(2) Stocks and futures: The game interaction between derivative pricing strategies and hedging between the CSI 300 Index and IH futures;

(3) Crude oil and natural gas The prices of crude oil and natural gas, which are jointly influenced, interact with each other in terms of production ratio, policy regulations, etc.

The BiB Exchange team believes that game theory can also be mapped to many aspects in the crypto market, such as the policy-making game between digital currency exchanges on transaction fees, trading and mining, and the long-short confrontation in the crypto market.

2. Game in the Crypto Industry

1. The long-short confrontation in the crypto market

In the crypto industry, we can use the "prisoner's dilemma" to explain the "bull-short confrontation" in the market. At this time, centralized exchanges such as BiB Exchange act as the "police" and have the power to punish both long and short parties; the project party plays the role of prosecutor and will report the sensational short party to the exchange. The long and short parties are like two captured prisoners. They face the choice of whether to cooperate (long-short equilibrium) or betray each other (long-short confrontation).

If both parties choose to continue the long-short confrontation, it is like two prisoners choosing to confess, and they will both face significant losses in project failure and reputation loss. If both sides agree to cooperate and bring the market long and short positions to an equilibrium, it is like two prisoners choosing to remain silent, and they can both avoid further losses, which is more beneficial to the project. However, the typical dilemma of the prisoner's game is that both parties often choose a non-optimal Nash equilibrium result because they cannot trust the other party's choice.

2. Collaborative Game of Community Governance

There are game theory mechanism designs in some decentralized organizations and open source communities. Here, the BiB Exchange team will use the community governance of ifier as an example to illustrate:

(1) Establish a token reward and penalty mechanism. Design corresponding token rewards based on the contributions made by members to the community. Members who do not contribute will have their tokens confiscated to encourage collaboration;

(2) Introducing different categories of decision-making power. Based on the members’ holdings, contribution size and other criteria, multiple levels of voting rights and proposal rights are designed to encourage members to participate in governance. They use prediction markets to aggregate the preferences of all parties, and through prediction markets, tokens supporting different proposals can be traded with each other, thereby more accurately reflecting the preferences of the entire community;

(3) Setting collaboration parameters. Certain thresholds and parameters are set in the community governance process to limit unilateral and overly selfish preferences and promote collaboration;

(4) Multi-round open decision-making game. Governance decisions are divided into multiple sub-problems, and the results of each round will affect the voting preferences of the next round, thereby promoting gradual collaboration.

3. The competition between L2 and L1

Some time ago, the market was once again in the L1 craze due to Avalanche’s subnet expansion and NEAR’s unified user experience. The BiB Exchange team analyzed that in the last bull market, other public chains mainly competed for users through airdrop rewards, relied heavily on liquidity mining, and lacked application innovation. However, with the bear market and the emergence of Ethereum L2, other public chain users and TVL began to return, and L2 began to threaten non-Ethereum L1.

However, L2 is still at the stage of copying Ethereum applications, lacking its own innovation and having problems with token economic design. In comparison, Ethereum L1 represents greater security and a richer ecosystem, and the old public chain tokens are gaining favor again. The emergence of L2 forces other L1s to constantly differentiate and innovate in order to survive in the competition.

In fact, there is also a prisoner’s dilemma among L2s, the most typical example being ARB. Although it is used frequently and is very popular in the market, its price just can’t go up. Even though there were many L2 ecosystem projects that once flourished, only a few survive today.

4. The game between the hottest projects and their exhausted prices

Filecoin is a good example that reflects the relationship between the application prosperity of blockchain projects and the performance of token prices. As a decentralized cloud storage network, Filecoin's application indicators such as storage capacity, storage nodes, and retrieval volume have been growing rapidly.

Although Filecoin has gradually become an important infrastructure with the continuous access of businesses such as IPFS and NFT, and its ecological applications are very prosperous. In sharp contrast, the price performance of Filecoin tokens is not as good as projects such as Optimistic. The price of FIL has continued to fall in 2022 and is far below the high point of the previous bull market.

There is a clear contrast between investors' recognition of Filecoin's ecological contribution and future value and their expected returns from holding FIL tokens, which to some extent reflects the disconnect between blockchain applications and the token economy, that is, it is difficult for token prices to rise simply based on the prosperity of applications. BiB Exchange believes that Filecoin reflects that after the development of the blockchain industry enters a more rational stage, we need more sustainable mechanism design and governance to reshape the value of holding tokens in the long run.

5. Behavioral game of market participants

The crypto market is full of competition among retail investors, big investors and project owners. So, what is the relationship between the various roles? BiB Exchange will give you a detailed introduction below:

(1) Game between retail investors and large investors: This is reflected in the distribution of profit margins during price fluctuations. Large investors can manipulate and influence market trends through their financial advantages, but retail investors are easy targets for profit.

(2) Game between large investors and project owners: This is reflected in the transparency of information disclosure and interest transfer. Large investors use their resources to put pressure on project owners, seeking information advantages and early profit exit;

(3) Game between retail investors and project owners: This is reflected in the decision-making power of asset allocation. Project owners use their information advantages to mislead retail investors and maximize their own interests.

It can be seen that financial strength and information mastery are the most important game elements in the market. In the three-party game, retail investors are at the most disadvantaged party. This is a typical game theory case, which requires policies to constrain and regulate in order to protect the rights and interests of investors.

Of course, judging from the intensity of the battle, the most intense one is the fight between the big players. To some extent, the big players here are divided into wild big players and associated big players. For example, in the case of A token, the investors who have followed the project since the private placement round are obviously associated big players. Usually, the associated big players will not suffer a large loss, especially when they know the first-hand information of the project party. For example, Amber sold DYDX before, and Korean investors sold TRB, etc. It is obvious that the associated big players are manipulating the market.

We can also describe it from another perspective. The former mainly refers to venture capital institutions, incubators, etc. that are relatively biased towards early-stage primary investment, such as Sequoia Capital, SoftBank Capital and other institutions. The latter is more inclined towards typical professional investment research teams, blockchain data institutions, etc., whose business focuses on industry analysis and research, tracking market trends and predicting token prices. Secondary market makers and quantitative teams, such as Bridgewater Fund and Swan Securities.

6. Arbitrage game in market transactions

In the crypto market, there are also trading games between retail investors, large investors and project owners. Next, BiB Exchange will continue to reveal the arbitrage games in market transactions:

(1) Cross-exchange arbitrage

Cross-exchange arbitrage is often traded and tracked by many quantitative institutions and teams. Usually, due to differences in platform liquidity, the same digital asset has price differences between different exchanges. At this time, you can obtain price difference income by buying on low-priced platforms and selling on high-priced platforms. In order not to bear the risk of price trend changes, institutions monitor price deviations through algorithms and conduct automated arbitrage transactions to achieve continuous profits and eventually find a stable Nash equilibrium point, which is a typical exchange game model. However, in exchanges with strict risk control such as BiB Exchange, such behavior is usually punished by freezing trading accounts (but tokens can be withdrawn). This is why many institutions have multiple quantitative accounts distributed in multiple exchanges. Relatively mature exchanges have strict anti-arbitrage measures and related teams that specialize in handling and studying such cross-exchange arbitrage games.

(2) Spot and futures arbitrage

Spot and futures arbitrage is a common method used by asset management institutions. They use currency price hedging to achieve relatively stable and sustained positive returns on the assets they manage, through basis arbitrage between spot and futures, as well as positive and negative hedging. Both the spot and futures markets have their own price discovery mechanisms, but the futures prices based on spot delivery have premiums or discounts due to price fluctuations, which provides strategic opportunities for arbitrageurs.

Finding an optional Nash equilibrium between the two markets, when the futures price on the delivery date is higher than the spot price (premium), you can sell futures and buy spot. When the futures price on the delivery date is lower than the spot price (backwater), you can sell spot and buy futures. Continuously locking in arbitrage through positive and negative operations can avoid the risks caused by unilateral price changes. This bilateral arbitrage strategy changes the game results between the two markets.

(3) Stablecoin arbitrage

Stablecoin arbitrage is to earn interest rate spreads through exchange arbitrage between stablecoin pairs. It exists in two or more stablecoin markets, such as between USDT and other stablecoins BUSD and USDC. Due to market segmentation and liquidity differences, the exchange rate between them is not completely 1:1, which provides strategic opportunities for arbitrage institutions or algorithms.

The BiB Exchange team analyzed that we can find optional Nash equilibrium between different stablecoins, and achieve low-buy and high-sell through cyclical currency exchange operations to obtain the price difference income in the middle. Furthermore, we can also use exchanges and decentralized transactions on the chain to achieve automated high-frequency arbitrage. By changing the profit matrix of the game, we can find a balance point for sustainable profit, and even if the market price fluctuates, it will not affect the overall profit, and finally achieve risk isolation.

(4) Cross-chain arbitrage

Cross-chain arbitrage refers to the use of cross-chain bridges and independent public chains to arbitrage the price difference of the same token on different trading chains. There are two parties in the game: different public chain markets with independent price discovery mechanisms, such as Ethereum and Polkadot markets. The same asset will have different cross-chain prices due to differences in liquidity and information, which provides strategic opportunities for cross-chain arbitrageurs.

BiB Exchange believes that this is equivalent to finding a Nash equilibrium in a compound game. Arbitrageurs buy assets on the low-priced chain and then transfer them to the high-priced chain through the cross-chain bridge for sale. By arbitrage between bilateral chains, they can lock in profits without taking the risk of price changes on a single chain.

(5) DEX and CEX arbitrage

Carry out conversion arbitrage between centralized and decentralized exchanges, such as arbitrage on BiB Exchange and DEX. Due to the differences in liquidity, transaction fees, etc. between these two digital currency trading markets, there is usually a price deviation for the same currency. When the price of an asset on DEX is higher than that on BiB Exchange, we can first buy the token on the BiB Exchange platform and then sell it through the DEX platform; vice versa.

We can go deeper here, such as the previous "attack" incident of dYdX. At that time, YFI recorded a drop of about 45% in one day. The plunge affected the long positions on dYdX, causing a chain of liquidations on the positions on dYdX, which eventually led to the liquidation of nearly 38 million US dollars, causing dYdX to lose more than 9 million US dollars. Here, when users buy or sell, the corresponding counterparty will sell or buy. Liquidation is a system-enforced operation. When the market changes extremely, liquidation faces the result of draining liquidity and lacking sufficient counterparties. When the account is to be liquidated, the insurance fund will bear the loss, which is the reason for its loss. Therefore, dYdX later banned high-profit trading strategies. This case is actually a game between the initiator of the attack from CEX to DEX.

(6) Leveraged trading arbitrage

Leverage and reverse shorting are used to hedge risks. Investors are usually faced with the choice of going long or short in the market. Both going long or shorting alone are risky because we cannot predict the market trend. However, the combination of leveraged long and reverse shorting can make profits in both rising and falling markets, allowing investors to maximize their profits in market competition and avoid the risk of large unilateral losses.

There may be arbitrage opportunities between different varieties, different exchanges, and spot and futures markets. Mastering arbitrage strategies can obtain stable returns. This is a major functional game behavior in the crypto market.

Conclusion

Being in the crypto industry, we will have to face market forecasts and multi-party fund games. BiB Exchange believes that we must learn to use game theory knowledge to more accurately analyze future market trends and predict the behavior of trading counterparties. Although games are not gambling, they also have gambling elements. When we are in it, we should bet carefully, reduce trading risks, and learn to enjoy the excitement of games!