„It´s all in the game, yo” – Omar Little (The Wire)
Game theory is the study of interactions among agents, useful for making decisions regarding strategy when other players actions and their payoffs are known. The idea of it is perhaps best illustrated by an example: Prisoners dilemma. This experiment deals with two prisoners, who are being interrogated and both face two choices: to keep quiet about their crimes and spend a year in prison, or to confess, resulting in the confessor being freed and the other being imprisoned for 3 years. The issue, of course, is that they cannot communicate with one another. The possible solutions which could come of such a situation can be illustrated as below:
If both prisoners do not talk, both will spend a year imprisoned. If Prisoner 1 talks, he will in turn be free, Prisoner 2 will spend 3 years in prison however, and vice versa. If both of them talk, neither will be free and both have to spend 2 years in prison.
Enter John Nash. A brilliant mathematician, he worked on Game Theory, earning him the Nobel prize in economics in 1994, among others. He devised the Nash equilibrium, which is the point in which every player´s strategy maximizes his respective outcome.
In the example above, if Prisoner 1 does not talk, he will either spend 1 or 3 years in jails, depending on the actions of prisoner 2. If he does talk, he will either be free, or spend 2 years in jail, once again depending on Prisoner 2. In both of these cases, he is better off talking compared to staying silent. Regardless of the actions of Prisoner 2, Prisoner 1 is always better of pursuing a strategy of talking. Of course, the same is true for prisoner 2. This is called a dominant strategy, and the Point in which they meet, where both Prisoners talk, is the Nash Equilibrium, the solution to the game. Not every game has a Nash Equilibrium or a dominant strategy, while some games even have multiple Nash equilibria.
Now this explains the naming of the thought experiment, the prisoners face a dilemma, as both of them not talking would lead to an overall better outcome for them. However, due to their inability to communicate and the personal incentives each of them has to betray the other, they end in the dilemma of both confessing on each other and going to prison for longer.
After understanding this fundamental part of economics, we can turn towards the application of theory in practice. And few better places than the world of cryptocurrencies, with strong materialistic incentives, a huge number of players and many interesting cases. An interesting project, which itself used game theory in explanation of its goal, is the KlimaDAO. The goal of this project was quite noble, it recognized the need for solutions to climate change and devised a strategy to combat it.
The specific problem KlimaDAO sought to solve was that of carbon credits. Carbon credits are a kind of certificate for projects which help the environment by reducing the amount of carbon dioxide in the atmosphere, such as planting a large number of trees, or not producing with a lot of pollution. Companies that exceed environmental regulations, such as airlines or car manufacturers, will buy these carbon offsets to achieve their emissions goal. The idea is that if they cause too much pollution, financing a large tree plantation will net out the effect on the environment.
Now, the market for these offsets was considered suspect at best, with different verifiers using different standards for hard to compare projects. KlimaDAO would solve this issue, by creating a sophisticated marketplace to allow the trade of these assets, while also buying them themselves to push corporations to pay higher prices for the offsets. It would start with the cheaper offsets, leaving the higher cost, higher impact ones for corporations. In theory, this would allow Klima to legitimize the market and incentivize corporations to actually reduce their emissions, as otherwise they would need to pay a high price for carbon offsets.
The way it set out to do this was by issuing its own cryptocurrency, KLIMA. Participants could exchange carbon base tons, tokens representing the carbon credits, and be rewarded KLIMA, with each KLIMA representing one carbon offset of one carbon ton. To drive participation, participants could use bonding, allowing them to receive discounted KLIMA compared to market prices by committing their carbon credits to the KLIMA treasury, or staking, which is more interesting in this instance.
Staking meant that a holder of KLIMA tokens stakes them, effectively giving them back to KlimaDAO in return for sKLIMA, staking tokens. These would rebate every few hours, allowing the holder of sKLIMA to gain a small interest daily, which at times amounted to some 100 000% over the course of the year, if the interest stayed the same. This increase would be based on the excess reserves of carbon credits compared to tokens. At any point in time, a participant could also undo the staking, receiving the same amount of KLIMA for his current amount of sKLIMA, which he is then free to sell.
Now this brings about an obvious issue, in which the amount of sKLIMA, and thus KLIMA is ever increasing. Traditional economics teaches us that if the supply of something increases more than the demand, the price of it will decrease. However, KlimaDAO recognized this situation in the nature of game theory, in which it openly stated that if market participants work together, ignoring selfish incentives, they could all reap the rewards. A common way to portray this idea in cryptocurrency was the meme (3, 3), first originated on the OlympusDAO, which was the inspiration for KlimaDAO. It referred to the options a market participant has, and the expected outcomes one can expect when choosing a strategy. The payoff matrix created by OlympusDAO and referenced by KlimaDAO is below:
Now this table looks familiar to the original table of the prisoner’s dilemma, the only difference being that selling is the worst strategy for any player to consider, bonding and staking have the same payoffs for whoever considers them and of course, if both players choose staking they would earn the maximum reward for everyone involved. KlimaDAO expanded on this meme characterization:
The trees symbolizing the best possible outcome not only for participants, but also for the environment. By locking the carbon credits as tokens in the KlimaDAO treasury, the price of carbon credits would increase, meaning the value of the treasury would increase, ultimately making each KLIMA token worth more. Those who stake their tokens would reap this reward not only in the appreciation in the value of each token, but also by increasing their total number of tokens.
However, what KlimaDAO failed to consider, was for participants to realize these gains, they would need to sell their tokens. This, coupled with the inflation due to the huge annual interest early participants earned, led to a more classical version of prisoner’s dilemma, in which incentives to act in personal interest strong outweighed those of the collective good. Selling KLIMA quickly became the best option to realize the value gained, or at least the remaining balance of the investment. Strong volatility in the market price for KLIMA did not help this situation and after an early spike coinciding with the peak of interest in the project, the price settled on a steady decline, as could be predicted by the inflation of KLIMA supply:
Initially worth 2.000 USD, a KLIMA token now sells for roughly 3 USD, and even with the high annual interest (which has since decreased to around 400% annualized), earlier buyers are almost entirely wiped out. Using KLIMADao´s published index number, a person who staked one KLIMA on the launch day would now be holding 15.83 sKLIMA. If he were to convert this to KLIMA and sell at the market price, he would realize less than 50 USD, from an initial investment of roughly 2000 USD, depending on the time of buying, translating to a 97.5% loss.
This case shows that traditional economic models, such as game theory, can still have merit when applied to hypermodern situations, such as a cryptocurrency promising to bring about the future of the carbon credit market and in doing so solving climate change. Even though participants could theoretically communicate in this game, their personal incentives still outweighed the common good, leading to the practical failure of the DAO and the classical dilemma of a Nash equilibrium, in which participants acting in their self interest end up in the worst possible outcome for everyone involved.
Of course, the fall of KLIMA was attributable to more than just actors pursuing the best strategy for themselves, but KLIMADao´s misinterpretation of the prisoner’s dilemma and accompanying incentives to cheat one another, or even to just sell their KLIMA to avoid further losses, did not help in the transition to a more sustainable world.