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Playing to Win: How Game Theory Can Help You Succeed in DeFi

February 27 at 12:15
Education, Ethereum

What is Game theory and how does it relate to DeFi? Uncover the underlying mechanism upon which the entire DeFi structure is built and learn how to use it to your advantage.

If you have been navigating DeFi for some time, it is quite easy to spot certain patterns with incentives. Does not matter what type of DeFi service we are talking about, because they all have one thing in common - they reward a certain type of behavior. It is no coincidence that DeFi is built this way. 

Without a central authority, the system has to be able to function on its own. Together we will examine the underlying principles of how incentives are created and maintained. Read on to learn how to navigate DeFi beneficially.

TL;DR

  • Game theory tells us about how rational players act in different situations
  • DeFi is set to function on its own by utilizing incentives for users
  • Incentives are set in a way that makes selfish interests beneficial for the entire platform
  • The majority of incentive structures are incomplete and require constant adjustments
  • Incentive tokens of DeFi platforms often carry little to no inherent value

Game Theory and its applications in DeFi

Maybe you are wondering what does a mathematical discipline, such as Game theory, have to do with DeFi. In order to function properly, there has to be a unity in objective between all the participants of the system. Essentially the actions done for self-benefit will also be beneficial for the entire ecosystem.

Game theory tells us how to achieve this state of cooperation, where participating is beneficial for all sides.

Basic concepts of Game theory

In simple terms, Game theory allows us to model and predict how people will behave in situations where the outcomes of their decisions depend on the decisions of others. By studying the behavior of rational participants in games, we can gain insights into how they will act in real-world situations.

  • Game: a situation where two or more individuals make decisions that affect each other's outcomes
  • Players: the individuals or groups making decisions in a game
  • Strategies: the possible actions a player can take in a game
  • Payoffs: the rewards or consequences a player receives based on the outcome of the game

Nash Equilibrium and the Prisoner's Dilemma

One of the most important concepts in game theory is Nash equilibrium. This is a state in which each player takes the best possible action, according to the known strategies of other players. That player would therefore not benefit from changing his strategy - equilibrium establishes.

A classic example of Nash equilibrium is the prisoner's dilemma. In this game, two suspects are arrested and interrogated separately. Each suspect has the option to cooperate with the authorities or betray their partner. The payoffs for each possible outcome are as follows:

  • If both suspects cooperate, they both receive a light sentence
  • If one suspect betrays the other, the betrayer goes free and the other suspect receives a heavy sentence
  • If both suspects betray each other, they both receive a moderate sentence

In this scenario, the Nash equilibrium occurs when both suspects betray each other. Although this is not the best possible outcome for either suspect, it is the most stable and predictable outcome given the actions of the other player.

How are incentives designed?

As an example, let us consider a decentralized exchange (DEX) where buyers and sellers can trade cryptocurrencies without an intermediary

What is needed for a DEX to function? The incentive structure has to be set in a way that all participants work together, this is done through a series of steps. Each step has to be the most beneficial option in a given situation in order to push users in the right direction.

Swapping

The option to make a swap from one token to another provides people with motivation to use the platform. In an ideal case, the swap should be cheap, intuitive, and provide lots of tokens to choose from.

This is the first incentive step according to the Game theory - the DEX provides a valuable service for people to use. They gain some kind of benefit, such as swapping one token for another.

Providing liquidity

In order for the swap function to work properly, the platform needs a pool of liquidity. This liquidity is gathered by providers, who lend their assets to the platform in exchange for a certain yield percentage (APR/APY).

The next incentive step is to ensure that providing liquidity is beneficial for users, otherwise, swaps would be very difficult to conduct.

  • High yield on assets is a great motivation for users to provide liquidity
  • The yield comes from fees and incentive tokens. For more info on this topic, refer to our Liquidity mining dictionary post

The problem with incentive tokens

A problem occurs when the yield from fees is not sufficient to incentivize users to provide liquidity. In that case, the platform usually starts to issue its own incentive token.

Incentive tokens usually have only one main purpose and that is to artificially make the yield higher for liquidity providers. It usually works for a while, until liquidity providers decide they want to cash out their rewards.

Liquidity providers sell rewards - the price of incentive token decreases - holders of incentive token panic - even more sell pressure and further spinning the wheel.

The underlying cause of these problems is that incentive tokens do not carry any inherent value or utility. Some projects have therefore tried to assign them some utility - staking, prediction markets, NFTs, yield farming, governance, and so on. However, those solutions are only meant to persuade users not to sell the tokens and delay the inevitable price drop.

Governance and DAOs

Decentralized governance is another experimental model where incentives are used. By giving users the possibility to participate in the project's governance, you are essentially aligning the interests of both to work together.

When users hold a substantial amount of governance tokens, it will be in their own interest that the project prospers. This includes creating beneficial proposals, community discussion, and voting.

DAO is a governing entity that works in a decentralized manner and without supervision. Without users having their own stake in the organization of the project it would be difficult to imagine this kind of decentralized cooperation.

Common pitfalls of DeFi

Knowing and understanding these incentive concepts can help you understand what is genuine value and what is just a speculative bubble.

Sometimes the most beneficial step to take is not the most obvious one. Incentive structures are designed to guide rational players through certain steps, but as you probably guessed, not every player is rational

Because we are operating in an open ecosystem, it is subjected to many influences - volatile market swings, algorithmic trading, leveraged positions, emotional reactions, and so on. Due to these unpredictable factors, the incentives are never set 100% correctly and require constant adjustments. There are loopholes in these systems that can be exploited, but every time a particular loophole is used too much, it usually becomes unprofitable.

What to keep in mind

The Game theory basically sits at the foundation of all crypto. To build a system functioning in a decentralized manner without supervision, it is essential for the selfish interests of the users to be aligned with the overall interests of the projects.

So far, DeFi has been a massive social experiment in this regard. At this time it's too early to tell if it succeeded, but as time passes, the pain points gradually clear out, eventually leaving us with a fully functioning and sustainable system.

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