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The War of All Against All
Hobbes and the State of Nature. Crypto's "Bold Experiment" in Incentives vs. Regulation. Paths through the chaos.
Back to The State of Nature
Last week, someone attacked the Terra blockchain with an aggressive shorting strategy.
The specifics are interesting and you can read about them here. But the quick summary is that the attackers paid billions of dollars in Bitcoin to "mint" a lot of "stable" coins pegged to $1. This unexpected surge in supply flooded the market for the coin and lowered its price below $1. Investors panicked that their tokens were now worth less than $1 and began to sell en masse creating a bank-run.
The attacker, who bet on this happening, made $1B on the trade. The collapse of the Terra ecosystem wiped out $40B in wealth. And that’s before we account for the panic it introduced to the broader crypto market.
If you’ve been paying attention, you know that this is not the first major exploit in crypto.
Earlier this year, a hacker exploited a flaw in software used by Axie Finity to walk away with a $644M profit. That topped a hack in 2021 that made an attacker $611M. The first popular Bitcoin exchange, Mt Gox, was hacked for a sum of $480M way back in 2014.
These hacks have a real human cost. Here’s a tweet from last week:
Let me start by stating an uncomfortable truth: the design of the cryptoverse, unequivocally, makes these attacks more likely.
We can reverse transactions in the traditional system, but blockchain transactions are irreversible. We can shut-off buggy code in traditional systems but blockchain code is immutable. We rely on regulators to police our traditional markets, but we eschew regulators on-chain.
So an honest accounting of last week’s carnage has to acknowledge that we don’t know if web3's problems are tractable. That’s because crypto is a bold experiment in designing unregulated institutions.
By creating a bypass around institutions, crypto has not just recreated the Wild West. We have recreated the State of Nature. We have opened a new front in what Hobbes called “The War of all Against All.”
The overarching project of the cryptoverse is really two-fold:
Prove that we can engineer incentives that help us escape “the War of All Against All.”
Prove that our new system will create surplus value over the state-based system through permissionless innovation.
As of last week - nature is winning. But the game isn’t over yet.
The State: How We Escaped From Nature The First Time
The War of All Against All is not a metaphor.
The State of Nature is a brute battle for survival. It is fighting other humans and animals for food. It is no rules or punishments around killing, rape, theft. It is a free-for-all.
Hobbes described the consequences of the State of Nature: "No arts; no letters; no society; and which is worst of all, continual fear, and danger of violent death: and the life of man, solitary, poor, nasty, brutish and short."
So the most important thing we have ever achieved as a species was finding a way out. Getting out of the state of nature required embracing its organizing principle: violence. So we banded together into groups, set rules for those groups and used violence to enforce them.
Max Weber once defined the state in terms of violence. He said that it was a “community that successfully claims the monopoly of the legitimate use of physical force.” The state is the guarantor of security because we authorize it to use violence to assert its will.
And, actually, this approach works pretty well.
We sacrifice total freedom for the protections that a state affords. This is the basic social contract. But a system incentivized to find safety will sometimes over-prioritize it. In doing so, it introduces very real costs on the people it serves. These can include public health overreactions – China’s Zero COVID policy – or national security - the Global War on Terror/Patriot Act.
In the economic sphere, the state’s sprint to safety results in over-regulation.
I am not a libertarian. Regulation is often important to protect people. We probably need more of it - certainly on matters of climate and public health.
But regulation imposes real costs. Creating a company today requires time-consuming registrations and annual fees to governments. Public companies have onerous reporting requirements that encourage many businesses to stay private. Investors are means-tested before being allowed to invest.
In a state-driven regime, regulation and freedom are always in tension. This is inevitable. But the blockchain regime rejects the entire “protector”/”protected” social contract. Crypto is often described as a “solution in search of a problem,” but that’s not actually true. The problem is just not an individual one – it’s a systemic one. The problem is the costs of regulation imposed by a “trust” based system.
So is it possible to create a system governed by incentives rather than by a monopoly on violence? Can we create a trustable system not centered on a state?
If yes, then the consequences are massive. No need for regulation. No need for lawyers to write or manipulate contracts. No government or legal friction at all. A perfectly operating invisible hand.
It’s a big, big utopian swing. And every utopian idea needs a manifesto. If social contract theory has John Locke, blockchain theory has Satoshi Nakamoto.
Satoshi’s Insight and Principles of a Self-Regulating System
Imagine you want to create a digital currency that doesn’t rely on a bank checking to make sure each transaction is legitimate before sending it.
… why would you want to do this?
You might not need to. It may shock crypto bros that Satoshi Nakamoto, himself, wrote that the traditional system “works well enough for most transactions.” So even Satoshi wasn’t a blockchain maximalist.
But, Satoshi posited, that we also needed a digital analog for cash. Specifically, he believed that there was value in a digital way to move money without going through banks.
Institutions, Satoshi saw, were great for most things. But their frictions engendered deadweight losses that a peer-to-peer system (like cash) could solve:
It would lower transaction costs and fees;
It would enable new types of transactions that were prohibitive due to transaction costs;
It would lower the requirements for collecting information. This would create both privacy and efficiency gains.
In exchange for these lower costs, there would be a necessary step away from the protections of our institutional system. Just like when we hand over cash, we don’t have reversibility, mediation or protection of any kind. We are on our own.
So is it back to the state of nature, anon?
Well, not quite. Because Satoshi’s genius was in finding ways to replicate some basic protections through the incentives of his system.
Principle 1: A “trustless” system depends on perfect transparency of all actions.
You see, digital cash was not a new idea. People had tried and failed to create digital money that could move as seamlessly online as cash did in real life for decades. But these systems could never solve an issue called “the Double Counting Problem.” Put simply, if I have a digital dollar that I want to use to buy your product, how do you know that I have not already spent that dollar somewhere else? In real life, the dollar bill physically moves so you know you have it. Online, there is no such proof.
So the Bitcoin approach introduced a new design principle: Perfect transparency. All transactions would appear in the shared-public ledger. This ledger would be a publicly viewable chain of every transaction block. A blockchain, if you will.
Principle 2: A “trustless” system relies on the consensus of many, many redundant copies.
But this created its own problem. How could we be sure that the ledger itself wasn’t being manipulated? How could we be certain that a bad-actor wouldn’t just create a new ledger moving all the money to themselves? In traditional markets, we would use courts and police to decide on who really owned what they claimed to own.
But we need a different tact for a “trustless” system. So we rely on letting anyone create and maintain copies of our ledger. Then we go with whichever “truth” is agreed upon by a majority of these copies.
Principle 3: Introduce incentives that make cooperating more profitable than cheating.
But if all we need is a “majority of computers” then anyone could generate a lot of IP Addresses to spoof a majority consensus. This is called a Sybil Attack.
To prevent it, we need to find a way to make cheating costly. We can do this by learning a lesson from Harry Potter about bloodletting.
Yes, seriously. Bear with me for a second. I swear it connects.
In the sixth Harry Potter book, Harry and Dumbledore are trying to hunt down a soul-fragment hidden by the evil Lord Voldemort.
They arrive at a cave but before they can enter, Dumbledore must cut his hand and expose blood so that the cave will allow them to enter. If you want a chance to win the treasure inside, you have to expend effort and cause yourself pain.
In blockchain terms, we describe what Dumbledore does as “proof of work.” He expends effort to enter the cave.
Proof of work is proof of effort. It’s bloodletting.
If Voldemort had designed a proof of work system, he would have required way more bloodletting to enter. Silly, Dark Lord, horcruxes are for crypto.
Bitcoin mining, for example, rewards miners who do two things:
Produce a proof that they have reached an answer aligned with the majority of other miners;
Solve a very, very hard math problem that requires a massive amount of energy (the mining).
So anyone who wants to "overturn" the chain's consensus would need to have more computing power than all other "good" validators. The energy they would need to achieve this is worth more than the Bitcoin they would stand to earn. This makes cheating irrational.
This last point is the essential insight of Bitcoin. It is also the core political philosophy of blockchain regimes. Rather than regulate, incentivize.
The Cambrian explosion in blockchain projects are variations on this theme. They all use incentives to align networks of selfish actors. But, whereas Bitcoin has withstood attack after attack, many new projects are untested.
So you would think that we should be careful in testing these new systems before rolling them out. But crypto is growing quickly. Retail investors are being exposed to untested incentive systems.
Worse still, the untested systems use complex math to hide their flaws from lay-investors. Complex financial instruments that hide fraud are a time-honored sign of bubbles.
And the challenge with a bubble in crypto is that the regulatory world wants this experiment to fail. Big explosions like Terra leave no alternative to regulatory interventions.
As it was eloquently explained by way of comparison to a popular, extremely risky project called OHM:
The blockchain regime is new and needs to be iterated upon, but costly missteps will lead to state intervention and a curtailing of the project. To that end, we need to invest in a new set of tools - decentralized risk rating, decentralized smart contract insurance programs (we’ll cover that one next week) and potentially software that can simulate market conditions to “stress test” contracts. Building these tools may not be as fun as shipping a new NFT project, but — like checks and balances were for the state — they represent a necessary step in solidifying the foundations of the crypto revolution.