When people have competing interests, how can they establish enough trust to engage in some cooperative or transactional behavior? The answer to this question lies at the core of several scientific and humanistic disciplines, such as economics, sociology, behavioral psychology, and mathematics. Some of those disciplines give us "soft" answers, that depend on concepts such as reputation, fairness, morality, even religion. Other disciplines give us concrete answers that depend only on the assumption that the participants in these interactions will act rationally.
In broad terms there are a handful of ways to ensure fair outcomes in interactions between individuals who may have competing interests:
* Require trust - you only interact with people who you already trust, due to prior interactions, reputation, or familial relationships. This works well enough at small scale, especially within families and small groups, that it is the most common basis for cooperative behavior. Unfortunately, it doesn't scale and it suffers from tribalist (in-group) bias.
* Rule of law - establish rules for interactions that are enforced by an institution. This scales better, but it cannot scale globally due to differences in customs and traditions, as well as the inability to scale the institutions of enforcement. Nasty side-effect: the institutions become more and more powerful as they get bigger and that leads to corruption.
* Trusted third parties - put an intermediary in every interaction to enforce fairness. Combined with the "rule of law" to provide oversight of intermediaries, this scales better, but suffers from the same imbalance of power: the intermediaries get very powerful and attract corruption. Concentration of power leads to systemic risk and systemic failure ("Too big to fail").
* Game theoretical fairness protocols - this last category emerges from the combination of the internet and cryptography and is the subject of this section. Let's see how it works and what its advantages and disadvantages are.
Cryptographic systems like Bitcoin and the Lightning Network are systems that allow you to transact with people (and computers) that you don't trust. This is often referred to as "trustless" operation, even though it is not actually trustless. You have to trust in the software that you run and you have to trust that the protocol implemented by that software will result in fair outcomes.
The big distinction between a cryptographic system like this and a traditional financial system, is that in traditional finance you have a _trusted third party_, for example a bank, to ensure that outcomes are fair. A significant problem with such systems is that they give too much power to the third party and they are also vulnerable to a _single point of failure_. If the trusted third party itself violates trust or attempts to cheat, the basis of trust breaks.
As you study cryptographic systems, you will notice a certain pattern: instead of relying on a trusted third party, these systems attempt to prevent unfair outcomes by using a system of incentives and disincentives. In cryptographic systems you place trust in the _protocol_, which is effectively a system with a set of rules that, if properly designed, will correctly apply the desired incentives and disincentives. The advantage of this approach is two fold. Not only do you avoid trusting a third party, you also reduce the need to enforce fair outcomes. So long as the participants follow the agreed protocol and stay within the system, the incentive mechanism in that protocol achieves fair outcomes without enforcement.
The use of incentives and disincentives to achieve fair outcomes is one aspect of a branch of mathematics called _game theory_, which studies "models of strategic interaction among rational decision makers" footnote:[Wikipedia "Game Theory": https://en.wikipedia.org/wiki/Game_theory]. Cryptographic systems that control financial interactions between participants, such as Bitcoin and the Lightning Network rely heavily on game theory to prevent participants from cheating and allow participants who don't trust each other to achieve fair outcomes.
While game theory and its use in cryptographic systems may appear confounding and unfamiliar at first, chances are you're already familiar with these systems in your everyday life, you just don't recognize them yet. Below we'll use a simple example from childhood to help us identify the basic pattern. Once you understand the basic pattern you will see it everywhere in the blockchain space and you will come to recognize it quickly and intuitively.
In this book, we call this pattern a _Fairness Protocol_ defined as a process that uses a system of incentives and/or disincentives to ensure fair outcomes for participants who don't trust each other. Enforcement of a fairness protocol is only necessary to ensure that the participants can't escape the incentives or disincentives.
==== A fairness protocol in action
Let's look at an example of a fairness protocol, which may be familiar to any reader, perhaps as a memory from their childhood.
Imagine a family lunch, with a parent and two children. The parent has prepared a bowl of fried potatoes ("french fries" or "chips" depending on which English dialect you use). The two siblings must share the plate of chips. The parent must ensure a fair distribution of chips to each child, otherwise the parent will have to hear constant complaining (maybe all day) and there's always a possibility of the unfair situation escalating to violence. What is a parent to do?
Any similarity between the scenario above and Andreas' childhood experiences with his two cousins is entirely coincidental and should not be mentioned again. The battles of the french fries created enough drama and should be left in the past.
There are a few different ways that fairness can be achieved in this strategic interaction between two siblings that do not trust each other and have competing interests. The naive but commonly used method is for the parent to use their authority as a trusted third party: they split the bowl of chips into two servings. This is similar to traditional finance, where a bank, accountant or lawyer acts as a trusted third party to prevent any cheating between two parties who want to transact.
The problem with this scenario is that this puts a lot of power in the hands of the trusted third party. The parent is accused of playing favorites and not sharing the chips equally. The siblings may fight over the chips, dragging the parent into their fight. Eventually the parent threatens to never again cook french fries if it always results in fights. It is an empty threat, and so the cycle repeats daily.
But a much better solution exists: the siblings are taught to play a game called "split and choose". At each lunch one sibling splits the bowl of chips into two servings and the *other* sibling gets to choose which serving they want. Almost immediately, the siblings figure out the dynamic of this game. If the one splitting makes a mistake or tries to cheat, the other sibling can "punish" them by choosing the bigger bowl. It is in the best interest of both siblings, but especially the one splitting the bowl, to play fair. Only the cheater loses in this scenario. The parent doesn't even have to use their authority or enforce fairness. All the parent has to do is _enforce the protocol_; as long as the siblings cannot escape their assigned roles of "splitter" and "chooser", the protocol itself ensures a fair outcome without the need for any intervention. The parent can't play favorites or distort the outcome.
In order for a fairness protocol like this to work, there need to be certain guarantees, or _security primitives_ that can be combined to ensure enforcement. The first security primitive is _strict time ordering/sequencing_: the "splitting" action must happen before the "choosing" action. It's not immediately obvious, but unless you can guarantee that action A happens before action B, then the protocol falls apart. The second security primitive is _commitment with non-repudiation_. Each sibling must commit to their choice of role: either splitter or chooser. Also, once the splitting has been completed, the splitter is committed to the split they created - they cannot repudiate that choice and go try again.
Cryptographic systems offer a number of security primitives that can be combined in different ways to construct a fairness protocol. In addition to sequencing and commitment, we can also use many other tools:
- Hash functions to fingerprint data, as a form of commitment, or as the basis for a digital signature.
- Digital signatures for authentication, non-repudiation, and proof of ownership of a secret.
- Encryption/decryption to restrict access to information to authorized participants only.
This is only a small list of a whole "menagerie" of security and cryptographic primitives that are in use. More basic primitives and combinations are invented all the time.
In our real-life example, we saw one form of fairness protocol called "split and choose". This is just one of a myriad different fairness protocols that can be built by combining the building blocks of security primitives in different ways. But the basic pattern is always the same: two or more participants interact without trusting each other, by engaging in a series of steps that are part of an agreed protocol. The protocol's steps arrange incentives and disincentives to ensure that if the participants are rational, cheating is counter-productive and fairness is the automatic outcome. Enforcement is not necessary to get fair outcomes - it is only necessary to keep the participants from breaking out of the agreed protocol.
Now that you understand this basic pattern, you will start seeing it everywhere in Bitcoin, the Lightning Network and many other systems. Let's look at some specific examples, next.
The most prominent example of a "fairness protocol", is Bitcoin's consensus algorithm _Proof of Work_ (PoW). In Bitcoin, miners compete to verify transactions and aggregate them in blocks. To ensure that the miners do not cheat, without entrusting them with authority, Bitcoin uses a system of incentives and disincentives. Miners have to use a lot of electricity doing "work", that is embedded as a "proof" inside every block. This is achieved because of a property of hash functions where the output value is randomly distributed across the entire range of possible outputs. If miners succeed in producing a valid block fast enough, they are rewarded by earning the block reward for that block. Forcing miners to use a lot of electricity before the network considers their blocks means that they have an incentive to correctly validate the transactions in the block. If they cheat or make any kind of mistake, their block is rejected and the electricity they used to "prove" it is wasted. No one needs to force miners to produce valid blocks, the reward and punishment incentivize them to do so. All the protocol needs to do is ensure that only valid blocks with proof of work are accepted.
The "fairness protocol" pattern can also be found in many different aspects of the Lightning Network:
* Those who fund channels make sure that they have a refund transaction signed before they publish the funding transaction.
* Whenever a channel is moved to a new state, the old state is "revoked" by ensuring that if anyone tries to broadcast it, they lose the entire balance and get punished.
* Those who forward payments know that if they commit funds forward, they can either get a refund or they get paid by the node preceding them.
Again and again, we see this pattern. Fair outcomes are not enforced by any authority. They emerge as the natural consequence of a protocol that rewards fairness and punishes cheating. A fairness protocol that harnesses self-interest by directing it towards fair outcomes.
