The Trustless Economy - Understanding Ethereum

Humans are fundamentally reliant on trust for society to function. From personal relationships to global economic systems, trust is the glue that binds us together.

The great question is, how strong is that glue?

In small-scale settings, it can be highly sticky. This comes from the fact that trust is based on relationships, knowledge, and direct accountability, with a person’s reputation directly impacting the relationships they develop.

However, when the number of interactions increases and scales, the relative strength of trust becomes incredibly fragile to maintain. Why? The larger the group of people, the fewer interpersonal relationships forged, the less impact reputation has, the better the incentives have to be aligned and the better the system has to work.

Table of Contents

• The Trustless Economy - Understanding Ethereum

  • Trust Stories

  • The Great Game

• The Creation of Ethereum

  • Vires In Numeris

  • Trustless Code

  • Bitcoin vs Ethereum

  • The World Computer

  • Economic Security

  • The Programmable Economy

  • Decentralized Applications

  • Decentralized Finance

    • Decentralised Stablecoins

    • Lending Markets

    • Decentralized Exchanges

    • Liquid Staking Protocols

  • Decentralised Autonomous Organisations

  • The trustless economy

Trust Stories

In the book "Sapiens," Yuval Noah Harari explains that trust can be maintained in groups of up to ~150 individuals, a figure known as Dunbar's number. When the group expands beyond this size, humankind relies on the development of shared myths, religions, and ideologies.

In today’s day and age, as the scale of relationships increases to larger organizations, corporations, or global markets, society’s solution is to institutionalize trust. In effect, crafting a narrative that certain individuals in the system are reputationally “trustworthy”.

The image below shows one way to visualize this.

As simple as it sounds, this unsurprisingly doesn’t always work out…

In the 2008 financial crisis, financial products deemed incredibly safe (rated AAA) by these “trust-approved” banks and credit-rating agencies turned out to be the opposite. Banks had been wrapping dogshit in shiny wrapping paper and selling it as diamonds. Once people realized this, the system broke, catastrophically.

Stock markets plummeted, wiping out approximately $30 trillion in global equity market value. The U.S. housing market saw home prices fall by 30%, and over 3 million homes were foreclosed.

To grasp the enormity of a $30 trillion figure, consider this: if you stacked $1 bills, the height would reach about 2 million miles, or more than eight times the distance from Earth to the Moon. Or, if you spent one million dollars every. single. day. It would take over 82,000 years to spend!

The 2008 financial crisis is just one of the many, many times that trust has catastrophically failed and caused a system to cripple.

• Enron Scandal (2001): Enron Corporation's fraudulent accounting practices led to its bankruptcy, eroding trust in corporate governance and auditing standards.

• Wells Fargo Account Fraud Scandal (2016): Wells Fargo employees created millions of unauthorized bank and credit card accounts, leading to significant financial losses and a loss of trust in the bank.

• Facebook-Cambridge Analytica Data Scandal (2018): The misuse of personal data by Cambridge Analytica, harvested from Facebook users without consent, highlighted the risks of centralized control over personal data.

• Equifax Data Breach (2017): A major data breach at Equifax exposed the sensitive information of 147 million people, undermining trust in centralized credit reporting agencies.

The Great Game

Why do these trusted entities constantly break our trust?

Is it just an innate behavioral trait of all humans to be greedy, or is there mathematical reasoning? As it turns out, it’s kind of both.

Life is one big game. You roll the dice, move forward on the board, buy your house, collect $200 when passing Go, level up in skill sets, build alliances, make foes, and ultimately build and break trust. It’s a never-ending cycle.

To analyze life’s great decisions quantitatively, we can look to Game theory - a mathematical study of strategic interactions.

The most common introduction to this field is “The Prisoner's Dilemma” - a game where two individuals are arrested and held separately. They can either choose to cooperate and remain silent or defect and betray the other.

If both remain silent, they serve a short sentence. If one betrays and the other remains silent, the betrayer goes free while the silent one serves a longer sentence. If both betray each other, they serve a moderate sentence.

The dilemma illustrates the conflict between individual and collective rationality, showcasing how individual pursuit of self-interest can lead to worse overall outcomes for society.

If we map out this mechanic over many iterations and calculate the probabilities for success (adding points up), you may imagine that a society of defectors would begin to increase; as the age-old statement goes - nice guys never win.

The results, in fact, are quite different. Once this game was iteratively programmed into a computer and allowed to run thousands of times, with scores cumulatively added together, some interesting findings were discovered.

The most successful computer program was known as Tit-For-Tat and had the following traits:

• Nice - Not the first to defect

• Retaliatory - If your opponent defects, strike back immediately

• Forgiving - Retaliate but does not hold a grudge

So being nice and trustworthy does benefit society?!

I mean, it makes sense - In almost all of life’s situations, one would be better off favoring cooperation. This is evident across team sports, interpersonal relationships, and within a business. The ones that work well together tend to be the best!

What I find particularly interesting is that another pattern emerges when mapped out over far larger time horizons and mapped into areas such as biological evolutions.

As Cooperative societies grow, they reach a point of instability due to any individual inclined to defect instantly upsetting the balance, and degrading interpersonal relationships (see above, Dunbar’s number). This is evident in the formation of cooperation within countries or businesses, the rise of an empire until it reaches maturity, and its inevitable decline once internal defection and unbalance ensue.

Put simply, in a team of nice guys, it only takes one bad actor to take advantage.

Evolutionary selection favors strategies that base the decision to help on the previous reputation of the recipient. In a small-scale setting, this is possible, but this has points of failure as the group increases beyond the 150 limits we previously discussed where reputation is based on a central authority.

To enable vast and advanced societies of cooperation there must be a supporting structure that allows for it. I, and many others believe that the global financial system and the livelihood of every member of society cannot solely rely on the ‘good word’ of those economically incentivized to manipulate the truth for their benefit.

Financial trust is begging to be redefined.