Counter party risk in ownership
Ignoring counterparty risk in 'honest, advanced, first-world' economies, such as the United States, represents a significant oversight of considerable magnitude. This perspective overlooks the complexity and sophistication of fraud enabled by modern technology, including artificial intelligence and personal devices like smartphones and computers. These technologies equip individuals with far more advanced means of committing fraud than traditional methods, thereby not only broadening the scope for deceit but also challenging our traditional understanding of counterparty risk. Wait until AI learns to mimic your voice, and instructs your bank to send the perpetrators of fraud your money, as if the wire transfer instructions came from you during a phone call with your bank. Consequently, recognizing and addressing counterparty risk becomes an essential consideration for both individuals and institutions. But this is just what we have to look forward to in the future, let us for now only consider what we know about the past.
For example, the FBI's Operation WireWire in 2018 exposed the global extent of 'Business Email Compromise' (BEC) schemes, resulting in the arrest of 74 individuals across multiple countries. Similarly, the takedown of the Infraud Organization by the U.S. Department of Justice shed light on a vast network involved in the sale of stolen credit card and personal identification information, leading to over $530 million in losses. The concerted effort to dismantle the Avalanche network, implicated in phishing, malware distribution, and money laundering, further exemplifies the complex web of cybercrimes that cross borders. Additionally, the shutdown of Liberty Reserve for laundering over $6 billion underscores the sophisticated mechanisms behind modern financial crimes.
These incidents not only illustrate the various manifestations of counterparty risk—from phishing scams and investment frauds to identity theft and cybercrime rings—but also underscore the necessity for vigilance and contemporary protective measures in the digital era. And keep in mind, these are just the examples caught, many more go unreported. And these aren’t even the most common examples of counterparty risk.
Beyond the recent surge in electronic manifestations of counterparty risk, it's essential to remember that at its core, counterparty risk entails the risk of a trade partner failing to fulfill their obligations. This is often exemplified by cases where a business partner embezzles funds or a company becomes insolvent and can no longer meet its commitments, such as conducting warranty repairs on defective products. It also encompasses scenarios like a builder not delivering a house as promised and on schedule, or the issuance of counterfeit bank checks, among other instances of counterparty risk. Any situation where a counterparty fails to honor their commitments in an honest and fair trade is considered a breach of agreement. Such breaches result in the fraudulent acquisition of wealth by the perpetrator and a corresponding loss of purchasing power for the aggrieved party due to the failure of trading partners to uphold their obligations under the agreement.
We readily acknowledge the frustration accompanying delays in preparing your home for sale or move-in due to counterparty risk, especially when your contractor fails to complete the job as agreed upon and on schedule. Encountering bounced checks or dealing with stolen credit cards is equally distressing, as is discovering embezzlement by a business partner. These examples all represent manifestations of counterparty risk, each uniquely distressing. However, the loss of asset ownership stands as the most severe outcome of counterparty risk, particularly when measured by the resulting wealth losses. This essay explores this critical issue, examining its implications and suggesting solutions to mitigate such risks.
The collapse of Lehman Brothers serves as a stark reminder to US investors of the dangers of counterparty risk in asset ownership. Many investors, whose leverage exceeded the Securities Investor Protection Corporation (SIPC) coverage limits, permanently lost their shares in companies like Amazon due to Lehman Brothers' failure to fulfill their custodial duties. In a similar vein, US investors holding shares of Sberbank through US-listed American Depositary Receipts (ADRs) found themselves cut off from their shares, despite Sberbank being an active, ongoing enterprise traded in Moscow.
The importance of diversification cannot be overstated, extending beyond asset selection to encompass the mechanisms of ownership itself. The selection of a counterparty, especially those tasked with upholding the principle of exclusion, warrants meticulous scrutiny. Ownership confers the right to exclude others from extracting use value from one's property, a principle whose enforcement is fundamental. Without a dependable counterparty to enforce these rights, the essence of ownership is compromised. For example, in the real estate domain, a landlord's capacity to evict non-paying squatters directly impacts the intrinsic value of property ownership. In places like New York, where significant obstacles exist to evict non-paying tenants, the inefficacy of law enforcement and judicial systems in enforcing eviction notices substantially reduces the market value of rental properties. This contrasts sharply with locales like Florida, where a more streamlined eviction process upholds the principle of exclusion more effectively. The resultant effect on market values stands as an empirical fact, irrespective of any subjective views on the societal benefits of rent control policies, which consistently lower the market prices of regulated properties.
This example demonstrates how counterparty risk, exemplified by the challenge of evicting squatters, necessitates higher expected returns and lowers the price of real estate, aligning precisely with the CAPM principles that link higher risk with increased capital costs and greater expected returns as compensation for assuming non-diversifiable risks within a portfolio. Setting aside CAPM, let's examine counterparty risk through the lens of mathematical game theory. Incorporating mathematical game theory into our understanding of counterparty risk opens promising pathways for developing more effective risk management frameworks. By modeling the interactions between counterparties as strategic games, we aim to identify equilibrium states that minimize the potential for fraud and ensure equitable outcomes for all involved parties. This approach not only improves our capacity to guard against traditional forms of counterparty risk but also prepares us to confront the novel challenges posed by the digital economy.
Counterparty risk in cryptocurrencies represents a unique and significant challenge, differing markedly from traditional financial systems but holding comparable importance. The inherent risk in cryptocurrency transactions does not stem from the storage of funds on the blockchain. Thanks to digital signatures and cryptographic hash functions, the blockchain provides robust security features that render fraudulent attempts to spend funds easily detectable. This ensures that, as long as no transactions occur, the blockchain remains a secure ledger for recording transactions.
Bitcoin is often lauded as a potent store of value, a status underscored by incidents where a considerable amount of Bitcoin has become irretrievably lost due to owners forgetting their wallet's private key information. However, Bitcoin's utility as a medium of exchange is undermined by the double spending problem, which introduces significant counterparty risk into cryptocurrency transactions. Double spending—a scenario where a buyer attempts to spend the same digital currency units multiple times—mirrors the concept of 'bouncing a check' in conventional financial dealings. This not only highlights the risk of fraud inherent in digital transactions but also challenges the reliability of cryptocurrencies like Bitcoin as a medium of exchange.
The 2008 Bitcoin white paper addressed the issue of double spending by introducing a consensus mechanism known as proof of work (PoW). This mechanism delegates the responsibility of processing payments to the first miner who solves a complex but arbitrary mathematical puzzle. This solution serves as proof of the miner's commitment to processing transactions honestly, in return for which they earn rewards in the form of newly minted bitcoins and transaction fees. The difficulty and computational expense of the puzzle ensure the integrity and security of the transaction ledger by making fraudulent activities prohibitively expensive and thus unlikely.
Since Bitcoin's inception, numerous alternative consensus mechanisms have been developed, including proof of stake (PoS), proof of history (PoH), and others. These methods delegate payment processing to a subset of network participants deemed trustworthy, based on various criteria specific to each mechanism. For example, PoS selects validators based on the amount of cryptocurrency they are willing to 'stake' or lock up as collateral, reducing the energy consumption associated with PoW.
From the perspective of mathematical game theory, however, all these alternative mechanisms are considered to be inherently more susceptible to fraud than PoW. This assertion is based not only on mathematical analysis but also on market dynamics. The market capitalization of Bitcoin, which continues to use PoW, significantly exceeds that of any competitors, including Ethereum, which has been moving toward a PoS consensus mechanism. Bitcoin's market value, nearing $1 trillion, reflects its perceived security and trustworthiness in the eyes of investors, underscoring the enduring appeal and robustness of the proof of work model.
From the perspective of game theory, the cryptocurrency ecosystem is characterized by a significant amount of asymmetric information among its participants. This disparity is particularly notable between those individuals capable of becoming validators, such as Ethereum wallet holders with sufficient wealth to hold a substantial amount of cryptocurrency, and Bitcoin miners who can afford costly mining rigs, versus the average users whose transactions are facilitated by these potential validators or miners. This asymmetry introduces a complex dynamic, where the potential for fraud is theoretically influenced by the resources available to different parties.
The real-world costs of committing fraud within the Bitcoin network—spanning electricity, cooling, and mining equipment expenses—substantially lower the risk of theft. These tangible costs erect a formidable barrier against fraudulent activities, rendering the theft of Bitcoins less feasible compared to other cryptocurrencies that do not necessitate such heavy investment in hardware and energy.
As outlined in this article, TNT, an acronym for trust network technology, stands as an exception and is posited as the only cryptocurrency offering greater security than Bitcoin. This claim is anchored in its financial disintermediation model, which enables direct transactions between the sender and receiver of funds, thereby eliminating third-party involvement. This direct processing model fosters a game-theoretic Nash equilibrium, optimizing security and efficiency while minimizing counterparty risk. Consequently, TNT emerges as a compelling choice for both a store of value and a medium of payment.
The TNT-bank money system accomplishes disintermediation by enabling recipients of funds and all participating peer-to-peer bank clients to independently verify the adequacy of funds in spending wallets during specific intervals, akin to 'time outs.' During these periods, such as odd-numbered minutes, all participating nodes temporarily cease to accept new payment instructions. This pause allows for a consensus-building process similar to how traditional banks reconcile transactions overnight. In these moments, the network's honest nodes agree on a consistent set of transactions that will subsequently be validated collectively by the entire network of honest peer-to-peer nodes.
We expect that the majority of clients will prefer to use one of the several core-primary validator nodes made available by the TNT system, distinguished by their provable honesty. This honesty is assured through the verifiability of both the software environment in which they operate and the accuracy of account balances within the database they oversee. These balances are required to be in perfect agreement with those maintained by all other honest peer-to-peer nodes within the network, ensuring a unified and trustworthy ledger.
This approach mirrors the current trend in the cryptocurrency community, where most users rely on system-provided nodes rather than operating their own peer-to-peer nodes. In the Bitcoin network, for instance, users connect their wallets to these peer-to-peer nodes (distinct from miners) for processing spending requests, facilitating miner communication, and keeping the blockchain database current to ensure accurate wallet balance verification.
Adopting such a setup enables users to contribute to a secure, decentralized verification process, enhancing the overall integrity of the system. TNT supports this inclusivity by encouraging the operation of independently owned nodes running TNT’s open-source banking software. To facilitate this, TNT offers pre-configured and cost-effective AWS virtual machines, making it straightforward for clients to participate directly in the network's maintenance. This practice not only upholds the decentralized nature of cryptocurrency but also improves accessibility and security for all network participants, reinforcing the system's collective strength and resilience.
By promoting the use of core-primary validator nodes and facilitating the direct involvement of clients in the network's decentralization, the TNT system exemplifies a model that balances the foundational principles of cryptocurrency with practical, user-friendly solutions.
By requiring each node to participate in this collective validation during designated 'time outs,' the TNT-bank money system fosters a robust environment of trust and verification among its users. This innovative approach not only minimizes the potential for fraud but also reinforces the system's resilience against attacks, making it a compelling model for financial disintermediation in the digital age.
In the TNT system, the risk of a double spending, akin to a check bouncing, is eliminated. This stems from the system's design, which incorporates scheduled payment settlement sessions. During these intervals, the acceptance of new payment instructions is paused, allowing every participating node the opportunity to reach a unanimous agreement on a specific set of debit-credit pairs. This process ensures that each transaction can be independently verified by all nodes to confirm that the sums of debits equal credits and that no account is left with a negative balance.
However, the TNT system takes the verification process a step further by enhancing the security of incoming payments. It achieves this by implementing a requirement for dual approval, extending beyond just debits to include credits as well. This means that every transaction must receive explicit approval for both the deduction from one account and the addition to another, allowing bank clients to independently verify the legitimacy of incoming payments. This dual-approval process not only reinforces the system's resilience against fraudulent activities but also empowers clients with direct involvement in the verification of their transactions' integrity.
In the TNT system, each wallet is equipped with not just one, but two public-private key pairs, elevating the standard of transaction security beyond what is commonly found in existing cryptocurrencies. The first public key functions in a familiar manner, being utilized to sign debits or spending requests, akin to the operational mechanism in current digital currencies. This ensures the authorization of transactions by the spender.
The innovation in the TNT system is embodied in the second public key, a feature unique to this platform. This second key grants the recipient the authority to sign all incoming credits within a block that has reached universal agreement, thereby signifying their acceptance of the payments. For a transaction to be considered valid and to effectuate a change in the account balances, it must be doubly signed: once by the spender, using their first key for the debit, and then by the recipient, with their second key for the credit. Any payment lacking these dual signatures is deemed null and void, leaving the balances of both the spending and receiving wallets—or TNT-bank accounts—unaffected, irrespective of the funds available in the spender's wallet.
This dual-signature mechanism affords recipients an unprecedented level of control, enabling them to make informed decisions about accepting transfers, including the timing and the identity of the counterparties. By mandating the explicit consent of both the sender and the receiver for the validation of every transaction, the TNT system significantly enhances the security of financial exchanges. Moreover, it provides users with increased autonomy, allowing them to navigate their financial interactions with greater discretion and safety.
Although this feature represents a significant advancement in digital transaction security, it is anticipated that the majority of TNT-bank clients may prefer to use their wallets in a mode that automatically accepts all incoming payments, leveraging the convenience of traditional transaction systems. Alternatively, some clients might choose to delegate the management of payment acceptance to a custodian bank. This arrangement would enable the application of rigorous Anti-Money Laundering (AML) and Know Your Customer (KYC) protocols, capitalizing on the capability to selectively reject payments based on compliance criteria.
Such flexibility in transaction management allows the TNT system to cater to a wide range of user preferences, from those seeking simplicity and ease of use to entities requiring stringent compliance controls. This adaptability, coupled with the enhanced security measures, positions the TNT system as a versatile and secure platform for digital financial transactions, potentially setting a new standard in the industry.
In the realm of mathematical game theory, the TNT system introduces an innovative approach to transaction validation and consensus, distinct from the proof-based mechanisms that underpin many existing cryptocurrencies. Unlike PoW, PoS, or PoH, which require validators to demonstrate some form of commitment—be it computational power, stake in the currency, or a chronological record of events—the TNT system operates on a principle that obviates the need for such proofs. By design, every action taken by any participant within the TNT network is made transparent and visible to all other participants, thereby achieving a state of perfect information symmetry.
This unparalleled level of transparency guarantees that all participants have identical information regarding transactions and account balances, thereby eradicating the information asymmetry that often underpins fraudulent activities. Analogous to the impossibility of spending a counterfeit gold coin when its authenticity can be independently verified by the recipient, issuing a fraudulent check within the TNT-bank system becomes unfeasible. Any such attempt is promptly exposed during the designated timeouts for payment processing. Fraudulent transactions can be effortlessly circumvented by recipients simply choosing not to validate the transaction with their signature.
In the framework of mathematical game theory, this scenario of perfect information symmetry harmonizes the objectives of all network actors towards mutual honesty and collaboration. The feasibility of fraud is not merely reduced; it is eradicated. Any deceitful attempt is immediately noticeable to every participant within the network and can be collectively dismissed without complication. This mechanism effectively aligns with the principles of a Nash Equilibrium, where no player has anything to gain from unilaterally deviating from the established path of honesty, as such actions would lead to immediate detection and nullification of the deceitful attempt.
Therefore, in the TNT-bank system, the strategic interaction fostered by perfect information symmetry not only deters fraudulent behavior but categorically renders it futile. The system’s design inherently encourages a cooperative environment, where fraud is not just impractical but categorically impossible, thereby ensuring the integrity and trustworthiness of all transactions within the network.
Let's delve deeper into the implications of this approach:
Nash Equilibrium: In the TNT network, where every participant's actions are transparent and verifiable by all, the concept of Nash Equilibrium plays a pivotal role. It drives the network towards a default state of honest behavior. This suggests that, both theoretically and practically, under conditions of fully voluntary participation, the possibility of fraud becomes negligible, except in cases of asymmetric information regarding the exchanged items. This principle of self-regulation underscores why an estimated 30% of all Bitcoins are permanently lost, attributed to individuals losing access to their private keys. Such incidents highlight the critical importance of rigorous private key management and the efficacy of Bitcoin's decentralized verification in fraud prevention. When the blockchain's authenticity is independently verifiable, it leads to perfect transparency or symmetrical information, rendering theft unfeasible.
Reduction of Counterparty Risk: By eliminating the necessity for trust in a single validator or a group of validators, the TNT system significantly reduces counterparty risk. The dual-signature requirement for transactions further bolsters this by ensuring mutual consent, thereby minimizing the risk of unapproved or fraudulent transactions.
Impact on Proof Mechanisms: Compared to PoW, PoS, and PoH, the TNT system's approach shifts the focus from computational challenges, stakeholding, or historical accuracy to mutual transparency and verification. This shift has profound implications for energy consumption, stake concentration, and historical data reliability, addressing some of the common criticisms leveled against traditional consensus mechanisms.
In summary, the TNT system's reliance on perfect information symmetry and mutual transparency presents a stark contrast to proof-based mechanisms, offering a novel solution to counterparty risk that leverages game-theoretic principles to foster a secure and cooperative network environment. This model not only enhances security and trust within the network but also opens up new avenues for addressing the limitations of current blockchain technologies.