Monday, January 13, 2014

The Bitcoin Problem When Bitcoin Hits "Peak Bitcoinage"

Adam Levitin explains:

Mining is done by private parties--participants in the Bitcoin network--but not every Bitcoin user is a miner.  Mining takes a lot of computing power, which requires equipment and electricity. In other words, mining has costs. So while there isn't a central verification party that has to be paid, there are decentralized verification parties that have to be incentivized to conduct verification through mining.

There are two incentives to mine:  successful miners receive a bounty of newly created bitcoins (thereby expanding the bitcoin supply and resulting in bitcoin inflation) and they may also receive a transaction fee for the verification service, if offered by the party whose transaction they are verifying. Bitcoin is designed to making mining difficult and to adjust the difficulty of the mining to the success--mining is supposed to produce roughly one "block" every ten minutes.

Here's the catch. Right now, no one is offering transaction fees for Bitcoin mining. The sole incentive at the moment is the creation of new bitcoins. But the number of bitcoins in the system is capped at roughly 21 million. Currently there are between 12 and 13 million coins in the system; the rate of new coinage is controlled, such that it is supposed to take around 100 years before the system cap is reached. Yet as the computing demands for successful mining increase, there may well be a point at which mining ceases to be a worthwhile endeavor simply for the coin bounty. Let's call that level "Peak Bitcoinage" (see here for some discussion).

Whenever we do reach Peak Bitcoinage, be it from hitting the 21 million ceiling or from mining costs outweighing bounty benefits, then the only thing that would incentivize further Bitcoing mining--and transaction verification to deal with the double spend problem--are transaction fees. Once those transaction fees start to appear, the appeal of the Bitcoin system should begin to drop. Right now, one of the attractions of Bitcoin is the absence of transaction fees. There are no swipe fees in today's Bitcoin. But the system is designed in a way that users will have to pay the freight either through the inflation that occurs through the bounties or through transaction fees.

There's a bit of a behavioral economics move going on here that I find interesting. The inflation currently occuring in the system is not very salient--that's the nature of inflation. A Bitcoin user never pays a fee, but the value of the bitcoins simply decreases because of the slow and steady expansion of the bitcoin supply. Moreover, the costs of inflation are borne pro rata by all bitcoin users, not simply those transacting.  This decreases the cost on any particular transactor. Currently this inflation are doubly hidden because it is offset by the deflation caused by growing demand for bitcoins, but it is still built into the system with the mining bounties.

Once bounties cease, then the inflation will cease and the costs of using Bitcoin will be more transparent, as the system cannot work unless there is verification to prevent double spends. That means users will have to pay transaction fees at market rates. As these are user-paid fees paid at the time of a transaction, they will be quite salient. They will not be spread out among all holders of bitcoins, only on those who transact, so the fees will be more concentrated. (It's not quite clear to me how those fees will get set, as transactions will be accompanied by bids without knowing if the bids will be matched to any asks in the market. In other words, A will pay B before A and B know if the transaction fee offered is high enough to verify the transaction. I suppose that they could up their bid subsequently, but in the meantime, A might have also paid C and had the second transaction verified.)

Post-Peak Bitcoinage bitcoin transaction fees may still be favorable relative to other currency/payment systems, but I suspect that greater transparency of the costs of using Bitcoin will reduce its attraction as a payment system, much the way at-cost credit card surcharging would reduce the attractiveness of credit cards as a payment system. Bitcoin seems to have taken a page out of the credit card playbook for how to get consumers to use a payment system--disguise the costs. I don't write this as a knock on Bitcoin--I'm rather agnostic about the whole endeavor, other than to find it fascinating as an academic who studies payments. Instead, it underscores a key problem of any payment system--the network externality--and how disguising costs (deliberately or just by function of system design) is key to encouraging adoptions to overcome and then leverage the network externality.

13 comments:

  1. There are many misunderstandings about how the bitcoin network operates and this post reveals several of them. The biggest misunderstanding is that people think a massive world wide mining network is necessary to run bitcoin. It is not. There is a massive world wide mining operating because bitcoin has value and people want to dig that bitcoin gold out of the ground, so to speak.

    However, and this is a critical point, it it *not* necessary. For many years bitcoin ran just fine with some college kids running GPU miners in their dorm rooms. And, guess what, nothing has changed. It can *still* run just fine with a bunch of college kids running miners in their dorm rooms.

    This is a self balancing system. The entire network can run just fine off of a dramatically lower financial incentive. That said, if bitcoin still exists years from now then it will also support a much larger amount of economic activity than it does today, to such an extent that even just small fees could amount to a lot of money.

    However it all balances out in the end, the idea that there is some massive hidden fee structure built into the system is not correct. Once the block-reward goes down, or even away entirely, then quite likely the big expensive mining operations will fold up shop. However, millions of kids in their college dorm rooms will be quite happy run a mining operation on their spare resources to get a few bit-pennies from transaction fees.

    A massive expensive mining operation is in no way necessary for the bitcoin network to survive and thrive!

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    1. Yeah right, assuming that Bitcoin transactions go mainstream---with millions upon millions of transactions, there is no way it can be run by college kids in their dorms. That makes no sense. They will have nowhere near the computer power to do so.

      I have heard a lot of defenses of Bitcoin, but "college kids in dorms" takes the cake.

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    2. Agreed. The mining rewards and transaction fees are not "hidden" in any way as the author of this article seems to imply. Heck, most of us who are using bitcoin for payments are already voluntarily paying about 8 cents for each transaction.

      I gladly pay these fees to gain the benefits of bitcoin - they cost me much less than the costs of using the current fiat system. I just bought a $200 item on Overstock for $1. How? The bitcoins I used were acquired at $5 apiece. At current exchange rates the cost of the item was .20 bitcoins.

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    3. @ Anonymous January 13, 2014 at 1:29 PM

      True, that is a bad argument. The better argument is that, even if the fees rise quite high, most small transactions will be conducted "off chain" and only then settled on the blockchain periodically - bringing back down the average transaction fee.

      Also, if it becomes unprofitable to mine, many miners will simply drop out until an equilibrium price is reached (Econ 101). That is the beauty of the free market - it is self-regulating.

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    4. You fail to understand how the network functions. It is a peer to peer distributed network which needs no more than a few thousand computers synchronizing and mining to keep things healthy. This network operated just fine for four years with about one one hundred thousandth the computing power currently being thrown at it.

      Guess what, the protocol didn't change! It can still run absolutely fine with a few thousand computers in college dorm rooms.

      Are you a software engineer? Have you synced, built, and compiled the source code? Have you researched the protocol and the blockchain?

      I have done all of these things. You are simply making comments about things you do not understand. The reason there is a massive amount of computing resources being thrown at bitcoin is *NOT* because it is needed to make the network function, it's because there is a huge profit motive in doing so.

      Bitcoin is a self-regulating and self-balancing system. The concerns raised in this article do not apply to bitcoin because it will simply balance itself as the landscape changes.

      John

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    5. @Honey BadgerJanuary 13, 2014 at 1:42 PM, you write:

      "I gladly pay these fees to gain the benefits of bitcoin - they cost me much less than the costs of using the current fiat system. I just bought a $200 item on Overstock for $1. How? The bitcoins I used were acquired at $5 apiece. At current exchange rates the cost of the item was .20 bitcoins."

      So by your "logic," those who bought bitcoins at $1200 must pay a premium of 30% at Overstock?

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    6. @ Anonymous January 13, 2014 at 2:30 PM

      They won't be paying a premium, they will be selling at a loss.

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    7. You can't have it both ways. A couple of comments ago you were crowing about how cheap you were able to buy things at Overstock, but suddenly it is not a "premium" for those who bought bitcoins over the current price. You are a fraud.

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    8. @ Stanley January 13, 2014 at 5:28 PM

      I didn't say I was having it both ways. I spent the coins I acquired at the lower price. If others spend coins they acquired at the higher price then they will take a loss. What is fraudulent about that? Take off your "bitcoin hater" glasses and think clearly for a minute.

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    9. haha, honey badger just had his ass handed to him about shitcoins! what a useless "medium of exchange." please! it's true, you are always crowing about the "benefits" of shitcoins and more and more posts reveal the "benefits" to be dwindling by the second.

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    10. @ Chris B January 13, 2014 at 11:32 PM

      Yeah, Chris, you keep thinking bitcoins are a useless medium of exchange. Meanwhile, I'll keep laughing all the way to the (bitcoin) bank. I'm now officially putting you on "ignore" because you have proven that you have nothing to offer in a mature debate.

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    11. what do you mean "thinking?" I know they're useless! did you buy any at $1200? what? is that crickets I here? I'll stick with something tangible, something that won't possibly drop to zero overnight. short term gains me nothing and just show me they're a "get rich quick scheme" and nothing more. Pure pump and dump.

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  2. There actually is an interesting question regarding the relationship between the algorithmically declining subsidy, limited throughput of the blockchain, transaction fees, and network difficulty/hash rate needed to ensure security. Having said that, this is not a particularly urgent problem (in the mid-term I expect that the block size limit will simply be raised in order to increase blockchain throughput); the current focus appears to be transaction anonymity (generally referred to by Bitcoin developers as privacy and fungibility).

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