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.
Monday, January 13, 2014
The Bitcoin Problem When Bitcoin Hits "Peak Bitcoinage"
Adam Levitin explains: