Beyond the Doomsday Economics of “Proof-of-Work” in Cryptocurrencies

Abstract

This paper discusses the economics of how Bitcoin achieves data immutability, and thus payment finality, via costly computations, i.e., "proof-of-work." Further, it explores what the future might hold for cryptocurrencies modelled on this type of consensus algorithm. The conclusions are, first, that Bitcoin counterfeiting via "double-spending" attacks is inherently profitable, making payment finality based on proof-of-work extremely expensive. Second, the transaction market cannot generate an adequate level of "mining" income via fees as users free-ride on the fees of other transactions in a block and in the subsequent blockchain. Instead, newly minted bitcoins, known as block rewards, have made up the bulk of mining income to date. Looking ahead, these two limitations imply that liquidity is set to fall dramatically as these block rewards are phased out. Simple calculations suggest that once block rewards are zero, it could take months before a Bitcoin payment is final, unless new technologies are deployed to speed up payment finality. Second-layer solutions such as the Lightning Network might help, but the only fundamental remedy would be to depart from proof-of-work, which would probably require some form of social coordination or institutionalisation.

Do Fintech and Cryptocurrency Initiatives Make Banks Less Special?

“…The fundamental remedy would be to depart from proof-of-work and, instead, use "some form of social co-ordination or institutionalization". Against this background, one conclusion is that "in the digital age too, good money is likely to remain a social construct rather than a purely technological one" (Auer, 2019).…”

A model of the optimal selection of crypto assets

“…Another strand of the literature studies economic incentives embedded in blockchain platforms, with particular reference to Bitcoin. In [ 11 – 13 ], the incentive mechanism of mining fees and the costs associated with mining activities are investigated. In [ 14 – 16 ], modelling and analysis of cryptocurrencies incentives is performed and optimal cryptocurrencies designs are proposed.…”

Embedded Supervision: How to Build Regulation into Blockchain Finance

“…The rise of so-called cryptocurrencies has also threatened to bypass existing legislation, in particularly with regard to anti-money laundering/know-your-customer (AML/KYC) legislation and facilitating illicit activity (see Möser et al (2013), Foley et al (2018) and Fanusie and Robinson (2018)), thus calling for a response to level the playing field (see Carstens (2018a,b,c), Landau and Genais (2018), Auer andClaessens (2018 and, and FATF (2018)). Whereas "regulation" is the process of writing the rules that apply to the regulated entities, "supervision" is the enforcement of these rules.…”

“…If there is no central counterparty capable of vouching with a legally binding signature, some different criterion for transaction finality must be established. This paper focuses on the concept of economic finality proposed in Auer (2019), ie the notion that a transaction is final once it is no longer profitable to reverse it. 6 To this end, I develop a distributed and permissioned market in which "blocks" of financial contracts are verified by third parties.…”