Why bitcoin is doomed by its own economics, according to BIS

Posted: 23 January 2019 6:17 pm

But to be fair, every single monetary system ever devised has either died already or will in the future.

  • Bitcoin's economic model is inherently flawed and all roads lead to doom.
  • The reasons for this are relatively straightforward.
  • As long as bitcoin prices keep growing, it will be decades before it becomes a pressing serious issue.

In a new research paper titled Beyond the doomsday economics of "proof of work" in cryptocurrencies, the Bank of International Settlements has laid out its reasons for arguing that without some serious changes bitcoin is a doomed technological dead end.

The reasoning is relatively straightforward.

Cause and effect

Bitcoin depends on its miners for network security. These miners invest heavily in mining machines and in turn get paid with bitcoin.

If there aren't enough miners, it's too easy for someone to take control of the network to carry out 51% attacks of the kind that have been rocking the shallower end of the cryptocurrency world lately. This hasn't happened to bitcoin yet, but if it does, then bitcoin is doomed.

To save bitcoin...

To prevent that from happening, bitcoin miners need to be well paid, which they currently are.

Their payment comes with each block they mine and consists of two parts.

  • The block reward: This is a flat reward (currently 12.5 bitcoin) that is given to the miner of each block.
  • The transaction fees: These are the transaction fees paid by users. A miner gets the transaction fees of every user who sends a transaction on the block they mine.

The block reward is made up of newly created bitcoin. The amount distributed here will gradually reduce over time, eventually dropping off to near zero after many years. The transaction fees consist of the fees paid by everyone who sends a bitcoin transaction on the block that the miner processes.

If the miner rewards, which consist of both the transaction fees and the block rewards, eventually drop too low, then there won't be enough miners to defend the network. Therefore, the miner rewards need to stay nice and high.

The problem is block rewards are designed to drop over time. There will only ever be a maximum of 21 million bitcoin, so they can't keep creating more bitcoin forever.

This has already happened twice. At the very start, bitcoin miner rewards were 50 bitcoin per block. Then they halved to 25 bitcoin. Currently, they're at half that – 12.5 bitcoin. The next halving is expected to come about a year and a half from now, at which point the block reward will only be 6.25 bitcoin.

So the miner block rewards are dropping over time as they're designed to do. But if they get too low, miners won't be adequately paid and bitcoin is doomed.

To save bitcoin...

There are two ways bitcoin can solve this problem.

  1. The first is if the value of bitcoin keeps increasing. The block rewards are measured in bitcoin, so if the price of bitcoin keeps increasing, then miners can continue being well paid even as the block rewards decrease. This is what's been keeping miners well paid so far.
  2. The second is if miners start earning a lot more in transaction fees. This hasn't happened yet, and so far the transaction fees have been a negligible part of the miner's total pay.

The problem is that the first option can't last forever. There can only ever be 21 million bitcoin and eventually the block rewards will be so low that they alone aren't enough to pay miners adequately, no matter how much bitcoin is worth.

Therefore, the only option is for miner transaction fee earnings to increase. If miners don't start earning more from transaction fees, bitcoin is doomed.

To save bitcoin...

So no matter what, in the long run bitcoin miners need to earn a lot more from transaction fees. There are two ways this can happen.

The first is that average transaction fees get much, much higher. We're talking hundreds of dollars per transaction. Needless to say, this would make bitcoin completely impractical as a payment network and no one would use it, in which case there's a reasonable chance that bitcoin will be doomed.

To save bitcoin...

Therefore, the only way to save bitcoin is for a lot more people to use it, with everyone paying small transactions which can together support enough miners to secure the network.

The problem with this is that bitcoin transaction fees work as a marketplace. Essentially, people who want to send bitcoin bid for a place on the blocks. Those who bid highest are the first to get a spot. Those who bid the lowest are at the bottom of the queue. This means bitcoin transaction fees change based on how much demand there is for a spot on each block.

Here's what this system has done to average bitcoin transaction fees over time, measured in US dollars:

Notice how it's kind of an all or nothing thing?

This is because there either is enough space to carry all transactions with minimal waiting times or there isn't.

When everyone was going crazy for bitcoin in December/January 2017-2018, average bitcoin transaction fees were approaching US$40 because there was not enough space and people started bidding higher and higher. When there is enough space, such as throughout most of the rest of 2018, people can bid almost as low as they want.

This is a problem.

  • When the bitcoin network does not have sufficient capacity, the transaction fees get too high for the network to be usable and bitcoin is doomed.
  • When it does have sufficient capacity, the transaction fees cannot get high enough to pay the miners and bitcoin is doomed.

When you follow bitcoin's economic model to the end of the line, it ends with bitcoin being doomed.

Opinion: Is there any way to save bitcoin?

There are two ways bitcoin might be saved.

Option 1: Change bitcoin

This will not happen. The entire foundation of bitcoin is its economic model, and the strict rules around transaction fees, block rewards and a strict 21 million block size limit.

These elements are central to bitcoin mythology and no one will ever get enough support from bitcoin miners and users to change them. The bitcoin community will see the entire blockchain burnt to the ground before changing its economics.

This wasn't always the case, but the rapid expansion of the cryptocurrency ecosystem in recent years has seen a lot of the more flexible ecosystem participants shift their support to other projects. As a result, the bitcoin community of today has a reputation for dogmatism (not to be confused with dogematism).

Option 2: Just ignore it

There are a good many years before the bitcoin block reward will drop enough for this to be a concern. The halving occurs every 210,000 blocks, and with an average block time of 10 seconds this means it only pops every 4 years or so.

The next halving, from 12.5 bitcoin per block mined to 6.25 bitcoin, is expected to occur around May 2020. The next one will probably be in 2024, and then 2028 after that. And as long as bitcoin prices either continue rising, or at least don't drop too dramatically, these should go through without too many problems. As long as prices keep rising, it will be decades before bitcoin is seriously threatened by these issues.

In a nutshell, barring some kind of unprecedented change, bitcoin is absolutely 100% doomed in the end. But it's worth emphasising that none of this is new information, and people have known about these issues for a long time.

How quickly it starts being a problem depends on what bitcoin prices do. If they continue dropping, it could start being a fairly pressing issue after the next halving. If they go back up above their all-time high and stay there, it might be decades before it becomes a pain point.

Sure bitcoin is doomed. But hey, who isn't?

There's not a currency in existence that lasts forever, and expiry dates aren't always a bad thing. Frankly, if you've been using the same currency for more than a few hundred years, it's probably time for an upgrade.

Disclosure: At the time of writing, the author holds ETH.

Disclaimer: This information should not be interpreted as an endorsement of cryptocurrency or any specific provider, service or offering. It is not a recommendation to trade. Cryptocurrencies are speculative, complex and involve significant risks – they are highly volatile and sensitive to secondary activity. Performance is unpredictable and past performance is no guarantee of future performance. Consider your own circumstances, and obtain your own advice, before relying on this information. You should also verify the nature of any product or service (including its legal status and relevant regulatory requirements) and consult the relevant Regulators' websites before making any decision. Finder, or the author, may have holdings in the cryptocurrencies discussed.

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