- Bank for International Settlements (BIS) released a new paper, which argues that Satoshi’s updating process has two limitations: high transaction costs to ensure payment finality and that the system cannot generate transaction fees in line with the goal of guaranteeing payment security
- BIS says that proof-of-work can only achieve payment security if mining income is high, but the transaction market cannot generate an adequate level of income
- BIS says that the users are free riding on the security provided by the transaction fees of other transactions in the chain, which makes the transaction market unable to generate an adequate level of “mining” income
Raphael Auer, Principal Economist of Monetary and Economic Department at the Bank for International Settlements (BIS), wrote a paper titled “Beyond the doomsday economics of “proof-of-work” in cryptocurrencies.”
BIS, an international financial institution owned by central banks, has traditionally been quite critical of Bitcoin and cryptocurrencies in general. Agustín Carstens, General Manager of the BIS, gave a speech in July titled: “My message to young people: stop trying to create money.”
The paper starts with showing how the popularity of Bitcoin and other cryptocurrencies soared in late 2017, outstripping interest in sovereign currencies, or even gold. But yet Auer points out that according to research by Chainalysis, few people were actually using Bitcoin to buy things.
According to Auer, the appeal of cryptocurrencies stems from two points:
- there is no government needed to issue them
- they can be held and traded without a bank account
Auer defines blockchain as a shared ledger of transactions that is updated by a decentralized network of miners via “costly computations.” Proof of Work is defined as “a simple cryptographic tool that allows [sending of] a credible signal to others that a certain amount of money has been wasted on electricity and equipment.”
Auer argues that Satoshi’s updating process has two limitations:
- proof-of-work axiomatically requires high transaction costs to ensure payment finality (double-spend attacks)
- system cannot generate transaction fees in line with the goal of guaranteeing payment security
The paper defines ‘economic payment finality’ when it is unprofitable for any potential adversary to undo it with a double-spend attack. Auer argues that double-spending is very profitable and that attackers stand to gain a much higher bitcoin income than an honest miner because they collect the double-spent amount on top of transaction fees and block rewards. The paper states that “proof-of-work can only achieve payment security if mining income is high, but the transaction market cannot generate an adequate level of income.”
The paper introduces a model, which shows that Bitcoin (or any other Proof of Work cryptocurrency) is safe from a double-spending attack as long as:
The model makes the assumption that an attacker will be able to rent all the hashrate necessary for an attack, which is unrealistic; especially when talking about larger Proof of Work currencies.
Auer argues that because the block rewards are decreasing with time, the security of payments decreases and transaction fees become more important to guarantee finality. He says that “the economic design of the transaction market fails to generate high enough fees.” Auer continues with saying that users are free-riding on the security provided by the transaction fees of other transactions in the chain, which causes the transaction market to be unable to generate an adequate level of mining income.
The proof-of-work and hence the level of security is determined at the level of the block in which a transaction is included, whereas the transaction fee is set by each user privately. Auer says that the key result is that the fee set on a decentralized basis is much lower than the optimal fee, which results in long times before finality is reached.
The paper argues that the second-layer solutions such as the Lightning Network can improve the economics of payment security, but notes they face their own scaling issues. Auer says that there is a trade-off between efficiency and centralization, which leads him to believe that the network won’t be decentralized in the long run. The paper says that “a hub-and-spoke Lightning Network might not look too different from the setup of today’s financial infrastructure.” Auer says that in order to prevent the problem of decreasing liquidity, Bitcoin would need to depart from using proof-of-work because it is not sustainable without block rewards.
Auer concludes that Bitcoin’s liquidity will fall substantially in the long run in the absence of relevant technological advances. The block rewards represent the vast majority of miners’ income and thus underpin the security of payments. But since the block rewards are being gradually phased out, the paper argues that the security of payments is also set to deteriorate.
According to Auer, claiming that technology alone cannot do the trick doesn’t render it useless. But he thinks that the focus will likely shift away from replacing traditional financial systems and transform to rather complement and improve the existing monetary and financial infrastructure.
Auer says that the societal value of Bitcoin is substantial – Bitcoin’s developers have created the backbone of a first-generation decentralized infrastructure that, over the past decade, has survived many attacks. He says that the value of cryptocurrencies “might be to catalyze our thinking on how society can handle access to data and the right to edit it, a much-needed impulse at a time characterized by loss of privacy and the rise of technology-driven disinformation campaigns.”