Working Paper: CEPR ID: DP13506
Authors: Raphael Auer
Abstract: This paper discusses the economics of how Bitcoin achieves data immutability, and thus payment finality, via costly computations, ie “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.
Keywords: cryptocurrencies; digital currencies; blockchain; proof-of-work; proof-of-stake; distributed ledger technology; bitcoin; ethereum; money; finance
JEL Codes: D40; D20; E42; E51; F31; G12; G28; G32; G38; L10; L50
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| proof-of-work (J54) | high transaction costs (D23) |
| high transaction costs (D23) | payment finality (G33) |
| transaction market fails to generate adequate mining income (D47) | reliance on block rewards (E42) |
| reliance on block rewards (E42) | liquidity decline (G33) |
| block rewards (Y60) | payment finality timing (G13) |
| proof-of-work (J54) | economic incentive structure favors attackers (D49) |
| double-spending attacks (E41) | profitability (L21) |
| lightning network (D85) | temporary relief (H84) |
| proof-of-work (J54) | sustainability of bitcoin (Q01) |
| shift from proof-of-work (E42) | transition to proof-of-stake (P20) |