Bitcoin's money supply and security

(This was originally posted at https://medium.com/@yarivs/bitcoins-money-supply-and-security-10cbf87ce39e.)

It’s evident that Bitcoin has been designed to reward hoarding by its early investors. It’s encoded in the protocol that the supply of new bitcoins will gradually diminish, halving every four years until the last bitcoin will be mined in 2140. In its first four years, each Bitcoin block rewarded the miner with 50 btc. Today, the reward is 25 btc; in 3-4 years, it will be 12.5 btc, and so on.

Furthermore, mining bitcoins used to be much more accessible. In the early days of the network the hash rate (the global hashing power dedicated to mining bitcoins) was much lower. Since less hashing power was competing for the discovery of new bitcoins it used to be possible to obtain a large number of new bitcoins by mining with commodity hardware. Today, however, it’s difficult to mine profitably without custom-built, bleeding edge ASICs and cheap electricity. The combination of cheap price, high block rewards, and low competition in mining has allowed the earliest bitcoin buyers and miners to accumulate large stakes of the currency.

The scheme seems to have worked as planned. Bitcoin’s price rose from ~$14 in early 2013 to more than $1,200/btc near the end of last year (it’s now hovering around $700), yielding fantastic returns to those who accumulated a large stake of bitcoins early in the game.

The sharp rise in bitcoin’s price has led many people to call Bitcoin a bubble or Ponzi scheme. I believe that the Ponzi scheme accusation is misplaced because there’s no apparent intent to enrich early investors at the expense of late adopters or to cause late adopters any losses, which is characteristic of Ponzi schemes. In addition, while Bitcoin’s price has been undeniably volatile, whether it’s bubble or not remains to be seen. If people see Bitcoin as a reliable store of value, like gold, it’s quite possible its price will increase over time. Of course, it’s also conceivable that its price will plummet if, say, someone invents an alternative crypto currency that’s better than Bitcoin in every way and users adopt it in droves.

Whether Bitcoin’s skewed wealth distribution is fair or not is worth debating. I think that there are merits to both sides of the argument. Early investors should be rewarded for taking a risk, but if Bitcoin keeps appreciating it could be problematic that so much of its wealth should be concentrated in the hands of a few people. What is clear to me, however, is that if Bitcoin hadn’t rewarded hoarding by early investors, Bitcoin would have been much more vulnerable. In fact, it may not have been a viable new cryptocurrency at all.

The reason is that the hoarding behavior indirectly gives miners a much needed incentive to secure the network in its early days. Bitcoin can only be secure when a large amount of mining power is spent protecting the network from a 51% attack (an attack where a single entity controls 51% of the mining power and is then able to essentially rewrite the history of the blockchain and thereby launch double spend attacks). For a completely decentralized system designed for moving money, Bitcoin’s security so far has been remarkably strong. It’s unclear exactly how much it would cost to launch a 51% attack against bitcoin but I’ve heard estimates from a few hundred million to over a billion dollars. Regardless of what the actual number is, the aggregate amount of mining power that’s dedicated to securing the network is very high and that gaining control over 51% of it to launch such attack would be very expensive.

Miners aren’t volunteering their computers to the network altruistically. They have a dual incentive to mine: every time they mine a new block they earn new coins as well as transaction fees from anyone whose transaction is contained in the block. Five years into Bitcoin’s creation the transaction fees that miners make are still quite small of the amount miners earn in “block rewards” through minting new coins (only 0.29% according to https://blockchain.info/stats).

Earnings from any given block are determined by the total market cap for Bitcoin at the moment in time when the block is mined and the basic forces of supply and demand are what determine the market cap. The demand for bitcoins is driven by new investors as well as by users who want to acquire bitcoins in order to send them to other people or to buy things. The supply is driven by miners who use the newly minted coins to pay for their operations as well as by investors who sell their coins.

If Bitcoin’s incentives were inverted and investors were encouraged to sell their coins rather than hoard them, the supply of bitcoins would increase and the price would drop. Miners would lose a proportional incentive to contribute to the network the computational power that’s needed to secure it.

When early investors hoard their coins they’re propping up the price, which increases Bitcoin’s market cap and attracts more mining power to protect the blockchain. This serves the function of priming the network’s mining power in its early days before enough transactions go through the network to provide large numbers of miners with sufficient transaction fees to continue mining profitably. Because the minting of new coins dilutes the ownership stake of early investors, early investors who hoard their bitcoins are arguably paying (indirectly) for bitcoin’s security ahead of Bitcoin’s readiness to become used as a currency by large numbers of people. In fact, according to https://blockchain.info/stats, the current price per transaction (measured by dividing miner revenues by number of transactions) is $34.68, most of which is paid for almost exclusively by the block reward, i.e., existing bitcoin holders.

The current high price per transaction seems unsustainably high — and it is. To ultimately succeed, bitcoin must see growing transaction volumes and a gradual inversion of the relationship between transaction fees and block rewards. Barring these trends, it’s likely that mining revenue will decline, causing miners to eventually drop out of the network. If a large portion of miners do so the network’s security will be at risk, causing investors to flee, the price to drop, block rewards to depreciate, more miners to leave, etc, in a downward spiral.

While this dystopian scenario is possible, it’s unlikely in the near term: Bitcoin is only five years old and, by design, miners will continue being rewarded with new bitcoins for over a century. Until then, Bitcoin has plenty of time to gain popularity as a transactional currency. This will require much infrastructure to be built, from exchanges to wallets to payment providers, but much of the work is already under way. It will also require greater acceptance by merchants and users.

Thinking about this makes me appreciate the cleverness of Bitcoin’s design. On the surface, it offers a novel solution to the problem of distributed consensus (aka the Byzantine General’s Problem). But beyond that, it’s also a very carefully orchestrated economic system that would have failed very easily—and quickly—if its creator(s) hadn’t so deliberately aligned the incentives of investors, miners and users, seemingly with an eye towards maximizing the network’s security throughout its stages of adoption.

Such conceptual cleverness, however, cannot guarantee lasting success in the real world, where it remains to be seen whether Bitcoin can withstand market, regulatory, and competitive forces. It’s conceivable that someone will invent an altcoin that’s even better optimized to rewarding miners (for example, an altcoin with a perpetual inflation rate that’s high enough to give miners significant additional revenues but low enough to not scare away investors). If this happens, and this altcoin one day surpasses Bitcoin in mining power, will Bitcoin remain relevant? It’s hard to say, so grab some popcorn and enjoy the ride.

(Full disclosure — I own some bitcoins, which I bought in late 2013.)