Piers Ridyard

Why Bitcoin Could Face a Slow Heat Death

Bitcoin
February 1, 2018

Cryptocurrencies have transitioned from a financial afterthought to a new asset class with fresh investors piling in every day. However, a key question still remains: how can we make sure these assets will continue to exist and operate in 10, 20, 50, or 100 years time?

There is a potential danger that, like the 2nd law of Thermodynamics, Bitcoin as a finite and closed system may simply stop moving and eventually die.

This is the problem hidden in the beauty of the fixed supply system. Decreasing mining rewards over time, combined with an increased desire to hold rather than transact, takes away the very lifeblood of what makes a decentralized network function in the first place: incentives.

Bitcoin is the most famous example of a Proof of Work (PoW) system, programmed to steadily reduce the mining reward over time. This leads to a halving every four years, with the last Bitcoin scheduled to be mined by 2140. That may sound like a far-flung future concern, but it quickly reduces the block reward, as shown below:

Mining Reward Timeline

The mining reward is scheduled to decrease dramatically in the coming years

As such, within 20 years the mining reward will be less than one Bitcoin per block. The original design for Bitcoin envisioned that as the mining reward decreased, the total number of Bitcoin in active circulation will have increased such that transaction fees, not mining rewards, would eventually be the main incentive for miners.

Unfortunately, this is unlikely to happen. The current block size limit is making transactions increasingly expensive and the limited supply combined with an inherently deflationary nature is leading to a situation where participants hoard coins in expectation of further price growth. As On the Instability of Bitcoin Without the Block Reward concluded, it may also lead to deviant mining behavior, further undermining the network.

When Bitcoin is too valuable to use

But why does this matter in 2018? After all, cryptocurrencies are in their infancy, a Bitcoin is highly divisible (currently up to a Satoshi), prices have been rising with no end in sight and the mining rewards don’t actually end for another century.

However, the scenario outlined above will likely lead to miners becoming centralized, and the merging of large holders of Bitcoin with network operators. The motivation of miners over time will move from that of income generation to network maintenance and protection, operating solely to preserve their own holdings. This is because as block rewards decrease, for hash power to stay roughly constant the price of Bitcoin must constantly and consistently increase.

Paradoxically this required price increase means there is less and less incentive to sell or use Bitcoin, leading to smaller and smaller amounts of transactions. At some inflection point the tokens essentially only move to pay for the maintenance of the network, removing almost all utility and active circulation. This lack of use may end up being the thing that kills Bitcoin; it dies because it becomes too valuable to use.

Bitcoin, while remaining the dominant cryptocurrency, suffers from the same disadvantage as all pioneering technologies. As the original solution, it blazed a trail absent the experiences of others. Indeed, Satoshi Nakamoto’s whitepaper refers only briefly to the prospect of the end of block rewards, simply concluding: “The incentive can also be funded with transaction fees…once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”

Future-proofing cryptocurrencies

But if not Bitcoin, then how to best future-proof a cryptocurrency? As the space has progressed and we’ve learned how it’s used in the real world, the issue of block rewards has become increasingly important, and different solutions have begun to emerge as viable alternatives.

One potential option is to use a continuous, not fixed, supply. This ensures that there are a minimum fixed block reward and an indefinite flow of coins.

Projects such as Monero utilize this method, providing a fixed minimum block reward of 0.3 XMR. The level of this minimum reward can be altered (or it could be fixed so that it is unchanging from Day 1 onwards), but most projects have kept this to a low rate designed to keep inflation levels to a minimum – often, for example, below the historical inflation rate of gold. This reward, while low, incentivizes without the need to rely on just transaction fees.

A second method is to enforce an inflationary supply. There are multiple means to achieve this:

  • Increase the block reward over time, inverting the Bitcoin distribution pattern
  • Follow a ‘camel distribution’ (where the issuance is slow to start, then rises to a peak following anticipated user adoption, and then tails off again)
  • Regulate a disinflationary supply in which the amount of inflation decreases year on year

Ethereum operates according to this latter method. It aims to balance the ETH lost each year with the rate of issuance, although co-founder Vitalik Buterin stated that “The issuance is whatever it needs to be to ensure reasonable lvl [sic] of security.”

This cognizance of the security risks involved with a lack of block rewards is reinforced through the proposed switch from Proof of Work (the mining-intensive solution utilized by Bitcoin) to Proof of Stake (PoS).

Among other advantages, the reduced energy and thus financial burden of PoS means that there is not the same need to motivate miners through block rewards. It does not, however, really reduce the likelihood of miner centralization.

The economies of scale that make it largely unprofitable for all but the biggest entities to compete in Bitcoin mining are reduced, but not eliminated. Currently, it is expected that a minimum of 32 Eth is required (down from 1,250), so mining pools are still likely for the long tail of Ethereum, and the few whales in the system will still be hoovering up the majority of the rewards.

A third, and thus far less widely used, the alternative involves a variable supply. In these systems, the protocol inflates or deflates supply depending upon the market situation, and can be used to facilitate coins with substantially reduced volatility, which aim to reduce the swings experienced by most cryptocurrencies. A variable supply can work in a number of ways including:

  1. Upon demand from a user, a new token(s) backed by pledged collateral is created; upon repayment, the previously created token(s) is destroyed. Supply and demand is balanced through incentivizing people to hold or use the token through increasing or decreasing the capital gains (i.e. interest payments) received
  2. Match an increase in demand with an equal increase in supply. In this example, the purchase by a user of new tokens is matched by the generation of tokens for the rest of the market, tokens which are subsequently distributed between all other balance holders. Price remains constant – but users holdings increase as the user participation increases.

Bitcoin was borne of the 2008 global financial crisis and came of age in an era fraught with the worldwide increase of monetary supply through quantitative easing. Given this background, it is unsurprising that one of Bitcoin’s most important features is the fixed total issuance of just 21 million coins. This is and will remain, an enduring feature.

However, the wave of new cryptocurrencies need not follow the same path. People with ambitions to create cryptocurrencies that are a future-proof, viable, and actively used means of currency (Nakamoto’s initial aspiration for Bitcoin) should be mindful of the need to create a system resistant to miner centralization, which minimizes security risks to future holders and encourages – not punishes – transacting and spending.

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