Decentralized Mining in Centralized Pools
51 Pages Posted: 22 Mar 2018 Last revised: 24 Oct 2018
Date Written: October 2018
An open blockchain's well-functioning relies on adequate decentralization, yet the rise of mining pools that provide risk-sharing leads to centralization, calling into question the viability of such systems. We show that mining pools as a financial innovation significantly exacerbates the arms race and thus energy consumption for proof-of-work-based blockchains. Moreover, cross-pool diversification and endogenous pool fees generally sustain decentralization --- dominant pools better internalize the mining externality, charge higher fees, attract disproportionately less miners, and thus grows more slowly. Consequently, aggregate growth in mining pools is not accompanied by over-concentration of pools. Empirical evidence from Bitcoin mining supports our model predictions, and the economic insight applies to many other blockchain protocols.
Keywords: Arms Race, Bitcoin, Blockchain, Cryptocurrency, Financial Innovation, FinTech, Mining Pools, Risk-Sharing.
JEL Classification: D47, D82, D83, G14, G23, G28
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