Beyond the Doomsday Economics of 'Proof-of-Work' in Cryptocurrencies

31 Pages Posted: 13 Feb 2019

See all articles by Raphael Auer

Raphael Auer

Bank for International Settlements (BIS)

Multiple version iconThere are 2 versions of this paper

Date Written: January 21, 2019

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, crypto-assets, digital currencies, blockchain, proof-of-work, proof-of-stake, distributed ledger technology, consensus, bitcoin, ethereum, money, digitalisation, finance, history of money

JEL Classification: D40, D20, E42, E51, F31, G12, G28, G32, G38, L10, L50

Suggested Citation

Auer, Raphael, Beyond the Doomsday Economics of 'Proof-of-Work' in Cryptocurrencies (January 21, 2019). BIS Working Paper No. 765, Available at SSRN: https://ssrn.com/abstract=3331413

Raphael Auer (Contact Author)

Bank for International Settlements (BIS) ( email )

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