A Structural Analysis of Bitcoin Cash's Emergency Difficulty Adjustment Algorithm

Abstract

In this paper, we analyze the equilibrium behavior of miners involved in mining Bitcoin (BTC) and Bitcoin Cash (BCH) cryptocurrencies during the period of April 2017 - February 2018. BCH was born out of a contentious BTC fork in August 2017 and inherited BTC’s characteristics such as its mining and difficulty adjustment algorithms. BCH developers introduced the Emergency Difficulty Adjustment (EDA) algorithm to incentivize miners to process BCH’s transactions over that of BTC’s. Based on the strategic actions of the miners, difficulty changes brought through EDA resulted in dynamic changes to the difficulty adjusted profitability of BCH. This manifested in wild swings in their mining rates. Consequently, it leads to ques- tions regarding the effectiveness of such emergency mechanisms and their economic validity. Therefore, we construct an equilibrium model of cryptocurrency mining to uncover miners’ profit motivations, with and without such mechanisms. We utilize a two-step structural approach to recover the model primitives. Using the publicly available chain data, we find that competition among miners is a major contribution to miners’ per-period payoffs. However, contribution of competition is dependent on the state variables affecting profits. The ability of EDA to affect such state variables leads to differing impacts of competition. Through our counterfactual simulations, we assess the sensitivity of miners’ profits to the EDA algorithm’s configuration and its impact on the cryptocurrency reward-halving schedules.

Keywords: cryptocurrencies, bitcoin fork, bitcoin cash, emergency difficulty adjustment, structural modeling