Saturday, March 29, 2014

Bitcoin dynamics

Good discussion of Bitcoin by Mark Andreesen in the Times Dealbook: Why Bitcoin matters. There are also good points made in the comments (see Reader Picks). For example:
... Bitcoin is arguably more like a commodity than a currency as it has no physical assets or central bank behind it. As a commodity should it not therefore be liable to be taxed for any capital gains/losses should the regulators define Bitcoin as a commodity, as in Finland recently? (The example of the guy buying a second-hand Tesla with Bitcoin raises the question, at what price did he originally purchase the Bitcoin? I'm sure the IRS would be 'investigating'.) To conclude, for the 'regular' guy there is very little advantage of getting involved with Bitcoin, apart from speculating on its price.
... Andreessen handwaves away the most important problem: there's no reason for anyone to want to hold bitcoins, particularly given the bitcoin-dollar rate volatility. He waves this away by saying that people can just conduct transactions in Bitcoin and then immediately convert the bitcoins into dollars, as though actual money is just transmuted into this special form while it's sent over the wire and then both parties cash out. Well and good; but if that's the case there has to be a market-maker out there. You need someone with a large dollar reserve who can convert dollars to bitcoins (and vice-versa), and who can even balance international currency flows. That's a valuable service; it's foolish to think it'll remain free forever.

Similarly, the math behind Bitcoin requires a huge amount of electricity and computing power to record current and future transactions. Right now that's covered by speculators who are basically paid in bitcoin seignorage; but any time you're consuming real resources and expecting to get them for free you're being either naive or dishonest.

And honestly, if we just wanted a new payment system, we could do that with far less technical and physical overhead than Bitcoin requires.

In short, I'm sure lots of people would love to have financial transactions be free. That doesn't mean they actually will be.
Has anyone worked out the equilibrium compensation required for miners to maintain the transaction record (this involves the cost of energy, etc.)? It seems that if there are lots of micro transactions the cost of maintaining the record might exceed the expected benefit to the miners. The volume of trades is in principle independent of the total amount of value in the system, so there seem to be bad regions of parameter space. I read the original Bitcoin paper a long time ago but haven't followed any of the theoretical developments since then. Don't forget: bits = carbon!  :-)

My question is partially addressed in the Bitcoin FAQ -- they reserve the right to charge transaction fees to help compensate miners. Who, exactly, is "they"?


Harry Moreno said...

They is the writers of the implementation and protocol. Most of the core team needs to agree to go forward on development. And most of the miners have to agree to update to newer versions.

steve hsu said...

Seems like a potential governance challenge if they want to pursue micropayments ...

Douglas Knight said...

No, I don't think that there is any need to change the protocol.

Yes, the implementation needs to change, but that's not a big deal. The person who wants a transaction bids a "fee" paid to the miner who records the transaction. That is, fees are supposed to be set by auction. Whether the miner pays attention to the auction is a matter of decentralized implementation, not centralized protocol. I believe that the current implementation does prioritize based on the size of the bid. What needs to change, when the fees become large compared to seignorage, is that the software must set a reserve price and consider the option of not mining to save electricity.

dxie48 said...

"Has anyone worked out the equilibrium compensation required for miners to maintain the transaction record"

"One conclusion drawn by Kroll and his Princeton colleagues Ian Davey and Ed Felten is that those rules will have to be significantly changed if Bitcoin is to last.
Miners earn newly minted bitcoins for adding new sections to the
blockchain. But the amount awarded for adding a section is periodically
halved so that the total number of bitcoins in circulation never exceeds
21 million (the reward last halved in 2012 and is set to do so again in
2016). Transaction fees paid to miners for helping verify transfers are
supposed to make up for that loss of income. But fees are currently
negligible, and the Princeton analysis predicts that under the existing
rules these fees won’t become significant enough to make mining worth
doing in the absence of freshly minted bitcoins."

steve hsu said...

Ah, my old Page House contemporary Ed Felton :-) Class of '84 or '85 IIRC. He was a physics major at the time ...

Douglas Knight said...

The actual paper is here, and the relevant section is 4.2, but it is idiotic. Shame on Page House and shame on physicists.

steve hsu said...

Care to elaborate on what is wrong with their paper? Maybe you should blame Princeton CS instead of Page House and the physicists :-)

Adam Marsh said...

There is no "they"; fees can be built into a proposed transaction as part of the protocol. When BTC incentives expire, transactions lacking a fee will fail to be added to the blockchain.

WRT equilibrium compensation, from the original paper: "to compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour. If they're generated too fast, the difficulty increases." In a perfect market, the difficulty (cost) should then adjust to yield zero profit for miners given the BTC reward or average proposed fee (price); however this is complicated by things like the volatile value of BTC incentives, the variability in cost vs difficulty via ASICs, imperfect markets ;-), etc.

The effective transaction costs for BTC are actually quite high, and confirmation times are slow, making it in theory a poor payment system but a good store of value. You might want to check out Ripple, which is a crypto protocol designed from the bottom up (actually by core BTC devs) to be a good payment system.

Douglas Knight said...

They say that the auction brings the rewards for mining down to zero.
Of course, it really brings the marginal profit for mining down to
zero, after the expense for electricity. Moreover, they go on to say,
with no explanation, that it's a bad thing, different from the current
regime. In fact, it's exactly the same as the situation in the current

There is a difference, which is that in the current
regime the rewards from mining change abruptly, as new miners come
online and as currency fluctuates. So investment in new hardware is a
long term bet made under great uncertainty. When seignorage ceases to
pay for electricity, prices will be driven by short term auctions that
will immediately correct for fluctuations in currency and electricity.
Currency risk is gone, but uncertainty about the number of future miners
remains the big risk for investment in new hardware.

ESRogs said...

You might be interested in what Mike Hearn has worked out about funding mining in the future. See: (much more detail than the FAQ section you found).

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