Bitcoin Can Never Become a Currency. Part 2: Reward Distribution.
Part 1 that covers the problem of the scarce supply is here.
Satoshi Nakamoto created a truly groundbreaking concept of the first fully decentralized and independent payment system. Its design, however, wasn’t flawless and there were some inherent problems that didn’t allow the platform to become what it was conceived.
We have already analyzed the first major problem, which lies in the scarcity of the supply. Satoshi supposed that limited emission would make Bitcoin much more attractive in contrast to constantly inflating fiat currencies and we cannot state that he was wrong about that. The problem is that Bitcoin simply turned out too attractive to perform money functions and became a hedging and speculative asset instead.
The second problem lies is in the model of the system’s support and particularly in the reward distribution scheme proposed by the creator.
How it was conceived
In the original paper, Satoshi describes a peer network in which each node contributes available CPU power for a time-stamping service. Nodes are not decoupled from miners and the author unlikely envisioned mining as a separate professional activity. That can be seen from the description of the network functioning, where all nodes are prescribed to participate in PoW.
Satoshi denotes the described concept of a Sybil resistant timestamp network as a one-CPU-one-vote system. It was likely expected that each participant would run a node on his PC that would keep the record of the database and perform the required hashing work. In such a scenario, the platform looks purely egalitarian: participants play an equal role in the system support and have the same chance to obtain a reward.
In fact, the described egalitarian model is a matter of equal importance to the concept of decentralization itself. Not only the system gained the ability to progress in a trustless permissionless setup, but also the distribution of trust became almost absolute.
At the same time, the initially proposed model had one significant shortcoming: the reward was granted to a single winner of the lottery for each block. Given the total number of participants reaching a hundred, a node would get a reward each 16 hours in average, which is sufficiently frequent. If we raised the number of participants to a hundred thousands, however, the gap would expand to almost two years, which makes the incentive for participation rather dubious.
How it turned out
As we all know, during the early stages the system worked roughly as Satoshi described, but the appearance of ASICs and mining pools changed everything. The efficiency of ASICs drove CPUs out of mining and the emergence of mining pools accumulated trust in the hands of a small group of actors.
To date, we can claim that Bitcoin nodes have split into two different types:
1) Blokchain keepers: nodes that only keep the record of the blockchain and provide information to other nodes upon request.
2) Miners: nodes that perform hashing and participate in the block production.
Nodes that store the blockchain are all that is left from the original concept. Mining turned into a professional activity that requires a meticulous approach to marginal efficiency and is not affordable for ordinary users with consumer-level hardware. The initial egalitarian concept thereby turned completely elitist.
The emergence of mining pools caused the centralization of power and severely reduced the distribution of trust, but on the other hand, provided a solution to the problem of too low chances of getting a reward: the reward for a block is now distributed among the participants of a pool, instead of being granted entirely to a single miner who found an appropriate hash.
How it affects the economy
Now let’s investigate how this all affects the economy of the platform. In my previous post, I proposed two approaches to modelling a crypto economy. While researching the scarcity of the supply, it seemed more convenient to consider Bitcoin as a secondary currency powering the national economy.
In the case at hand, however, it looks better to stick to the second approach. Say Bitcoin forms its own virtual borderless economic zone. Of course, it’s not a fully-fledged economy, as Bitcoin doesn’t power entire production cycles and, what’s most important, wages and taxes are not paid in bitcoins. With some restrictions, however, we can assume that Bitcoin powers a separate economy and count certain variables including GDP. Assume that Bitcoin’s economy consists of two main sectors:
1) Financial sector, which is formed by operations of exchanging BTC into other financial assets.
2) Real sector, which is formed by operations of exchanging BTC into goods and services.
The ratio of these components tells us to what extent BTC can be perceived as a currency. If the real economy prevails, we can conclude that BTC is more of a currency than a non-cash financial asset and vice versa. Apparently, the growth of the real GDP of Bitcoin indicates its adoption as a currency, and if we want to proliferate Bitcoin and achieve the initial goals of Satoshi, we should find a way to support the real economy and reduce the influence of the financial sector.
The growth of the real GDP can be induced from different sides:
1) Merchant side.
The appearance of goods that can only be bought for bitcoins will trigger the response from consumers, who will seek to obtain bitcoins to buy the desired goods. The problem is that business always follows the path of least resistance, so they will only offer payment methods that consumers prefer. It is highly unrealistic that a merchant will agree to lose customers only in the name of Bitcoin’s prosperity.
Setting Bitcoin as an alternative payment option seems more realistic, but it won’t bring the desired result: most ordinary users can obtain BTC only by exchanging fiat money for them on exchanges, which is pointless, since they could also just use fiat money directly to buy the desired goods.
The only relevant situation is the distribution of goods that cannot be sold for cash or there are other obstacles to using conventional payment methods. This is why the major part of Bitcoin’s real economy is currently formed by the darknet market.
2) Consumer side.
A much more realistic way to achieve the same result is to ensure that consumers accumulate a significant number of bitcoins, which will trigger the instant response from business in the form of increasing supply of goods ready to be sold for BTC.
At this point, we address the problem of Bitcoin’s reward distribution. For this scenario to be realized properly, both following conditions should be met simultaneously:
1) A large number of consumers should obtain coins on a regular basis. Merchants will add BTC as an optional payment method only if it provides a notable increase in sales. This can only be achieved if issued coins are dispersed among the majority of users and not concentrated in the hands of a minority group.
We need a number of the recipients of coins reaching hundreds of thousands or even millions for this concept to work properly. Even if the award of each user will be insignificant, the total number of distributed coins will incentivize business to attract coin holders.
2) Each consumer should obtain an insignificant number of coins. If the worth of the obtained BTC becomes comparable to users’ income, users may start preferring saving BTC, for they are a better value storage than fiat money due to the scarce supply model. After accumulating a significant amount of BTC, users may turn to speculations and will unlikely consider BTC a means of payment. The speculative motive will prevail over the transactional motive, which will launch the development of the financial sector instead of the real economy.
To start the desired scenario, users should get the amount small enough not to be considered a significant investment and not to let the user overcome the initial reluctance to get involved with exchanges. Only in such a case, the likelihood of Bitcoin to be used for payments will be high enough to launch the growth of the real economy and overcome the speculative stage.
How it could be applied to the initial concept.
Had the initial egalitarian concept worked, it looks like it would have contributed to the proliferation of Bitcoin as a means of payment: as bitcoins accumulated in the hands of consumers, merchants would have likely started accepting BTC as payment. However, as was mentioned, before mining pools emerged, the reward for a block had been granted to a single user.
Considering a 10 minutes average block time, it would take too long to distribute coins among a sufficient number of users. Besides, with the growth of the user base and the corresponding growth of the value of BTC, the value of the reward for each block would likely exceed the boundary where it starts to be considered a substantial investment and becomes subject to hodling.
Given the absence of an algorithm that could disperse coins among the majority of users, we can conclude that the initial concept couldn’t launch the desired scenario and the system would likely end up in the same state as it currently is.
How it could be applied to the current situation.
Although mining pools allowed to distribute the reward for each block between multiple participants, hence fixing one the problems described above, the appearance of ASICs changed the approach to the system support entirely.
Since mining turned into a professional activity, instead of consumers, miners became businessmen themselves. For this reason, we cannot expect them simply spending all earned BTC without considering the most potential profit and hence the involvement in speculations.
In fact, this problem is intrinsic to the concept of PoW and any implementation of a PoW-based blockchain will share the same fate. Even systems with hashing functions that are optimized for GPUs, hence allowing to mine efficiently on a pretty standard hardware, require professional approach, as the most common rigs, which contain 6–8 graphics cards, are not something an average user can easily afford. Moreover, PoW protocols proved to favor players with higher hashing power, which further obstructs the participation of amateurs.
As miners got completely separated from users and formed a small elite cast, there is no incentive for the development of a real economy: miners prefer maximizing profits instead of simple spending and common users can obtain BTC only in exchange to fiat, which is irrational in most cases, unless we speak about illicit activities where BTC starts to provide notable benefits.
Under such conditions, the real economy of Bitcoin is sustained only by the darknet market and a small number of enthusiasts who behave irrationally to support the ideas of Satoshi and the concept of decentralization as an opposition to conventional fiat systems.
Conclusion
To become a fully-fledged currency, Bitcoin should power a real economy instead of the financial sector. This can be achieved by the distribution of bitcoins among a large number of consumers who will be ready to spend BTC for goods and services, which should trigger the response from business and lead to the subsequent growth of Bitcoin’s real GDP.
Unfortunately, neither the initial model, nor the current implementation features an appropriate mechanism of coin distribution. As miners adhere to the professional approach, we cannot expect them to behave as ordinary consumers. Caring about the maximization of profits, miners prefer speculative behavior, while users simply have no ways to obtain Bitcoins apart from exchanging fiat money into them. Without a sufficient demand, business has no incentives to sell goods for BTC.
Combining the stated arguments with the conclusions from Part 1, we can state that, due to several fundamental flaws, Bitcoin couldn’t succeed in embodying the initial ideas of Satoshi and becoming a global peer-to-peer electronic cash system. Instead, Bitcoin became an investment asset or a hedging tool and will likely stay in this role from now on.
