Research

All Things Bitcoin; Incentive Structure

August 13, 2021
Steven McCormack
3 mins

Back to class, folks. Let's start with a quick recap on my interpretation of Bitcoin mechanics. I view it as a natural extension of the internet; a network of distributed computers (nodes) that maintain a self-audited record (ledger) of value transfer. This record becomes more legitimate over time as transaction history (i.e. the communication of value between network users) is time-stamped, 'blocked' together and cryptographically 'chained'. Hence the term blockchain. Consider it like a radio broadcast; songs can be simultaneously heard by all those tuning into the same station. Everyone can agree on what the playlist was. Bitcoin transactions follow a roughly similar dynamic.

What, When and Who

With network expansion comes increased security, as more computing resource is dedicated to auditing, blocking and chaining. The result is a happy one; anyone can reliably explore the ledger to determine what moved when, without relying on a centralised authority for verification. As for the who, buyers and sellers interact via Bitcoin addresses (represented by a string of numbers and letters). This allows you to direct value ('sending' bitcoins) towards a recipient's virtual location on the network. For full privacy, they are only meant to be used once (per transaction). A Bitcoin wallet can generate new addresses, 'store' bitcoins (i.e keep score of your network history) and protect private keys, which approve transactions. This permits network visibility without disclosure of sensitive information (names, physical locations etc).

Moths to a Flame

What emerges is Bitcoin's true genius; digitally engineered, distributed trust. Property rights are established by consensus. Time and energy is converted into security. Transactions are transparent. This creates a formidable flywheel; legitimacy encouraging growth, which in turn generates trust, resulting in more legitimacy. And so on. But Bitcoin cannot survive alone on impressive technical credentials. After all, there is a cost to all of this auditing, blocking and chaining. So for the flywheel to keep spinning, we must introduce an economic reward for network participation. Which brings us nicely to Bitcoin's incentive structure.

Thankfully, much smarter brains than moi have already explored the three main components that facilitate such reward (big hat tip to Hugo Nguyen). So I'll be borrowing heavily for my own explanations. With that admission of intellectual laziness, we'll crack on:

1) Controlled Supply

We are naturally drawn to value scarcity. Just look at how gold, classic cars, vintage wine etc. carry a certain allure. It must be a response baked in from our prehistoric era, when we were all scrambling about for limited supplies of food, shelter and fresh water. In short, we place a higher status on finite resource. Contrast this with our casual attitude towards a single pound, dollar or euro. As common as muck! So it caught my attention when I learned of the 21 million bitcoin supply cap (which each bitcoin further divided into 100 million units, known as satoshis).

One thing however; scarcity can only really derive value where there is an inherent demand. I still need pounds, dollars and euros to meet daily expenses. I can't quite argue the same for Bitcoin. This dilemma is highlighted by Frances Coppola, who deftly points out that '21 million of things no one wants is abundance (or “oversupply”), not scarcity'. So a controlled supply alone does not offer sufficient reward.

2) Mining Subsidy

That brings us to mining, a whole topic in itself. I'm not the biggest fan of this term, as it plays havoc with my imagination. I tend to picture little tiny people inside computers, toiling away with little tiny pickaxes, to find blindingly shiny and magical coins. As cutesy as this may be, it trivialises the keystone of the incentive structure. So before we go any further, let me propose a perspective shift. In a nutshell, mining refers to the process of time-stamping, blocking and chaining together the transaction of history of Bitcoin. Personally I prefer 'auditing', which aligns much better with the requirements for verification and prevention of fraud.

To maintain the integrity of the network, the mining process is computationally heavy by design (proof of work, difficulty adjustment etc). So miners are compensated for their efforts with newly created bitcoins (i.e. the mining subsidy). Initially the subsidy was very high, at 50 bitcoins per block, which helped to drive demand in the early days of the network. However with rising Bitcoin adoption, there has been a corresponding reduction in the available subsidy (known as the 'halvening'). This is set in stone through code, occurring roughly every four years. The current reward is now 6.25 bitcoins, and will reduce to 0 once the final bitcoin is created. My take on this is that there was an anticipation (or divine vision) that artificial demand, via subsidy, would eventually be surpassed by real demand, via network effects, as Bitcoin gained legitimacy.

But once the last bitcoin is created, who will bother to sustain the network? Well those smart Bitcoin folks had a solution for that too.

3) Transaction Fees

By the time we reach 21 million bitcoins, mining becomes a truly outdated term. There is nothing left to uncover! We may have network effects. We may enjoy holding our valuable bitcoins. But we still need auditing, blocking and chaining to sustain Bitcoin. Time and energy will still be required to process transactions and maintain security. At the moment miners are further incentivised (on top of subsidies) to complete this work via transaction fees. Consider it the price you pay for value verification on the blockchain. Fees are subject to the law of supply and demand, and set accordingly. As per Nguyen, 'when blocks are full, fees are high. Vice versa, when blocks are empty, fees are at their lowest.' This will continue after the mining subsidy expires.

And with that we will all live happily ever after. At least in theory. You see, no one knows what will happen when that last miner puts down his little tiny pickaxe (expected in 2140). It is a completely abstract event that we will not witness. Instead, we have faith that it will just sort of, work. Our great grandchildren will celebrate our collective genius at moon festivals and during interstellar backpacking (funded of course by their bitcoin inheritance).

Bigger Quandaries

To bring it all together, economic motivation is woven into the fabric of Bitcoin. The incentive structure has allowed the network to spread far from its niche beginnings (within the cryptography community). And its power lies in its simplicity. Cap supply. Stimulate demand. Sustain interest. Combine that with Bitcoin's technological integrity and a fraying fiat backdrop, and you might just have yourself an alluring store of value.

But what of all the recent price volatility?! Shift your perspective, amigo. From 6 months to 6 years. Look behind the headlines. From dollar denomination to rate of adoption. As Raoul Pal reminds us over and over (and over) again, the entire digital asset space is subject to network effects (Metcalfe's Law); intense, exponential growth. It offers a solid explanation for the internet's success and the network driven companies it has spawned such as Facebook, Google and Amazon. It represents Bitcoin's journey from obscure tech in 2009, to an established protocol for truth in 2021 and beyond. This thing's got legs.

-Value for the User according to Metcalfe's Law
https://www.researchgate.net/figure/Metcalfes-Law-1993-The-Value-of-Compatibly-Communicating-Components_fig10_336923249

It is not all plain sailing, however. We cannot rely alone on blind faith and theoretical framework. Bitcoin's perception as a dependable asset relies on its ability to scale. How will it perform with 500 million users? 3 billion users? That is the next challenge for the network, and also our next topic of discussion. And before we wrap up, a little more food for thought. How will humans even behave in 100 or 200 years time? Will we still value scarcity, consensus or property rights? That calls for some Vervaeke meaning magic; Bitcoin as a pyschotechnology, anyone? Watch this space.

Signing out, Steven.

Photo by Xiang Gao on Unsplash

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