Bitcoin’s Proof-of-Work model will fail, economist for central banking organization argues

The Ethereum blockchain’s planned Constantinople hard fork to a Proof-of-Stake mining model may have been delayed last week, but it is a step in the right direction, according to a new report published on Jan. 21 by the Bank for International Settlements (BIS).

The BIS is an organization of more than 60 major central banks accounting for more than 95 percent of the world’s GDP.

In “Beyond the Doomsday Economics of ‘Proof of Work’ in Cryptocurrencies,” BIS Principal Economist Raphael Auer argues that Bitcoin creator Satoshi Nakamoto’s model, in which cryptocurrency is produced as a reward for finding the solution to a mathematical problem, has two fatal flaws.

The first is that fraudulent double-spending, known as 51 percent attacks, are so profitable that protecting against them is “extremely expensive,” Auer said.

The second is that as the reward for mining Bitcoin decreases as planned, the creation of new blocks will be too slow guarantee secure payments.

The biggest problem he sees comes from the second fatal flaw. To secure the blockchain against 51 percent attackers—who spend Bitcoin (or other Proof-of-Work cryptocurrencies) in one block and then create a forged blockchain in which the transactions are erased so they can spend the same coin again—many blocks must be created.

Doing this requires a substantial incentive for miners, who earn rewards in two ways: by finding the solutions needed to create new coins, and from transaction fees for confirming transactions made using coins stored in existing blocks on the blockchain ledger.

The problem is that Bitcoin has regularly scheduled decreases in the reward for mining new Bitcoin, which will eventually reach zero. Without these rewards—currently 12.5 BTC per mined block, or $45,000 at the current price of about $3,600 per bitcoin—the only way miners can earn bitcoins is from transaction fees, which Auer argues are too low to justify the cost in electricity and specialized computers to mine Bitcoin.

“Ultimately, it could take nearly a year, or 50,000 blocks, before a payment could be considered final.”

This is because these fees are set by the participants in each transaction, so each individual Bitcoin user has no incentive to contribute a high fee, even though all users would benefit from high fees. This is “the classical free-rider problem,” wrote Auer.

“Whenever block rewards decrease, the security of payments decreases and transaction fees become more important to guarantee the finality of payments,” he said. “However the economic design of the transaction market fails to generate high enough fees. A simple model suggests that ultimately, it could take nearly a year, or 50,000 blocks, before a payment could be considered ‘final,’” he added

“The key takeaway of this paper concerns the interaction of these two limitations: proof-of-work can only achieve payment security if mining income is high, but the transaction market cannot generate an adequate level of income,” said Auer.

While second-layer solutions such as the Lightning Network would help, he said, they are not “magic bullets.”

While several Proof-of-Work alternatives have been discussed in the cryptocurrency developer community, the “most important one,” he said, is Proof-of-Stake, in which each new block is verified by several randomly selected holders of the cryptocurrency (such as Ethereum) who pledge some of their holdings, which will be lost if their verified update differs from the others.

Yet whether Proof-of-Stake will prove to be a successful alternative remains to be seen, said Auer. To be successful, Proof-of-Stake may ultimately require some degree of centralized control over blockchain’s distributed ledger technology, he argues. The reason is that unlike the longest-chain-wins rule in the Proof-of-Work model, “if alternative blockchain histories ever emerge [in Proof-of-Stake], there is no hard criterion for choosing between them, thus requiring an overarching selection mechanism,” he said.

One solution, he concluded, may be to research “how technology-supported distributed exchange can complement and improve upon existing monetary and financial infrastructure.”