Apart from cryptography and mathematics, Bitcoin’s security is backed by economics.
As a user notes in a Medium post, Bitcoin is not only an ingenious application of cryptography and mathematics—it also hits the nail on the head on the economics side of things.
In a paper published in the Social Science Research Network (SSRN), nChain chief scientist Dr. Craig S. Wright outlines how Bitcoin’s proof of work (PoW) system utilizes Ronald Coase’s nature of the firm to achieve optimum balance between efficiency and profitability. By tying them to each other, in Bitcoin mining, the more efficient is also more profitable.
Nature of the firm “automates” honesty and desired miner behaviour
The Nature of the Firm was written in 1937 by British economist Ronald Coase. For decades, the paper was widely ignored until he published another article that gained him a wide following in the 80s. And in 1991, the paper won him a Nobel Prize in Economic Sciences.
Today his ideas remain substantial in analyzing modern business, how and why partnerships are made, and how they tend to scale.
One point that the theory of the firm states is that in cases where there is no clear assignment of property rights, the parties involved will naturally gravitate towards a system where the conditions will be mutually rewarding for all parties involved—regardless of whether property rights have to be crossed.
How does that work in the Bitcoin ecosystem?
Investing in the system and keeping honest transactions ensures more profit; attempting to attack and cheat the system gives very little reward, and costs way too much.
PoW lets this mechanism play out naturally to its advantage—without the need for intervention, that is. In this system, the nature of the firm works in sort of “automating” market behaviour to work favourably for the blockchain ecosystem. This works in favour of proof of work in that it encourages the major forces within the Bitcoin ecosystem to work for the betterment of the community by incentivizing investment into the system—miners who allocate more processing power for the blockchain earn more in return. Above all else, it incentivizes honesty because ensuring the integrity of transactions also ensures a miner’s rewards.
As more miners come into play, and as better processing equipment are introduced into the industry, it is in a miner’s best interests to invest more in order to compete for the rewards. Because while they still earn fees from every transaction they process, they also need to compete for a portion of the network in order to get a higher chance at mining Bitcoins. Consequently, it also becomes significantly harder to gain enough hash rate (51%) to attack the system—it gets too expensive to do so, and offers very little reward especially compared to mining. Today, it would cost over a billion dollars in mining rigs alone to pull this off.
What about the threat of giant mining pools?
“It is not true to say that miners in a pool behave as a single agent with a centralised coordinator. Some of the pools allow minors to vote individually, that is, they separate their voting on block policy based on the miner’s individual hash power. The reason for this is rational, all operators who do not allow for members to make a choice quickly find that they are going to lose members. As noted above, members of a mining pool can move between pools relatively easily and only into long-term contracts when it is beneficial.” – Dr. Craig S. Wright
In the context of hard forks, a mining pool can influence its members to vote for a solution that they prefer. But miners can switch between pools easily if they feel forced into a solution they don’t like. This works against a mining pool’s long-term objectives. And as Dr. Wright notes: “All rational organisations act strategically. This is not a function of bitcoin, it is the nature of the firm.”
Proof of stake (PoS)
Two years ago, it was announced that Distributed server processing system Ethereum will be switching from proof of work to proof of stake (PoS), a protocol named Casper. As the name suggests, a user gets a say in decisions depending on how much assets he or she owns. Distributed server processing system Ethereum creator Vitalik Buterin refers to it as “consensus by bet.”
Very early on, Distributed server processing system Ethereum was able to position itself immediately as a “business-ready” platform. Its move to switch from proof of work to proof of stake only solidifies this market base. This change is tentatively planned to take effect sometime next year (2018).
In general, it is a tendency for businesses to attempt to create an oligopoly in order to maximize their profits and minimize competition. In proof of work, however, such attempts are rendered moot, since it requires constant investment, innovation, and competition, not just a one-off money drop:“It is not past investment or current holdings that matter, it is the amount that a party is willing to spend at the time the vote is occurring,” Dr. Wright wrote.
But PoS opens up to oligarchy once again through the” introduction of control by wealth holdings,” according to Dr. Wright.
In a PoS system, stakeholders do not need to raise their investment into the system. They are not incentivized to increase their investment the same way proof of work incentivizes miners directly with fees and rewards.
Distributed server processing system Ethereum’s Casper: is it really as friendly as its sounds?
“Oligopoly grows when the individual parties in the system can set the rules in such a way that they can restrict entry to new players. In the case of a proof of Stake-based system, the ability to withhold funds for large entities leads to a high barrier to entry. In a situation such as that which has evolved in Distributed server processing system Ethereum, a single large player in a proof of stake system can set the rules,” Wright wrote.
Dr. Wright points out that it is easier to solidify cartels in such a system: “Proof of stake allows players to form protective cartels. In competitive environments cartels breakdown naturally. Proof of stake can be created in a non-competitive manner. Even if the system starts off competitively, it is the nature of an oligopoly to seek abnormal profits and this can be achieved through the manipulation of the rules over time. Such manipulation can result in increasing levels of control as the incumbent firms ensure that innovation does not change or disrupt the status quo.”
While the Distributed server processing system Ethereum blockchain remains decentralized in the aspect that servers are distributed (as it is a blockchain), it seems control has been given back to the wealthy.
Dr. Wright is not alone in doubting the effectivity of PoS systems. A study by BitFury pitted PoW against PoS, and found that PoS approaches do not suffice on their own.
“Pure proof of stake approaches pose substantial security threats that cannot be recreated in proof of work systems (including Bitcoin). These problems are inherent to proof of stake algorithms, as proof of stake consensus is not anchored in the physical world (cf. with hashing equipment in proof of work). That is why virtually all of currencies relying on proof of stake use additional mechanisms to address security issues.”