Part 1: Why Bitcoin could face a slow heat death
Disclaimer: This article was produced for Radix DLT. The full post can be found here.
Cryptocurrencies have transitioned from a financial afterthought to a new asset class with fresh investors piling in every day. However, a key question still remains: how can we make sure these assets will continue to exist and operate in 10, 20, 50, or 100 years time?
There is a potential danger that, like the 2nd law of Thermodynamics, Bitcoin as a finite and closed system may simply stop moving and eventually die.
This is the problem hidden in the beauty of the fixed supply system. Decreasing mining rewards over time, combined with an increased desire to hold rather than transact, takes away the very lifeblood of what makes a decentralized network function in the first place: incentives.
Bitcoin is the most famous example of a Proof of Work (PoW) system, programmed to steadily reduce the mining reward over time. This leads to a halving every four years, with the last Bitcoin scheduled to be mined by 2140. That may sound like a far-flung future concern, but it quickly reduces the block reward, as shown below:
As such, within 20 years the mining reward will be less than one Bitcoin per block. The original design for Bitcoin envisioned that as the mining reward decreased, the total number of Bitcoin in active circulation will have increased such that transaction fees, not mining rewards, would eventually be the main incentive for miners.
Unfortunately, this is unlikely to happen. The current block size limit is making transactions increasingly expensive and the limited supply combined with an inherently deflationary nature is leading to a situation where participants hoard coins in expectation of further price growth. As On the Instability of Bitcoin Without the Block Reward concluded, it may also lead to deviant mining behavior, further undermining the network.
When Bitcoin is too valuable to use
But why does this matter in 2018? After all, cryptocurrencies are in their infancy, a Bitcoin is highly divisible (currently up to a Satoshi), prices have been rising with no end in sight and the mining rewards don’t actually end for another century.
However, the scenario outlined above will likely lead to miners becoming centralized, and the merging of large holders of Bitcoin with network operators. The motivation of miners over time will move from that of income generation to network maintenance and protection, operating solely to preserve their own holdings. This is because as block rewards decrease, for hash power to stay roughly constant the price of Bitcoin must constantly and consistently increase.
Paradoxically this required price increase means there is less and less incentive to sell or use Bitcoin, leading to smaller and smaller amounts of transactions. At some inflection point the tokens essentially only move to pay for the maintenance of the network, removing almost all utility and active circulation. This lack of use may end up being the thing that kills Bitcoin; it dies because it becomes too valuable to use.
Bitcoin, while remaining the dominant cryptocurrency, suffers from the same disadvantage as all pioneering technologies. As the original solution, it blazed a trail absent the experiences of others. Indeed, Satoshi Nakamoto’s whitepaper refers only briefly to the prospect of the end of block rewards, simply concluding: “The incentive can also be funded with transaction fees…once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”