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Part 2: Why Bitcoin could face a slow heat death

Part 2: Why Bitcoin could face a slow heat death

Disclaimer: This article was produced for Radix DLT. The full post can be found here.

Future-proofing cryptocurrencies

If not Bitcoin, then how to best future-proof a cryptocurrency? As the space has progressed and we’ve learned how it’s used in the real world, the issue of block rewards has become increasingly important, and different solutions have begun to emerge as viable alternatives.

One potential option is to use a continuous, not fixed, supply. This ensures that there are a minimum fixed block reward and an indefinite flow of coins.

Projects such as Monero utilize this method, providing a fixed minimum block reward of 0.3 XMR. The level of this minimum reward can be altered (or it could be fixed so that it is unchanging from Day 1 onwards), but most projects have kept this to a low rate designed to keep inflation levels to a minimum – often, for example, below the historical inflation rate of gold. This reward, while low, incentivizes without the need to rely on just transaction fees.

A second method is to enforce an inflationary supply. There are multiple means to achieve this:

  • Increase the block reward over time, inverting the Bitcoin distribution pattern
  • Follow a ‘camel distribution’ (where the issuance is slow to start, then rises to a peak following anticipated user adoption, and then tails off again)
  • Regulate a disinflationary supply in which the amount of inflation decreases year on year

Ethereum operates according to this latter method. It aims to balance the ETH lost each year with the rate of issuance, although co-founder Vitalik Buterin stated that “The issuance is whatever it needs to be to ensure reasonable lvl [sic] of security.”

This cognizance of the security risks involved with a lack of block rewards is reinforced through the proposed switch from Proof of Work (the mining-intensive solution utilized by Bitcoin) to Proof of Stake (PoS).

Among other advantages, the reduced energy and thus financial burden of PoS means that there is not the same need to motivate miners through block rewards. It does not, however, really reduce the likelihood of miner centralization.

The economies of scale that make it largely unprofitable for all but the biggest entities to compete in Bitcoin mining are reduced, but not eliminated. Currently, it is expected that a minimum of 32 Eth is required (down from 1,250), so mining pools are still likely for the long tail of Ethereum, and the few whales in the system will still be hoovering up the majority of the rewards.

A third, and thus far less widely used, the alternative involves a variable supply. In these systems, the protocol inflates or deflates supply depending upon the market situation, and can be used to facilitate coins with substantially reduced volatility, which aim to reduce the swings experienced by most cryptocurrencies. A variable supply can work in a number of ways including:

  1. Upon demand from a user, a new token(s) backed by pledged collateral is created; upon repayment, the previously created token(s) is destroyed. Supply and demand is balanced through incentivizing people to hold or use the token through increasing or decreasing the capital gains (i.e. interest payments) received
  2. Match an increase in demand with an equal increase in supply. In this example, the purchase by a user of new tokens is matched by the generation of tokens for the rest of the market, tokens which are subsequently distributed between all other balance holders. Price remains constant – but users holdings increase as the user participation increases.

Bitcoin was borne of the 2008 global financial crisis and came of age in an era fraught with the worldwide increase of monetary supply through quantitative easing. Given this background, it is unsurprising that one of Bitcoin’s most important features is the fixed total issuance of just 21 million coins. This is and will remain, an enduring feature.

However, the wave of new cryptocurrencies need not follow the same path. People with ambitions to create cryptocurrencies that are a future-proof, viable, and actively used means of currency (Nakamoto’s initial aspiration for Bitcoin) should be mindful of the need to create a system resistant to miner centralization, which minimizes security risks to future holders and encourages – not punishes – transacting and spending.

Five questions surrounding the BitGrail ‘hack’

Five questions surrounding the BitGrail ‘hack’

Part 1: Why Bitcoin could face a slow heat death

Part 1: Why Bitcoin could face a slow heat death