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Written by Kristopher Ives.

Context

This article was written in August 2012 when the price of Bitcoin in terms of USD was around $10. The price of Bitcoin has varied a lot over time and the numbers in this article are simply snapshots in time.

Analysis

At the core, Bitcoin is a cryptographic data structure that is distributed among many un-trusted peers that can be verified, but has no central authority. The blockchain is verified by peers in the network looking to cash-in on the next “jackpot” through a process known as mining. While it sounds trumped up, that’s a very accurate statement about the current status of mining Bitcoin.

Miners are the security backbone of the blockchain. They verify transactions by solving problems hard to computers and signing outstanding transactions in the process. Currently a miner gets 50 BTC (~$500 USD) award when they provide this service. It’s estimated that this award will halve in December 2012.

With the 50 BTC reward or even a 25 BTC award miners have a lot of incentive to keep the blockchain very secure. As time goes on the amount of coins awarded to miners validating the security of the network will decrease and eventually no “jackpot” reward at all, meaning someone who performs the service of securing the network gets no payout created from thin air, and the supply of coins will never increase again. Statistically this will occur around 2144 when the reward decreases to a number so small it cannot be represented in the system of numbers with the precision agreed upon by the network.

Bitcoin can always expand the numerical precision of the system to facilitate a minimum bound on new coins entering the system. While the current Bitcoin only respects coins with a value a small as 0.00000001, and in 2144 that will get so small it gets treated as zero if the precision was increased before that everything would continue like business as usual. New coins awarded by the system would still statistically exist.

Niggling over which years can add infinitely small coins to the network is rather moot for most practical purposes, but it does enable Bitcoin to escape any trap with being unable to facilitate trade due to lost coins after no more coins can be added to the system. Regardless of the exact years and numerical accuracies permitted the network will always trend to creating the least inflation to facilitate trade.

Save
Bitcoin subsidized itself and the initial security of the network into existence. It had to solve the problem of distributing coins and providing an incentive for miners to validate transactions before any coins existed to pay for this service. Early in the network this solves both of these problems, but eventually Bitcoin will cross a point where the subsidized rewards programmed into the software become less than the actual costs demanded by miners to keep the network secure. It doesn’t matter if this occurs statistically or because the cost of running computers gets more expensive. Either way miners have to be paid and the network will have stopped paying that bill for everyone.

But, what happens after that? Usually this discussion begins in a doom-and-gloom way of the demise of Bitcoin. It’s true that after that period of time miners will have been entirely cut off from the autonomous subsidization of the Bitcoin network. However, it’s replaced by an entirely organic market solution that is currently implemented today but virtually unused because peers would have to compete with the 50 BTC jackpot via the sum of their transaction fees.

Just like the jackpot reward a miner currently gets when verifying the security of the blockchain, all the transactions involved can include a “tip” so to speak for the miner.

These are called transaction fees and are entirely arbitrary values peers assign when making transactions. Unlike traditional services where someone sets their asking price and does work at that rate, this has an inversion of control. Peers making transactions engage in a very careful game of choosing the right transaction fee. They want to be as accurate as possible, because miners ultimately decide to verify a block or not. The result is a shelling point where everyone “just knows” what the current price needed to get transactions processed safely. You’re free to try and make transactions at a lower value with a risk they won’t get processed in time or could be exposed to security attacks. This process makes miners earn fees relative to their security utility in the network and the average Joe’s are still around to help a friend in need that needs to verify a block but is hard up on bitcoin.

There will be a trade-off between the level of service provided by miners. Even though they provide the same functionally identical service in the same way, verifying blocks, they do so with respect to time. The faster you can verify blocks the more business you will earn on the network and the higher BTC yielding transactions likely earned by more serious players that specialize in verifying the blockchain. Considering miners are subsidized right now and creating entirely customized electronic circuits pushing out some incredible power this is likely to be an industry with extremely rapid growth as their edge/improvements in technology will directly translate into revenue.

The beautiful result is that the entire global economy funds the security costs with nobody setting a single price or having any special privilege. As the gap between specialized hardware and average Joe’s changes, so do the transaction fees needed to keep the network secure. In the future, being behind on your technology will have highly modelable costs as you essentially have to outsource it to miners to keep your market actions safe.

Once spreading of the money supply growth has essentially been exhausted, the remaining problem is: What happens as coins “leak” out of the system? There are many projections but with most of them it’s clear that people are going to lose coins. The rate people lose coins isn’t important because the precision can be increased. However, a time will come when more coins are being lost than added by infinitely small growths in the money supply and the market adjusts the prices to cope with this.

The result will likely be that as we lose what we can never get back we’ll start to appreciate it more and more. As time goes on and the growth of the money supply approaches zero, the currency itself will become more scarce and demand fiscal responsibility.

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Kristopher Ives is a programmer from Oregon. He was recently in the media for donating bitcoin to Edward Snowden. You can donate a tip to him at 18czpKSVmfvHyU5S5FrRH5WwrETx97ivLh