One of the most controversial features of Bitcoin and Cryptocurrencies in general is their deflationary nature. This feature is unique in that it’s more ubiquitous than proof of work, yet is in no way necessary to the protocol or security of the network and is completely arbitrary and arguably illusionary (as it can always be forked out at a later date). While among Crypto evangelists and many early enthusiasts it is considered one of the core tenets of cryptocurrencies, I would argue that it’s the asset’s biggest flaw.
While capping the supply of a coin may make it seem appealing as a store of value, ultimately it has detrimental and possibly debilitating effects on both adoption and use of the coin as a means of transacting. In addition even the basic function of a store of value is threatened by the fact that restricted supply limits do not properly incentivize mining, and as a result have allowed many existing coins to become incredibly vulnerable to attack. Privacy coins are especially vulnerable here as security, adoption, and utility are much more important to such coins than acting as a store of value. Thus I would like to propose the creation of a protocol that allows miners to control the emissions rate up or down by some percentage every block.
In my experience, the problem people have with inflation isn’t the mechanism itself but rather who benefits from it. The way that inflation is implemented, in fiat currencies, tends to benefit key institutions and individuals with the benefits which only slowly trickling down. While cryptocurrencies were supposed to fix this; by allowing those who secure the network to benefit from inflation, with the assumption that they would have to sell the coins to pay for electricity and hardware; however evidence indicates this has caused even more centralization than we see in fiat.
Since I am proposing something that may be quite controversial and is certainly not well discussed in this community I accept that the burden of proof falls upon me. To this end I will spend a considerable amount of time explaining the factors that influence this proposal laying out the negative effects of deflation on adoption and utility, discussing and reviewing the security implications of deflation, both theoretically and on existing coins, and finally detailing what I propose.
In addition I would like to highlight the following articles in support of my arguments and as further evidence of how the current system tends to encourage hording, by miners and early adopters, as well as exacerbate the negative effects of deflation.
We must be able to measure blockchain decentralization before we can improve it.
78 percent of Bitcoin currency stashed under digital mattress, study finds
More than three-quarters of the digital coins in the Bitcoin digital currency scheme aren't circulating because they…
Bitmain Holds One Million Bitcoin Cash and LTC, 22,000 Bitcoins and Almost No Eth
Bitmain holds more Bitcoin Cash than Satoshi Nakamoto at 1,021,316 as of March 2018, amounting to $600 million at…
Problems with Deflation
Whether a hard cap, like Bitcoin, or soft cap, like Ethereum, these caped inflation rates turn coins into extremely deflationary asset where eventually more coin will be lost per year than are created thus shrinking the total supply and exacerbate all the intrinsic problems with deflation exponentially, this will eventually leave such coins essentially illiquid, or perpetually unable to meet market demands for liquidity. In addition to the basic liquidity issues caused, deflation leads to a host of other problems including; making the first-in the best-off , as well as the rich richer, and disincetivizing use, while some of these issues have not been massively detrimental thus far and may have even helped increase early adoption, they are not necessary to the protocols and will disincetivizes further adoption compared to identical inflationary coins.
First off, the supply caps on crypto assets, whether soft or hard, coupled with the nature of crypto assets (the fact that wallets will be lost and/or coins burnt) mean that eventually these coins will have negative inflation rates. So what does this mean for the value of these coins? Well, while many people like to compare Bitcoin to gold, gold actually has a very consistent positive inflation rate on a percentage bases, averaging 1.55% over the last 12 years and gold production has grown relatively consistently over the last century. So if Bitcoin’s inflation rate isn’t comparable to gold, then what is a good comparison? Well there aren’t many deflationary assets for good reason, they become illiquid over time and thus can’t be used practically or transacted in freely. The closest (though problematic) comparison I can come up with would be a particular vintage of wine, which do tend to increase in price over time, as the total supply decreases, never the less the market for any particular vintage also shrinks until it eventually becomes completely illiquid in the hands of a small number of collectors. While many Bitcoin enthusiasts argue that this will not happen to Bitcoin since they can be broken down into infinitely small fractions, allowing the market to sustain liquidity, the problem with this argument is that it’s only true if we measure that liquidity using an inflationary asset such as dollars, the liquidity measured in Bitcoin will obviously be decreasing. So inevitable you are left with an ever greater number of people competing for an ever shrinking quantity of Bitcoin until it becomes unsustainable and something has to give, since the quantity of Bitcoin can’t increase the number of people interested in competing for it will have to give.
One thing that deflation does that has, thus far, been helpful to crypt is that it makes the first-in best-off, which has incentivized lots of people to buy in, with the hopes that they will be bought out at a later date, and has increased early adoption. However long term this is not sustainable as it would require that every new wave of adoption buy in at a higher price, and rely on the wave of adoption that comes after them for the value of their coins. Effectively this making the coin very similar to a pyramid scheme where finding the new actors to buy-in and bringing in the new stakeholders needed to increase the overall level of adoption becomes exponentially harder, since new stakeholders benefit exponentially less, thus making scaling the coin increasingly difficult.
This leads me to the first important benefit of inflation, which is to prevent the rich-get-richer effect where, without inflation, people who have money will automatically gain wealth by not investing it, while people who spend money will loose wealth even when they use their money to buy useful products. So whoever can go the longest spending the smallest percent of their wealth ends up the richest, and since the wealthiest by definition have the most wealth and thus need to spend the smallest percent of that wealth to sustain themselves the rich-get-richer. This obviously encourages people to stop; spending, making risky investments, or using their coins at all.
Thus lack of inflation disincentivizes adoption of the coin for its intended use, as the longer you can go without spending the coin the more it will be worth and the less you will have to spend giving rise to the HODL state we see in many coins. To illustrate this, let’s say someone has half their money in dollars and half in a coin and they have to pay for something, since there is a cost to acquiring the coin (conversion fees, time and effort, etc) they are better off saving the coin they have, since it will likely be worth more tomorrow, and using their dollars, which will likely be worth less tomorrow, to make payments. This means that the expected appreciation of the value of the coin, relative to dollars, is actually an additional cost that the user must pay to realize the benefits of the coin (such as privacy). However, were the coin to be inflationary at the same rate as the dollar then the user would have an incentive to always opt to use the coin, since they would achieve the benefits that the coin offered for free, and these benefits could even offset the costs of exchange encouraging the user to exchanging dollars into coins and then use the coin, when possible, instead of dollars. What this means is that while deflation may make the coin appreciate in value, relative to the dollar, this appreciation becomes a cost to transacting in the coin and is detrimental to the overall value of the system as well as adoption and use of the coin as anything other than a store of value.
Spiral of Insecurity
Disincentivizing transactions has alarming implication on the security of the coin’s network, since this security is paid for largely by these transactions, this can and I believe will lead to 51% attacks becoming increasingly common on ever larger networks.
Let me start by explaining the logic underlying PoW coins in general and what makes them secure:
The security of the network is relative to the value of the network IE: If the market cap of a coin is $100 and there is $200 worth of mining occurring on the network, then you know it would be very difficult to profit from performing a 51% attack on the network. Now let’s say the market cap is $1,000,000 and there is only $200 worth of mining occurring on the network, now it would be easy to profit from performing a 51% attack on the network, for instance you could short the coin, then publicizing a 51% attack on the network allowing the value to tank, and/or spend it and then 51% the transaction to keep the coin, or do both. Either way the attacker should easily be able to recover more than the cost of the attack; so you can see that as the value of a coin increases the potential return from attacking it also increases. So, in order to keep the network secure, it must pay for people to mine on the network.
So how does the network pay for its security?
The security of the network is paid for in two ways; by emissions and transaction fees. As the emissions rate of a coin decreases, in order to keep the incentive to secure the network constant, the portion of the networks security paid for by transaction fees must increase. Meaning that as the emissions rate of the coin decreases, users must either choose between increasingly low relative levels of security or increasingly larger transaction fees, either from increased volume or from increased fees, to sustain the same relative security.
So what does this mean?
Driven by an increased expected future value of the coin and a decreased desire to transact in the coin, both caused by deflation, users will continue to prefer lower transaction fees over higher security, thus making the network increasingly insecure until there is a failure. This is to say that while gross transaction volumes will likely increase, absent technological barriers, never-the-less the increase in total transaction fees will not be proportional to the increased value of the coin.
In this way we can see that emissions/inflation allows for the security of the network to be paid for through the coin’s value. While any coin that doesn’t have an increasing emissions rates ultimately has capped its security relative to its value and the number of transactions on the network.
Vulnerability to Attack
I intend to write a whole post on this subject soon.
For those who don’t know, the security of Proof of Work coins are derived from the amount of work that is done securing the network. That is to say, if a coin that has a market cap of $1,000,000 is only secured by $1,000 worth of equipment, then one could 51% attack it for $1,100. Meaning that if someone could obtain $1,100/$1,000,000=1.1% of the coin and spend it on mining equipment, they could 51% attack the network and theoretically get their coin back. Using the coin as our metric of value, they would have risked nothing and acquired the mining equipment for free. Obviously this would not be true if we value things in dollars, however if they could sell the mining equipment at break even (possibly by pre-selling the equipment or mining with it long enough to break even before performing the attack) then any value that the coin, gained through the attack, retains would have been made at zero risk.
In the above example anyone who can acquire 1.1% of the total supply of the coin would have an economic incentive to attack the network. Obviously the higher this % the harder it would be for a single actor to acquire that amount of coin (especially without incurring added costs due to moving the price of the coin) and thus the more secure the network. If every dollar of value on the network is secured by a dollar of mining equipment the network is 100% secured, meaning it will always cost more to attack the network than the attacker could make.
What does this look like for Bitcoin?
(As of early August 2018)
Well Bitcoin’s current network hashrate is roughly 45,500,000 TH, and the cost of an Antminer S9 from Bitmain is $655 which produces 14TH. (note that I am going to use this number to measure the cost of attacking the network, in reality it would most likely be much cheaper as a attacker could most likely produce equivalent miners for a much lower cost.)
So we have 45,500,000/14*$655=$2,128,750,000 of equipment on the network. Current market cap of Bitcoin is $141,182,470,188 so $2,128,750,000 / $141,182,470,188 =1.51%.
This means that if someone could obtain 1.51% of all Bitcoin (less than half the typical daily volume) and spend it on mining equipment, they could 51% attack the network and get their coin back. This seems like it should be alarming to people who believe in PoW.
Introducing Miner Controlled Emissions (MCEs)
Miner Controlled Emissions (MCEs) is a relatively simple solution. The idea is to have an initial emissions rate per block and to include a field in each blocks that adjusts the emissions rate future blocks. This field could and probably should be limited to a very narrow range, depending on the block propagation rate, with the range being further restricted if blocks are produced faster.
For example lets take a chain that starts with an emissions rate of 1 coins per block producing 1 block every min, and allows miners to change the emissions rate by between +0.0001% and -0.000101% per block. This would mean that in order to increase or decrease the emissions rate by 1% it would take 10,000 consecutive blocks voting the same way. This would allow miners to gradually shift the emissions rate to respond to market demands.
Economics of MCEs
Under the above proposed MCE structure, each miner could increase the inflation rate by a percentage and there would be no cap on the max inflation rate, rather inflation could increase exponentially. Alternatively the inflation rate could be reduced logarithmically towards the natural rate of deflation caused by lost or burnt coins.
Economically speaking miners would want to increase the inflation rate so long as the Price Elasticity of Supply is less than 1 IE: PES<1. At the point that PES>1 then increasing supply would decrease the returns on mining so miners would be reducing their profits, so this should cause PES to go towards 1 over the long term.
Predicted Benefits of MCEs
- Increase returns on mining, vs other coins, thus more miners would mine the coin making the network more secure.
- Encourages miners to sell their coins, due to increased expected inflation, thus forcing coins to actually hit exchanges and allowing inflation to spread efficiently rather than in fits and spurts due to hording
- Create some level of price stability, by creating stable inflation
- Encourage people to use the coin rather than hold them
- Allow supply of the coin to meet demand such that Es (Price elasticity of supply) should tend towards 1 over the long term