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A new report on Bitcoin and cryptocurrency has been published by the Bank of Canada, the country’s central bank.
Entitled “The Economics of Cryptocurrencies—Bitcoin and Beyond,” the staff working paper details how blockchain networks achieve resilience and resistance to attack. The bigger the network, the more costly an attack, the less vulnerable a cryptocurrency becomes.
According to the report,
“Costly mining helps discourage double spending in each transaction, independent of the number of transactions. At the same time, the intensity of mining increases with the total rewards. Hence, with more transactions, it becomes easier to finance mining rewards to protect the system.”
The authors detail risk factors for small-cap cryptocurrencies such as Monacoin, Bitcoin Gold, Zencash and Litecoin Cash which have suffered 51% attacks.
“Our analysis also confirms that smaller cryptocurrencies (in terms of market value and transaction volume) can be at risk for double-spending attacks as they do not generate enough mining rewards to disincentivize such attacks. When the potential gains from a double-spending attack are small, the mining reward required to protect the system will be lower.
This would be the case for a system used only for low-value transactions. In conclusion, a cryptocurrency would work best as a retail payment system where there is a large volume of transactions that are relatively small in value. To the contrary, using a cryptocurrency for infrequent large-value payments seems to be very costly.”
The authors also conclude that Bitcoin, the world’s leading cryptocurrency, could be greatly improved if it switches its consensus protocol from proof-of-work to proof-of-stake.
“For Bitcoin, we find that the cryptocurrency is not only extremely expensive in terms of its mining costs, but also inefficient in its long-run design. However, the efficiency of the Bitcoin system can be significantly improved by optimizing the rate of coin creation and minimizing transaction fees. Another potential improvement is to eliminate inefficient mining activities by changing the consensus protocol altogether…
Our analysis finds conditions under which PoS can strictly dominate PoW and even support immediate and final settlement.”
According to the report, such a switch would impact Bitcoin’s inefficiencies and make it more competitive against traditional monetary systems.
“Using the growth rate of 25 bitcoins, for every block and average transaction fees in 2015, we find that Bitcoin generates a large welfare loss that is about 500 times as large as in a monetary economy with 2% inflation.6 The reason is that, in its current form, Bitcoin spends too many resources to rule out double spending.
Reducing the growth rate to 0, but relying on sufficiently large transaction fees – like in the long-run design of Bitcoin – will reduce these costs significantly. Still, the optimal design of Bitcoin implies relatively large welfare losses. Compared to the first-best allocation, an optimally designed Bitcoin protocol would lead to a loss of about 0.19% of the consumption in the first-best allocation. This is equivalent to the welfare loss that would be generated in a monetary system with a moderate inflation rate of about 45%.”
The authors, Jonathan Chiu, a senior research advisor in the funds management and banking department at the Bank of Canada, and Thorsten V. Koeppl, an associate professor in the department of economics at Queen’s University, note that the views expressed in the report are solely their own and “may support or challenge prevailing policy orthodoxy” of the Bank of Canada.