Money for nothing: Bitcoin Cash & the economics of hard-forks (part II)


[continued from part I]

Obstacles to hash-rate equilibrium

There are important caveats to the preceding argument. First we made a simplifying assumption in equating “mining rewards” to coinbase rewards. That neglects additional earnings from transaction fees collected on every payment taking place in that block. For much of the history of Bitcoin, this would have been a reasonable assumption: coinbase rewards dominated fees. In fact this dynamic made possible the extremely low fees that inspired many an optimistic pundit to sound the death-knell of other payment systems that charge usuriously high transaction costs in comparison. Over time as blocks became increasingly congested with scaling solutions stuck in a political quagmire, fees have continued creeping up. At some point in early 2017 the network achieved a state of inversion: transaction fees exceeded coinbase rewards in their contribution to overall mining revenue. That dynamic will continue to be exacerbated as the reward decreases periodically through the “halving” events baked into the bitcoin monetary supply.

That said, the decision criteria for choosing a chain is the relative expected reward per block. Imagine one chain has massive congestion and very high fees (consumers racing to out-bid each other to get their transactions through) while another chain has plenty of spare capacity in its blocks, with correspondingly low fees. That second chain is less appealing to miners, all else being equal and may not merit switching even if it appears to be trading at a premium based on coinbase rewards alone. On the other hand, the congested chain is also much less appealing to users: why continue paying exorbitant fees if you can transact on the other other chain faster and at lower cost? (After all the raison d’etre of Bitcoin Cash is ostensible adoption of 2MB blocks that squeeze more payments into one block, with reduced fees expected to follow as natural side-effect as artificial scarcity is eliminated.) It is unclear to what extent lock-in effects exist for cryptocurrencies. But assuming that some users are free to defect, the second blockchain may appreciate in value over time relative to the first. As more people conclude they can reap greater benefits transacting on that chain, they will bid up the value of the currency (and incidentally, start filling up those blocks with more transactions.) From this perspective, a miner is sacrificing short-term revenue by accepting lower transaction fees in exchange for anticipated future increase in value of accumulated reserves, due to better economics/features offered by the forked chain.

Short-term instability

The second caveat is that the analysis focuses on steady state, after block times have adjusted. As pointed out in the hypothetical scenario of the 1% miner, the introduction of new hash power into a network that follows Bitcoin-type rules leads to temporarily increased profitability for all participants. While the system has mechanism to adjust mining difficulty in response to available capacity, those adjustments take effect slowly. They happen approximately once every 2 weeks in the case of Bitcoin, and use an unweighted average over that time. If the sudden influx of hash power took place in the middle of that window, the algorithm will under-correct: it averages out the hash power before and after the arrival of a new participant, instead of giving higher precedence to more recent history. It may take up to two adjustment periods to fully correct for the spike. The good news is introduction of hash power also hastens the arrival of  adjustment, which is measured in number of blocks. Sudden removal of hash power on the other hand leads to a destabilizing cycle: blocks take longer to mine and the adjustment period to correct that itself will take longer to arrive. Because that reduces the profitability of mining, it may inspire additional defections resulting in even longer block times in a vicious cycle.

Bitcoin Cash experienced a relatively mild version of that phenomenon after the hard-fork: because the minority chain split off with the full difficulty level of Bitcoin proper but only a small fraction of its hash rate, blocks were extremely slow to arrive at first. Granted BCH proponents had anticipated this problem and built an emergency adjustment feature into their protocol. But even that proved insufficiently responsive to correct for the deficit initially. Adding insult to injury, the mechanism over-corrected as miners began jumping into BCH mid-August to exploit the arbitrage opportunities. As a result difficulty and amount of hash-power began to experience wild fluctations two weeks after the hard-fork, with BCH exceeding BTC in hash-rate at one point. (So much for the simple rule “the chain with the majority hash-power is Bitcoin” proposed for anointing the winner after a contentious hard-fork.) To summarize: in the short-term there can be significant divergence from predicted equilibrium due to the relatively slow adoption of mining difficulty in comparison to how quickly network capacity can change due to sudden entry or departure of miners.

Animal spirits all the way?

One unresolved question remains: if market value of a cryptocurrency can drive rational miners to participate in supporting that blockchain, what gives rise to that valuation in the first place? Is there causality in the other direction where miner support (expressed in actual hash-rate, not press releases and blog posts) is sufficient to prop up market value? Consider the initial point where Bitcoin Cash split off from Bitcoin, and a coalition of miners accounting for 10% of total rate made a credible pledge to mine BCH regardless of market pricing. It could be that they have a grievance with BTC, they are being otherwise being compensated by participants with an axe to grind or they are simply irrational. Does that information allow investors to price BCH in relation to BCH?  Proportionality based on hash-rate does not make sense. Blockchains involve winner-takes-all dynamics and network effects. A compatible blockchain with 1% the hash-rate of Bitcoin does not have 1% of its security or censorship-resistance: since many existing Bitcoin mining pool have more power than that, any one of them could easily overpower the minority chain to execute 51% attacks.

Similarly a cryptocurrency with 1% of user-base of another one does not have 1% the utility: it would be the equivalent of an alternative social network that only 1% of your friends participate. From these perspectives, BCH started out with a major disadvantage. Very few wallets support it out of the gate; the chances of being able to pay a friend in BCH was much lower compared to BTC. Most exchanges announced they would not open up order-books for BCH; it will be more difficult to convert BCH into fiat or other cryptocurrencies. While merchants have made symbolic gestures of accepting Bitcoin to signal their “forward-thinking,” no one has put out press releases touting BCH acceptance. Given that one BCH was valued at hundreds of dollars in the immediate aftermath of the fork even before the dust settled, its current hash-rate can be explained as consequence of miner incentives. The more troubling question for future hard-forks is: given the long odds of competing against the main chain, how any splinter fork can achieve that market valuation in the first place.

CP

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