It’s the (Bitcoin) Protocol, Stupid

Introduction:  Remember the day when a coin was just a bothersome piece of metal that you were happy to toss in the tip jar to benefit the underpaid baristas at your local coffee shop? Well no more. Now a coin might be worth more than many people make in a week. Over the next few weeks Economist David Evans will be taking a deeper look at bitcoin–why it is so special, whether it can provide stable value for investors and if it has a future far beyond its embryonic phases as a digital currency.

Missed the first edition? Don’t worry, you can read the first installment of the Digital Currency Deep Dive: What Makes Bitcoin So Special here.  You can also get a look at Dr. Evans’ technical paper on his  SSRN page here.

It’s the Protocol, Stupid

“Bitcoin as a currency is so last year,” is more or less what my friends in Silicon Valley say.  “Yes, of course, no one really takes this currency stuff seriously. It’s the protocol, stupid.” Ok, they don’t actually say stupid to me, at least not to my face, but you get the point.

Serious enthusiasts of bitcoin and its brethren—what I’ve called the bitcoinesque currencies—insist that the profound innovation here, the thing that will change the world, is “the protocol”.  By that they are referring to the blockchain and the rules for verifying and recording transactions.  And it is very clever.

In its current form, though, this is a rather unusual protocol because it requires, by design, an army of ants to carry the coin—the container that carries the information on the transaction—around the public ledger.   That’s the next topic in my deep dive into digital currency.

Maintaining the Public Ledger Is a Lot of Work

The public ledger is the fundamental innovation behind bitcoin.  Think of this as a huge bookkeeping system in which every transaction—a debit and credit of a bitcoin—gets entered in full public view.  Except the address that gets entered for each sender and receiver is numeric. No names, phone numbers or email addresses used here.

Many “laborers” use computers to verify a transaction.  When they agree that the transaction is valid, it gets recorded in the public ledger.  There are lots of technical details I’m leaving out here including all the cool cryptographic stuff involving hash tags and complicated algorithms that these laborers have to solve.

These laborers aren’t like the big bicep guys who move furniture.  And they have to have some powerful computer equipment to do the work. Not to mention electricity.  So moving the container requires effort and money.

When Bob in Boston wants to buy some programming help from Jose in Buenos Aires, and pay Jose in bitcoins, a number of laborers around the world will need to set their computers spinning to actually verify that Bob has valid bitcoins. They need to make sure Bob isn’t trying to use the same bitcoins to buy a necklace from Nnakeme in Lagos.  That’s the double-spending problem that Satoshi Nakamoto set out to solve in the original white paper that introduced bitcoin to the world.

Why would these laborers want to spend their time and money verifying and recording a transaction between Bob and Jose? After all, Bob and Jose are just doing business together and aren’t exactly charity cases. Well they wouldn’t.  To motivate them the bitcoinesque currencies need to have an incentive system.

Paying the Workers

The Bitcoin protocol operates to give some coins to the workers for manning the public ledger.  Now, you might have thought that the “miners” were working to uncover bitcoins just like a guy with a hardhat and a pickaxe heading into a goldmine.  In terms of function they are actually more like the guys with the green eyeshades keeping the books straight. Except instead getting a weekly paycheck they have their names entered into a lottery, in effect, and get some bitcoins thrown their way if they win.  They may also get some transaction fees that senders of bitcoins can volunteer to pay to get quicker processing on the register.  The miners—or the guys with the green eyeshades—get new bitcoins and this is also how the bitcoin supply increases over time.

There’s an element of this that, like many aspects of Bitcoin, is very clever.  Satoshi killed two birds with one stone. He provided incentives to help with processing bitcoin transactions on the public ledger, and thereby moving the container between senders and receivers, while at the same time providing a mechanism for expanding the bitcoin supply.  Moreover, he gave many people a vested interested in making bitcoins valuable. Those bitcoins are worth something only if others believe they are worth something. The miners became paid cheerleaders.

In the long run, however, to meet the ambitions of bitcoin backers, this incentive system has to be able to elicit the optimal amount of effort to run a global financial services platform based on the decentralized public ledger. Unfortunately, it would be by sheer happenstance that this mechanistic system would provide the right incentives to supply effort to work on the public ledger.  No one would ever set up an organization this way.

An employer could go out and hire more workers and offer overtime and bonuses when there is peak demand. An employer could also lay workers off and adjust wages downwards when there is slack demand.  The bitcoinesque incentive plans don’t do that. Now you might think that when there is increased demand that the price of bitcoin will rise and that will induce more effort. It might. But the price of bitcoin should reflect long run opinions on its value and not temporary increases or decreases in demand for using the public ledger.

From Workers to Capitalists

The bitcoinesque wage systems can also have what may seem like perverse incentives.  As the price of bitcoin has increased and as the likelihood of getting a reward has decreased several things have happened.  An industry has emerged that provides powerful specialized expensive hardware for “mining”. Meanwhile the opportunities for solo miners have largely vanished.  Because the bitcoin awards are random you can invest a lot of time and money in processing work for the public ledger and get nothing. That’s a risk that not many people can bear. The result is that mining pools have formed where the members of the pool share in the reward.  That’s effectively a way of diversifying some of the risk away. At one point one of the mining pools accounted for more than50 percent of the processing capacity.

As far as I know this hasn’t happened but there’s no reason why firms with employees and access to capital couldn’t emerge to take on the processing work. There are scale economies in the hardware. And the probabilistic nature of the rewards provides advantages to larger firms as the formation of pools demonstrates.  If that’s the case than the notion of a decentralized third party intermediary goes kaput!  There could be one or a handful of firms conducting all the processing work. This sounds more like First Data and less like open source nirvana not to mention all the talk about freeing us from banks and governments and other central authorities.

There are other possibilities over time though. There’s no guarantee that there’s going to be enough money in processing bitcoinesque transactions to induce enough workers never mind to support a public-ledger processing firm. Then we could be back to individual laborers who are desperate for money.  This could happen for example if the price of bitcoinesque currency declines.

A decline in compensation is also programmed into the algorithm in the long run since the supply of bitcoins increases asymptotically to 21 million. That means that the supply of bitcoin rewards decreases asymptotically as well.  In that scenario it isn’t clear that there is enough incentive for a functioning labor force for managing the public ledger. Then we’re in the voluntary fee world, which is a great unknown.

Of course someone could fix all this, right?  The answer depends on how the bitcoinesque currency is governed.  With strong centralized leadership and a flexible “constitution” a bitcoinesque currency could modify the incentive scheme to always optimize the level of effort to have a smoothly running public ledger. It could also make rules on whether firms are allowed to provide this work and to regulate the size of firms or for that matter of labor pools.

Can Bitcoin Avoid OpenSSL’s Heartbleed Fiasco

If you need any evidence that incentive schemes are important for bitcoinesque currencies you need look no further than the “Heartbleed” fiasco for OpenSSL. One of the reasons that OpenSSL developed a security hole big enough to drive an army of hackers through is that this critical part of the Internet was operated by a group of unappreciated volunteers with essentially no funding.  There were really minimal incentives for anyone to pay much attention to it.  That is not an inevitable fate of open source projects as we’ve witnessed with Linux, which has a foundation that employs Linus Torvalds—a great leader and solid guy—and plenty of corporate money paying a core developer team.

The issue of incentives though is far more important for bitcoinesque currencies than for typical open source projects. Open source projects like bitcoin and its brethren have to get programmers to contribute effort to work on the code, improve it, and add features to it.  But bitcoinesque currencies, unlike any open source project that I know of, has to enlist effort to operate the peer-to-peer network of servers and to verify and record transactions on the public ledger.

The fate of the bitcoinesque currencies therefore depends on the governance mechanisms they develop.  We’ll do a deep dive into that next week