Bitcoin: Have Incentives Gone Wrong?

In his original whitepaper, Satoshi Nakamoto introduced Bitcoin as a “Peer-to Peer Electronic Cash System.”

More than a decade later, Bitcoin has proved that it has clearly solved the double-spending problem; it has allowed for transactions to happen with no intermediaries and has scaled into a trillion-dollar network without having had any serious security breach.

More amazingly, it has managed to scale solely based on the incentive mechanism built in the protocol described in the above-mentioned whitepaper 10 years ago. Unlike any other technology, it never has had recourse to traditional equity finance or traditional governance.

Despite all those achievements the jury is still out as to whether it will ever become a widely used currency or fulfill the decentralization potential of blockchain technology and the associated positive societal externalities.

Bitcoin might have succeeded in becoming a store of value thanks to the trust, rarity, and immutability inherent to its underlying technology. Those attributes, when combined with its code and monetary supply, which are fixed in stone, resulted in a monetary supply that is only owned and mined by a few.

While we doubt Satoshi Nakamoto had any intentions either to benefit only a few or to have such a negative impact on the environment, the problems might come from the same incentive design that was at the root of its success.

Firstly, the embedded rarity and the fixed money supply have highly deflationary implications. Why spend now when not only the supply is capped, but supply growth is also constantly decreasing. To be a medium of exchange or unit of account, a currency supply must be adjusted so that the price of goods and services is stable over the medium to long term. This is the only way the supply and demand side of an economy can make any rational decisions.

Secondly, the security of the network relies on an incentive mechanism that rewards those using the most resources, in this case, the use of electricity and computer processing power, while punishing bad actors simply by having wasted those same resources. While the number of transactions and their size do not impact the network or its speed, the hoarding of coins does by bloating its memory, as described by Andreas Antonopoulos in his book “Mastering Bitcoin.” In a network where all participants but miners are only rewarded with price appreciation, spending is not incentivized. Combine that with a fixed monetary supply, and the prophecy is self-fulfilling.

Thirdly we feel that Bitcoin’s failure to adapt is caused by the centralization of its ownership. The resource requirements to run a full voting node, let alone a mining operation makes participation very expensive. Those in control know too well that for it to become a widespread medium of exchange, price appreciation will have to stop, and the price of it be stable. They might well prefer the status quo or the introduction of a few stable coins on the network as in Ethereum while keeping Bitcoin as a Reserve Currency, the ultimate collateral.

Finally, one has to wonder what will happen when all the coins are mined. At this point, miners will only be rewarded by transactions fees, which, unless things dramatically change, will be very little. What will happen to the security of the network at this point?

Maybe the price will stabilize, and the miners of tomorrow will be rewarded by the fees generated by the sheer amounts of transactions while the holders of the past unleash their reserves…In this case, Satoshi Nakamoto’s incentives will have gone right the world will have witnessed the most brilliant long-term application of Game Theory.