Effects Of The Inevitable End To Production Of New Bitcoins

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When The Tap Runs Dry: Effects Of The Inevitable End To Production Of New Bitcoins

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Abstract

Bitcoin is the first commercially successful digital currency. The definition and categorization of Bitcoin is debated among scholars, financial institutions, governments and technical community. There is no consensus and it is referred to as virtual currency, investment target or cryptocurrency. But, there is no doubt to its efficacy in fulfilling the fundamental role of currency - Bitcoin can be exchanged for real-life products and services with names like Microsoft, Dell, Subway, WordPress, Expedia etc accepting Bitcoins.  Bitcoin requires no central authorities like central banks or governments, or trust in any central authority to make it valid or secure. It is thus immune to control by banks and governments. Due to the technology involved and the currency creator's design, there is only a finite number of Bitcoins that can be in circulation. This paper looks into the reasons that went into making this currency a finite-supply currency, compare the finite-supply currency with the traditional fiat currencies where arbitrary amounts can be legalized or nullified at will of the governments, predict the effects of this gradual drying up of the supply of fresh Bitcoins on the stability, security, trade and even the existence of the currency.

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Keywords:  banks, money, finances, currencies, bitcoin
Bitcoin is a digital currency which has been revolutionizing the financial markets and the role of central banks and governments in money itself. Also, it is the first successful digital currency. Many have come before it but went bankrupt  before making any effect in the financial systems of the world e.g. DigiCash (Pitta, 1999). The categorization of Bitcoin is not clear and there is no consensus among , financial institutions, governments and technical community. It has been labeled as "virtual currency" (Shasky Calvery, 2013), "investment target" ("China’s Bitcoin Exchanges Say Banks Will Close Their Accounts", 2014)  and "cryptocurrency" (Lachance Shandrow, 2014). As per Vergne & Swain (2016), in the British media alone, Bitcoin has been associated with 112 different labels. This is an indication of a phenomena which is revolutionary and defies the centuries old way of working.
What is currency? What is money, for that matter? Bitcoin may not have been categorically assigned a category, but it fulfills the promise of money. It serves a currency's purpose of  being a medium of exchange (Greco, 2001) - something  that may not have any intrinsic value of its own  but that can be exchanged for goods and services. Bitcoin is being accepted by both large and small businesses in conjunction to the traditional means like credit cards. Some of the larger companies include Microsoft (Warren, 2014), Dell (Flacy, 2014), WordPress (Skelton, 2012) and Expedia (Biggs, 2014) and smaller businesses include Massachusetts Institute of Technology student bookstore (Chokun, 2016). Thus, it is clear that as per the current trend, Bitcoin is a legitimate medium of exchange, a currency.
Bitcoin does not have any central organization and thus no concentration of power either with any central bank or with government. It is built on the foundations of decentralization. As per the Bitcoin creator Satoshi Nakamoto's original paper (Nakamoto, 2014), a peer-to-peer currency would go directly from one party to another without going through a financial institution. And he contends that the main benefits of a peer-to-peer currency are only valid as long as there is no trusted third party. Thus, decentralization is at the very core of Bitcoin. Another characteristic of a decentralized currency like Bitcoin is the lack of requirement of trust. As an illustration, you may be having say $1000 in your bank account. Beyond a number shown in your account statement and a trust in the bank, you have nothing. This centralization of control and flow of money brings some conveniences but also makes money vulnerable. In a centralized system, the one on which the world has been running on for centuries, central banks and governments can demonetize or print more currency at will. These actions may or may not be for the benefit of the citizens and nation, but such powers exist in centralized system. A recent example is India's sudden and surprise demonetization of its 500 and 1000 Rupee notes, about 85% of the currency in circulation ("Shock as India scraps 500 and 1,000 rupee bank notes - BBC News", 2016). As per Sparkes (2014), such "land grab could not happen with Bitcoin".
Another disconnect with traditional currencies is the supply of currency in circulation. Traditional currencies, which are backed by governments and central banks are called fiat currencies. The point to note is that the central authorities can print as much or nullify as much currency as they want at will. This is not the case with Bitcoin. Bitcoin is not printed in a mint, but mined i.e. increasingly demanding computation has to be expended to create a new unit of the currency. What happens is that a person uses his computer to perform complex mathematical calculations to aid Bitcoin in its internal processes and gets rewarded with Bitcoins whenever his computer successfully completes a process. This reward is the incentive for people to contribute their resources either using a single computer or setting up tailored Bitcoin mining facilities or by joining mining pools, and as per Eyal & Sirer (2014) is essential for its decentralized nature. The next logical question becomes that is there any limit to this mining of new coins of Bitcoin. Yes, from the day one of Bitcoin, a well-defined limit to the maximum possible number of Bitcoins is in place and as this paper will explain later, the actual number available for use might be lesser than that also. Thus, what will happen when the tap runs dry i.e. no more Bitcoins can be minted? This is significant because the incentive to mine i.e. expend computing resources to help run Bitcoin's internal process (and keep the currency alive) will vanish overnight.

Aim

The aim of this paper is to analyze Bitcoin's ecosystem, compare it to traditional centrally controlled currencies, understand why people contribute resources to the functioning of Bitcoin and estimate the effects when the supply of new Bitcoins will permanently exhaust. All this is important because as discussed above, Bitcoin is beginning to compete with traditional currencies and is serving the role of a currency, by allowing to exhange Bitcoins for real-life goods and services. But, being without any central authority to oversee it also implies a lack of definite future once the incentive for contributing to the currency's functioning is gone. This becomes all the more important because Bitcoin's increasingly complex mathematical calculations require powerful machines (which do not serve any valuable purpose in and of itself) and thus cooling systems also. This cost in initial hardware/software and electricity is not only a concern for business return on investment but is also wreaking havoc on the environment (Quiggin, 2015) (Malmo, 2015) (Gimein, 2013). 

Objectives

The objectives of this paper include understanding fiat currencies, compare them with finite-supply currency like Bitcoin, evaluating why and when the Bitcoin will exhaust the mining of new coins eventually, and  the effects and future implications of this event.

Research Methodology

For this paper, mainly secondary data has been studied. The sources include books, research papers from peer-reviewed journals, and authored and dated reports on reputed websites on Internet. It is believed that due care and ethics were exercised by the primary researchers in arranging the data, evaluating and analyzing. This paper build upon the efforts of many people and thanks them for the inputs provided by their works.

Literature Review

There is substantial amount of literature published on Bitcoin and a review of the literature indicates interest in the working of Bitcoin, the proof-of-work (PoW) concept, environmental costs of Bitcoin, security and possibilities of cheating in Bitcoin, and some interest in the history and reasons for success of Bitcoin as compared to other similar endeavors. 

History of Bitcoin

Bitcoin took birth in 2009 ("FAQ - Bitcoin", 2016) by Satoshi Nakamoto, when he released the first draft and a proof of concept in a cryptography mailing list. As for Satoshi Nakamoto, some believe that this name is fake and the community has not heard of him since April 2011 (Barber, Boyen, Shi, & Uzun, 2012). Some authors laud him for his ingenuity to have created "thirty-five million dollars of value" out of thin air by just inventing a new currency, though his motivations were political and not economic as indicated by his essay condemning the requirement of trust that needs to be put in the central authorities like banks and governments (Davis, 2011). This core idea is embodied in the complete decentralization of the Bitcoin's economy and complete independence from any central authority - they are neither required nor can be accommodated even if someone wanted to. As Simonite (2011) summarized succinctly, "Unlike other currencies, Bitcoin is underwritten not by a government, but by a clever cryptographic scheme."

Reasons for Success of Bitcoin

As mentioned earlier, Bitcoin is not the first cryptographic currency and many have been attempted before, but all of them failed, went bankrupt and are now history. Bitcoin and other similar currencies are based on ideas of cryptocurrency, published by Wei Dai (Dai, 1998) on cypherpunks mailing list ("FAQ - Bitcoin", 2016). The core tenets were first published as early as 1982 when Chaum (1983) published his plan for an anonymous electronic cash. There is research available that has looked into the possible reasons for Bitcoin shining, while the others died, for example the work by Barber, Boyen, Shi, & Uzun (2012). Bitcoin did not do anything out of the ordinary as far as the technology is considered. Also, some well-know flaws in it have been discovered and the research community is working on solutions to them also. The master stroke of Bitcoin was to channel the greed of people, the natural interest of a rational human to make profit or at the least be compensated for the effort put in to its advantage. As per Barber, Boyen, Shi, & Uzun (2012), Bitcoin addresses the problems of incentive best. Some reasons for its success include decentralization, a predictable money supply (which will eventually stop), divisibility and fungibility support, transaction  irreversibility (this is not exclusive to Bitcoin and other avenues of payment like Western Union also have this feature ("Answers to your questions about fraud | Western Union", 2016)), low fees and readily available implementations.
As per the primary reason identified, Bitcoin made expending effort rewarding. Rewarding by giving Bitcoins to those accounts whose computers help in completing the increasingly very complex computations. And these computations are required to maintain the security and validity of Bitcoin. But Bitcoin added the carrot to the stick by awarding the newly minted Bitcoins to the account that was able to complete the computation while fulfilling the ironclad mathematical constraints. Now, as long as there are Bitcoins to be mined, this incentive is compelling enough for hobbyists as well as professional miners, but once the Bitcoins are out of supply forever, what will happen is a different question.

Comparison of Bitcoin with Traditional Currencies

As detailed earlier in this paper, Bitcoin is completely independent of any central authority and this is by design. The original creator had a strong distaste for the requirement of trust that had to be placed in these central authorities (Nakamoto, 2014). Traditional currencies are controlled by central banks and governments, and are often backed by gold, silver or other precious metals. Also, the authorities may print more money at will, or demonetize money at will, or even take money at will Sparkes (2014) in case of these fiat currencies to create inflation or deflation. Some authors contend that fiat currency is less about money and more about control (Evans, 2009). 
Bitcoin is decentralized and peer-to-peer, thus bypasses any central authority. Now, what about the trust? If there is no central authority to place trust in, or to sue in case of a fraud, how can the system maintain its sanctity? To do this, Bitcoin does away with the trust in the conventional sense i.e. a Bitcoin payee or receiver does not need to trust the other person , and neither is this possible since due to the anonymity of hashed strings everyone is dealing with complete strangers. The sanctity of transactions, authentication and preservation of  double-spending problem is maintained by complex cryptographic calculations that require an enormous amount of processing, and this complexity is only going to increase. Thus, the trust shifts from the greedy and unreliable human to neutral, publicly scrutinized and ironclad mathematics. Specifically, it is the complexity in which the Bitcoin ecosystem puts its trust to ensure that invalid transactions will be detected and rejected. Also, the number of Bitcoins is limited, and this brings deflationary tendencies into Bitcoin.

What Could Be the Effects of Finite Supply?

The limit of 21 million Bitcoins is arbitrary and is intended to create scarcity (P. Hanley, 2015). Also, some of these Bitcoins have been lost and will be lost in future also when legitimate owners of Bitcoins lose access to their private keys. These Bitcoins have been taken out of the circulation and can never be used again by anyone. Thus, the real number of Bitcoins available for use will always be lesser than the theoretical limit of 21 million Bitcoins. Scarcity is one of the factors that help a currency maintain value, and appreciate. Barber, Boyen, Shi, & Uzun (2012) contend that whether by design or by accident, Bitcoin has extreme deflationary characteristics built into it. As per them, what happens when the supply of currency is capped that due to scarcity and being used in commerce for exchange of goods and services, the currency has no option but to appreciate tremendously. Now, care must be taken to understand that when deflation happens, the price of goods and services in absolute terms of currency declines. This may or may not be due to the reason that the value of the goods or services themselves have declined, but because the value of currency increases ("Deflationary spiral - Bitcoin Wiki", 2016).
Quelling the fear that deflation, a guaranteed deflation with no chance of ever inflating, is dangerous, Simonite (2011) explains that in the traditional currency, such events are unexpected and thus very destructive. But for a finite-supply currency like Bitcoin, deflation is anticipated and thus people will not be in for supply shocks and will be well-aware that the Bitcoins they own today will be able to purchase more goods than today in future.
As explained in the paper, incentive is one of the things that Bitcoin got right, which ensured it success and the failure of which made the other cryptocurrencies fall by the wayside. But this incentive comes with an expiry date and diminishing returns (Donnelly, 2016). The number of Bitcoins awarded are halved every four years, all the while when the expenses to earn the rewards increase. Bitcoin's aim is to maintain a ten minute gap between each successful reward and updates the algorithm to adjust difficulty levels so that the ten minutes duration is maintained irrespective of the number of miners working to mine the Bitcoins. As per Stogdill (2014), this maintenance of the block processing time to ten minutes is purely an arbitrary exercise with no benefits seen in security or otherwise. Now, when the supply ends, and the reward for Bitcoins exhausts, the only way of profit would be the transaction fees - same as the one credit card companies charge. It must be noted that transaction fees in Bitcoin are possible currently also and serve to incentivize the miners to verify their transaction first. However, the businessmen of today are more motivated by the reward and not the transaction fees. The transaction fees are the onus of the payee, but low transaction fees is one of the selling points of Bitcoin and if these have to rival the fees charged by credit card companies or online payment gateways like PayPal, then the advantage of Bitcoin is washed away.
In addition, if the Bitcoin mining business is not profitable then many miners will exit the business, and this drop in processing power will be accounted for by reducing the complexity of the computation required. However, lesser miners mean slower Bitcoin transactions, and it must be clear that without someone performing the very complex mathematical computations, Bitcoin economy is stagnant. This threatens the very existence of an economy in which not only people's  hard work is locked but which has also raised numerous mining farms where specialized hardware is running round-the-clock  running away processor cycles, consuming electricity and producing heat. As per Stogdill (2014) the incentives are disproportionate and thus have given rise to a gold rush where new mining farms are being brought online regularly and this is causing the computations to become more and more complex (to keep the block processing time to ten minutes). He wonders what will happen once this incentive is exhausted, and questions how will the businesses will stay afloat then. This is bound to have serious consequences for the security of the system as transaction fees will be an unpleasant surprise as the users are being sold a zero or very low processing fees charges in Bitcoin.

Conclusion

Bitcoin  has been built to be decentralized and sends money from one person to another without any intermediary (like central banks) and without any requirement of trust among the people transacting. The trust is in the ironclad mathematics, extreme complexity of calculations and the assumption that no single person or mining pool will have a large portion of  network under its command. Bitcoin is the first successful cryptocurrency and the primary reason that it has been so while other similar failed is in its method of providing incentive for people to expend computing resources to be rewarded with Bitcoins. Bitcoin is being accepted by many businesses as mentioned in the paper.  However, this reward is diminishing with increasing costs required in terms of computing power. Eventually the supply of new Bitcoins will exhaust as an arbitrary limit of 21 million Bitcoins has been set by the creator and the only way of profit once this limit is reached would be transaction fees. But the currency is being sold as a zero or very-low transaction fees currency. So a scenario where high transaction fees become essential for a transaction to go through would not be different from a marketing bait-and-switch. Some researchers feel that the current system is over-incentivizing the system, with the inverse hypothesis that once the rewards of Bitcoin is exhausted, there will be under-protection of the system as there will not be enough miners to process the transactions and this bringing the Bitcoin economy to a halt. Also, among all this economics and looking into the future, attention must be paid to the environmental costs of the proof-of-work required for maintaining the sanctity of Bitcoin. Many many researchers liken this computation of exceedingly difficult calculations to burning fuel (electricity) and still not producing anything of intrinsic value. This scenario may be similar to paper currency, but in Bitcoin the costs are going to increase with time. All in all, even if Bitcoin remains marginal as compared to government-backed currencies, it is still giving competition and that should be good for people. Whatever may be the future of Bitcoin, it still signifies crowning glory of human intellect and the power of market in guiding businesses.

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