Bitcoin’s search volume for the global market as a whole piqued in Q4 of 2017 when it’s price hit an all-time high of ~$20,000.
This search volume for Bitcoin far exceeded that of Gold, Silver, US Dollar. Much of the appeal/attraction for Bitcoin or other cryptocurrencies comes from the fact that there is no central controlling authority and the fact that one can be their own bank.
As exciting and promising Bitcoin sounds, a paper published by Bank for International Settlements says otherwise. The paper titled “Beyond the doomsday economics of “proof-of-work” in cryptocurrencies” mentions how Bitcoin’s Proof-of-Work [PoW] consensus mechanism has two flaws. The paper also touches on the economics of Bitcoin and PoW, whilst imploring what the future might hold for Bitcoin and other cryptocurrencies that are based on similar consensus algorithms.
The first limitation that the paper stated was that Proof-of-Work axiomatically requires high transaction costs to ensure payment finality.
As per Satoshi Nakamoto, double-spending is an attack by a large miner controlling a significant fraction of the network’s computational power. The paper stated:
“Nakamoto’s definition of payment finality (although not explicitly spelled out as such) is thus operational: the deeper a payment is buried in the ledger, the less likely an adversary with given computational resources will succeed in a double-spending attack.”
Double-spending on such a network of nodes would actually be more profitable than mining, hence, the blockchain for Bitcoin includes “economic payment finality” – the instant that payment to another party is completed, at which point the receiving institution has irrevocable access to the money.
This can be avoided by incentivizing miners with a very high required ratio of income as compared to the transaction volume [the amount that can be double-spent].
Moreover, the paper provided a rough example that the mining income must amount to 8.3% of the transaction volume, which is a multiple of the transactions fees in today’s mainstream payment services.
The second limitation that the paper stated was that the system cannot generate transaction fees in line with the goal of guaranteeing payment security and that the system either works below capacity and users’ incentives to set transaction fees are very low or the system gets congested and suffers scalability issues.
Furthermore, the paper noted:
“Underlying this is a key externality: the proof-of-work and hence the level of security is determined at the level of the block one’s transaction is included in, with protection also being provided by the proofs-of-work for subsequent blocks… While each user would benefit from high transaction fee income for the miner, the incentives to contribute with one’s own fee are low.”
The paper concluded that PoW can only achieve payment security if mining income is high, but the transaction market for Bitcoin will not be able to generate an adequate level of income. As a result, the liquidity is set to deteriorate substantially in the future.
The paper stated:
“A simple model suggests that ultimately, it could take nearly a year, or 50,000 blocks, before a payment could be considered “final”.”
Moreover, the research indicated that the second-layer solutions for Bitcoin and other PoW-based assets like the Lightning Network or Sidechains can improve the economics of payment security but they in themselves still face scaling issues.
Due to the above-mentioned facts, the liquidity of Bitcoin and other digital assets that have forked from Bitcoin and PoW based cryptocurrencies will eventually need to migrate from PoW consensus algorithm to a more fitting and evolving consensus algorithm.