As of February 16th, a single Bitcoin could be traded for $50,000 (its highest value since it was created). Large corporations such as Tesla, Mastercard or Paypal have already announced they will accept payments and facilitate transactions using Bitcoin. As corporate acceptability increases so does the hope that bitcoin can become a mainstream currency and store of value (some wonder if it could become “The digital gold”).
Bitcoin is a decentralised digital currency – meaning it does not rely on a Central Bank or on any single authority. Transactions and account (wallet) balances are verified and updated not by a trusted third party, but rather by a decentralized process that relies on users agreeing in which is the correct record of transactions, forming a public ledger, called the blockchain. However, not all is simple, Budish (2018) explores how bitcoin can have serious economic limitations.
The author considers basic economic conditions as the rent-seeking competition from the “Miners” (users competing to update the blockchain in a way others will verify as correct, and which receive an economic reward in the form of bitcoin) and incentive compatibility (ensuring the costs of trying to cheat the system are lower than its benefits). Together these conditions imply that the flow cost of running the blockchain is large relative to the one-shot value of attacking it. To cheat the system an attacker needs to generate a false chain of transactions faster than the honest chain, for that he would need more computational power than all the honest miners combined (such power requires enormous costs).
Even under these conditions, Budish (2018) proceeds to show that if bitcoin is to become sufficiently economically important (very high transaction values) it becomes an alarming possibility that an attacker has an economic incentive to proceed, threatening the economic value of the blockchain.
- 3Blue1Brown. 2017. “But How Does Bitcoin Actually Work?” YouTube Video. YouTube. https://www.youtube.com/watch?v=bBC-nXj3Ng4&t=1120s.
- Budish, Eric B. 2018. “The Economic Limits of Bitcoin and the Blockchain.” SSRN Electronic Journal, no. https://doi.org/10.2139/ssrn.3197300
- Frankenfield, Jake. 2019. “51% Attack.” Investopedia. May 6, 2019. https://www.investopedia.com/terms/1/51-attack.asp.