21 January 2019

BIS: Beyond the doomsday economics of "proof-of-work" in cryptocurrencies

The paper focuses on how Bitcoin and related cryptocurrencies verify that payments are final, ie irreversible once written into the blockchain. It points to the high costs of achieving such finality via "proof-of-work". It then weighs the outlook for cryptocurrencies based on this kind of algorithm, and looks at possible future avenues for progress.

The paper shows that two economic limitations affect the outlook of cryptocurrencies modelled on proof-of-work:

• The first lies in the extreme costs of ensuring payment finality in a reasonable space of time.
• The second is that these systems will not be able to generate transaction fees that are adequate to guarantee payment security in future.

The paper shows that the future of Bitcoin and related cryptocurrencies is crucially affected by the interplay of these two limitations.

After surveying the market for transactions and the way fees are determined, the paper finds that the liquidity of cryptocurrencies is set to shrink. In this light, the paper then asks how technical progress might raise the efficiency of Bitcoin-type payments.

So-called second-layer solutions such as the Lightning Network could help. Or methods other than proof-of-work could be used to achieve payment finality. But these might require coordination mechanisms, implying support from a central institution.

Thus, the current technology seems unlikely to replace the current monetary and financial infrastructure. Instead, the question is rather how the technology might complement existing arrangements.

Working paper

© BIS - Bank for International Settlements