Werner’s Blog: The economic vulnerability of Bitcoin mining
In this excerpt from his latest blog post, Werner Antweiler, Associate Professor & Chair, Strategy and Business Economics Division at UBC Sauder School of Business, discusses the economic vulnerability and other downsides of Bitcoin, and the more stable alternatives available both now and likely in the near future
Cryptocurrencies are all over the news these days. Bitcoin prices have been excessively volatile in recent months. Anyone looking to use Bitcoin as a storage of value should think twice before buying in. Prices took off from around $10,000 USD last summer to reach a peak of over $60,000 USD in early April 2021, only to fall back to about $36,000 USD today – a rollercoaster ride that is more reminiscent of a hyped-up penny stock than a global currency.
In a recent contribution to The New York Times, Cornell University professor Eswar Prasa delivered The Brutal Truth About Bitcoin. He writes: "Bitcoin became cumbersome, slow, and expensive to use" and "Bitcoin's unstable value has also made it an unviable medium of exchange." As a currency, Bitcoin is an abject failure in two of the three functions of money: medium of exchange, unit of account, and store of value.
The environmental harm of Bitcoin mining has been well publicized. For example, in February 2021, The Guardian's Lauren Aratani reported that Electricity needed to mine bitcoin is more than used by ‘entire countries’. The method that is used to process and validate Bitcoin transactions and add them to distributed ledgers, known as "proof of work," is immensely computation-intensive and therefore electricity-intensive. Bitcoin mining is carried out in several jurisdictions with a high coal content in their power supply, notably China. Worldwide Bitcoin mining is estimated to exceed 100 Terawatt hours (TWh), although estimates are not very reliable at this point. All this power use contributes to climate change and, ultimately, can also drive up electricity costs. The rising environmental footprint of Bitcoin mining is worrisome and worsening. Proof-of-work cryptocurrencies are wasting enormous amounts of resources. An April 2021 study by a group of Chinese researchers published in Nature Communications concluded that "without any policy interventions, the annual energy consumption of the Bitcoin blockchain in China is expected to peak in 2024 at 296.59 TWh and generate 130.50 Megatonnes of carbon emissions." Laudably, China's government has started taking action: China bans financial, payment institutions from cryptocurrency business.
But will Bitcoin mining continue to grow or will it eventually fail because it is no longer profitable? In fact, Bitcoin mining is standing on a fatally flawed business model. The essence of using distributed ledgers means that many people must carry out Bitcoin mining in order to verify transactions. The people who carry out Bitcoin mining (and thus provide transaction verifications to the network) are rewarded by receiving new, freshly-mined bitcoins. However, the total number of bitcoins is limited at 21 million. As of today, 18.7 million bitcoins are in circulation, leaving just 2.3 million bitcoins to be mined. At current prices, these would be worth about $83 billion USD. This is the reward that is being chased by Bitcoin miners, and it explains why people are buying up specialized GPUs. As The Economist reported on June 19, Crypto-miners are probably to blame for the graphics-chip shortage. But how many more transactions can be processed before it is no longer profitable to do so? Our financial system charges fees for each transaction, with an unlimited revenue stream for the future. Not so for bitcoins: the revenue for processing all future transactions is limited, and eventually will dry up because prices will not rise forever. Research also suggests that the marginal cost of production of a bitcoin is a floor for its value (Hayes 2018).
Let's apply some economic thinking to the Bitcoin mining problem. As more bitcoins are being mined, the remaining number will shrink. At the same time, Bitcoin mining will get harder as the transaction ledgers grow in size and the mining algorithm requires more and more proof of work to receive the next bitcoin. In other words, marginal costs of Bitcoin mining are rising. The only way for Bitcoin mining to remain profitable is therefore through rising marginal revenue; that is, a rising price of Bitcoin. Unless the Bitcoin price rises to astronomical levels, the economic logic implies that at some point, marginal costs will exceed marginal revenue. When Bitcoin mining is no longer profitable, it will cease. And with nobody processing transactions, the entire system collapses. The only way for Bitcoin to survive is to become infinitely precious, but if confidence in this ever-growing price bubble weakens, collapse is the only logical outcome.
Bitcoin mining cannot defy the laws of economics. One such principle is self-evident: there is no free lunch; someone has to pay for it, even if you don't pay for it yourself. In the case of Bitcoin, someone has to pay for processing these cryptocurrency transactions. Either Bitcoin prices keep on rising faster than the cost of proof-of-work computations or the system implodes. Owners of Bitcoin should be well aware that the entire Bitcoin system is built on quicksand. The decentralized system of Bitcoin makes it impossible to introduce a transaction fee system because of the unlimited potential for free-riding. The way I see it: the inventors of Bitcoin (whoever they may be) should have taken a course in economics first.
Should regulators wait until market forces reign in Bitcoin all by themselves? There are significant costs to the current laissez-faire approach. The environmental cost is significant. There are also important societal costs. Bitcoin remains the payment method of choice for criminal activity of all kinds, including money laundering, Internet fraud, ransomware attacks, and the financing of terrorism. While a significant number of Bitcoin users are simply speculators, there can be no doubt that Bitcoin has facilitated criminal activity as well.
While Bitcoin is harmful, the same is not true about all types of crypto-money. There are alternatives to the computation-intensive "proof of work" approach, such as proof of stake or proof of bid. Central Bank Digital Currency (CBDC), fully backed by a government's central bank, would provide a digital counterpart to cash. CBDCs could deliver what Bitcoin cannot: lower transaction fees, value stability, full fungibility, and immediacy. The latter point is about the problem that confirming Bitcoin transactions takes considerable time, on average about 10 minutes, but on occasion much longer. CBDCs would facilitate true, real-time transactions as they can be processed in fractions of a second. The Bank of Canada is conducting active research on this topic (see here) as are other central banks. There is a bright future for cryptocurrencies, but not for Bitcoin. Elon Musk, please take note!