On Inflation, Transaction Fees and Cryptocurrency Monetary Policy

The Economics of Blockchain Security: Inflation, Transaction Fees, and Monetary Policy

As the use of blockchain technology continues to grow, so does the need for robust security measures to protect these decentralized networks. Two primary expenses that must be paid by a blockchain are security costs and transaction fees. The question is, how much "defense spending" is required for a blockchain to be secure, and given a particular amount of spending required, which is the best way to get it?

Absolute Size of PoW/PoS Rewards

To provide some empirical data for the next section, let's consider Bitcoin as an example. Over the past few years, Bitcoin transaction revenues have been in the range of 15-75 BTC per day, or about 0.35 BTC per block (or 1.4% of current mining rewards), and this has remained true throughout large changes in the level of adoption.

The reason for this may be due to the fact that increases in BTC adoption will increase the total sum of USD-denominated fees (whether through transaction volume increases or average fee increases or a combination of both) but also decrease the amount of BTC in a given quantity of USD, so it is entirely reasonable that, absent exogenous block size crises, changes in adoption that do not come with changes to underlying market structure will simply leave the BTC-denominanted total transaction fee levels largely unchanged.

The Cost of Taking Over a Blockchain

In 25 years, Bitcoin mining rewards are going to almost disappear; hence, the 0.35 BTC per block will be the only source of revenue. At today's prices, this works out to ~$35,000 per day or $10 million per year. We can estimate the cost of buying up enough mining power to take over the network given these conditions in several ways.

First, we can look at the network hashpower and the cost of consumer miners. The network currently has 1,471,723 TH/s of hashpower, the best available miners cost $100 per 1 TH/s, so buying enough of these miners to overwhelm the existing network will cost ~$147 million USD. If we take away mining rewards, revenues will decrease by a factor of 36, so the mining ecosystem will in the long term decrease by a factor of 36, so the cost becomes $4.08m USD. Note that this is if you are buying new miners; if you are willing to buy existing miners, then you need to only buy half the network, knocking the cost of what Tim Swanson calls a "Maginot line" attack all the way down to ~$2.04m USD.

However, professional mining farms are likely able to obtain miners at substantially cheaper than consumer costs. We can look at the available information on Bitfury's $100 million data center, which is expected to consume 100 MW of electricity. The farm will contain a combination of 28nm and 16nm chips; the 16nm chips "achieve energy efficiency of 0.06 joules per gigahash". Since we care about determining the cost for a new attacker, we will assume that an attacker replicating Bitfury's feat will use 16nm chips exclusively. 100 MW at 0.06 joules per gigahash (physics reminder: 1 joule per GH = 1 watt per GH/sec) is 1.67 billion GH/s, or 1.67M TH/s. Hence, Bitfury was able to do $60 per TH/s, a statistic that would give a $2.45m cost of attacking "from outside" and a $1.22m cost from buying existing miners.

The Ramsey Problem

Let us suppose that relying purely on current transaction fees is insufficient to secure the network. There are two ways to raise more revenue. One is to increase transaction fees by constraining supply to below efficient levels, and the other is to add inflation. How do we choose which one, or what proportions of both, to use?

Fortunately, there is an established rule in economics for solving the problem in a way that minimizes economic deadweight loss, known as Ramsey pricing. Ramsey's original scenario was as follows. Suppose that there is a regulated monopoly that has the requirement to achieve a particular profit target (possibly to break even after paying fixed costs), and competitive pricing (ie. where the price of a good was set to equal the marginal cost of producing one more unit of the good) would not be sufficient to achieve that requirement.

Game-Theoretic Attacks

There is also another argument to bolster the case for inflation. This is that relying on transaction fees too much opens up the playing field for a very large and difficult-to-analyze category of game-theoretic attacks. The fundamental cause is simple: if you act in a way that prevents another block from getting into the chain, then you can steal that block's transactions.

How to Distribute Fees?

Even given a particular distribution of revenues from inflation and revenues from transaction fees, there is an additional choice of how the transaction fees are collected. Though most protocols so far have taken one single route, there is actually quite a bit of latitude here. The three primary choices are:

Fees go to the validator/miner that created the block

Fees go to the validators equally

Fees are burned

Targeting Policy Variables

Let us suppose that we agree with the points above. Then, a question still remains: how do we target our policy variables, and particularly inflation? Do we target a fixed level of participation in proof of stake (eg. 30% of all ether), and adjust interest rates to compensate? Do we target a fixed level of total inflation? Or do we just set a fixed interest rate, and allow participation and inflation to adjust? Or do we take some middle road where greater interest in participating leads to a combination of increased inflation, increased participation and a lower interest rate?

In general, tradeoffs between targeting rules are fundamentally tradeoffs about what kinds of uncertainty we are more willing to accept, and what variables we want to reduce volatility on. The main reason to target a fixed level of participation is to have certainty about the level of security. The main reason to target a fixed level of inflation is to satisfy the demands of some token holders for supply predictability, and at the same time have a weaker but still present guarantee about security.

Conclusion

The economics of blockchain security is a complex and multifaceted issue. The choice between inflation and transaction fees is not a simple one, and there are tradeoffs to be made between different policy variables. However, by understanding the underlying economics and using tools like Ramsey pricing, we can make more informed decisions about how to secure our blockchain networks. Ultimately, the key to a secure blockchain is a balance between different security measures, and a deep understanding of the underlying economics is essential to achieving this balance.

Source: https://blog.ethereum.org/en/2016/07/27/inflation-transaction-fees-cryptocurrency-monetary-policy