The economics of Blockchain do not work.

(Why cryptocurrencies are destined to fail)

T_K Martin, Feb 2018

Overview

  • The economics of decentralised public ledger blockchain technology do not work when priced in public currency.
  • Blockchain promoters devised a clever system to circumvent this reality by inventing their own private currencies.
  • These new private currencies will not solve the issues faced by blockchain technologies nonviable economic design as sooner or later, the problems that all private currencies throughout history have faced will present themselves, and the market will demand the usage of public currency under which blockchain cannot compete.
  • Public blockchains face a free market paradox — Unregulated free market operation of what is now a regulated market system will lead to physical centralisation of these systems at the lowest cost destination in the global production landscape.
  • Centralising blockchain systems at the physical location of the lowest global price point will create new security risks.
  • In the long term, absent accommodative regulation, competitive market forces will erode the comparative trust advantage of open distributed public ledger blockchain vis-a-vis its competitive alternatives in the marketplace.
  • Private blockchains will develop and improve private sector efficiencies but blockchain will not revolutionise the world and eliminate intermediaries as has been claimed because ‘true’ public ledger blockchains are far too expensive and untrustworthy in an actual free market economy.

Blockchain technology has been hailed by many of its fervent disciples as a revolution, a completely new way of structuring everything from elections to contracts and currencies, and whilst this may indeed be true in theory, the technological uptake so far has proven less than stellar for reasons of both technological inefficiency and, as this essay will discuss, blockchain’s highly unfavorable economics.

Unless an unprecedented revolution in the operation of national currencies takes place whereby countries either adopt or allow in parallel the existence of competing currency systems, publicly distributed blockchain technology is unlikely to live up to any of the promises made by its proponents. Here we will explore the systems by which distributed ledger blockchain technology currently operates, and the economic incentives offered within the system which are likely to impede its widespread adoption.

What is blockchain technology?

At its simplest description, blockchain technology is an accounting system. A record ledger. Record ledgers have existed for aeons in the course of human societies. They are a way to coordinate the documenting and storage of everything and anything that we deem worthy of being recorded and documented. They have taken many forms throughout history, evolving in lockstep with human awareness and the associated technologies available to the persons making the recordings at the time.

In that sense, there is nothing new about blockchain, it is simply the latest iteration of a concept that has undergone many changes over the passages of time. Fifty years ago, this sort of work would have been done by an office filing lady, but today it’s cheaper and more efficient for computers to hold most of our records. In the future, some believe it will happen via blockchain technology on a publicly distributed ledger.

Decentralised

The revolution that blockchain proposes to deliver is that by decentralising the storage of information contained on accounting ledgers we can free ourselves from the burden of centralised entities, their associated costs, and in the minds of some advocates, their associated regulatory obligations.

It’s important to note that for the purposes of this discussion we are talking about a publicly distributed blockchain ledger. Private blockchain ledgers also exist but these share many more attributes with centralised ledger systems.

Understanding Accounting Ledgers

Let’s look at the three types of ledger systems so we have a clear conception of what’s different about blockchain when compared to other accounting ledgers.

Types of Ledgers;

  • Centralised — All information is stored in one place.
  • Decentralised — Information is held in several key storage areas or ‘nodes’.
  • Distributed — Common information held by numerous parties is broadly distributed.

Each of these systems has various benefits and drawbacks over the other;

  • Centralised — Easier to manage, efficient, cheaper, controlled by the entity, trust issues.
  • Decentralised — Hybrid System, can be more secure than centralised, more expensive to manage.
  • Distributed — Safer, uncontrolled by any one entity, slower, inefficient, more expensive.
Storage systems in information technology

It is the last of these points that are critical to the success of blockchain. The technology is inefficient at present, we know that much. But here we are going to focus on the final issue, cost. Right now, blockchain technology is simply not a cost-effective solution in a free market economy when compared to a centralised system because it involves large-scale replication. Paying a great number of entities to do the same thing that one entity used to manage is simply not going to be cheaper than having a single entity do it.

But what if you don’t have to pay them?

Under this scenario, the system gains viability, but how could you convince people to undertake a task that has an (increasingly large) financial input cost in conventional monetary terms, but offers no realistic way of generating a return on that expense?

Bitcoin and Cryptocurrency

Bitcoins are the receipts that are generated when information is verified and stored on the blockchain network. The first node in the network to solve a mathematical puzzle wins the game and receives a prize, ownership of the receipt, or in the nomenclature of the blockchain world, a ‘hash’.

The information on this hash is then transmitted to all the other nodes in the network who record it, store it and use it as a key to access further information arriving into the network.

At some point, it was conceived that these receipts, the hashes, might have value as a means of exchange in the digital realm. And so, an exchange facilitating their trade was created, and bitcoin the currency was born.

Cheap and Easy

In the early days, being a node in the system was reasonably cheap and simple. It did require a level of technical understanding but beyond that, there were no other major impediments to anyone getting involved and verifying information on the blockchain ledger via hashing to earn themselves bitcoins. A moderately capable computer and a reliable internet connection were all that was required.

Compounding System

But because blockchain is a compounding system, each piece of information building on the information recorded previously is like a growing stack in a game of Tetris. The system has over time become larger and more cumbersome to operate as every piece of information that has ever been recorded needs to be verified each time a new piece of information is entered for security purposes. The more information you add to the system, the more verification that needs to take place, the more computing power you need, and the more scale required to operate effectively within the system. It expands exponentially. This has led to an enormous increase in the cost of operation of the bitcoin blockchain system.

What are the costs that make blockchain so expensive?

There are two main input costs that make blockchain systems expensive-replication of hardware and electricity costs.

With 7000 entities performing the work that one entity used to undertake, the replicated system is obviously a lot more expensive, as each node needs to receive some form of remuneration as incentive for undertaking the work. Paying 7000 globally distributed filing ladies costs more than paying one.

Electricity Costs — Operating a system close to 7000 times larger also means a gigantic increase in other operating costs, electricity being by far and away the biggest. Electricity is needed to power the servers and to provide air conditioning to keep them cool as servers generate a lot of heat and will ‘meltdown’ if not kept at a safe temperature. As an outsourced and decentralised system, each entity involved in the operation covers its own costs in this market.

Lately, another reason has also arisen because of the way bitcoin, the original blockchain technology is structured — establishment costs. To win the competition and solve the computational problem to receive the ‘hash’ (bitcoin), you needed to be the fastest. To be the fastest, you need the most computing power. To get a large amount of computing power, you need lots of hardware. It has suddenly become a digital arms race, and these days, it is very expensive to set up a bitcoin mining operation as well as to operate it.

Market-Based Incentive Structure

For the economic incentive to get involved in a blockchain accounting system, the profit must exceed the cost of providing the service at a suitable rate of return to the user. Current estimates for ‘mining’ bitcoin suggest about US$1,000 per coin and growing rapidly. Other cryptocurrencies and blockchain systems have lower operating costs but these are still costs that need to be covered nonetheless, and right now, distributed ledger blockchain technology simply does not stack up against the current system on a cost basis. The numbers may improve over time but as it stands, they have a very long way to go to get anywhere near the alternatives.

However, there is one thing we do know from the only large-scale public blockchain system currently in operation, and that is, the administration of the system is going to go where it is cheapest to operate it.

Our Globalised Economy

An acceptable rate of return for doing something differs, depending on who and where you are. As with all other industries under globalisation, blockchain systems operation will naturally be outsourced to those global entities most willing to accept the lowest rate of return for operating the system. Wherever input and operating costs are low, blockchain operators will go.

Hardware gets made cheaply in China so it makes sense that most blockchain operations will take place there as transporting bulky equipment elsewhere has a real-world cost. Energy is also comparatively cheap in China giving it a further advantage. It is logical then, that like manufacturing, textile production, goods processing and a myriad of other industries, most of the world’s blockchain nodes are going to end up in China or places very near to it. This is a trend that is already in place with a globally decentralised bitcoin mining marketplace now migrating rapidly towards its lowest cost destination.

Estimates suggest that around 90% of bitcoin mining is now taking place in China.

All nodes lead to China

Colocation & Rationalisation

As this market matures and every last economic advantage is squeezed from the competitive system, what you will eventually end up with is co-location, a phenomenon already seen in the financial world among high-frequency traders who house their servers en masse right next door to the exchanges to benefit from faster access to the marketplace. In the case of blockchain, it will be driven by the cost savings and economies of scale offered by building the servers next to each other, possibly even in the same building. Centralising the decentralised, free market rationalisation at work. Centralisation of this much global data will obviously present major security risks, especially in those places where it is likely to take place. From here, we move back towards square one, negating to some extent, the major problem that is intended to be solved by using the blockchain.

Domestic Deregulation Creates Globally Centralised Markets

In effectively every industry that has been deregulated, global centralisation has been the resulting outcome due to the economic principle of comparative market advantage. This is a self-reinforcing phenomenon whereby a small cost advantage held by the destination with the best economics can become a large overall advantage over time. The formally decentralised infrastructure that supported many nodes of production in many different places globally now develop and scale themselves in the single destination that had the original comparative advantage. A market monopoly then begins to form.

Incorruptible?

Given the above scenario plays out because no central entity controls or regulates the blockchain accounting ledger, and it is free to move to the absolute lowest cost destination, we must then ask, who is going to be operating the system in this place? And, given the way blockchain systems are designed, what would be required to overtake and corrupt the system? As it’s entirely naive to assume it is not going to be attempted.

Let’s take the example of an unregulated blockchain of large-scale financial information and transactions. This kind of blockchain very obviously presents a gigantic honeypot for anarchists and outlaw capitalists.

How difficult would it be for an entity to onboard the required number of nodes to overtake and corrupt it?

With 7000 nodes in the system, under the 51% rule, if you gained control of 3501 of them, then in theory this would be possible. How much would it cost and how difficult would it be to gain control of 3501 decentralised nodes? Probably quite difficult and expensive under the assumption that they are actually globally decentralised and operated by independent actors.

But given the system is operating in a globally rationalised free market structure, how much would it cost and how difficult would it be to establish 3501 nodes once the inevitable centralisation of the network takes place?

Let’s run with an example. Assume China, with their cheap electricity, low-cost land, and cold climate becomes the global leader in systems operation, which seems likely, and the network has a cost of US$100,000 for each node’s establishment;

3501*$100,000

= $35,100,000

For $35 million give or take, the system could be overtaken with this cost structure. Now I am not an expert on what the costs might actually be, in reality they might be ten times higher or ten times lower but in either case, what could the return on investment from a hack into the multi-trillion-dollar financial system be from a heist of that scale?

It’s a ginormous honeypot indeed. Are there entities in the world that could stump the money to attempt a heist within the system? Yes, absolutely.

Would they? I’ll leave the answer to that question to the reader’s own beliefs on the strength of human morality.

Paradox of Cost for a Secure Blockchain

Given the way that it is structured, with no single entity legally responsible for its oversight, the cheaper a decentralised blockchain is to operate, the more easily it will be able to be corrupted. Alternatively, a high cost to entry will be a prohibiting factor for some entities engaging in potentially nefarious behavior, both in terms of raising the necessary capital needed to set it up, and considering the opportunity cost of having it fail. This lowers the possibility of corruption, but it also substantially reduces its advantage in a competitive marketplace offering alternative options. Herein lies another free market paradox facing a public blockchain. The more expensive the system, the safer and more effective it is, but less attractive to use vis-a-vis the alternatives on a pure cost basis. Ironically, the way to solve this issue would be oversight from a regulating body. But then…

Blockchain’s Cryptocurrency Catch 22

Having worked as financial markets dealer, and knowing the heavyweight of overhead that compliance places on financial market-related businesses, it is the author’s view that cryptocurrencies cannot survive the ever-increasing burden of global financial regulatory compliance. The costs of compliance are simply too high and will destroy the belief that cryptocurrencies can become a useable mainstream medium of exchange. They are now, and will remain, simply too expensive to make everyday transactions in.

As mostly large fixed costs, the compliance costs operators face will need to be spread over too small of a user base given the modest and disbursed uptake of global cryptocurrency usage. Anyone who works in a bank compliance department will know the scope of work involved in compliance with KYC/AML laws (Know Your Client / Anti Money Laundering Law). To have to run this system in every country you operate, which conceivably means almost every country in the world — that’s a whole lot of overhead cost that will need to be passed through to users, and that’s in just one portion of the regulatory requirement!

To expand the user base further beyond the core of devotees and into the mainstream cryptocurrency needs legitimacy. To get legitimacy, cryptocurrency needs approval from the regulatory bodies and compliance with their systems. This is cryptocurrencies’ (and blockchains) ultimate unclosable circle, a true catch 22. Will the current attempts to sell cryptocurrency to the world at large and garner the required scale be effective enough? It would seem there is a long way to go.

Private Currency Issues — Problem with Issuing Your Own Currency

So far, there’s been little conversation in the economic inefficiencies of blockchain because all the conversation seems to assume that blockchain will take place as its own standalone system, separate from the systems we have in place now, operating in its own currency or currencies.

In theory this is fine, money can be anything, so why not have it be some form of receipt generated by a machine operating an accounting ledger in the digital realm. It makes just as much sense as anything else we might decide to be money. The problem that will arise there however, is one that has plagued our species from the very first time a currency was ever issued. Namely, getting others to accept what you are offering them as being legitimate currency.

Modern Money

In our modern economies which operate under a fiat currency system, money is a legal construct. It is a product of the law developed as a part of the national infrastructure. It is a feature of the constitution of almost every sovereign nation on earth that the state will be the sole issuer of currency for use by its citizens in that nation. In no country that this author is aware of are private entities, wholly disconnected from government allowed to administer the sovereign currency of the nation. Other forms of currency are often allowed for the purposes of private trade. But these currencies are not recognised by the state or its affiliates, and payments to the state cannot be made in these private currencies. Bitcoin and cryptocurrencies fit this latter category. They are and will remain nothing more than private currencies used for trade between small-scale entities.

Blockchain Legitimacy

For blockchain to work as a mainstream system of operation, it needs to operate under the auspices of an official currency system. There is simply no way around that. Bitcoin, ethereum, altcoins, hashes, dashs and dogecoins are simply not going to cut when it comes to making it in the big leagues. Governments and other market dominant entities such as public traded companies are just not going to use the blockchain system for legal and practical reasons if it does not work in their singular legally accepted currencies. I feel like I might be doing the equivalent of telling a whole generation (my own) that Santa does not exist by saying this, but governments are not going to change the rules to allow you to run your parallel network simply because you want them too. They don’t control your new network, they don’t benefit from your new network, they are not going to do your new parallel network any favors, and like it or not, they make the rules. Sooner or later, I suspect that a lot more countries will actually ban cryptocurrencies as some already have, or at least regulate them to the point of effective extinction.

Digital Currency Already Exists on a Massive Scale

Diverging for a moment from blockchain’s economics problems, a word needs to be said about what a digital currency actually is. As already stated, the government creates public money in essentially every country. Here we’re talking about the coins and notes type money that we use in everyday physical cash transactions. On top of this, private banks also create money when they make loans. This money is not physical cash money, they don’t print new notes for themselves. It is money that exists in databases on computers in banks around the world, in semi centralised databases as opposed to the decentralised one’s that blockchain promotes but in all other respects, basically the same. It is digital money. Now for reference sake, it is useful to know that this money is created through a process of fractional reserve lending. This is what is being talked about when you hear people saying money is being created out of thin air. That’s true, it is, but the problem is not so much the governments doing as many suggest, but private banks. Banks can legally create legitimate claims on physical government created public money in the digital realm, effectively creating a ‘digital’ currency. This is a very important topic and one that goes to the heart of the debate around the flaws in our economic and monetary system and the need for alternatives, but I’ll leave that discussion for another essay. What needs to be understood here is simply that we already operate under a (mostly) digital currency. Around 97% of the money in existence in most developed economies is digital currency, and it is privately issued, by your bank, and other banks in the system just like it. These banks can get away with issuing their own digital currency because they are sanctioned to do so under the legal regulatory system constructed by the sovereign government by way of banking licenses. Private banks have the right to issue legitimate claims on public government created money because your government allows them. Blockchain-based currency creators do not have this authority. They would be charged with fraud and counterfeiting if they were to do so as you or I would. So, they issue their own type of money — cryptocurrency. But privately issued cryptocurrency is not going to become legitimate government sanctioned money anywhere, and at any time in the future. Many have tried to launch their own currencies in the past, and some of these stories make for interesting reading. Recent investors in the cryptocurrency space would do well to learn some of them.

This brings us back to our original point, that public ledger blockchain technology is not going to work in its current form because privately issued currencies will never gain mainstream recognition, and public ledger blockchain does not work when priced in traditional currency. There is an incongruous compatibility problem going on here.

Blockchain Faces Market Realities Even in an Alternative Currency World

As alluded to earlier in this paper, blockchain technology has very high operating costs for users in the network. Current estimates for ‘mining’ bitcoin suggest about US$1,000 per coin and growing rapidly. Some have fancifully suggested that the mining cost presents a ‘price floor’ for the price of bitcoin. The claim is laughable! Do these people understand what happens when the all-in cash costs of operating a gold mine are higher than the gold price? The gold price does not adjust, the mine simply closes. Such is the Darwinist reality of life in an open market. Other cryptocurrencies have lower operating costs than bitcoin but these are still costs that need to be covered with an acceptable profit margin on top for the private entities in the network conducting the facilitating operations. If and when returns fall below the cost to profitably operate, no one will. That is simply the way things work in a global free market economy, even one operating in an alt currency space. When costs exceed returns, the business shuts. The only entities that run operations at a total loss over a long-term time frame are governments. And what do they do to our liberty?

To put the net result of that reality very bluntly — A public decentralised blockchain faces the continual risk of the cost of operating the system rising above the required rate of return and the entire system collapsing on itself because the free market does not deliver the profit blockchain needs to operate its distributed ledgers securely. This might seem an obscure outcome, and in reality it might be, but it is still a statistical risk, a low probability outcome but one with huge ramifications if it ever comes to pass, a genuine black swan. Having that risk exist within the system erodes trust and confidence, probably to an extent which exceeds what it should, but that is a quirk of the way that the human mind functions. To assuage skeptical consumers to transfer onto the network, the network must be seen as absolutely 100% foolproof, and a free market blockchain with a profit motive incentive operating outside any regulation simply cannot deliver that.

Will Marx’s insight kill this libertarian dream?

Technology and Economics

In tech, what starts out as casual and recreational quickly becomes commercial. We have seen it in Uber, where casual drivers adding additional quantity to the market have supplanted established players in the taxi industry and developed their own professional class. We have seen it in Airbnb where renting an extra room for a bit of spare cash has spawned a new global class of professional landlords managing expansive property portfolios, and so it will also be with blockchain. But blockchain has a whole lot more at stake. Centralisation defeats the entire premise underlying the distributed ledger blockchain system. Centralisation and market dominance of a few major players erodes trust in this market. Establishing trust is the raison d’etre of blockchain technology. Somehow, the technology needs to find a way to overcome this free market contradiction, and it needs to do it relatively soon.

Moore’s Law

Blockchain networks have a lot of work to do on the technological front to achieve anything like a globally functional platform, but the improvements in the technological requirement are greater than most realise, given the economic factors outlined here. With a trend towards smaller and more mobile digital gadgetry, blockchain needs Moore’s law on steroids to achieve a realistic hope of going mainstream and having everyone with enough computing power to get involved in assisting to run these networks. Otherwise the job is going to fall to a professional class, a segment of specialists that will manage the market because they are best endowed to do so. The only remaining option beyond that is pro blockchain legislation which allows it to succeed and supplant its competitive market alternatives.

A Window of Opportunity to Solve the Riddles

Blockchain must prove itself while the funding opportunities are available or face the challenges of raising finance for experimental technology in an unenthused market. Once the price of operating the system’s ‘mining’ becomes greater than the rewards on offer, private money flows will dry up rapidly, interest in the space will wane, speculative activity will decline, and prices of cryptocurrencies will fall.

Following from that venture capital, who prior to the advent of cryptocurrency usually would be (and are currently also) providing the funding for this type of innovation will become gun shy, and governments will drop the ball as they tend to do as receptacles of fickle public moods.

Public blockchains still have no large-scale projects currently in existence outside of bitcoin and similar dubious speculative currency schemes. Controlled private blockchain systems such as ripple’s banking transfer technology are charting a path to market acceptance, and innovations along similar lines led by existing market players using private blockchains will probably reshape some industries for the better. But these are incremental improvements in private sector operations; they are not public nor will they be the stuff of societal revolutions. The ambitious claims of those at the farther ends of the blockchain universe, that all transactions will become decentralised, freeing us from the burdens of controlling authorities do appear rather naive and utopian.

It may be presumptive at this early stage to state this, but blockchain runs the risk of being this century’s communism. A concept that was thought by some to work whilst a theory but failed in practice due to an incomplete understanding and important contingencies about the true nature of the world failing to be considered. It’s ironic enough in this case, given the libertarian bent of many of its backers, that the contingencies being ignored are the economic realities of a free market system.

Will the technology continue to evolve? Yes, absolutely it will, and new uses for it will evolve along with it.

Will public ledger blockchains ever succeed in exempting us from the burdens of controlling centralised bureaucracies and deliver us into a libertarian paradise of free market individual independence? Given the above, that seems pretty doubtful. I know with certainty that I won’t be exchanging any of my own money to bet on it.