The ultimate deep dive into Bitcoin security model
Is Bitcoin's current security model flawed?
What could be done to the Bitcoin network to ensure that it is sustainable?
Today we're going to be talking about a just that on this CoinMarketCap episode.
So let's dive right in.
The Bitcoin security model is the ultimate final boss for Bitcoiners
dream to once and for all bury the fiat system.
But is the Bitcoin security model up to the task?
Some high profile investors think that it's not.
But ask a bitcoin supporter and they will probably tell you the exact opposite.
So which one is it?
Well, the Bitcoin security model is a combination of factors
that keep the Bitcoin network functional and decentralized.
It combines the power of proof of work, which is expensive with protocol
incentives so that it is difficult to achieve a monopoly control of Bitcoin.
So why Bitcoin's security model may be broken and why that matters?
Bitcoin's security is derived from the cost of attacking the network.
The higher the cost, the more secure the network.
We can calculate the cost of attacking the network
by looking at the revenue that miners receive from validating new blocks.
This miner revenue is commonly used as a proxy for the Bitcoin security budget.
So where's the problem?
Well, currently 99% of miner revenue comes from the block
reward, also known as block subsidies, only a 1%.
It comes from transaction fees.
This is a problem because the block reward is halved every four years.
This has Bitcoin's famous having, and the reason
why is inflation tends to zero until all the coins have been mined.
But this also means
that the security budget will soon have to come from transaction fees alone,
although that is estimated to be sometime in 2140.
So shout out to all the people watching this because I'm not alive.
Remember Miner revenue is a proxy for the security budget.
If miners do not receive revenue
from the block reward, it must come from transaction fees.
So what if the security budget does not increase?
The short answer is that Bitcoin may become a victim of the Turkey fallacy
with a security budget that is too low.
The incentives for an attack increase.
The network works flawlessly until it doesn't.
Time for a quick refresher on how we know that transactions are secure.
How Bitcoin security works?
When you send a transaction over the Bitcoin network, that transaction
is included in a block.
Each block can include several transactions
up until a certain limit called the block size.
Some chains have bigger block sizes like Bitcoin cash, and some have smaller ones.
Like Bitcoin, blockchain transactions are immutable, and in the bitcoin network
miners validate transactions.
They do so by producing blocks.
A block is valid when the miner has performed
the famous proof of work mechanism in plain English.
Miners perform
a bunch of complex computations that require a lot of computing power.
These computations are performed with the specific hardware called ASICs.
The more computing power
a miner has, the more likely they are to win the block reward.
So in other words, it pays to spend more on ASICs
that improves a miner's chances of making money when it comes to money.
So the conclusion is miner income, it comes from the block reward
and the transaction fees.
Miner expenditure is electricity costs and the cost of hardware.
So using one of the most popular bitcoin mining devices, the Bitmain Antminer
S19 Pro as an example, which produces 110 TH/S a second
and a power consumption of 3250 watts and the average U.S.
electricity costs of $0.16.
Clearly shows that mining is not a profitable endeavor for individuals.
So let's see how that affects a miner's incentives.
Bitcoin security problems.
Is cheating possible?
The key incentive structure to know about miner behavior is miners
have the incentive to stay honest as long as their income exceeds
their expenditure.
In other words, yes, cheating is possible, but the network is set up in such a way
that no rational actor would want to cheat.
But what if, for example, what if expenditures exceed income?
This is known as miner capitulation.
There is a high upfront cost to mining.
If miners create new bitcoins at a loss, they start selling their bitcoin inventory
to cover costs.
Some may capitulate and close their farms by selling their hardware
to other mining farms with lower variable costs.
Pursue estimates that miners
have to put up one entire year of block rewards to mine Bitcoin for two years.
So in other words, if you decide to get into the mining business tomorrow,
you will mine for one entire year to cover the cost of your hardware first.
Therefore, miners have the incentive to mine honestly.
They do not want to kill their cash account.
Okay.
But if someone wanted to cheat, could they do it? Yes.
And that is called a 51% attack.
If you control a majority of the computing power used to validate new blocks,
so the hash rate, you can refuse to add new blocks from other miners.
You can also engage in a double spend attack.
The Nakamoto consensus postulates that the longest chain is the true chain.
Therefore, a miner with the majority of the hash rate
is in control of the network.
Of course, an attack would destroy
the chain's value proposition and the price of Bitcoin would crash.
In the case of a double speed attack.
The attacker would have to gain in monetary or other value for an attack
to be worthwhile.
So let's see how that could happen.
Motives for attacking the Bitcoin network.
For the sake of this example, we assume that an attacker would engage
in the most devastating form of an attack double spending coins.
There are two possible motivations for attacking the network.
Both attackers
would have to take into account
these same variables to calculate the expected value of an attack.
A probabilistic estimation of the price after the attack to sell the double
spent coins.
The amount of coins gained in the attack, the cost of acquiring the necessary
hardware and operating costs for electricity, the probability
of other network participants defending against the attack through various ways,
like switching to different hashing algorithms
or suspending the consensus mechanism.
So keep in mind that a sabotage attack is less concerned with the post attack
price or possible defense mechanism for such an attacker.
A price crash is a feature, not a bug.
They're not looking to attack in order to double spend the coins,
but to disrupt and destroy the network's credibility and functionality.
Possible defense mechanism.
Even if they're successful, could they undermine the network's legitimacy?
For example, switching to a social consensus to save Bitcoin
would reveal that proof of work wasn't the actual security backstop.
In that case, it would have to be a social consensus
like the OGs agreeing on the true chain that secured Bitcoin.
All along, however, there is currently no incentive for an economic attack.
The primary defense against this form
is the spread between the expected value of honest mining and attack mining.
If miners expect the long
term value of honest mining to be bigger than that of attack of mining,
the network works
as designed over with miner rewards getting halved every four years.
Transaction fees have to make up the difference and this is the crux.
Thus, if this trend continues, the spread between the eve of honest
mining and attack mining shrinks.
Still, how could an attack on Bitcoin be pulled off?
How to theoretically attack the Bitcoin network?
Joe Kelly laid out the blueprint for attacking Bitcoin in his excellent
three part series called How to Kill Bitcoin.
In essence, only state actors
have the means and motivations to attack the network.
A state's cost benefit analysis is driven by more than just economic gain.
Kelly argues
that if a state wants to attack Bitcoin, there's little defense forum for one.
A state would first block entry points to the network by banning exchanges,
effectively canceling that Bitcoin and shunning interaction with them.
The next step could be to seize mining equipment and announced that
the state will do whatever it takes to acquire a hash rate majority.
The state sponsored flood would probably cause a price crash
and to lower the cost of an attack since the state is not concerned
with the economic profit,
even increasing its hash rate at a small loss is a viable strategy.
Once a hash majority is acquired, the stake in overtly or covertly starts
entering transactions or outright sabotage the network with double spend attacks.
This process would be neither quick nor cheap over.
Kelly argues that this is not the point.
If the perceived political gain
of banning Bitcoin for whatever reason is deemed to worth the cost.
A state can essentially field unlimited resources to engage in such an attack.
Still, the costs of such an attack would be prohibitive for all
but a handful of state actors.
So let's talk about the risk factors for the Bitcoin network.
While that's a bummer, seems like if they wanted to kill Bitcoin they could.
But what factors increase the risk of an attack?
Well, Kelly has some answers to this as well.
For now, the attack surface is low.
The Bitcoin based economy is tiny compared to other financial markets,
and many addresses can be traced back to KYC to account
for the more capital markets do not have a lot of liquidity.
To short a possible attack and hedge a price drop.
However, Kelly argues that the attack surface will increase
if Bitcoin continues to develop as envisioned.
More privacy features, deeper derivatives markets and a bigger Bitcoin
based economy.
A consistently increasing hash rate has no effect on Bitcoin security.
Newer hardware can compute more hashes, but an attacker would only be concerned
with the potential costs.
New mining hardware produces more hashes per dollar spent.
For now, Bitcoin's biggest asset is its irrelevance.
It is simply not big or dangerous enough to merit an attack.
At the same time, the cost is too high for rational actors.
But if a country was significantly exposed to the network, either
because Bitcoin mining has become a relevant factor of its energy policy
or because it has, for the same reason, acquired a significant chunk of coins.
The incentives for other states to disrupt the network increase.
Is there any way to defend the network?
How to Defend Bitcoin's Security.
Bitcoin suffers from its own security trilemma.
There can only be two out of the following three.
Bitcoin can introduce a perpetual inflation rate
that would continue the block reward.
Alternatively, the network could force users to spend old coins or devalue them
through something called demurrage, but that would make it less scarce.
Or the network can become less liquid if the demand for transactions
does not pick up and higher transaction fees does not materialize.
There will be less incentives to pay fees.
A tragedy of the commons would be the result where users wouldn't
have to wait longer for confirmations and or send smaller
transactions not to increase the incentive to reverse them.
Alternatively, and most probably Bitcoin will have to become less decentralized.
This will lead to minor cartels developing and de facto already a thing
and more custodial trading and off chain settlements to avoid transaction fees.
However, some changes to the Bitcoin protocol are not socially acceptable,
as has to research.
Decentralized systems do not have an identity
and thus rely on a subjective consensus around core values.
For Bitcoin that is resistance to change.
In his surveys, intermediation and deliberate inflation
were rated highly unacceptable by Bitcoiners.
But how can we defend the Bitcoin network in that case?
In the case of attacks, several solutions have been proposed.
One would be changing the hashing algorithm
over honest miners would be the collateral damage.
For this to make sense.
Hashing with ASICs would have to become a thing of the past.
Even then, it would not prevent an attacker from trying again.
A better solution
would be a social consensus as to which chain is the true chain over.
Kelly points out that
this political solution would render the entire existence of proof of work moot
if the true defense of the network is not proof of work but a social consensus.
Why do we have proof of work to begin with?
Although it does serve
as a deterrence, it's questionable whether the cost would justify the ends.
Finally, a hypothetical hash war
between states would de facto back the network by state power.
This could happen directly or indirectly with, say, states
using bitcoin mining to monetize non rivalrous energy sources.
Still, as we pointed out earlier,
this could also increase the incentive for an attack by hostile states.
Say the U.S.
used bitcoin on a large scale to mine with flare gas.
China and Russia may become a lot more interested in attacking the network.
Thus, a one sided dependency on the network
could also be a strategic weakness.
So what's the best case scenario?
Well, massive bottom up adoption of the network with Bitcoin
becoming so entrenched that the costs of attacking the network
would incur such a massive economic collateral damage to make it undesirable.
At the same time, the state would be incentivized
to help defend the network from potential outside attackers.
There's only one way this can happen.
More transactions need to be settled on Bitcoin.
Let's see if that's happening.
The Bitcoin transaction fee market.
Unfortunately, data always paints a fairly bleak picture
of the state of bitcoin transaction fees.
Market for one price capitulation lead to miner capitulation.
Miners remaining in the game are those with extremely cheap energy contracts,
new and more efficient mining
machines, good access to capital markets or good treasury management.
Grid Balancing Applications.
Retail miners are only profitable in highly specialized cases.
That confirms what we already suspected.
Mining tends by design to become more centralized.
That is because only
the most recent generation of ASICs have significant profit margins.
Remember, this data is from June of 2022.
Things are likely bleaker now as the bear market drags on.
Centralized mining also makes regulation of the business easier,
but you have probably already heard enough bad news.
The biggest problem with transaction fees is that they are pro-cyclical.
This rose during the 2021 bull market would have been mostly flat sense.
Even more worryingly, the revenue share of fees is back to 2018 levels.
The latest data shows that demand for Bitcoin block space peaked
only during liquidation events, but saw no clear trend in 2022.
So that means that in four years
there has been virtually no growth in demand for Bitcoin transactions.
That is not what the models promised us.
During the last bull run, fee revenue was predicted to equal block
reward revenue in the next 2021 bull run and subsequently exceeded.
Well.
See for yourself.
In other words, the ratio of transaction fees
to block reward revenue hasn't been this low in more than a decade.
Where is this problem coming from?
A big reason is most likely bitcoin's value proposition.
Bitcoin has over the years firmly moved into the store of value
corner, however, being a store of value means that coin velocity is low.
You won't spend your bitcoins if you believe they preserve your wealth.
There is really no way around this fact. Bitcoin needs
to become a medium of exchange to have a sustainable security model.
If we assume that the community does not want any significant changes
to the protocol, that is the only solution.
This will inevitably lead to a degree of centralization.
Even though the Lightning Network also allows for non-custodial transfers,
some people will prefer custodial transfers.
The Bitcoin community is well advised to embrace this.
Luckily, at least the Lightning Network is growing, albeit a tiny base.
Even though 5100 bitcoin public capacity on lightning
is the proverbial fart in the wind compared to wrapped coin on Ethereum.
It is all utility based liquidity.
Adoption of the Lightning Network will likely be the key
to a sustainable security model for Bitcoin over the Lightning Network.
Also has a major shortcomings.
For example, it would take 128 years
to onboard the entire planet to non-custodial lightning wallets.
That is to say that even with the Lightning Network in full
adoption mode, some centralization will be inevitable.
Is merged mining a wildcard solution?
Maybe there is another solution that can at least support
faster bottom up adoption.
Bitcoin researcher Paul Sztorc suggests merge mining
in his own two part deep dive into the Bitcoin security budget.
Merge mining
is simply mining another cryptocurrency with the same algorithm at the same time.
In practice these would be sidechains of bitcoin that run on the same
SHA 256 algorithm and leverage the security of the bitcoin blockchain.
Mining.
These sidechains would increase miners revenues and de facto increase
the block size stores also refutes the claim that merged mining
is prone to centralization and inherently not secure enough.
He contends that mining is already significantly centralized
and that centralization through specialization is not a security risk
as long as the decentralization of nodes is guaranteed.
Merge mining would de facto be a scaling solution that allows
paying miners fees without diluting the bitcoin supply.
However, there would still need to be demand
for the block space Any sidechain offers to make economic sense.
Therefore, merged
mining can be a complementary solution, but does not solve the adoption problem.
So let's talk about the conclusion Bitcoin's
security depends on its security budget.
Now the budget is all block revenues, but soon it won't
have to come from transaction fees.
There is currently no economic incentive to attack the network.
Only the most powerful states would even have the means to do it.
If Bitcoin becomes a more widely adopted in the future, it also becomes
more interesting to attackers.
Having a sustainable security model is key.
There are several solutions to this, but more bottom up adoption of Bitcoin
as a medium of exchange is probably the most sustainable and realistic one.
Currently, there is no growth in demand for Bitcoin transactions.
A spike in demand was a temporary bull market factor.
Adoption of the Lightning Network looks to be the key to the solution
and the network is growing quickly from a tiny base.
Merged mining can supplement
miner revenues as long as there is demand for the blocks based on sidechains.
To conclude, Bitcoin's security model is unsustainable as it stands today.
In other words, a Bitcoin with 2022 adoption rates and a lower block
rewards will be much more vulnerable to an attack two halvings from now.
Luckily, the community is still has time to figure things out.
Given how conservative bitcoiners are,
big protocol changes look out of the question.
Increasing the medium of exchange value proposition via lightning
does not contradict
having Bitcoin as a store of value and should be embraced by the community.
However, lightning will have to keep
growing exponentially to make up for the currently poor numbers.
Let us know what you guys have to think in the comments down below.