In Bitcoin We Trust

“The best way to find out if you can trust somebody is to trust them.” ― Ernest Hemingway

Most of the cryptocurrency news this month has been about Bitcoin’s plummeting prices, but there was a recent series of events which flew under the radar. Namely, a bug that was patched about two months ago during the v0.16.3 release for Bitcoin Core (aka Bitcoin). In short, a vulnerability had been exposed for over a year that enabled malicious miners to double-spend from their accounts. This should have been a catastrophic moment for Bitcoin as the only value of the network is the fact that users can’t double spend. So why did the network survive, and why did most Bitcoin Core users never even hear of the news?

Primer on Bitcoin

Bitcoin Core (aka Bitcoin) is the largest digital currency by market capitalisation. It acts as a virtual, trustless IOU; Bitcoin isn’t mediated by any centralised body. It is cryptocurrency’s flagship token and is helping to pave the way to mainstream adoption of blockchain technology.

If you’re interested in learning more about Bitcoin you can read this article and for information on blockchain technology you can read this article or this article.

The Bug

During the 0.14.0 release of Bitcoin Core’s protocol, which occurred in March 2017, the infamous bug was introduced. The technical details of the bug aren’t that important for this article. If you are interested, you can read the details of the bug in Bitcoin Core’s official release.

The important takeaway is that the bug introduced a way for miners to double-spend transactions during a single block. It has been patched now in the 0.16.3 release, which was pushed out on September 18th.

What was amazing was that during the 12-month-long exposure no miners fraudulently tried to include any illegitimate transactions into their blocks. There is a chance that it is because no miners noticed the bug in the source code, but this is fairly unlikely as the entire source code of Bitcoin Core can be found online. So why didn’t the miners exploit this bug?

The Economics of Trust

What makes Bitcoin and cryptocurrency interesting is that although it isn’t backed by any centralised authority, the tokens and coins themselves have some tangible fiat-value attached to them. There are, of course, multiple complex and intertwined factors that influence the value of a token in an ecosystem. However, as a high-level approximation, there are two main factors that directly influence the price of Bitcoin.

The Cost of Mining

One of the most important parts of any currency, digital or otherwise, is that it near-impossible to counterfeit. In Bitcoin’s case this is done through hard-to-guess cryptographic hashes. Miners, which act as securers of networks, expend computational power to solve these cryptographic puzzles in return for being rewarded for their hard efforts. This mechanism for securing a network using computational power, which is impossible to fake, is called Proof-of-Work. Bitcoin is one of the networks which use proof-of-work. (If you aren’t familiar with Bitcoin mining you can read this article that explains the underlying concepts)

Since the network is secured with real, tangible power, it is easy to quantify the cost of minting Bitcoins. The cost to mine Bitcoin comes in the form of both capital expenditure (through the GPUs, fans, warehouses, etc.) and operational expenditure (the price of electricity). Hence, at a fundamental level, the price of a single Bitcoin should be exactly what it costs to mint a brand new one.

The cost of minting a Bitcoin varies on the geographic location and can vary between US$500 to US$26K. The price of Bitcoin today is about US$6K and previously reached an all-time high of US$20K.

Figure 1: The cost of mining Bitcoin. Source: Elite Fixtures.

The Value of Trust & The Network

So where is this additional value being generated? Shouldn’t the trading price of Bitcoin be approximately the same as the electricity (and hardware) costs to produce it?

The value of Bitcoin actually lies in its network. This value is both in terms of usage and of trust. The network has the widest user-base of all cryptocurrencies and is starting to be accepted in the “real world”. This utility is part of what gives Bitcoin value over other store-of-value coins such as Litecoin or Tether.

There is another element of value within the trust users have in Bitcoin. The Bitcoin network has been in existence since 2008 and to date there has never been a catastrophic event which has undermined its ability to be a safe store of value. This is one of the major reasons why Bitcoin is the most valuable cryptocurrency even though it has less functionality compared to protocols such as Ethereum or EOS - users trust that the Bitcoin they buy will be theirs forever and that there is no way for any users to defraud the system and devalue the currency.

The Resilience of Bitcoin & Why The Bug Wasn’t Exploited

In the context of the above economic factors that influence Bitcoin’s price, it is perhaps more apparent as to why miners didn’t exploit this bug: there is a value to Bitcoin in the trust in the network.

Let’s assume the following scenario: a miner includes a fraudulent block which is rejected by the network. In this case, the other miners in the network notice that more cryptocurrency is being spent than is available. These miners, seeing this as an unfair advantage to themselves, will reject that miner’s block. With their transactions now being rejected, they will forfeit the block reward of 12.5 Bitcoins. This is after expending compute power in finding a solution, which of course costs the miner a significant amount of money. This is a huge disincentive force for the miner and hence they are unlikely to forge fraudulent transactions.

Now consider a second scenario: a miner includes a fraudulent block which is accepted by the network. This is already an extreme and unlikely case, but worthwhile exploring out of interest. For a fraudulent transaction to be accepted, it would either must go completely unnoticed or be a 51% attack on the network. The former is unrealistic, and the latter expects that a miner holds, or is able to influence, majority of the compute power in the network. Assuming that it is accepted, this would be the first time in Bitcoin’s history that its security has been breached and enabled the double-expenditure of funds. Therefore if miners attempt to make money by double spending, they will immediately cause their own holdings to plummet as users cannot know how much the currency is worth.

There is one final scenario: a miner includes a fraudulent block in order to crash the market, making a profit through shorting Bitcoin. In this case the malicious miner is hoping that the transaction is accepted, and that it crashes Bitcoin’s price, so the miner’s put option (i.e. short) will be in-the-money. How does Bitcoin’s meta-economic model prevent this from happening?

There is a lot of risk involved with this method, mainly in the form of majority of the market participants hedging long. All of these market participants are incentivised to not let the price of Bitcoin crash and would reject the fraudulent block. The only way this would work is if there was another 51% attack on the network. In this case the 51% attack is much more difficult to achieve. The attackers need to coordinate their efforts, and simultaneously short the market, while also not altering any market participants who are long Bitcoin (and hence incentivised to patch the bug).

There is also another way to address this issue: forking. If the network was “crashed” due to this bug, all the major miners and market participants would have to do is create a new copy of Bitcoin, fix this bug and issue a 1-to-1 conversion of tokens onto the new network pre-bug exploit. Of course, this would influence the price of the “Bitcoin 2.0” but Bitcoin would still live on as a store of value.

A Self-Regulating System?

It’s hard to predict what this result means for Bitcoin and cryptocurrencies. This case study however is indicative of how cryptocurrencies has developed a monetary system that is resilient to counterfeiting without the need of any external enforcers. The difference is that Bitcoin has financial and economic disincentives whereas fiat currencies have disincentives in the form of governments punishing those who counterfeit.

Do you agree that miners were influenced by economic factors to behave legitimately? Or was this simply an unnoticed bug that no one had the chance to exploit? If you have any thoughts or feedback please tweet to us at @AllectusCapital or get in touch with us via the form below!

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