Concentration in Cryptocurrency Mining: Why We Should Not Care

Ville Savolainen - Hanken School of Economics, Helsinki, Finland

-- Is decentralization of mining power important for sustainability of cryptocurrencies? Our research claims that it is not. Our paper, “Too Big to Cheat: Mining Pools' Incentives to Double Spend in Blockchain Based Cryptocurrencies”, coauthored with Jorge Soria, considers pools’ opportunity costs from double spending and examines conditions for which it is costlier for a pool of any size, than for an outsider, to conduct a double spending attack – i.e. use the same funds multiple times and hence leave the sellers of goods (assets) without a payment.

In Bitcoin Cash, two large pools jointly conducted a majority attack in May 2019. However, in lieu of double spending they reversed a malevolent transaction. This could indicate the following: first, that pools can join forces to attack; second, that it might be in pools’ interests to protect the cryptocurrency against misconduct – not to attack against it.

Since Nakamoto’s white-paper, decentralization of mining power has been considered a corner stone of functionality. In addition, the genesis of blockchain based cryptocurrencies is deeply rooted in quixotic enthusiasm for trustless systems and avoidance of monopolies – private or public. Contrary to this ideal, a prominent feature in all major cryptocurrencies is that most of the mining of new blocks is conducted by very few large pools. Additionally, in Bitcoin, there have been at least three occasions since 2011 where a single pool controlled a majority. Economic intuition reveals that this occurs naturally due to miners’ willingness to insure against idiosyncratic risk by joining pools.

Should we be concerned? If indeed, centralization was such a problem, one would wonder, why have the major cryptocurrencies gained in popularity and market value, instead of being already collapsed due to dysfunctionality. Besides, why would a large pool or a coalition of them, even if more capable, do anything nefarious while the whole business model depends on the appeal of a particular cryptocurrency?

How does double spending harm pools? The value of a cryptocurrency is dependent on a probability that a transaction will stay as a part of the accepted history after the goods have been delivered. If there is a possibility that a seller would be left without a payment, the sellers should increase prices accordingly. This would cause inflation and a decrease in exchange rate against traditional currencies. Consequently, a pool, of which profits depend on a value of the cryptocurrency, would suffer.

Are the observed pool fees large enough to make it costlier for pools to double spend than for an outsider? Our modelling exercise indicates that pool fees 100 to 1,000 times smaller than the usual fees in major cryptocurrencies (a bit above two percent) are sufficient. Unfortunately, there is very little data about actual profitability of pools. As an exception, Bitmain – a large pool operator, proprietary miner, and mining gear manufacturer – reported 80 to 89 percent gross profit margins from pool services in its 2018 Proof of Application filing to Hong Kong Security Exchange.

If the ubiquitous concern about centralization is merely tilting at windmills, what should developers of new blockchain protocols instead be concerned about? We’d like to argue that, the prevalent threat for any cryptocurrency comes from agents not having vested interests in it. For example, a large-scale miner or pool in a major cryptocurrency has only its altruism (and possibly the compatibility of its mining gear) restraining it from attacking a smaller cryptocurrency. Therefore, to build a permissionless blockchain protocol one might consider inducing protocol specific fixed costs and barriers of entry for the miners. This should help to make miners long-term investors; and hence, align their interests with those holding and using the cryptocurrency. This occurs, somewhat naturally, in Proof-of-Stake protocols.

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