Innovations in Bitcoin: Nakamoto Consensus
I’m excited about the rise in Bitcoin price too, but the Bitcoin white paper didn’t mention anything about designing an asset with an impressive Sharpe Ratio. If investment thesis is what attracted you to Bitcoin, that’s fine, and I can relate. But, stick around for the fundamental advancement in censorship resistant money, not for the lambo. With the backdrop of $20k+ Bitcoin let’s briefly discuss one the core innovations presented by the invention of Bitcoin. Arguably everything about Bitcoin is an innovation and barring having domain level expertise in economics, game theory, cryptography, computer science, thermo-dynamics, finance, and law it would be hard to wrap your head around all of it. I have domain level expertise in none of these areas but I’ve seen movies where actors play experts in some of those areas which seems like sufficient credentialing. More importantly, a user doesn’t need to understand Bitcoin’s building blocks to benefit from Bitcoin, though it certainly helps to be a bit more than uninitiated. You don’t have to understand catalytic converters or combustion engines to benefit from owning a car, but it does offer greater independence to know what is under the hood.
So, what is under the hood of Bitcoin? Arguably the single most important innovation underpinning Bitcoin is Nakamoto Consensus, named after the pseudonymous creator(s) of Bitcoin: Satoshi Nakamoto. Nakamoto Consensus is what solved the problems presented by digital currencies that predated Bitcoin and in and of itself Nakamoto Consensus has a couple distinct elements. Each is required to solve the problem in computer science known as the Byzantine Generals Problem. For a distributed computing system to function where the intentions, reliability, and honesty of the network nodes is unknown, the network requires a set of parameters incentivizing rational behavior in alignment with the proper network function. Where this is achieved the network is said to be “Byzantine Fault Tolerant.” Allow me to put a few pieces together.
Proof of Work & Block Selection
The Proof of Work (PoW) mechanism in Nakamoto Consensus delivers an inherent randomness (aka stochastic) to the selection of which node will create (aka mine) the next block in the Bitcoin blockchain and makes dishonest node behavior difficult, expensive, and at odds with the economic best interests of the mining node. The valid Bitcoin blockchain is considered to be the longest one (aka the one with the most computational “work” behind it). When a miner expends enough processing power and underlying energy in securing the Bitcoin blockchain, the miner has a chance to propose (aka solve) the next block as the result of the random serial dictatorship function of PoW. Having more computational power (aka hash power) gives a miner a better chance, but there’s no way to predict who will successfully propose the next block.
If successful in solving for the next block, the mining node will receive all of the transaction fees from that block as well as the coinbase reward from the coins newly minted in the process. Because the hash power required to mine Bitcoin is immense and successful miners receive payment in Bitcoin, it would be irrational for a node to allow dishonest behavior (e.g. double spending) in the block that it mines since it might adversely affect the price of BTC and would ultimately be unlikely to be accepted by the honest nodes it in the network. I would caveat this somewhat given recent development in the financialization of Bitcoin. Now that facilities exist to place levered short positions on Bitcoin, it could be argued that a miner with intentional short exposure to Bitcoin would be acting rationally in behaving dishonestly so long as the costs and losses on the mining side were outweighed by the gains from the short, however shortsighted. This is somewhat hedged by the use of Application Specific Integrated Circuit (ASIC) Chips in mining. They are very good at mining for Bitcoin and little else so miners would lose their capital expenditures if they acted against Bitcoin’s best interest since their ASICs are not easily repurposed.
Proof of work and block selection describe the process that drives Nakamoto Consensus, but it is the long-term alignment of incentives among network participants that encourages honest behavior. This is not to say that there aren’t checks and balances in Bitcoin, there are. Miners want higher fees and lower difficulty while users want the opposite, for instance. Miners may try to increase their rewards by adding more computational power to the network which has the effect of increasing that miner’s chance of being selected to mine the next block and causes blocks to be mined faster. In turn, the Bitcoin protocol has difficulty adjustments in the complexity of the mining algorithm every two weeks which ensures that proof of work difficulty keeps pace with mining hash power. Difficulty adjustments are an important example since they ensure that block time remains close to ten minutes, driving the programmed issuance of Bitcoin, which, in turn, is a large part of what drives the alignment of incentives in Bitcoin since network reliability underpins confidence in Bitcoin’s monetary policy. Solid monetary policy creates demand for Bitcoin which increases its price. As price goes up, miner rewards become more valuable which further incentivizes network consensus. Wash. Rinse. Repeat.
Since Bitcoin is the native and only currency of Nakamoto Consensus, all network participants benefit from network stability and the resultant coin value appreciation. Whether we think of Bitcoin as deflationary or dis-inflationary, it is clear to all network participants the exact schedule upon which coins will be issued and the exact cap to the total possible number of coins. If network participants believe that Bitcoin has current value, regardless of which value narrative they ascribe to (e.g. store of value, medium of exchange, global settlement, etc), and they understand that scarcity is programmed in, then it stands to reason that over time, the value of Bitcoin is more likely to increase than decrease until it reaches a point of full adoption, (and by even the most bullish current estimates of unique active users, we are far from it). We have seen this play out over the first few boom/bust cycles of Bitcoin’s price discovery where massive and economically painful retracements have cut 80%-90% of Bitcoin’s value during prolonged draw down but we have yet to see macro long-term upward trends dismantled as is nicely evidenced but the steady ascendance of the 200 day SMA (in orange below).
Mining Bitcoin costs money in the form of electricity, therefore it has intrinsic value, which I realize is reductive but bear with me. Bitcoin is the sole monetary unit in Nakamoto Consensus, therefore miner economic incentives and token health are intrinsically linked. Bitcoin is scarce, therefore as its function and utility increase, the value of coins to network participants will increase as well. Oversimplified conclusion: it is in the best interest of all network participants, the miners, the users, the full node operators, the merchants, the speculators, and the hodlers, to participate in and encourage the healthy, continuous operation of the Bitcoin blockchain. This kind of symbiosis, at scale, without reliance on trust, had never been achieved in computer science prior to Bitcoin. Nakamoto Consensus didn’t invent all the solutions, granted, but it did integrate and improve on the work of predecessors like Hal Finney, Nick Szabo, David Chaum, Wei Dai, Adam Back, Ralph Merkel and hosts of others to deploy the first, thus far, successful digital, programmable money. Bitcoin is far more than a novelty or a collectible, it is a large step forward in distributed networking and a fundamental change in ‘money.’ So, while some might have us distracted by price, don’t forget to stick around to learn, build, and contribute to ensuring Bitcoin’s success.