Tuesday, June 29, 2021

Taleb On Cryptocurrency Economics

Nassim Nicholas Taleb has a draft paper entitled Bitcoin, Currencies and Bubbles that applies quantitative finance and economic arguments to cryptocurrencies. It is definitely worth reading. Spoiler, he's not an enthusiast! Below the fold, some commentary on it.

Taleb's Fig. 1
Taleb makes a number of points, one of which is based on the consistent extreme volatility of Bitcoin and other cryptocurrencies, as shown in his Figure 1. This volatility is what makes cryptocurrencies so attractive to traders, especially those perpetrating pump-and-dump schemes. But Taleb points out that, even disregarding its inordinately slow, expensive transactions, its appalling carbon footprint, its notorious incidence of theft, which requires users to maintain a level of operational security beyond ordinary mortals, thus forcing them to trust untrustworthy exchanges, Bitcoin's volatility alone rules out its use as a currency:
Let us go deeper into how a currency can come about. No transaction is analytically pairwise in an open economy. The root of the confusion lies in the prevalent naïve-libertarian illusion that a transaction between two consenting adults, when devoid of coercion, is effectively just a transaction between two consenting adults and can be isolated and discussed as such, pairwise. One must consider the ensemble of transactions and the interactions between agents: people happen to engage in contractual agreements with others; for them a given transaction is just a piece. To be able to regularly buy goods denominated in bitcoin (that is, fixed in bitcoin, floating in U.S.$ or some other fiat currency), one must have an income that is fixed in bitcoin. Such an income must come from somewhere, say, an employer. For an employer to pay a salary fixed in bitcoin, she or he must be getting revenues fixed in bitcoin. Furthermore, for the vendor to offer a can of beer in fixed bitcoins, she or he must be paying for the raw material, and have the overhead fixed in bitcoin. The same with a mismatch of assets and obligations on a balance sheet. All this requires a parity bitcoin-USD of low enough volatility to be tolerable and for variations to remain inconsequential.
Taleb's Fig. 2
Taleb's Figure 2 shows that this volatility, when combined with the "price" bubble, leads to extraordinary swings in the headline "market capitalization":
In 2021 a swing of half a trillion dollars in the capitalization of bitcoin took place.
Another of Taleb's arguments starts from this observation:
A central attribute is that bitcoin depends on the existence of such miners for perpetuity.
Taleb explains why this is important:
A central result (even principle) in the rational expectations and securities pricing literature is that, thanks to the law of iterated expectations, if we expect that we will expect the price to vary, then by backward induction such a variation must be incorporated in the price now. When there are no dividends, as with growth companies, there is still an expectation of future earnings, and a future expected reward to stockholders — directly via dividends, or indirectly via reverse dilutions and buybacks.

Earnings-free assets are problematic.
Taleb doesn't explicitly state it, but cryptocurrencies' substitute for future earnings is the belief that "number go up". This is thought to be inevitable because each cryptocurrency has a limited supply (ignoring the fact that there is an unlimited supply of cryptocurrencies, around 10,000 of them as I write). Thus the importance to the whales of maintaining the belief that "number go up", if necessary by a judicious pump. If the belief fails:
The implication is that, owing to the absence of any explicit yield benefiting the holder of bitcoin, if we expect that, at any point in the future, the value will be zero when miners are extinct, the technology becomes obsolete, future generations get into other such "assets" and bitcoin loses its appeal to them, then the value must be zero now.
HODL-ing is a bet that the HODL-er will be able to get out, selling to the greater fool, ahead of the eventual rush for the exits, similar to the bet the holders of fossil fuel stocks are making.

Taleb explains the abundance of greater fools:
More generally, the fundamental flaw and contradiction at the base of most cryptocurrencies is that, as we saw, the originators, miners, and maintainers of the system currently make their money from the inflation of their currencies rather than just from the volume of underlying transactions in them. Hence the total failure of bitcoin in becoming a currency has been masked by the inflation of the currency value, generating (paper) profits for large enough a number of people to enter the discourse well ahead of its utility.
It is easy to see why there might be a rush for the exits. Bitcoin mining currently gets only about 8% of its income from transaction fees, 92% of the enormous cost of the average transaction (over $100 for the whole of the last year) comes from the block reward, i.e. from "inflation of their currencies". But as the mining reward reduces through time, the end-state of the Bitcoin system is a fee-only system. A number of academic analyses have concluded that a fee-only Bitcoin doesn't work. Here, for example, is the TL;DR of 2019's Beyond the doomsday economics of “proof-of-work” in cryptocurrencies by Raphael Auer of the Bank for International Settlements:
The key takeaway of this paper concerns the interaction of these two limitations: proof-of-work can only achieve payment security if mining income is high, but the transaction market cannot generate an adequate level of income. ... the economic design of the transaction market fails to generate high enough fees. A simple model suggests that ultimately, it could take nearly a year, or 50,000 blocks, before a payment could be considered “final”."
In 2016 Arvind Narayanan's group at Princeton published a related instability in Carlsten et al's On the instability of bitcoin without the block reward. Narayanan summarized the paper in a blog post:
Our key insight is that with only transaction fees, the variance of the miner reward is very high due to the randomness of the block arrival time, and it becomes attractive to fork a “wealthy” block to “steal” the rewards therein.
I discussed this issue at length in The Economics Of Bitcoin Transactions, Economic Limits Of Proof-of-Stake Blockchains, and in Cryptocurrency's Carbon Footprint where I described the three unattractive alternatives:
  • If security stays the same, blocksize stays the same, fees must increase to keep the cost of a 51% attack high enough. ...
  • If blocksize stays the same, fees stay the same, security must decrease because the fees cannot cover the cost of enough hash power to deter a 51% attack. ...
  • If fees stay the same, security stays the same, blocksize must increase to allow for enough transactions so that their fees cover the cost of enough hash power to deter a 51% attack. ...
More generally, the analysis of The Economic Limits Of Bitcoin And The Blockchain by Eric Budish essentially concludes that, for safety, the value of transactions in a block must be less than the sum of the mining reward and the fees it contains. Consider the block discussed by Nicholas Weaver:
The miner(s) of this block earned a total reward of 6.25000000 BTC ($199,193.88). The reward consisted of a base reward of 6.25000000 BTC ($199,193.88) with an additional 1.28084760 BTC ($40,821.92) reward paid as fees of the 2644 transactions which were included in the block. The Block rewards, also known as the Coinbase reward, were sent to this address.

A total of 41,385.39124085 BTC ($1,318,994,631.94) were sent in the block with the average transaction being 15.65256855 BTC ($498,863.33).
Note the arithmetic error; the total reward was actually 7.5308476 BTC ($240,015.80). So the value of the transactions in the block was about 5,500 times the mining reward plus the fees. Budish would not consider this safe.

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