- Payment finality using proof-of-work is expensive
- High transaction fees or mining rewards are required to ensure payment security
- Bitcoin and altcoins need to depart from Proof-of-work in order to prevent a decline in liquidity, according to some experts
Raphael Auer, a Principal Economist at the Monetary Policy unit of the Bank for International Settlements (BIS) on January 21 released a paper titled, “Beyond the doomsday economics of proof-of-work in cryptocurrencies”, and it focuses on the limitations of virtual currencies like bitcoin that use Proof-of-work (PoW) algorithm for payment finality.
Proof-of-work not best for Bitcoin
Auer’s paper highlights how payments are finalized on the Blockchain using proof-of-work, which he believes to be needlessly expensive in making payments permanent and therefore, confirm blockchain’s immutability.
First of all, the document outlines that these digital assets which have garnered a lot of interest since 2017, thanks to the massive price surge that year, make use of protocols to communicate between transacting participants.
In this case, blockchain is usually updated to reflect all new transactions using the Proof of work algorithm.
According to the paper, Satoshi Nakamoto’s aim for developing Bitcoin was to create a balance between the cost and reward each time the distributed ledger is updated.
While the cost determines if a transaction is processed, the writer notes that the reward is paid to miners for successfully updating the ledger in order to prevent double spending and forgery of transactions.
Proof-of-work poses two major limitations
Nevertheless, this consensus algorithm poses two significant economic limitations which question the efficiency of proof-of-work in validating payments and providing high rewards to miners to ensure payment security.
These limitations in Bitcoin and some altcoins are a high cost of transactions during payment finality and the inability to generate high miner rewards that will ensure payment security states the report.
Regarding the former, Auer points out that the concept of payment finality involves making it unprofitable to undo transactions once it has been completed, thereby making it impossible for an attacker to orchestrate a 51% attack.
Also, this concept differs from Nakatamo’s view of double spending which can occur if the miner has more control of the computational power and payments are accepted as final speedily.
The second limitation, in the writer’s opinion, is the system’s operation at less its capacity and user’s incentives to increase transaction fees, which could potentially raise a miner’s income.
As a result, the high income will ensure that the block that is used is well protected.
However, the paper notes that this is not the case given that some users are unwilling to increase the transaction fees, which may also lead to a drop in liquidity shortly.
Therefore, to prevent a decline in liquidity and avert other limitations, Auer suggests that Bitcoin and other cryptoassets powered by PoW need to adopt another consensus algorithm since proof-of-work algo is not sustainable.