The Byzantine Generals Problem
Bitcoin is a decentralized system, so users and miners do not know each other and have no way of trusting the data they receive from each other. For example, if a user sends or receives a transaction, how do they know when it is settled? If another user tells them it is settled, how can they trust that user?
This problem is called the Byzantine Generals Problem, and it has plagued decentralized consensus-based systems for many years. Until the invention of Hashcash, it was the biggest obstacle to the invention of a decentralized electronic cash system.
Hashcash and Proof-of-Work (PoW)
In 2002, Adam Back invented Hashcash, a Proof-of-Work (PoW) mechanism intended to stop spam and Denial of Service (DoS) attacks.
Hashcash worked as follows: In order to send an email to a Hashcash user, the sender would have to find a hash of the email that fell within a certain range. Since a hash is a large, unpredictable number, producing such a hash takes many guesses. This system imposes a cost on sending email. The cost would come in the form of time and compute power, and would discourage spammers and make DoS attacks less efficient.
The size of the range of valid hashes is a direct measure of the difficulty of finding a valid hash, and thus, of the time and work required to produce a valid hash. Users who wanted strong spam prevention could set a small range, requiring more work for all those wishing to send them emails. Users who were satisfied with weaker spam prevention could set a larger range, requiring less work.
Proof-of-Work and Bitcoin
When Bitcoin was invented, Satoshi Nakamoto applied Proof-of-Work to Bitcoin. In order to add a Bitcoin block to the blockchain, a miner must generate a hash that falls within a certain range, just like with Hashcash.
Proof-of-Work serves three purposes for Bitcoin:
- Analogous to Hashcash and email, PoW imposes a cost on producing blocks, preventing spam and DoS attacks.
- PoW serves as an objective way for decentralized parties to agree on which version of the blockchain is valid. It is a solution to the Byzantine Generals Problem.
- PoW imposes costs on the creation of new bitcoin, making it scarce and encouraging decentralization in the mining industry.
Bitcoin’s Difficulty Adjustment
Hashcash allowed every user to individually set the range of valid hashes, which we call the difficulty. However, since Bitcoin is a consensus system, there must be exactly one difficulty. One of Bitcoin’s greatest and most innovative features was its difficulty adjustment algorithm. Bitcoin’s difficulty is adjusted roughly every four weeks, in order to ensure that a valid hash (and thus a Bitcoin block) is found on average every 10 minutes.
If, during a given four week period, blocks are produced at a faster rate, then the difficulty will be increased, meaning the range of valid hashes will shrink. Conversely, if blocks are produced at a slower rate, the difficulty will drop, and the range of valid hashes will rise.
When Bitcoin was launched in 2009, Satoshi Nakamoto served as the only miner. Slowly, others joined him, and dedicated more compute power to guessing hashes for blocks. Without the difficulty adjustment, this increase in the number of miners would have caused blocks to come in faster and faster, enabling spam and causing rapid accrual of all bitcoin to the earliest miners.
The difficulty adjustment ensures that no matter how many miners join the network, spam is unprofitable and the emission rate of new bitcoin stays relatively stable.
Proof-of-Work and the Byzantine Generals Problem
The Proof-of-Work and difficulty adjustment system described above also provides an objective solution to the Byzantine Generals Problem, allowing all members of the Bitcoin network to agree on which version of the blockchain is objective.
The simple rule is that the chain with the most work is the most valid. In practice, this usually means that the chain with the most blocks is the most valid. Since the amount of work in each block is objective and immutable, there is no room for disagreement about which chain has the most work.
The Economics of Proof-of-Work
Bitcoin was invented with sound economic principles in mind. Proof-of-Work and the difficulty adjustment force the marginal cost of mining bitcoin to hover around the cost of bitcoin, the token, itself. This mirrors the economics behind all goods in a free market.
This mechanism scales Bitcoin’s security: as the Bitcoin price rises, more miners tend to join the network, and the Bitcoin network becomes more secure. It also means early bitcoin miners did not receive unfair advantages or benefit from Cantillon Effects. At all points in Bitcoin’s history, Bitcoin miners paid roughly the same price for the bitcoin they were allowed to create as a consumer paid to buy bitcoin directly.
Is Proof-of-Work Wasteful?
Many Bitcoin critics have claimed that Bitcoin’s Proof-of-Work mechanism is useless and wasteful. This criticism lacks both economic, social, and technological understanding and principles.
From an economic perspective, critics claim that Bitcoin mining is wasteful because it is performing useless computations. This criticism is based on Bitcoin’s costs, either in terms of energy or money. Economic judgement can never be based solely on costs; it must also take into account benefits. For Bitcoin mining to be truly wasteful, the costs must outweigh the benefits. Since hundreds of thousands of Bitcoin users regularly pay the miners fees and buy their newly minted bitcoin, from an economic standpoint, Bitcoin is clearly worthwhile to Bitcoin users.
Secondly, an environmental argument is made that Bitcoin consumes too much energy. This criticism ignores the fungibility of energy usage, and claims that Bitcoin’s energy consumption is qualitatively different from the energy consumption of other economic activities. Energy used on Bitcoin is equally subject to criticism as energy used on televisions, electric cars, and air conditioning. In all such cases, the cost of the energy must be weighed against the benefits of its usage. For Bitcoin miners, spending the energy mining bitcoin is the most productive and efficient use of the energy. Using it for anything else would therefore be a waste of societal wealth.Notice: River does not provide investment, financial, tax, or legal advice. The information provided is general and illustrative in nature and therefore is not intended to provide, and should not be relied on for, tax advice. We encourage you to consult the appropriate tax professional to understand your personal tax circumstances.
- Proof-of-Work is a mechanism which solves the Byzantine Generals Problem and makes the Bitcoin blockchain immutable.
- Proof-of-Work and the difficulty adjustment also regulate the emission rate of bitcoin.
- Proof-of-Work uses energy to secure the blockchain, making Bitcoin is the most secure network in the world.