Bitcoin: Is There a Looming Tragedy of the Commons?

Today, we recorded a podcast with Christian Decker. Before the episode, I asked him about the Lightning Network decreasing the demand for Bitcoin transaction and thus the revenues of miners. This has concerned me for a long time and a recent twitter conversation brought it up again. As I was speaking to Christian, a new way of explaining the problem occurred to me.

There are two types of revenues that miners make and that pay for the security of the network:

1. Block rewards
2. Transaction fees

The current inflation rate (annual supply increase) of Bitcoin is 3.8%. The average transaction costs ~$0.20. A Bitcoin user is charged by the network in these two different ways. One could think of inflation as the 'storage cost'. This is charged indirectly through dilution and not directly experienced by the user. Transaction fees are charged directly and occur for every transaction.

Let's say a particular user has $100,000 worth of bitcoin and creates 100 transactions in a year. If no new money enters the bitcoin space to buy up mined coins, his bitcoin position should be worth $100,000/(1+3.8%) = $96,340 after a year. You could say our users pays $3,660 to the network for securing his assets and 100*$0.2= $20 for transferring them.

Over time, the inflation rate has dramatically decreased and it will continue to do so. The storage cost will drop and in 2140 it will be zero. The only cost then will be transaction fees.

Right now, there seems to be some balance here. Speculation / store of value is the dominant Bitcoin use case. It makes sense that most value is extracted there. But the long term bothers me. Storage costs will trend to zero and I don't see why transaction fee revenues will necessarily increase. There could be wide-scale Bitcoin adoption through second layer like Lightning Network without high transaction demand on the main chain.

There is also a free rider problem. If I make lots of lightning payments or I just hodl my bitcoins without making transactions, I still benefit from the security of the Bitcoin blockchain. And it's crucial to note that these users have a real cost for the Bitcoin network. Let's say $10bn are held in the Lightning Network and miners make $0 from that. So these funds are not increasing the hash rate. If the value secured rises relative to the hash rate, attacks have become more profitable, but not more expensive. The security of the chain has decreased. This affects all Bitcoin users.

In a world without block reward, hodlers and layer 2 users become free-riders. This is a tragedy of the commons problem. We would all want the Bitcoin chain to be secure. But we will be able to get away without paying for it. I don't see why transaction fees would make up the shortfall. And even if they did, it would seem unfair/inefficient to lay the entire burden of network security and maintenance on the on-chain transaction users, instead of hodlers and layer 2 users also.

Many in the Bitcoin community hold the supply cap of 21,000,000 as a sacred thing. I'm not sure it should be changed. There is a lot of value to the solidity of Bitcoin's social contract. It creates trust in the system. And I've become much more appreciative of the benefits of the Bitcoin community's hesitancy to change over the  years. But if I think of the long term, I suspect a permanent inflation rate could result in a more balanced system.

I should apologize for the slightly clickbaity headline. With 'looming' I mean that the potential problem is probably 10+ years out in the future. Bitcoin is in a great position today. There is no rush. I do suspect that at some point we will revisit the question of block rewards. But given the speed of Bitcoin's evolution, it would be pointless to hypothesize what the right path to take would be then.