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Japanese Scholars Draft Proposal for a Better Bitcoin

| Published on November 7, 2014 at 15:24 BST

A team of Japanese researchers has published a paper with a set of proposals it says would improve bitcoin, effectively creating a hypothetical low-volatility digital currency called 'improved bitcoin' (IBC).

The paper, authored by four scholars from various Japanese universities, was published by the Institute of Economic Research at Tokyo's Hitotsubashi University.

The work explores the problem of bitcoin's instability from an economic viewpoint, suggesting a new monetary policy rule – effectively, monetary policy without a central bank – for stabilizing the values of bitcoin or other cryptocurrencies.

The new rules, they say, are based on currency board principles and inflation targeting.

Bitcoin’s ‘dual instabilities’

The researchers note that bitcoin intrinsically manifests two forms of instability, leading to extreme volatility.

“The first instability stems from an inflexible supply curve of bitcoin, which amplifies bitcoin price volatility, the miners’ revenue/reward fully absorbs any price changes. There is no stabilisation mechanism,” the researchers note.

The second instability comes from risks to the sustainability of mining. "During a bitcoin price boom miners engage in mining activity which guarantees the supply of bitcoin, but during a bitcoin price depression, no smooth way to induce exits from mining exists," they say.

Therefore, the researchers conclude, the current state of the bitcoin system can be described as “freezing equilibrium with dual instability”.

The team cautions that big price drops could have a very negative effect on the network in the long run.

In one possible scenario, miners would continue their efforts even if forced to operate at a loss for a limited amount of time. However, there is also a chance that they could gradually abandon bitcoin and use their computing power elsewhere, provided there is a viable alternative.

A third and more disruptive option is that bitcoin could suffer a sudden and substantial price drop, prompting many miners to simply pull the plug with no advance warning.

The researchers suggest:

“If the bitcoin price drops below a threshold, the bitcoin system as a whole may collapse or the bitcoin users are limited to a very small number of inner members with which bitcoin is exchanged at a very small scale.”

Applying a monetary policy

To address these shortcomings and other potential problems, researchers propose a number of design changes to bitcoin. These are intended to allow the use of monetary policy on bitcoin's decentralised system, effectively creating an autonomous monetary policy without a central bank.

IBC uses the currency board model as inspiration, effectively pegging bitcoin to the US dollar, euro or another currency. The system would include a supply rule that would address demand and price fluctuations. Thus, when the IBC value increases, the system would issue more coins until the value returns to the benchmark level.

The researchers explain:

“Suppose the market value/price of IBC is P dollar at the moment. A reward for the proof of work, V, is set to rise when the market value P is above the benchmark value and a reward V is set to be zero when P is below the benchmark. Alternatively, some difficulty parameter n, adjusting the speed of proof of work is to be changed.”

However, the team concedes that the currency board approach has a defect: it cannot absorb excess coins in circulation. Central banks, on the other hand, have the advantage of being able to absorb money by selling securities and other assets.

Solving supply issues

The researchers point out that the irreversibility of cryptocurrency supply is a major concern. The basic idea of a currency board-inspired system would have to be amended with a revaluation rule for exchange rates.

Such a rule would help absorb excessive currency in circulation by introducing inflation as another policy instrument, with the inflation rate controlled by a range of factors. The resulting inflation would disincentivize hoarding and push people to exchange their IBC.

Researchers noted that the rule is “closely related” to the inflation-targeting policy implemented by many banks and would serve the same purpose. However, it differs in that the revaluation rule would depend on economic principles tied to the bitcoin economy – that is, the cost structure of mining.

'Not a national currency substitute'

Although improved bitcoin is envisioned as a way of making the cryptocurrency more stable and appealing to mainstream users, the researchers admit that it would not be able to replace major currencies, identifying four problems that would be difficult to overcome:

  • Cryptocurrencies are significantly more expensive to produce than traditional currency
  • Reversibility of bank notes is based on the exchange between bank notes and government bonds, allowing central banks to buy and sell securities with bank notes – a feature cryptocurrencies lack
  • Bitcoin-type cryptocurrencies use "delayed finality" confirmation to avoid double spending, slowing down certain transactions
  • Cryptocurrencies are more vulnerable to security risks than bank notes.

While the third and fourth issues could be addressed, the researchers argue that the first two would remain insurmountable, as bitcoin is simply too expensive to generate. The network's reward-per-hour is 25 BTC and, at a bitcoin price of $600, costs $2m a day to maintain.

They note:

“This is not a small amount. The bitcoin system is often described as inexpensive because maintenance costs are not charged to the bitcoin users, but are generated as reward for mining. In short, bitcoin is based on a system that takes advantage of an externality. It is not a cheap system at all.”

The researchers warn that this 'capitalisation by externality' will have to be liquidated sometime in the future, potentially leading to a collapse in bitcoin value. However, new rules proposed in the IBC concept could help address some of these issues by preventing excessive currency demand arising from the externality.

Inflation research image via Shutterstock

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