Digital Scarcity: What makes a Satoshi on the mainchain worth having?

e4fa9420cfOriginally posted for https://medium.com/@twobitidiot or subscribe to the daily bit http://eepurl.com/JgGy5

The abundance of media and the speed at which it is streamed onto our devices gives many the impression that scarcity will no longer be relevant in a digital world. Services such as Spotify sold this vision to record companies as an inevitable step after the failures in limiting pirate music. Impressive subscription numbers across a range of service providers indicate the business model evolution well underway with millions of customers now paying for streaming services across music and film. This might spell the end for scarcity but there is a counter movement stirring in the cryptocurrency domain (and its not limited to the number 21 million). Cryptocurrencies mark a new type of digital scarcity that could underpin new markets.

Bitcoin was not the first digitally scarce money but its issuance has taken place in a fundamentally different way. In other digital / virtual currency schemes there had always been an issuer that stands behind the currency and determines the issuance, usually on a discretionary basis. We have seen financial crises in Second Life where an overvalued Linden Dollar that was plummeting towards its legal value of zero was saved by the land barons. In cryptocurrencies, we saw this debate rage with Ripple as Bitcoin advocates claimed that “pre-mined” currencies were unethical and could never work. Even though Ripple’s scarcity is predetermined, Ripple has discretion with 70% of the money supply of XRP. Any policymaker that has control over the money supply faces the same problem of credibility (and also possibly time inconsistency). Ripple need to have the credibility to issue XRP at a rate that benefits the majority of users or have the credibility to exit the market entirely and make no such promises. The scarcity in the 100 billion XRP units is obfuscated by the challenge of gaining credibility.

You may recall a debate that was raging a few months ago around sidechains where people claimed that altcoins diluted digital scarcity. But what is the essence of scarcity in Bitcoin? We know that bits in a blockchain are not scarce, I have a copy and you have a copy that does not make it scarce. The scarcity comes from the amount of work that goes into making the tokens. Hal Finney in 2004 extended Adam Back’s Hashcash to make Reusable Proof of Work tokens that could be transferred from user to user. This system ran with a centralised server and Finney warned at launch that resetting that server would invalidate all the tokens and best to avoid hoarding until out of beta. Each token was meant to have the same value as each other as the same amount of work went into making them. In Bitcoin, the work required to produce coins is slightly different. The amount of computing power that has been used to create the chain of proofs that make up the Bitcoin blockchain is scarce. A new block on the chain has only been created with marginal computing power and so as a resource it is less scarce. If someone else was doing the same amount of work at the same time they could actually destroy the tokens that had just been assigned on the mainchain. Conversely, one could say that Satoshi’s bitcoin stash from the early days of Bitcoin are the most scarce resource on the blockchain.

Now I am not arguing that the work done necessarily determines the value of the token, it is quite the reverse. However, when evaluating the scarcity of Bitcoin: you have to consider the amount of proof of work that has been committed to the chain that produced the transferable token. In this way there is no competition in digital scarcity between Bitcoin and the current altcoins. Bitcoin, due to its large hashrate is the scarcest resource currently in cryptocurrencies. Perhaps people have grasped this concept of scarcity and attributed the most value to it currently in the markets. The insight behind sidechains is that you can actually inject this scarce resource into a sidechain that is governed by different transactional rulesets and have people believe in the value that you are creating.

In many online games or virtual worlds we have seen the invention and sometimes unintended creation of virtual currencies. Typically, however, these were objects in games that were found in the right proportions to make a spontaneous financial system spawn. The purposeful design of markets and currencies that met the goals of the game developers (who now could be described as policymakers) came later. As services that commoditise other computer resources come online currency design and the creation of scarcity will play a major role. Market design from economics has matured as a discipline and many insights can be used from basic game theory principles. These lessons apply to application specific tokens like tokens that are used to pay for and be rewarded for contributing towards decentralised storage.

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