“The microeconomics of cryptocurrencies” Halaburda, Hanna, Guillaume Haeringer, Joshua Gans, and Neil Gandal

Question 1

What is the main idea?

Answer 1

Describes, what drives supply, demand, price and competition of cryptocurrencies.

Question 2

Describe Bitcoin.

Answer 2

Bitcoin is a digital cash ecosystem. Consists of users, miners and the blockchain.
Peer-to-peer, free entry, public.

Transactions created by users are broadcast to the Bitcoin network via Bitcoin nodes and processed in blocks by miners.

Total amount of bitcoins will be 21 mil.

Question 3

What is blockchain?

Answer 3

Blockchain is a ledger that records all transactions that have ever been made with bitcoins, and takes the form of a chain of blocks of validated transaction.

Question 4

What do miners do?

Answer 4

Miners create a hash (digital fingerprint) for each block.

Block created by miner must contain transactions, hash of the last block and the nonce (number chosen by miner, but not all fit, miner needs to guess it by trying – proof of work).

Once a miner has found a solution that gives an acceptable output, she will broadcast the new block to the network, expecting the other miners to add it to the blockchain.

Question 5

How do forks happen?

Answer 5

Multiple miners solving the same block –> they may find the nonce at same time –> fork (2 competing branches of the blockchain).

Can happen by accident or be a purposeful attack (an attacker privately operates their own blockchain for a period of time as a sole miner, and if the private blockchain grows quicker, then at one point that will be become an accepted branch under LCR).

Question 6

When are such attacks possible?

Answer 6

Nakamoto: only possible if attacker controls 50%+ of total computing power of the network
(hash power) because only then would the attacker’s private blockchain grow quicker.

Now discovered, that possible with less hash power, guaranteed to succeed with 50%+.

Question 7

What is Satoshi Nakamoto’s solution to the fork?

Answer 7

“Nakamoto’s consensus” – using proof-of-work together with the longest chain rule (to determine which blockchain version is correct).

This works because the pace at which blocks are added to the blockchain is stochastic → sooner or later one of the versions will be longer than the other versions

Question 8

How to prevent attacks?

Answer 8

Reward to miners for each new block has to ensure that the incentives of “bad” actors are muted.

Question 9

What properties define a true permissionless network? (What must miner picking system look like?)

Answer 9

Miner picking system must be
o Anonymous (if any two miners can change their identities they inherit the selection probability of one another)

o Robust to Sybil Attacks (miners can’t split their performance into several entities to increase probability)

o Robust to Merging (working together would increase probability)

Question 10

What kind of attack is the most dangerous?

Answer 10

Longest-Chain Attack, can lead to double spending.

Question 10

What are the 4 design choices of Bitcoin to make?

Answer 10

◦ Permission rights to become a miner
◦ Selection mechanism
◦ Miners’ cost structure (the nature of the computation problem miners are solving)
◦ Block reward 𝜃

Question 11

What are the 2 limiting factors on a simple majority attack?

Answer 11

◦ Some activities may require more than a simple control of majority of hash power

◦ For double spending attack, attacker may need to control the chain for some time due to escrow period that usually lasts six blocks in Bitcoin, i.e., transacting parties typically wait 6 more blocks before settling a transaction

Question 12

What are the crucial finding about preventing an attack?

Answer 12

◦ Reducing the incentives to attack requires increasing the hash power of the network
◦ Increasing the block reward is not enough, one also needs to increase the level of the transaction fees

Question 13

What is the main alternative to proof of work?

Answer 13

Proof-of-stake:
Entry for miners is not real computational power, but stake in the network (tokens), which signals a miner’s intent to operate honestly. These tokens are frozen as a “deposit”.

Problem: nothing at stake problem, doesn’t solve consensus problem

Question 14

What are the stages of use Bitcoin has gone through?

Answer 14

◦ Early stage (up to the beginning of 2012), dominated by miners
◦ “Illegal” stage (2012-2013), dominated by black market and gambling
◦ “Business” (since early 2014) or “legitimate” stage, dominated by cryptocurrency exchanges (mostly financial speculation)

Worrying: The number of one-time users and holders is increasing – less transactions

Question 15

What predicts Bitcoin price?

Answer 15

Innovation and technological progress, not “buzz”.
Because relatively small share of population actually participates in the market, and those would be on average more technologically inclined people.

For many people the extreme volatility and price increase of bitcoin is a sign of a bubble

Question 16

What is the irony of Bitcoin?

Answer 16

Bitcoin was supposed to be decentralized/trustless, but now high % of trading occurs through financial intermediaries.

Question 17

What is the general pricing pattern between Bitcoin and other cryptocurrencies?

Answer 17

When bitcoin’s price rises (falls,) the price of other cryptocurrencies rise (fall) more and bitcoin’s dominance declines (increases.) Thus, in some sense, bitcoin is the safe asset in the cryptocurrency ecosystem.

Question 18

What can you say about the cyclicality of Bitcoin mining capacity?

Answer 18

Concentration of mining capacity is counter-cyclical – decreases after sharp increases in Bitcoin price, increases after price drops

Also, concentration increases after block reward halves

Set of large miners is stable, small miners react to price shocks

Risk of 51% attack increases during price drops or halving events