Streetwise Professor

February 24, 2018

Are Trustless Transactions a Good Thing? I Don’t Know Until You Tell Me How Much They Cost

Filed under: Commodities,Cryptocurrency,Economics — The Profesor 2 @ 11:04 am

One of the most annoying crypto-tropes is the unconditional statement that Bitcoin and its competitors are great because they eliminate the need for trust in transactions. It is annoying because it is repeated ad nauseum despite the fact that it is seriously analytically incomplete. There is no free lunch: the banishment of trust comes at a cost, and a proper comparative analysis of cryptocurrency vis a vis alternatives (e.g., traditional bank-based payment mechanisms, fiat currency) requires a comparison of the costs of each. Which mechanism performs particular types of transactions more efficiently? Which mechanism performs particular economic functions more cheaply?

In Bitcoin, the economic function performed is the elimination of fraud (e.g., double spending, spending what you don’t have) in an anonymous setting. This is achieved via proof of work, which involves the use of real resources–notably, large quantities of electricity and computing power. That is, trustlessness comes at a cost.

The relevant question is whether this cost is higher or lower than the cost of performing the same economic functions (elimination of double spending, spending what you don’t have) using alternative mechanisms, such as traditional bank payment systems that rely on trust.

Trust is not free either. In essence, economic actors can be incentivized to act in a trustworthy way if they earn a stream of rents that would be lost if they betray trust.  But creating a stream of rents requires an increase in the price of an output and a reduction in the prices of the inputs of the trusted entity.  These price adjustments reduce output below the level that would be attained if transactions could be executed costlessly. (Proof-of-stake mechanisms use a variant of this to address double spend problems.)

The answer to this question is likely to differ, depending on the type of transaction at issue. For example, Bitcoin et al are likely to be cheaper for transactions for which anonymity or concealment of the identities of the parties from third parties  is highly desired by one or both of the transactors (which is a condition that may characterize many illicit transactions).*

It has yet to be shown, and there is room for serious doubt, that cryptocurrencies scale as efficiently as traditional trusted payment systems. Unless it scales, crypto will not be a viable replacement for large scale transactions, especially commercial transactions which represent the vast bulk of payments.

Another potential difference in cost involves security.  It is costly for trusted institutions to prevent theft and loss, but as has been seen of late, theft and loss are serious issues for crypto too. It is not clear which  mechanism mitigates theft and loss most cheaply.

Economics is all about the analysis of the costs and benefits of alternative means of achieving particular objectives. An analysis that hypes a feature of one such alternative (no trust required!) without comparing its costs with that for other ways of achieving the same objective (fraud-free transactions) is fundamentally flawed. Yet that is the default mode of discourse in cryptocurrency.

*The use of cryptocurrency in illicit transactions is close to the top of many elite/official criticisms of cryptocurrency–as it is in elite/official criticisms of fiat currency (“the war on cash”). I am at best ambivalent about this critique because the government decides what is illicit, and tends to overcriminalize transactions between consenting adults, and to overtax. As a Swiss friend told me when we were discussing the war on cash: “I would fight any attempt to eliminate cash. Cash is freedom!”

Print Friendly, PDF & Email

Powered by WordPress