July 18, 2017

Proof of Work as it relates to the theory of the firm


One of the little-known aspects of bitcoin is the nature of the proof of work system.   In a recent research paper (available for download), Dr. Craig Wright explores why bitcoin’s proof of work system is so effective, especially as compared against alternate proof of work or even proof of stake systems proposed by people who would want to change how the current bitcoin system works.

Dr. Wright’s paper addresses points raised by the many people, especially those who support a User Activated Soft Fork (UASF) or Proof of Work (PoW) change, who believe a distributed system should be completed as a mesh. In this, they confuse centralised systems with centrality. The truth of the matter is that no matter which proof of work is implemented, they all follow a maximal growth curve that reflects the nature of the firm as detailed in 1937 by Ronald Coase (1937).

The original bitcoin White Paper was very specific.  User of the system “vote with their CPU power”. What this means, is that the system was never generated to give “one person, one vote.” It is designed purely around economic incentives –  individuals with more hash power have provided more investment into the system.  These individuals who invest more in the system gain more say in the system.  At the same time, no one or even two individuals can gain complete control of the system.

No proof of work-based solution ever allows for a scenario where you have one equal vote to one person, irrespective of how much work that person invested into the system. The anti-sybiling functions of bitcoin and all other related systems based on proof of work or similar derivatives are derived from an investment based strategy. Solutions to the implementation of ASIC based systems are constantly proposed as a methodology of limiting the centralisation of proof of work systems as it is termed.  The truth of the matter is that the mining function within any proof of work system naturally aligns to business interests. This leads to corporations running machines within data centres.   This is similar to how democracies and republics have migrated away from small groups of people individually voting for an outcome towards a vote for a party; likewise, in a proof of work system, the transactional costs associated with individual choice naturally leads to corporate solutions. In this way, a corporation mirrors a political party.

In the paper, Dr. Wright addresses the issues of using alternate approval work systems – and in particular comparing an alternate “one person, one vote” scenario in place of the economic incentivisation and security behind the bitcoin proof of work system.  His paper demonstrates that all systems migrate to a state of economic efficiency. The consequence of this is that systems form into groups designed to maximise returns. The effect is that bitcoin is not only incentive-compatible but is optimal.  No system can efficiently collapse into an order of “one person, one vote” and actually remain secure.

This means that in bitcoin, miners have power and “vote with their CPU power.”  The rational decision is for any mining firm is to choose the most profitable strategy.  That most profitable strategy typically leads miners to form mining pools to take advantage of efficiencies, resulting in the proof of work system consolidating into the equivalent of corporate entities.  The bitcoin system was not and cannot be designed for individuals to control the network through any “one person, one vote” approach.

Segregated Witness is an attempt to divert power away from the miners, and instead give it back to developers, under the premise that users are the one who benefit from the bitcoin network and should have a say in its rules.  But bitcoin’s proof of work system works best because it rewards those who invest more into the system – the miners, who vote with their invested CPU power – not just any user.  As Dr. Wright explains, this is the nature of bitcoin and in fact is the optimal approach.

Dr. Wright’s full paper about the optimal nature of bitcoin’s proof of work system and the important role of miners is available for download here.