Creating a decentralised payment network:A study of Bitcoin

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Jonathan Levin

2Department of Economics,University of Oxford,Oxford, OX1 3UQ, UK.May 14, 2014

Abstract

Bitcoin provides the first case study of a decentralised payment network. Withno central authority, participants have to agree upon a set of rules in order to processtransactions. Delays in the transmission of information between participants createnetwork partitions, where some participants have different information sets. Thispaper presents an empirical study of this phenomenon and a model of incentivesfacing network participants as a result.

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This thesis is submitted in partial fulfilment of the requirements for the degree of Master of Philos-ophy in Economics. Word Count: 19 095

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I thank my supervisors Alexandre de Corniere and Mark Armstrong, for many helpful discussions.I am grateful to the Coinometrics team, in particular, Nadi Sarrar and the Organ of Corti, who helpedcollect data and provided a great sounding board throughout this assignment. I also thank manymembers of the Bitcoin community for responding to elementary questions. Any errors are my own.

 

1 Introduction

Bitcoin provides a case study of a new type of payment system. All existing paymentsystems have centralised validators that are trusted to process transactions and guardagainst fraud and double spending. In order to obtain the ultimate goal of havinga decentralised payment system with no single point of failure, Bitcoin has to solvethese security threats in more averse conditions than in traditional payment systems.There are no mechanisms to maintain trust between validators on the Bitcoin networkand as a decentralised system, it suffers symptomatic delays in sending and receivinginformation. With no centralised authority on the network, the Bitcoin protocol sets therules of engagement but has no way of enforcing them. Validators need to be providedwith economic incentives so that it is in their own best interest to obey the rules of theprotocol. This thesis combines empirical observations of activity on the Bitcoin networkand the rules of the protocol to derive the optimal behaviours of validators (“miners”)on the Bitcoin network.The financial crisis has been the focus of both academic and media attention in the pastfive years. Many models of macroeconomics are being reworked to include the role of banks as financial intermediaries. Banks in these frameworks are simply parties thatare able to exploit synergies between the provision of liquid deposits and equally illiquidloans (Diamond & Dybvig 1983, Kashyap et al. 2002). However, banks have alwaysserved as providers of payment services. In this role they transfer liquid claims quicklyand cheaply, with minimal legal uncertainty (Kahn & Roberds 2009). Recent trends infinancial innovation and deregulation have led to some of the core advantages of banksas financial intermediaries being eroded as new entrants and markets have replaced theneed for their services. Banks, with privileged access to wholesale payment systems, stillcommand great power in payment systems (Lacker 2006). However, this dominance isalso being challenged by the entry of new software as service platforms such as Pay Pal2

 

and Transferwise and peer to peer markets. Bitcoin presents a new model of paymentsystem, where peer to peer transactions are handled on top of a decentralised architecturewith no central authority. The analysis of these new ways of transferring value sit withinthe mechanism design approach of payment economics.In retail payment systems, principal policy debates have raged over issues of competitiveefficiency. Payment systems are a relatively expensive component of the financial infras-tructure, estimated to generate revenues of 3 per cent of GDP in the US (Humphreyet al. 2000). The industry is highly concentrated with only a few major players in thedeveloped markets. In 2003, Wal-Mart settled for $3 billion in an antitrust case againstVisa and MasterCard was settled. In Australia, card fees have been the focus of regu-latory efforts (Lowe & Macfarlane 2005). The electronic retail payment system has alsocome under scrutiny due to large amounts of data theft and privacy leaks resulting inoutright fraud. In 2013, Target, a major retailer in the US, lost up to 110 million cus-tomer records with their associated credit card details, email addresses, names and otherpersonal information (Harris & Perlroth 2014). Data leaks lead to further and more longterm implications with phishing ploys and other extortive methods. As other industrieshave undergone technological transformation since the invention of the internet, there aremany initiatives to radically transform legacy payments systems. The creator of Bitcoin,Satoshi Nakamoto (2008), had a decentralised vision of how the transfer of value canbe achieved. In avoiding central authorities, Bitcoin, by design, would serve to alleviatethe issues of market concentration and loss of consumer data as these responsibilitiesare placed squarely with participants. In its technical design Bitcoin achieves what itsets out for, however the challenge remains to incentivise a decentralised payment systemthat does not tend to an oligopolistic structure seen in the existing payments space. Thispaper looks at both the empirical reality of the Bitcoin network and creates a frameworkto understand the long run incentive structures that Bitcoin has created for itself.3