Work-backed blockchain money and

decentralised money creation

by SG

JANUARY 2018

Summary
This paper explores how decentralised work-backed money can be realized as a cryptocurrency on a blockchain,
and the economical features that can be expected. Our objective is to demonstrate tokens that does not serve as an
asset for enrichment or investment by themselves, but is capable of serving as means of exchange.

The core of the concept is that the new money brought into existence stands in direct proportion to the
computational work spent by miners. Everybody can decide to become a miner. Hence, everybody can, in their own
time and in their own amount, decide to convert computational work into money. Money creation becomes
decentralised and the total money cap will be the result of the independent actions of every participant in the
network.

Although there is no limit imposed on the money supply, it will display a self-limiting dynamics arising from the
cost associated with money creation, and market demand. The most crucial feature that can be expected is low
volatility and stable and predictable value.

Each unit of money, or coin, is a proof-of-work, exploiting a core feature already present in the blockchain. The cost
of creating new money arises from the cost of the electricity and hardware required to create them. It is shown that
application of Moore’s law makes possible a supply mechanism where the cost of money creation changes slowly
with time.

The supply of money and the value of money works in opposite directions and keeps each other in balance, as
illustrated in the figure below.
1 Introduction
Money has always been backed by work in some sense; it cost you something to get them. Their function is to
exchange work; money is a symbolic expression of work.

Compared to a barter society, a society with money allows for the diversity of work which is fundamental for
modern civilization. Work-backed money goes back in time almost as long as human history do. Shell money is a
good example; it has been in used for several thousand years — all the way up to recent history. The shells used for
money was not easy to find and gather — it was a process that required work, and that’s what gave them and
regulated their value. Gold is also an example of work-backed money. Gold’s value comes from the hardship in
finding and exploring it. Work-backed money get their value from the cost, or difficulty, of creating it. The basic
monetary principles behind work-backed, or cost-backed, money, has been proven by human history.

The advent of the blockchain and Bitcoin marks a new era in the history of money. Bitcoin, as a technology, allows
for secure exchange of money, or tokens, over the internet, without a controlling central authority. This
decentralized transaction system is the disruptive quality of Bitcoin. The bitcoins, the money, is only content on
the blockchain. The short history of Bitcoin has, despite some trivial technical issues, proven the workability and
robustness of the blockchain.

With the blockchain we have at hand a technology that allows secure transfer of money tokens over the internet
without a central authority. If one will use the blockchain to create a money system, the most important question to
be asked is: How are new money going to be created? There may be many answer to such a question, and Bitcoin
implements one — limited supply. The supply is controlled by design. It is argued here that work-backed money is
not only a very interesting answer — it is also the most natural solution because it eliminates the need for controlled
supply or distribution — it simply decentralizes the task to be an independent decision by each individual
participant.

The key benefit is price stability, which is needed for the exchange of goods and services — the core function for
money. Secondly, it does not give any group or time period the privilege to create cheap money at the expense of
those who do not achieve such a privilege. The last part is essential for trust and acceptance.

The next chapter explains how work-backed money can be implemented on a blockchain that is similar to Bitcoin.
The few technical concepts needed are explained in terms that can be understood without technical expertise.
Anyway, the economy chapter, which discusses the money dynamics of work-backed cryptocurrency, can be read
independently.

2 Technology — the money creation

2.1 Proof-of-Work

In Bitcoin transactions are collected in blocks. Fetching transactions published over internet and collecting them
into blocks is what the miners do. For a block to be valid, i.e. ready to be added to the blockchain, the miner must
perform a sort of computational work on it, called hashing. This hashing is a costly process that requires efficient
hardware and electricity. When a miner has a valid block, it is easy for other miners to verify that the work was
performed on the block, hence the term proof-of-work. The action of creating a valid block by this hashing
process is often, and somewhat misleading, called “finding” a block. The reason for this requirement of work is to
make it difficult to add new blocks to the blockchain. The reason it should be difficult is that it is desired to have
some time between new blocks found and transferred between the participants in the mining network. This time
delay will prohibit the network from being swarmed with new blocks and secures the integrity of the network. In
Bitcoin the desired time lag is 10 minutes between blocks. Every 2016 blocks, which corresponds to 14 days (given
10 minutes interval between blocks), the algorithm updates the work requirement by evaluating the number of
blocks produced the last 14 days. If it was more than 2016 blocks, the difficulty is increased and vice versa.

The work required to produce a valid block has an element of chance to it. A miner that start working on a block
may be lucky and get the valid hash result quickly or it may take a long time. The difficulty requirement, which is
set by the blockchain algorithm, represents the average number of computations needed to find a block.
In Bitcoin there is no relation between the amount of work delivered by miners and the amount of
new money created. This is because Bitcoin has a fixed deterministic money supply. In the next chapters we look
closer into the money supply mechanism, and show how it can be modified to become a work-backed money
supply.

2.2 Block reward

The Bitcoin miner has two sources of revenue; 1) the transaction fees, 2) new bitcoins created with each new block.
Since the issue here is money creation we shall focus on the latter part. Each time a new block is created, a specific
amount of new coins is created and can be acquired by the miner who created the block. The amount of new coins
created is called the block reward and is predetermined by the algorithm and was set by the original Bitcoin
programmers. In the first 4 years of the blockchain the block reward was 50 coins per block, the next 4 years it was
halved to 25 coins per block, thereafter halved again, etc. More precisely, the halving of the block reward takes place
for every 210.000 block, corresponding to 4 years if the ideal time of 10 minutes per block is maintained. This
halving represents an exponential decay of the supply and will limit the total number of coins ever created to about
21 million. At the time of writing 80% of all coins have already been mined and the annual increase of coins are
about 4% of the total coins, and constantly falling.

Written as a formula the block reward is:

There are a few important things to understand about the block reward:

1) The block reward constitutes the only money creation mechanism for Bitcoin.

2) It is not a part of the disruptive technology that comes with Bitcoin

3) It can be easily modified

2.3 Coins as Proof-of-Work

As discussed above, the blockchain algorithm determines by itself how difficult it is to find a block. This is done by
adjusting a number called hash target. For practical reasons we will stick to a number called Difficulty, D, that can
directly be derived from the hash target. The Difficulty is proportional to the number of hashes (in average),
required to find (or validate) a block. A Difficulty of 1 corresponds to 2³² hashes, or roughly 4 billion hashes.

If a coin is to be backed by the computational work, it means it is to be backed by hashes. Then the number of new
coins created must be proportional to the number of hashes delivered by the miner. This is accomplished by
changing the formula for the block reward so that the number of new coins created are proportional to the
Difficulty;

BlockReward = a*D

where a is an arbitrary constant defining the unit of money.

Let’s see what this means to the revenue for a miner operating under this paradigm. Consider a miner with a
mining hardware that produce a certain number of hashes per day — we call this number the HashRate. In average,
the number of days between finding a block by this miner is:

DaysBtwBlock = D*2³² / HashRate

The daily revenue obtained by this miner is the BlockReward divided on the DaysBtwBlock;

Revenue = a*D / (D*2³²/HashRate)

which gives

Revenue = a*HashRate/ 2³²

What we see here is that the revenue for the miner is proportional to the number of hashes delivered. Although the
difficulty parameter is used for calculating the miner’s block reward, the average revenue over time is not affected
by the Difficulty, only by the work produced.

2.4 Incorporating Moore’s law — time invariance

We have so far described how new money is created as computational work. The cost of creating money is given by
the cost of hardware and electricity. Regarding electricity it can be shown that it is relatively stable over time (to be
discussed more in later chapter). The cost of hardware is a quite different story. Most people know by their own
experience that computers get more powerful year by year. This continuous increase of computational power
follows a rather predictable pattern and is described by Moore’s law. This law tells us that the efficiency of
computers increase exponentially with time and has a doubling period of 18 months. Another variant of Moore’s
law is known as Koomey’s law, which tells us that the number of computations that can be obtained per unit
electricity increases with a similar exponential behaviour. In general terms we may say that from any given point in
time, the increase in computational efficiency at any number of months later will be:

Although Moore’s law is a result from human activity, computer history has proven its validity for a long time and it
can be considered as a kind of “natural law” for computers and computation. The exponent, or doubling time, may
be subject for discussion, but some minor variation here is not disruptive the objectives sought out here.

The new block reward formula,

BlockReward = a*D

would give the same amount of money for the same amount of hashes no matter of time. With the steady
improvement of hardware efficiency, it would always be cheaper to produce in the future than at present. However,
armed with the knowledge of Moore’s law and Koomey’s law it is straightforward to compensate for this effect by
simply multiplying in a decreasing factor that counteracts the increased efficiency:

If one has a blockchain with 10 minutes intervals between blocks, there would be close to 80 000 blocks in a period
of 18 months and the block reward formula could be written

This formula would give a block reward proportional to the Difficulty but with a halving of the proportionality
factor each 18th month. The formula may appear similar to the existing block reward formula for Bitcoin, but one
must keep in mind that the D-factor gives a completely different effect because it put a cost limit to coin
creation, and removes the limit on the supply. The supply is related to D which in turn is related to total
mining activity.

One may argue that Moore’s law is not exact and that the correct exponent, or doubling time, may be a subject for
discussion. This is not a major problem, as we do not — and cannot — know with detailed accuracy how the cost of
hashing will evolve in the future, but by including Moore’s law with this exponent or some better guess, we have
counteracted the bulk effect of always faster and cheaper hardware. If the future history shows small variations of
the exponent, it will only affect the cost in a slow and partly predictable manner, to which the market can adjust.

3 Economy — the money dynamics

3.1 Decentralised cost-based money creation

In the previous chapters it has been shown how a proof-of-work blockchain can support money backed by
computational work. The total volume of money created at any instant is the net result of the independent actions
of all participant in the network. To summarize:

Anyone can create new money by delivering computational work to the network. The amount of
money created by a single participant is only dependent on the amount of work the miner
delivers to the network, and is independent of the actions of other participants.

Moreover, it was shown that by taking into account Moore’s law the effective cost of money creation will only vary
slowly with time, which provide price stability and equal playing field for the present and future participants.

3.2 Money dynamics — individual level

Consider that there exist a developed marked using this coin for trading of goods and services, and that there also
exist exchanges where the coin can be traded with other currencies. If you as an individual actor needs to acquire
coins to purchase something, you have two options:

1) Produce the coins yourself

2) Purchase the coins on an exchange.

What option will you choose? The simple answer is: If you think the coin is too high priced you start producing it
yourself, otherwise you buy it from an exchange.

Producing, or mining, your own money will in reality be a complex decision. The profitability is to some extent
determined by your cost of electricity, but also depend on your will and ability to invest in hardware.

Most people will not be money producers, or miners. Yet it is important for maintaining the decentralised aspect of
money creation is that the barrier for entering into mining is low and that mining cannot be monopolised, meaning
that increased scale of operation, beyond reasonable level, should not be advantageous. Prospects for this are good
as the experience with Bitcoin shows that a large number of independent miners are participating.

So, to summarize the money dynamics at the individual level; each individual can express his opinion on the price
by choosing to produce money, or not. The actual price will be the collective results of such decisions.

3.3 Money dynamics — collective level

Consider an economic community of M individual actors. The cost of producing money will vary among those
actors, due to different cost of electricity, and due to the will and ability to enter money production, as discussed
above.
This individual variation of cost may be expressed as a distribution C(m), which means m out of the M individuals
can produce a coin for a cost lower than C(m). This distribution may look something like this:

The green curve shows C(m), which could represent the cost given in units of any other available currency. Now if
the price for a single coin is p, then there would be profitable for mp actors of the community to produce money. If
the price increases it would be profitable for more people to start producing money; mx will increase and the supply
increases. The increased supply will be a force working against the price increase. On the other hand, if the price p
of the coin is falling, less people can produce money with profit, the number mp will decrease, and so will the
supply. The lower supply will be a force counteracting the falling price.

What we see is an inherent system dynamics that always tries to keep price stable. This balance is arises from the
net effect of independent individual decisions, with no need for control of supply by authority or by design.

3.4 Scale invariance and network growth

A network phenomenon require growth in participants, typically an exponential growth. If the community of M
actors is doubled to 2M over a time period, for then to be doubled to 4M over the next period etc, the distribution
C(m) is only weakly affected by such growth; the number of people able to mine with profit will grow in the parallel
with the network. Thus, the balance between demand and supply can be maintained and is not disrupted by
network size. The system dynamics shows scale invariance, and will consequently be efficient in accommodating
growth.

3.5 Inflation and deflation

One must make a distinction between the inflation/deflation in numbers of coins versus the value of a coin. A
steady increase of the total cap of money does not necessarily mean there will be a reduction in the money’s value.
There are two deflationary factors that tends to drive the value up:

1) If an increasing number of people start using a coin, there will be an increasing number of goods and services
that should be covered by the same coin. If no new coins are produced the coin’s value — or purchasing power — will
increase. Such an increase in value will make the coin less useful for exchange of services and goods, and the
motivation for taking the coin into use will fall away. (The more people who wants to use the coin — the more
useless it becomes.)

2) In a free economy money always tends to accumulate at specific places and hands. This process will continuously
reduce the number of money in circulation, being a deflationary effect.

Consider also as a limit case a closed economy where 1) and 2) for any reason do not apply. If there is a constant
inflow of new money into the economy, we have this situation:
where r is the yearly creation of new money and N is the total money cap. Then, the yearly inflation in value after n
years will be

r/N = r/rn = 1/n

meaning that inflation will be inversely proportional with time, approaching zero.

What we see here is that the ‘natural forces’ in play is deflationary. This does however not rule out inflation, since
the actual supply of new money is a result of each individual’s decision to produce money or not. Their decisions are
in turn results of the free market forces, so in the end the market will get the inflation level it desires.

Although electricity appears to be a commodity that is stable in price, it may still be large variations between
different geographical locations. Such variations do not mean that the coin will favour some groups of people living
in places with lower electricity cost; as long as money can be transferred over the internet one may as well say that
those who live in regions with expensive electricity benefits from buying coins at a lower price than they could make
for themselves. The only requirement is that there exists real competition between those who produce money.

4 Final remarks
The core purpose of money is to serve as means for exchange of goods and services; to be a tool for cooperation
between humans in their efforts of creating development and prosperity. Stability or predictability of price, is a
condition for money to work in that manner. Assets or objects suitable for investment or speculation must by their
nature contradict those conditions and is not fit to function as money in this context.

Inflation, both in terms of value and money cap, is not implicit in the monetary system discussed here, but is left to
market forces in terms of demand and supply. The market will get the level of inflation it desires and requires. It is
likely that in a functional market where lending is a central part of the money’s function, some level of inflation is a
sign of health.

A community using this type of money is not completely dependent on the cooperation of financial institutions to
convert assets into blockchain money, since the same process can be achieved by spending of electricity and
hardware.

One may think that money creation by turning electric energy resources into money is a waste. That is however a
question of priority, since most human’s activities require spending of energy and many of those activities may be
considered as a waste from someone’s perspective, while for others not. Like so many other things, mining of gold is
also an activity where a large portion of the costs can be broken down to energy usage. The usefulness of spending
energy to sustain a functional decentralised money system should be judged by the benefits that such a system
produces — and what the alternatives are.

Regarding technical implementation, it’s possible to disconnect the transaction network from the mining network
as each layer can have different business models — transaction fees and block rewards respectively. Such a split is
advantageous for keeping the mining chain simple in code, data and protocol — for the sake of decentralisation and
voting power — and at the same time letting the transaction side be open for competitive solutions and
developments.

Reference links

Proof of Work / Money supply / Difficulty / Mining community

Moore’s law / Koomey’s law / Electricity price historic data / Discussion forum: powtalk.org