Using Economic Risk to Model Miner Hash Rate Allocation in Cryptocurrencies

TL;DR

This paper introduces an economic model based on Modern Portfolio Theory to predict miner hash rate allocation in proof-of-work blockchains, linking price data and risk tolerance to network stability and security.

Contribution

The paper develops a novel economic model that accurately predicts miner hash rate allocation and its impact on blockchain parameters using price and risk data.

Findings

Model predicts individual miner allocations with <20% error

Aggregate allocation model shows high correlation with actual data

Price shocks can significantly affect inter-block time (IBT) and network stability

Abstract

Abrupt changes in the miner hash rate applied to a proof-of-work (PoW) blockchain can adversely affect user experience and security. Because different PoW blockchains often share hashing algorithms, miners face a complex choice in deciding how to allocate their hash power among chains. We present an economic model that leverages Modern Portfolio Theory to predict a miner's allocation over time using price data and inferred risk tolerance. The model matches actual allocations with mean absolute error within 20% for four out of the top five miners active on both Bitcoin (BTC) and Bitcoin Cash (BCH) blockchains. A model of aggregate allocation across those four miners shows excellent agreement in magnitude with the actual aggregate as well a correlation coefficient of 0.649. The accuracy of the aggregate allocation model is also sufficient to explain major historical changes in inter-block time (IBT) for BCH. Because estimates of miner risk are not time-dependent and our model is otherwise price-driven, we are able to use it to anticipate the effect of a major price shock on hash allocation and IBT in the BCH blockchain. Using a Monte Carlo simulation, we show that, despite mitigation by the new difficulty adjustment algorithm, a price drop of 50% could increase the IBT by 50% for at least a day, with a peak delay of 100%.