There are rules coded into the protocol that govern Bitcoin’s supply. One of the rules is that only a maximum of 21 million bitcoin can ever be mined. Once the final block reward is mined, no more coins will be produced. Since block rewards subsidize costs so that miners have an incentive to continue producing new blocks, this rule has massive implications for the future security of the network. How will miners be compensated for producing blocks and security once the last coin is mined and block rewards come to an end?
The answer is that block rewards are not the only form of compensation that miners receive. Miners also receive transaction fees from users of the network in order to get their transactions included in the blocks that miners produce. So, miners are always receiving two forms of compensation: block rewards generated by the network itself; and fees paid by users of the network.
Users can pay any size fee they want. A user paying a larger fee provides financial incentive for miners to prioritize and process their transaction more quickly, but naturally most users will elect to pay a lower fee.
Rather than coming to an abrupt halt, block rewards are designed to be phased out gradually. Instructions are coded into the protocol to automatically halve block rewards every 210,000 blocks, which occurs about every four years.
When Bitcoin first launched, the block reward for the first four years was 50 bitcoins. This amount was reduced to 25 after the first halving, then 12.5 and will continue to reduce in half every four years until it reaches zero. The last block reward will be mined around the year 2140, which provides a long transitionary period of many years for miners to switch from block rewards solely to user transaction fees.
Phasing out automatic network generated payments in favor of user provided transaction fees may sound great in theory, but the reality has turned out quite different. The major problem with this model is the tragedy of the commons, whereby individual users, acting independently according to their own self-interest, collectively exploit a shared resource contrary to the common good of all users. A commonly cited example of the tragedy of the commons is the collective destruction of the environment by self-interested individuals attempting to achieve personal economic success.
In Bitcoin, the common shared resource is the blockchain and the security of the network itself. Users have a personal financial incentive to spend as little on transaction fees as possible; however, this self-interest has the effect of damaging the very system that they operate in.
As block rewards continue to reduce in size over time, miner compensation increasingly needs to be made up with user transaction fees. Without an appropriate level of fee compensation by users of the network, miners will not be able to afford the massive costs associated with mining, leading to the eventual shut down of their operations as funding runs low.
While users do care about the long-term health of the network, their immediate concern is saving as much money in fees as possible. Unfortunately this normal and predictable human behavior works against the financial interests of the miners who secure the network for them. In the future, if voluntary user transaction fees are not enough to sustain network security in the absence of block rewards, then unprofitable miners will continue to drop out until a majority of the hashing power is controlled by just a few people or even one large mining pool, which will put the network at serious risk from a double-spend attack.
Therefore, it is realistic to ask whether proof-of-work consensus will remain viable as a blockchain security protocol. It may still be secure right now, but due to flaws inherent in the system, that security may not be sustainable in the long-term.
Another factor to consider is the market price of blockchain tokens. Since Bitcoin miners are compensated in their native token (i.e. bitcoins), their profitability is dependent on its price. In times of price appreciation, miners don’t have so much to worry about because the coins they earn are sold for high valuations.
In times of price depreciation, however, the market may not value coins highly enough for miners to be able to pay their costs of operation. Proof-of-work network security is therefore dependent on the market price of blockchain tokens; this can put the network at risk if too many miners drop out because of unprofitability.