A Structural Analysis of Bitcoin Cash's Emergency Difficulty Adjustment Algorithm

Abstract

In this paper, we analyze the equilibrium behavior of cryptocurrency miners in the wake of a major cryptocurrency fork. Miners are responsible for validating transactions and ensuring smooth functioning of the cryptocurrency platform. Specifically, we are interested in their strategic interactions with the incentives provided by the developers of the newly born minority chain to prioritize its transactions over that of the dominant parent currency. We focus our attention on the Bitcoin (BTC) fork of August 2017 that resulted in the birth of Bitcoin Cash (BCH). BCH's developers introduced emergency difficulty adjustment (EDA) algorithm to incentivize miners to process BCH's transactions over that of BTC's. Based on the strategic actions of the miners, EDA dynamically altered the difficulty adjusted profitability of BCH, which resulted in miners exhibiting waiting (waiting for the EDA to trigger) and switching (switching to mining BCH after EDA activation) intents on the BCH chain despite BTC's much higher market price. We use a two-step structural approach to estimate the dynamic mining competition among miners for BTC and BCH blocks to uncover their profit motivations. Policy and transition functions governing equilibrium behavior are estimated in the first stage. Using a forward simulation procedure, we estimate the payoff parameters in the second stage. With the help of publicly available chain data, we find competition among miners for BCH blocks was a major contributor to profits during EDA-active periods. We also find that waiting was beneficial. Contrary to available online evidence, switching had a negative effect on miners' profits. Through our counterfactual simulations, we demonstrate BTC's robust stability and find that the implemented design of EDA resulted in maximal miners' profits when compared with other plausible designs. We also provide a comparative analysis of different EDA designs with respect to developers' tolerance for changes in the rewards schedule.