Unchained: Altcoins as Free Market Bitcoin Sidechains

As traffic on the Bitcoin network continues to grow, both Bitcoin proponents and skeptics have expressed doubts regarding its scalability. Can it really become the global payment network it set out to be? Visa averages around 2,000 transactions per second, and has a peak capacity of 56,000 transactions per second. The current Bitcoin network can handle only 7 per second. Even if the blocksize limit were to increase monumentally (which would have other consequences), Bitcoin would still be unable to handle the capacity of a truly worldwide payment network. And matching Visa’s capacity doesn’t factor the additional applications for the Bitcoin blockchain beyond simple monetary transactions, such as handling smart contracts. Bitcoin aspires to be much more than a global payment network, but currently it can’t handle being much more than a testnet for geeky libertarians.

Prometheus being chained by Vulcan, Dirck van Baburen, 1623

Another big constraint on the Bitcoin network — one that is written into the protocol — is the lag time for confirmations, and the ability to double-spend during that lag time. When a Bitcoin transaction occurs, it takes on average 10 minutes to “confirm” (secure) that transaction to the blockchain. Until that confirmation, a transaction reversal is possible. If you are trying to use Bitcoin to satisfy your Dunkin’ craving, 10 minutes is an unacceptable eternity. No one cares if after a few minutes the transaction is definitely settled, most of us just want to grab our donut and go.

These limitations are known, of course, to all but the most naïve Bitcoin enthusiasts. So why are we still enthusiastic about Bitcoin? Because we believe that technology will be created to enhance Bitcoin and overcome these hurdles. After all, Bitcoin itself is a technological marvel, so why not trust that more marvels are to come?

Sidechains

The solution to these issues of scalability and convenience generally fall into one of two camps:

(1) Enhance Bitcoin itself to overcome these hurdles.

(2) Add “sidechains” that work outside the Bitcoin network, but seamlessly integrate with it.

The first answer is simple to understand: just make Bitcoin better! But there are problems associated with it. For example, solutions might have to wait for better hardware, connectivity and other things outside of Bitcoin developers’ control. Software changes might also be incredibly difficult, involving deep changes to the Bitcoin protocol (and the raging blocksize debate has demonstrated how difficult “deep changes” can be).

One response to the difficulty in changing the core Bitcoin protocol is the creation of “sidechains.” In a sense, these are simply digital tokens (i.e., another cryptocurrency) that are deliberately pegged to Bitcoin’s value. For example, for sidechain “SideCoin” (SC), 1 BTC=1000 SC. Then transactions could occur on the SideCoin blockchain with the understanding that at any time, a person can convert their 1000 SC for 1 BTC. Bitcoin becomes the settlement layer and the reserve currency for a greater cryptocurrency ecosystem.

How is a sidechain pegged to Bitcoin? In simple terms, a sidechain creator sends a certain amount of Bitcoin to a special address on the Bitcoin network, which is then immobilized. This frees up the corresponding amount of the sidechain currency (1 BTC=1,000 SC) to use on its own blockchain. The reverse is also true — anyone who owns the sidechain currency can send their SC to an address to release the corresponding amount of BTC to the user. In effect, the person is always working in Bitcoin, and “SideCoin” is simply a smaller denomination of the Bitcoin currency itself, which only works on the SideCoin blockchain. Since the transactions are occurring off the Bitcoin blockchain, the sidechain process relieves the congestion on the Bitcoin network.

Sidechains are certainly an innovative and exciting idea which could advance the Bitcoin ecosystem. But perhaps a superior alternative already exists?

Altcoins

Scamcoins. Shitcoins. Anyone involved in the cryptocurrency world knows the general reputation of altcoins. Altcoins are essentially forks of the Bitcoin protocol which result in the creation of a new blockchain and currency. Currently there are 627 cryptocurrencies listed on coinmarketcap.com, and it is probably safe to assume that over 500 of them are frauds, failures, or exercises in futility. However, altcoins are an important part of the cryptocurrency ecosystem, for a number of reasons:

Altcoins provide competition for Bitcoin. If there were no altcoins, Bitcoin could quickly stagnate, taking an air of entitlement. With the existence of altcoins, however, not only does Bitcoin have to compete with government-issued currencies, but also with other cryptocurrencies. This forces Bitcoin to adapt to market conditions or die.

Altcoins allow for experimentation. We have only seen the tip of the iceberg in regards to what cryptocurrencies can do. However, with a multi-billion-dollar market cap, Bitcoin can’t afford to be a testbed for every new innovative idea. Altcoins become that testbed.

Altcoins provide for niche solutions. Imagine a small country or community that wants to have its own currency. It might have certain economic views that aren’t completely consistent with Bitcoin, but it can easily create its own altcoin and use that cryptocurrency as its own currency.

Even though altcoins in general have a reputation for scams and failure in the cryptocurrency world, they ultimately have the same barrier to entry as Bitcoin. Although they are easy to create, in order to be successful they must provide a valuable service that other cryptocurrencies (including Bitcoin) currently do not. Thus, the scams get weeded out, and only the strong survive.

Altcoins as Free Market Sidechains

Observant readers at this point will have figured out that sidechains are simply altcoins whose value has been pegged to Bitcoin. But is that pegging necessary? Could altcoins become in practice “sidechains” to Bitcoin without being pegged?

The biggest hurdle is the volatile exchange rate between Bitcoin and most altcoins. For example, the exchange rate between Bitcoin and Litecoin, the most established of the altcoins, fluctuated between .0079 and .0200 in a one month span last summer, a 150% increase.

Litecoin/Bitcoin Exchange Rate — June 8, 2015-July 8, 2015

Looking more closely, however, one sees that the most stable altcoins generally rise and fall with Bitcoin, thus making the exchange rate more flat over time. For example, other than that blip last summer, Litecoin’s value in terms of Bitcoin remained relatively the same from the beginning of the year to the end.

Litecoin/Bitcoin Exchange Rate — Jan 1, 2015-Dec 31, 2015

Further, if an altcoin were being used primarily as an unpegged sidechain to Bitcoin, one could expect it to become even more stable in relation to Bitcoin, as the free market would naturally tie the value of the altcoin to the value of Bitcoin.

I would also argue that an unpegged, and therefore more volatile, currency exchange is superior to a pegged, purely sidechain, system. An unpegged system allows for the free market to adapt to the value of each altcoin based on its usefulness. This will drive the most resources into the most valuable parts of the overall cryptocurrency ecosystem.

For example, suppose “RevCoin” initially pegged its coin at a 1 BTC=1,000 RC rate and “SmallCoin” pegged its coin at 1 BTC=10,000 SC. That means the exchange rate between RevCoin and SmallCoin is always and forever 1 RC=10 SC. Anyone mining, developing, or otherwise working on both RevCoin and SmallCoin will know that the value of each rises and falls strictly on the value of Bitcoin, not on the value the coins themselves bring to the ecosystem. So if RevCoin introduces some revolutionary innovation, it won’t be reflected in its price, only in Bitcoin’s overall price, which is determined by a whole host of factors including the value of its sidechains. A much less important sidechain such as SmallCoin will see the same increase — there is no change in the exchange rate between RevCoin and SmallCoin, even though their value to the ecosystem could change dramatically over time.

With a free market altcoin sidechain system, the exchange rate between altcoins and Bitcoin, and altcoins and other altcoins, is based on their value to the ecosystem. If RevCoin is truly revolutionary, and its price reflects that, then miners will be more incentivized to secure its blockchain. If the altcoin has a self-funding mechanism (like Dash), then developers will be more incentivized to improve the code. All sectors of the economy will flock to that coin, making it more secure and more robust than other altcoins, just as it should be.

Another advantage to using an established altcoin is network effect. This concept of a network effect — that the more something is used, the more valuable it becomes — is usually levied against altcoins in comparison to Bitcoin. But when comparing a new sidechain to an established altcoin, then network effect becomes an altcoin’s friend. Proven altcoins already have an existing decentralized, distributed, and tested network they can call upon. Instead of depending on new untested sidechains, only those altcoins which the market accepts — a state of affairs reflected in its changing price — will be used as unpegged sidechains.

A Crypto-Agnostic Future

In an ecosystem where altcoins work as free market Bitcoin sidechains, an altcoin such as Dash could be used for instant transactions through its InstantX feature, Ethereum could be used for smart contracts, and perhaps even Dogecoin could be of use for microtransactions (or maybe just to troll the stuffed-shirt financial world). Other new altcoins could continue to be developed, and when they are accepted by the market, they too can become useful unpegged sidechains to Bitcoin.

But doesn’t a multiplicity of altcoins just add more confusion and complexity to the user experience? Not necessarily. In this cryptocurrency-based future, the user may or may not even know what coin is being transferred. Perhaps she would just have a browser plug-in with a button that says “Buy” at any ecommerce site. That plug-in would be tied to some wallet that holds any number of cryptocurrencies. Further, when she hits “Buy” it might be the merchant, or the browser plug-in, that determines which currency to debit in the user’s wallet, and which to credit in the merchant’s wallet. It might even be determined dynamically, depending on which blockchain has the least congestion. The price of the product itself might be denominated in Bitcoin or fiat or any other cryptocurrency that is common to all ecommerce sites (or more likely, the browser plug-in just denominates everything in each user’s preference).

Sound far-fetched? We already have the beginnings of this process with Shapeshift, which offers users the ability to exchange just about any cryptocurrency for another, and offers merchants the ability to accept just about any cryptocurrency, automatically exchanging it to the coin(s) of their choice.

A truly free market will allow for a flourishing of altcoins to work alongside Bitcoin, possibly even as unpegged sidechains to their elder brother. By allowing the market to determine each altcoin’s worth, the whole cryptocurrency ecosystem will grow more organically and efficiently for everyone, leading the way to a fully cryptocurrency-based economy.