The Bitcoin Block Size: Listen to the Market

The Bitcoin block size debate is out of control. Censorship, name-calling, back-room dealings — we’ve seen all of it, and none of it has done any good for Bitcoin. All the controversy does is generate a huge amount of uncertainty, scaring away new entrants, as well as causing existing investors to reconsider the wisdom of their investment.

The Bitcoin XT ship has sailed, but the issue has not been put to bed. In case you’re not aware, the latest development is called “Bitcoin Classic.” Classic proposes a 2MB hard fork in the short term, and a changed governance model for determining what goes into the code (structure yet TBD). Classic comes with some strong voices behind it, including Gavin and Jeff, a number of large miners, and a number of important companies in the Bitcoin industry. The Bitcoin Core team, meanwhile, believes doing a hard fork at the present time is needlessly risky, and is instead pursuing SegWit via a soft fork for a similar sized potential gain in throughput. I’m not going to take sides here, or even really discuss how we got here. But I hope to shed light on how we can find a way forward.

There are a number of different sets of actors in Bitcoin: miners, developers, businesses, users, holders (aka investors), and of course, loud voices on social media. I make the assertion that none of these groups matter without the support of holders. It’s the holders’ willingness to hold $5 billion worth of Bitcoin in their portfolios which allows all the other groups to have something worth caring about. However, I think the great irony of the block size debate is that the holders have no real voice yet (besides by selling their coins and walking away from the whole business). I’d like to propose a way to change that.

To make a hard fork effective, a certain percentage of the miners must commit to support the fork. But how are they meant to make such a decision? Should they listen to the developers? to people on Reddit? to the big companies? What I think they’d really like to do is make decisions the way they normally do: with their pocketbooks. They (corrrectly) want to mine the coin which will provide them the greatest return on their investment. The problem is, miners don’t have a price with which to make a decision. However, they will have a price signal after the fork.

After a fork which has any contention, there will effectively exist two coins, call them A (old-fork) and B (new-fork). Any holders of BTC before the fork will hold coins of both A and B. And if there’s still an active coin A, then there will be a market price for it. Once the fork happens, the holders will finally have a voice: they will have a market in which they can choose to sell coin A and buy coin B or vice versa. So, we will have two prices: P(A) and P(B), which will likely be quite volatile initially, because it will be the first time anyone has been able to express a view financially between the two coins. Due to this volatility (which expresses the uncertainty of the situation), I think it highly likely that the sum of P(A) + P(B) will be less than the initial price P for pre-fork Bitcoin. In other words, we all lose, at least in the short run.

Wouldn’t it be much better if we could ensure that the fork would only happen if we knew for certain that B were truly the vastly preferred coin in terms of price? For example, if we knew that P(B) / P(A) was going to trade at 50:1, we could be relatively certain that the fork was desirable by the economic majority. And similarly, if we knew that P(B) / P(A) was more like 2:1, then we could predict that a fork could be pretty disastrous, and therefore decide against it. The exciting thing is, it is possible to get this price signal in advance of actually making the fork, and I’ll explain one way to do so.

What we need is a market on assets that do not exist yet (and actually may not exist, if the fork does not happen). Clearly, these assets cannot be delivered today, so what we’re talking about is a futures market or prediction market. Any Bitcoin exchange could theoretically make such a market.

The first thing an exchange needs to do is to allow a trader with BTC on deposit to split that BTC into virtual coins that we’ll call Alpha and Beta. Beta will be redeemable for B, if and at such time as a fork happens by a certain date. Alpha will be redeemable for A, if a fork happens, OR for BTC, if no fork happens by the deadline. At any time before the deadline, a trader can also re-combine N units of Alpha and N units of Beta into N units of pre-fork BTC, so traders are not locked into these future assets until the deadline.

The exchange may then set up order books for Alpha:BTC and Beta:BTC. Or they may be traded vs. USD or directly against each other. All of these are equivalent due to arbitrage. What’s important is to generate some liquid market for giving us a price signal for Alpha vs. Beta. Also, note that due to the ability to convert pairs of Alpha and Beta back to BTC, it should ensure that we should maintain a price relationship: P(Alpha) + P(Beta) = P(BTC).

This market should also be expected to be quite volatile. However, convergence should be reached relatively quickly. The reason is: once the price starts to tilt obviously in one direction, it is likely to continue in that direction. Almost all the value should eventually accrue to either Alpha or Beta, since there is a feedback loop which says that if Beta’s price is too low, then it is worthless (the fork will not happen due to miners looking at the low price for Beta). And similarly on the other side, if the Beta price is high, fork will almost certainly happen with high support, and so Alpha will be worthless. The important point is, meanwhile, this process should have caused minimal volatility in the actual BTCUSD market. If anything, there could be a price rise as uncertainty gets removed.

Decentralized consensus is a very tricky beast. In the early days, we had Satoshi as an effective central decision-maker who could settle arguments, but we no longer have that luxury (nor would we want it.) But without a North Star to point to, our arguments are likely to run around in circles forever (or until we blow the whole thing up accidentally). I am in agreement with Core that we ought to approach hard forks very carefully. But no amount of debating will give us as much information as getting a true market price for the fork. So let’s do that!