A sound Bitcoin financial system
Seeing as a handful of developers have been riffing on the current challenges of Bitcoin’s evolutionary path, I thought I’d throw my hat in the ring and offer, perhaps, a less technical take on some of the themes being explored.
For those just tuning in, the gist of the conversation revolves around the prospect of Bitcoin scaling to billions of users, and whether or not they get to enjoy its lauded sovereign properties.
The premise is simple and well publicized by now: blockchains don’t scale. UTXOs are unwieldy and expensive to transfer. Lightning, while universally acknowledged as a cornerstone of the puzzle, does not appear sufficient on its own. AJ Towns does a pretty good job laying out the technological argument in his post so I will spare you the details here.
The dreary conclusion everyone seems to arrive at is that users will need to interface with a range of entities, each with their own position on the decentralization spectrum. Centralized custodians, chaumian mints, federated sidechains, coinpools, etc. AJ, for himself, muses on a scenario wherein the user base is spread across a large enough number of such entities so that demand for Bitcoin transactions can be met without introducing systemic risks. A lot of thought goes into the prospect of equipping those adjacent protocols with minimal validation costs and maximize transparency in order to keep everyone in check, and honest.
A more recent post by Core developer James O’Beirne opines along the same line, offering various thoughts on the set of tradeoffs available to us and further exploring the design space. Of note, he emphasizes the importance of users having the option to exit from a selected operation so as to incentivize the latter to abide by the rules.
In a response, developer fiatjaf rejects this proposed paradigm, suggesting that Bitcoin’s time is running out. He argues, in perhaps fatalistic fashion, that if we are to risk the presence of any scale of custodianship into Bitcoin, we might as well hand over the keys of the kingdom to the devil we know rather than one we don’t. That is what Drivechains are, in essence, an idea which prescribes that the dynamic set of Proof-Of-Work signers enrolling to secure the Bitcoin blockchain should also be relied on as custodians to achieve a trust-minimized two-way peg. The underlying assumption being that fees generated by those sidechains should be sufficient to incentivize miners not to defraud their users. An entire article could be written about my issues with the proposal but for the sake of brevity I should only point out that the incentives, if any, are completely orthogonal to the ones miners have towards securing the Bitcoin chain.
The economic majority
Interestingly enough, this leads us to the core of the challenge. How can we engineer systems inspired by the incentives that secure Bitcoin?
As James observes in his article, “the ability to appeal to layer 1 is what makes it all work.” People have been discussing the opportunity to use the chain as an adjudicator for the better part of Bitcoin’s existence. Obviously, Lightning was the first protocol to leverage this idea. Anyone who has explored these types of construct quickly noted that this comes with a major caveat.
Indeed, appealing to layer 1 might prove costly, so much so that it may become outright uneconomical for some users to do so. I imagine this is what fiatjaf is referring to when he says “offchain” solutions like Lightning and Ark will not scale and they basically lose usefulness as more adoption happens and fees rise. Users who cannot afford increasingly expensive layer 1 “justice” will find themselves in a quasi-custodial scenario. The argument that usually follows is that if the average user has to compromise on sovereignty to use Bitcoin, then the project has failed.
With that in mind, I believe it’s important to go back to what this sovereignty is made of. Bitcoin works because an economic majority is aligning incentives for every constituent of the network. The longer tail of the economic distribution may choose to run a node and validate consensus but ultimately consensus follows the money.
The cost of validation, though, is not proportional. It’s increasingly prohibitive to skip validation the more bitcoins you own. Everyone should be encouraged to validate so long as they are perusing layer 1, regardless of their “size”. That said, it is more important that a supermajority of bitcoins received be validated than it is for a supermajority of bitcoiners to receive and validate. As long as we can maintain this incentive alignment, everyone benefits from the guarantees provided by the network.
Multi-party protocols
Having considered this, we can return to the matter of our inquiry into protocols, products and services that can mirror those economic guarantees. The most promising area of research at the moment appears to be coin pools. Multi-party protocols allow an arbitrary number of users to lift their UTXOs into a shared single one. Using script, an infinite variety of contracts can be designed that allow those pools of UTXOs to interactively update the distribution of bitcoins within and across them.
Much like Lightning, those contracts allow users unilateral exit from the pools, at a cost. The latter situation can become especially dire the larger they grow. Coordination is typically expensive. In Lightning, tangential issues have led to the emergence of Lightning service providers (LSPs). A new and interesting idea proposes to introduce coordinating services into coin pools, allowing for very efficient management of the users’ nested capital. A group of them could connect through a service provider who will exchange their UTXOs for virtual ones. The service provider is responsible for maintaining the state of the pool by posting regular on-chain transactions, updating the collective UTXO. In between “rounds”, the provider handles payment requests between users of the pool by initiating atomic transfers between the sender and the recipient. All of those payments, an arbitrary number of them, happen off-chain. The process completes only if those transfers are bundled and confirmed in a Bitcoin block, removing the need for trust in the service provider.
As counterparty to every exchange, the scheme is very capital intensive for service providers who are required to fund every pool transaction. To handle the liquidity requirements, virtual UTXOs (VTXOs) are ephemeral. The contracts that underlie them come with an expiry clause that returns the associated user UTXOs to the service provider. Users must therefore make sure that their contracts don’t “time out” to preserve spending authority over the funds. Updating a contract is trivially achieved by “refreshing” your virtual UTXO through a pool transaction. To better manage this, vTXOs come with different duration and users can select what fits them best.
In exchange for the liquidity, service providers charge processing fees which are expected to vary according to the cost of capital. Indeed, VTXO contracts of varying duration can be funded by setting a rate at which the provider can tap into capital markets to match the demand with an offer. The formation of those markets will allow service providers to operate at scale and may usher in a new type of reference rate for capital.
If you’re paying attention, you’ll realize what we have here is a pretty neat set of incentives that can align individuals at scale. An economic majority afforded with unilateral exit from pools can incentivize operators to be accountable for the interests of every user.
Pennies in front of a steam roller
Of course, users of multi-party protocols are similarly burdened by the cost of unilateral claims. Virtual UTXOs could become prohibitive to withdraw on-chain, leaving no option for its owners but to rely on the incentives of the system. Those users may still be able to transact through the pool, but in the event of fraud from the operator, they will be stuck with little resort.
Operating a coin pool is assumed to be a profitable operation. At scale, it may in fact be extremely lucrative. Those service providers, operators or ASPs being discussed have the potential to become a fundamental institution of Bitcoin’s future financial markets. A new generation of banks leveraging native Bitcoin capital markets and offering a range of services built atop their coin pool. So long as a supermajority of the bitcoins entrusted to them maintain sovereign rights, the system is economically aligned.
Any bank who would attempt to profit from vulnerable users is likely to lose business precipitately. By being naturally compatible with coinjoin architecture, coin pools also provide strong censorship resistance assurances. Lighting is positioned perfectly as a trust-minimized clearing house between those entities and allows users to route payments across the network of pools and beyond.
Considering virtual UTXOs still require block confirmation, they can function as a sort of checking account and support different payment methods. To enable further throughput and velocity, a Bitcoin bank may also operate ancillary protocols that can facilitate those operations. Chaumian e-cash mints, statechains and even more expressive sidechains. Crucially, the trust assumptions for those services remain rooted in the coin pool operation. The same game theory applies across the board. Picking the pockets of its e-cash users risks undermining the bank’s entire operation. Pennies in front of a steam roller.
These are, I believe, the seeds of a sound Bitcoin financial system. One that preserves the property rights of its participants using thoughtful economic incentives. Despite the very best advances in zero-knowledge technologies and other exotic primitives, I remain skeptical that a perfectly egalitarian protocol can emerge that guarantees trustlessness at global scale. Sovereignty is expensive and is not innate to Bitcoin or its technology. It is but the result of collective individual incentives.
