Bitcoin through the looking-glass
The text that follows was written close to two months ago but never published.
Bitcoin Cash didn’t exist. In fact it didn’t even exist as a concept. Since then, one of the dangers described here has happened. A great eruption of unreleased value in the form of a network split has brought a new branch into the real world. Partly caused by the forced insertion of segwit.
However, this does not take away other risks, and those risks are still sitting in the main Bitcoin branch (BTC). System destabilising suppressed value is still laying dormant. Keep this in mind in, and watch carefully for further signals of black swans waiting to be released into the wild.
Welcome to Bitcoin through the looking-glass.
A long-expected party
On The Future of Bitcoin, a conference recently held in Arnhem, Peter Rizun held an excellent presentation on Segregated Witness transactions (segwit), and their different properties as compared to normal transactions. The conclusion of the presentation pointed to some serious issues. Among them that the security mechanism of segwit is vastly different from normal transactions. This leads to, among other things, that they will trade at a lower price.
Although these are serious concerns, there are far bigger dangers with segwit. In fact, a lot points to that it is a systemic danger.
To create a segwit transaction, you send your coins to a different type of address. Segwit also has an artificial transaction fee deduction. If you want to convert back from the segwit transaction, you will need to pay a higher fee. Two conclusions follows from this. The first is that segwit transactions is something that you can convert to and from, and that there is a cost associated with it. The second is, maybe somewhat counterintuitive, that segwit is actually a different currency, living within the Bitcoin network. It also means that those transactions have a different value.
How big is this difference? If normal transactions is the base value, then the cost associated with moving to and from segwit should mean that they are at a price disadvantage. We can therefore assume that the price difference will be at a minimum the difference in transaction costs between the two types.
With segwit comes also a higher risk of holding such a transaction. This is due to several reasons. For one, Peter Rizun pointed to the different security model. Another is that segwit is implemented by redefining a rule of the old system, namely the ANYONECANSPEND sighash type. It’s a rule that says that anyone can spend the transaction, without a signature. With segwit, the miners have been asked to reinterpret that rule as a placeholder that will enable backwards compatibility (forwards compatibility really but that is a different story).
It’s difficult or impossible to estimate exactly how big the risk is with these two different properties, but we do know that there is a risk. Due to that, there must also be a corresponding reduction of the price.
So an estimation of the value of a segwit transaction is the value of a normal transaction, minus the transaction fee difference, minus the heightened risk of using segwit.
From this follows the conclusion that a network without segwit transactions has a higher value than a network with them.
Right now it seems to be generally assumed that this difference in value is just lost opportunity. This may not be the case. More probable is that this is value that still exists in the network, waiting to be released.
This points to a somewhat counter-intuitive conclusion. Due to that segwit transactions are also transactions that anyone can spend, just prevented from it by the miners, we will have embedded an alternate reality within the network. This alternate reality will continue to live within it as long as someone wants to uphold the old rules. In fact it is even worse. There does not even need to be network internal resistance. The value will still live on, laying dormant, waiting for an opportunity to expand. Either within the network. Or without.
The anyone can spend transactions have been described as an ever growing bounty, growing until it is released in an eruption that could split the network. In this scenario the original network may not be severely affected, since the eruption will happen as something network external. But the implications are far more subtle, and also far more dangerous. The value doesn’t have to be released in a network split, through miner or user revolution. The value may be released in a way that is not even visible or understandable to users. When that happens, it could in a worst case scenario kill the old network in the process. The growing bounty is also different from the value difference described here. That bounty is the sum of the value of all segwit transactions. The risk described here is the difference in value between a network with segwit and a network without.
Energy seeks its stationary state. Value seeks to be liberated. The release of the internal suppressed value could happen in a thousand ways. And it will happen, one way or the other.
Segwit is an extremely controversial change. You can be sure that a lot of users of Bitcoin are fiercely resisting it. What would happen if it was common knowledge that a segwit enabled network has a lower value? The resistance would probably be in the majority. This means that the enemy is no longer at the gate. He’s already inside the city walls, dressed up as a carpenter or the old man that manages the mules at the city well. You can be certain that they will do anything they can, when the time is right, to rid the network from any type of shackles holding it back. Some of them will probably see it as natural protection. Doing what is right. Others might do it for purely economical reasons. Releasing the unreleased value and if possible get a share of it.
So there is risk alright.
Assuming a future scenario where you have a price difference of a few percent between the two types of transactions and 20 percent of all transactions are of the segwit type, you have a value that is equivalent to one of the top ten crypto currencies. Sitting unfulfilled within the network. That’s a bounty that a lot of people would spend a lot of effort to get their hands on. Outside the network. Or inside.
The other side of the mirror
The unreleased network value will not go away. The pressure will always be there for it to manifest in some way. The alternate reality embedded within the network can be attributed to the way that segwit has been implemented. But not solely. The reasoning in this article is applicable to the block size cap as well, although it’s not as clearly visible as with the case of segwit. Value can manifest in a lot of ways.
Below are a number of possible scenarios. Common for all of them is that there is little or no way to foresee, or protect yourself from it. It’s worse if you hold segwit coins but in most cases you will be affected either way.
- The easiest way to release pressure in the system is by converting a segwit transaction into a normal one. Relieving pressure bit by bit. This is the least damaging and most peaceful way. No permanent damage will be done to the network and value can gradually be released. Each holder of segwit coins will pay little by little to add the value back.
- Total reversion of segwit. At some point in time, the network collectively decides to rid itself from the shackles holding the value back. All holders of segwit coins might loose all their holdings depending on the circumstances. Owners of normal coins will not be affected more than the potential disruptive effect of the sudden change.
- Through a network split. This could have many different outcomes affecting both value and network cohesion. If the split happens purely to manifest unreleased value, the value of the new non-segwit branch would be equal to the unreleased value in the old branch. Just evened out over the new currency distribution as a whole. That’s the friendliest way. A win for everyone. Except for segwit holders, who can’t take part of the new value. It could also happen more violently, as a reaction to actually get rid of segwit. The network decides for a new direction, consequences be damned. The outcome could be anywhere from the old segwit enabled branch loosing significant value to the newly created branch actually becoming the main branch. Killing the old branch in the process. Should this happen all segwit holders will of course have lost all their holdings. Both in the new and the old world. The worst outcome of a violent split could be as bad as complete system failure due to lost faith in the system.
- The value could be released in the form of lost momentum and network effect. Leaking value mainly into other cryptocurrencies. It could also go into traditional payment networks. The extent of the loss could be anywhere from the unreleased value only to a significant decrease of the total value of the system.
- The alternate reality could manifest in the real world through the appearance of a “viral” crypto currency. A new crypto currency that would track the Bitcoin ledger. Continually offering Bitcoin holders a safe haven to which they can escape. The separate currency could of course have any rules it wants, for example a larger block size. It could be very similar to the original Bitcoin, giving anyone holding Bitcoins the possibility to replicate their holdings on the new ledger. With the notably exception of segwit transactions, which would be spent by the miners of the viral currency in the same pace as they appear. This viral currency will live alongside the Bitcoin network, and continually draw resources from it, if successful.
All of what is described here may seem far fetched. It certainly is not. There are lots of ways that the hidden value can manifest in the real world. It is also certain that in all cases, owners of segwit coins will find themselves at the wrong side of the mirror.
As a segwit holder, there is no way that you can protect yourself from the seeping off of value. Nor is there any way to foresee it.
There will be people on the inside that is opposed to you, that actively will work against you, and you can never be sure who they are.
Considering this, I’d think twice before I stepped through the looking-glass.