Bitcoin’s Most Valuable Use-Case

The gold and silver money which circulates in any country, and by means of which, the produce of its land and labour is annually circulated and distributed to the proper consumers, is, in the same manner as the ready money of the dealer, all dead stock. It is a very valuable part of the capital of the country, which produces nothing to the country. The judicious operations of banking, by substituting paper in the room of a great part of this gold and silver, enable the country to convert a great part of this dead stock into active and productive stock; into stock which produces something to the country. The gold and silver money which circulates in any country may very properly be compared to a highway, which, while it circulates and carries to market all the grass and corn of the country, produces itself not a single pile of either.~Adam Smith, The Wealth of Nations

Bitcoin is still at an impasse. The article “Here’s Why All Rational Miners Will Activate Segwit” by Aaron van Wirdum foretells of an upcoming event which many suggest will unfold one way or another. A Chinese mining monopoly is said to be blocking a protocol upgrade that many bitcoin enthusiasts feel is badly needed while trying to convince enough network voting power to accept their own protocol upgrade (apparently necessary to retain the monopoly). The conclusion of the article is that a user activated soft-fork is destined to win out and therefore the rational action for miners would be to begin to converge on that protocol.

The problem with the conclusion is that it's based on this premise:

All else being equal, the market would value 148BTC (or UnifiedBTC) more than or equal to LegacyBTC. In other words, if hash power, re-org risks, or related considerations played no part, the market would prefer a bitcoin that has SegWit activated through BIP148 over a bitcoin that does not. Or at least, the market wouldn’t mind it if a bitcoin had SegWit activated through BIP148, and would value it equally to a bitcoin that does not. (This includes a bitcoin that has SegWit activated through a different activation method later on.)

This writing explores the tacitly held assumption that segwit and transaction capacity increase proposals in general inherently add value to the bitcoin network.

Bitcoin’s 7tx/s Capacity

Many people who have not considered the bigger picture feel they have a valid concern that bitcoin can only handle ~7tx per second (visa processes over 20,000tx per second). Once bitcoin’s transaction capacity is full a fee market is created and users either have to wait a longer period of time for their transactions to go through or they can pay an estimated fee in order to jump ahead of the line. When the network is “busy” overload transactions are sent to the “mempool”.

There is nothing inherently broken about the system. Over and over as bitcoin reaches its capacity, the mempool fills up, sometimes up to 100’s of thousands of overflow transactions waiting in the queue for their turn. The transactions are prioritized by fee and so far every time the system has reached capacity eventually the mempool cleared out and the network resumed normal function under the capacity threshold for a substantial fee market.

The system doesn’t have an upper breaking limit in this context because the fee market that arises just adjusts the transaction fee based on demand. Since the users decide what they want to pay the fees can only increase if there is demand to pay them. If fees increase to a point where no user are willing to pay less transactions would be expected as a result (ie users would use cheaper alternatives) and the mempool would begin to clear out. This would lower the transaction fee until users found value in using bitcoin over any alternatives again. From this perspective (all things equal) this suggests a market equilibrium (rather than total capitulation from bitcoin becoming “too expensive”).

The Big Blocker Complaint

The trade-off is that as bitcoin’s capacity is reached and transaction space becomes more dear, the fees rise to a point where average everyday “coffee” transactions are no longer feasible. Bitcoin becomes more a facilitator of large value transactions rather than the saviour of the unbanked population of the world. Big blockers generally complain that bitcoin cannot serve the unbanked while touting Metcalfe’s law claiming that the value of bitcoin’s network increases at a rate of n² for every user that is added.

The rest of this writing challenges such assertions.

Bitcoin’s Scaling Trade-off

Nick Szabo, known as an expert on all things crypto-currency related (and thought to be at least part of “Satoshi” himself) explains the trade-off that makes bitcoin the technological marvel that it is:

…greatly sacrificing computational scalability in order to improve social scalability. That is Satoshi’s brilliant tradeoff. It is brilliant because humans are far more expensive than computers and that gap widens further each year. And it is brilliant because it allows one to seamlessly and securely work across human trust boundaries (e.g. national borders), in contrast to “call-the-cop” architectures like PayPal and Visa that continually depend on expensive, error-prone, and sometimes corruptible bureaucracies to function with a reasonable amount of integrity.

The way that Satoshi was able to to surpass otherwise unsolvable problems was this scalability trade-off. From a user's perspective this means that bitcoin sacrifices a higher transaction capacity in the name of security. It is this security that allows users to have faith in the future value of the system. Without such security the markets, as one of the most forward looking technologies we can have, would not be able to find faith in bitcoin’s value.

Causal users that don’t have a strong knowledge of the associated literature and economics have a difficult time swallowing this limitation. And ignorance of this sort, being more plentiful than knowledge stored, was the problem to be solved in the first place.

Bitcoin As A Settlement System Scales Indefinitely

In contrast bitcoin as a settlement system does in fact scale indefinitely. The argument for increasing the block-size to increase the transaction capacity does not deny this. The big blocker argument simply worries about the small value players such as the unbanked that are “unjustly” cut out from using this new technology (which isn’t altogether true because they could still possibly hold bitcoin for savings and higher value purchases).

Big blockers argue, without a fundamental change, once the transaction capacity is reached the mempool will fill up and if the circumstances continued the fee to send bitcoin will increase. This fee would cause small transactions to become worth less than the fee to send them but for large players the fee will still be expected to be negligible especially in comparison to alternative methods of transacting large amounts of money (such fees would also be negligible for instances when bitcoin provides utility where no other medium of exchanges would suffice).

The increase in fees to transact with bitcoin also necessarily puts an increased pressure on bitcoin’s price which follows because since people are willing to pay more and more to transact with bitcoin they value bitcoin’s utility more (otherwise the mempool overflow wouldn’t be pushing up the fee market equilibrium).

The real byproduct is an increase in value which is related to the fee people are willing to pay to transact with bitcoin. Again we can note, it’s not possible for the network to get so valuable that the cost causes total abandonment. If no one was willing to use the network because the transaction fees were too high, then eventually the overflow would clear and the cost to transact would come back down to what lower value participants would be willing to pay.

The mempool simply settles the overflow and (all things equal in a mature environment) the price eventually increases (or decreases) to match a significant sustained increase or decrease in demand. If the transaction capacity is sustained and a fee market is created we can expect general rise in the price of bitcoin which in turn will (eventually) take pressure off the mempool as the (probably) higher frequency low value transactions are priced out.

We can see then that the “congestion” problem that big blockers are always pointing to is really just the bi-product of a very well functioning mechanism. This mechanism pushes up the market valuation of bitcoin. As the valuation increases bitcoin is able to settle higher and higher value transactions with the only trade-off being that it cannot also serve the lower value transactions.

Bitcoin As Coffee Money Doesn’t Provide A Unique Service

This is seen as unacceptable to the irrationally exuberant however it’s a completely acceptable trade-off once the implications are considered. If bitcoin were to provide a mechanism for high value settlement AND a banking network for the unbanked (ie citizens of 3rd world countries that don’t yet have banks accounts or perhaps ID cards) how would this impact the previously unbanked person’s lives?

The problem with the question is the implied blinders to other currency options such as litecoin and ethereum. There are many alternative options to bitcoin and each has their own specialty. Nearly all of these coins to date (ethereum is out-growing this capability) can transfer small amounts of value for near zero fees (relatively negligible).

What would bitcoin be providing by scaling its transaction capacity that isn’t already provided?

It can’t be argued that increasing bitcoin’s transaction capacity would provide anything unique to the unbanked population. The crusade to scale bitcoin to serve the unbanked or the average Jane or Joe is not a morally justified one. It does not promise to add value to their lives that they can’t already experience with any other alternative crypto-coin.

A small caveat to this that needn’t be ignored is that there might be different cost barriers associated with using alternative crypto-currencies. Szabo’s explanation of a Market Translator gives us a metaphor for understanding the problem with this complaint. There are different types of frictions associated with using one payment method or currency over another and these barriers (which might include a calculation, extra mouse clicks, time, or work etc.) in some form are equatable to costs. A market translator optimally reduces the costs to zero. So there is SOME argument that using a less mainstream currency than bitcoin does have SOME cost or barrier, however, with technological advances such as the ShapeShift service, the relative costs and barriers are almost already negligible. In the near future making payments in different crypto-currencies will simply be an automatic under-the-hood programming consideration that the user will never have to know about.

Increasing Low Value Bitcoin Usage Doesn’t Necessarily Increase Its Value As Per Metcalfe’s Law

We are left to counter the belief that increasing the number of users (ie nodes) of the bitcoin network increases the value as per Metcalfe’s law. Nick Szabo also gives a formal extension of Metcalfe's law and relates it to Adam Smith’s observations:

Metcalfe’s Law states that a value of a network is proportional to the square of the number of its nodes. In an area where good soils, mines, and forests are randomly distributed, the number of nodes valuable to an industrial economy is proportional to the area encompassed. The number of such nodes that can be economically accessed is an inverse square of the cost per mile of transportation. Combine this with Metcalfe’s Law and we reach a dramatic but solid mathematical conclusion: the potential value of a land transportation network is the inverse fourth power of the cost of that transportation.
A reduction in transportation costs in a trade network by a factor of two increases the potential value of that network by a factor of sixteen
While a power of exactly 4.0 will usually be too high, due to redundancies, this does show how the cost of transportation can have a radical nonlinear impact on the value of the trade networks it enables.

Note the use of the word “potential” and the redundancies noted. These are important caveats.

There is a relationship between the number of accessible nodes in a network and the potential of those nodes but there is nothing to say that a network is necessarily able to use all of the nodes to their maximum potential.

In terms of the bitcoin scaling debate if the capacity was increased significantly or indefinitely the network wouldn’t grow exponentially in value simply because everyone in the world was arbitrarily sending each other bitcoin. Picking up a medium of exchange and continually passing it back and forth doesn’t in itself create and harness value (there is no such argument that it does!).

The transactions must be USEFUL transactions-meaningful representations of efficiency gained.

Thus the big blocker complaint that cutting out a segment of the population from using bitcoin decreases its (potential) value is exposed. Keeping in mind the complaint is about unbanked or low value participants, if bitcoin’s network is full of high value participants Metcalfe’s law doesn’t really hold true. A low value participant added to the network cannot be expected to add the same value as a high value participant.

Metcalfe’s law assumes all participating nodes are participating equally.

Bitcoin As A Coffee Money Doesn’t Scale

Extending this line of thinking for each magnitude of lower value participants more participants are needed to fill the value of the previous tier. If the goal is to serve a population that transacts with less average value, in order for that population to be significant (assuming Metcalfe’s law even weakly held) there would have to be substantially more participants added. If the goal was to add 1000 participants transacting $1 in value a day there would need to be an equivalent of 10,000 participants transacting with $.10 per day increasing the transaction capacity need by the same order.

Deciding a limit on a world currency, and limiting its user base to “rich” people might seem a little bit tyrannical and anti-freedom until you think about how many transactions an average individual might need a daily basis (keeping in mind that higher value transactions are already accounted for regardless). For most of the world transactions less than a penny are not useful (and most use-cases for micro-transactions are going to be digitally based in the first place anyways).

This all paints quite an uphill battle which involves trying to provide a solution for a population that already has equivalent options. It’s an endeavor that doesn’t heed Nick Szabo’s cautions about bitcoin’s scalability trade-off nor does does it consider the diminishing aspect of the return. Furthermore the world has 7 billion people and at 7tx/s a x30 increase in capacity would be needed just to give each person one transaction. With a diminishing return and an uphill battle what is the reason for pursuing this direction for bitcoin knowing the moral considerations of serving the unbanked are already tended to by alternative crypto-currencies, especially at the cost of the networks security?

Money and Banks as Settlement Mechanisms

Returning to the concept of settlement and the initial Adam Smith quote from the introduction of this writing we can also view money itself as a different form of a settlement mechanism and this definition of money certainly includes different cryptocurrency options.

It is completely natural then that high value participants hold and transact some or much of their wealth in higher power money (ie gold or commodity money as George Selgin might refer to it as or digital gold etc.) while every day transactions are settled with a “paper” equivalent (where paper is a metaphor for a medium of exchange that is less costly to transact with but also carries less value and perhaps with less security).

To try to marry the division between high valued settlement and low valued transactions (settlement) would be to confuse the concept of settlement itself.

If player A is to transact with player B, and player B to player C, then why shouldn’t player A and C simply consider settling the balance? It wouldn’t make economic sense to arbitrarily favor a system of settlement with more frequent transactions of lower value.

An efficient settlement system has less use for increased transaction capacity.

In bitcoin’s case if the transaction overflow pool fills up and the fee market begins to rise a corresponding rise in the value of bitcoin will naturally free up the pool (or the price will continue to rise etc.).

Lightning network might arise on top of bitcoin as a 2nd layer which would provide this “paper” type solution and use bitcoin as the infrastructure for settlement (or the threat of). Altcoins plus “market translators” (such as ShapeShift) also provide this mechanism by which smaller amounts of value can be “shifted” into faster and cheaper money and “shifted” back on arrival. The costs associated are negligible and traded-off to trusted third parties such as exchanges that can themselves settle in bulk for a lower relative cost than their lower value customers. Here the excuse for trusting a third party comes from both the ability for the user to hedge risk (ie not keeping a significant amount of wealth on a trusted 3rd party platform) and by the advancing of technology (ie multisig) that effectively gives users the security which bitcoin is alleged to have promised from its inception.

Bitcoin As a Settlement Mechanism

Bitcoin’s greatest utility and most valuable potential role is that of a digital gold-a settlement system for high value players in our global financial system. The diminished returns sought by increasing the transaction capacity only serve to threaten the security of the network. There is no reason to believe any significant scaling could be done without perturbing the economic equilibrium that holds bitcoin’s value proposition stable and favored by the markets and there is no significant value to be obtained by ignoring the caution warnings by experts on this matter.

However, there IS great value in having bitcoin rise as our highest value settlement mechanism. This will happen as bitcoin’s market cap and liquidity rises to compete with institutions such as the IMF. Eventually the aggregated costs (this would include different vectors such as security and cost of changing or breaking laws etc.) of transacting using traditional mediums of exchange will exceed the barriers or costs associated with adopting bitcoin and larger and larger institutions will begin to settle on the bitcoin network.

This is why the markets might not prefer or even appreciate segwit and might even simply reject it along with any other proposals that open up a perpetual discussion about serving lower value participants.