Bitcoin, Not Crypto
A Comparative Analysis of Bitcoin’s Fundamentally Unique and Irreplicable Properties
This paper was originally published under the title, “The Blockchain That Matters”, by Social Science Research Network on June 10, 2021 http://ssrn.com/abstract=3880186
Abstract: The crypto industry comprises thousands of cryptocurrencies offering different versions of blockchain-based decentralization — a concept that was described originally in the Bitcoin Whitepaper in 2008. Bitcoin is a monetary asset that achieves immutability through a decentralized governance protocol. Such immutability is, in theory, the primary reason behind public blockchains. Besides Bitcoin though, what we see across the industry are blockchain-based tokens offering diluted or spurious decentralization which contradict and defeat the purpose of immutability altogether. This paper highlights these ‘blockchain-fallacies’ through a comparative analysis against Bitcoin’s unique and irreplicable achievement in decentralized governance.
Inimitably Immutable
The Oxford English Dictionary defines “inimitable” as, “impossible to copy”. And “immutable” is defined as, “that which cannot be changed”. Bitcoin’s real achievement is the invention of the world’s first and only digital bearer asset with inimitable immutability. To truly understand Bitcoin, it is necessary to appreciate these two specific properties that define it.
The average person’s journey into the crypto industry typically starts with Bitcoin. After all, it has been around the longest, has the largest market share in the industry, and attracts the most media attention. Shortly following the initial step, this individual will invariably hear the irresistible siren calls of other purportedly faster, more efficient, more secure, and more versatile cryptocurrencies promoted by social media influencers, sports personalities or eccentric billionaires. There have been countless “Bitcoin killer” tokens that have been unveiled over the last decade. How does Bitcoin’s “old” technology from 2008 “compete” with the latest cryptos of 2021? This paper is an attempt to answer this question by distinguishing “the signal from the noise” with respect to the crypto industry and blockchain technology.**
Since its invention in 2008, Bitcoin’s market capitalization has grown from zero to over a trillion dollars. It is estimated that over 110 million individuals worldwide, and over 17% of American adults have some Bitcoin investment exposure. Public and private companies, pension and insurance funds, asset managers and some of the biggest names in the financial services industry, now recognize Bitcoin as a new asset class and are committing immense amounts of capital and resources to it. Some of the world’s most renowned investors including Paul Tudor Jones, Stanley Druckenmiller, Alan Howard, Carl Icahn and Ray Dalio have declared their own personal investments in it. And the nation state of El Salvador has recently adopted Bitcoin as legal tender.
In parallel, Bitcoin has spawned an entire “crypto industry” with over 10,000 cryptocurrencies. What ties these thousands of cryptos to Bitcoin within the same industry, is the claim that they all use some version of Bitcoin’s underlying technology, called blockchain technology. It is unlikely that the author(s) of the 2008 Bitcoin Whitepaper ever envisaged this purported separation of the underlying technology from Bitcoin itself. In fact, words like “blockchain” and “cryptocurrency” do not appear anywhere in the original text of the whitepaper. Nevertheless, the industry now tracks this entire space as one, and puts out metrics such as “Bitcoin dominance” that track Bitcoin’s market share versus all other cryptocurrencies combined, thus implying that they are in competition with each other for a share of the same pie.
In this paper, we will first analyze Bitcoin’s unique achievement in digital decentralization that supports its immutability. We will then perform a comparative analysis of Bitcoin versus other cryptocurrencies to demonstrate the unique technological and historical aspects that make such decentralization unprecedented, revolutionary and most importantly, impossible to replicate. And finally, we will consider whether Bitcoin should be regarded as an asset class separate from the rest of the crypto industry given its distinct role as a store of value and alternative politically neutral monetary policy. The potential that Bitcoin has for the global economy, and humanity in general, makes it an industry unto itself, far beyond the crypto industry.
The Role of Immutability
A popular and stubborn misconception in the mainstream media and the economic and financial establishment is that Bitcoin represents a “payments technology” for everyday use. The Bitcoin network’s “slow” ten-minute settlement time is often pointed to as being vastly inferior to Visa, Mastercard and Venmo which allow you to complete your coffee purchase transaction within seconds. This leads to quibbles around Bitcoin having no real use case on the transactional front. Leaving aside the fact that such claims are now entirely invalid given layered technologies like Lightning Network that allow for instantaneous Bitcoin transactions, such perspectives entirely miss the point.
Bitcoin’s goal has always been to serve as a decentralized asset with a fixed, transparent and immutable monetary policy, with the potential to emerge as an alternative to central banking monetary policy. This intention is clear from statements of its creator(s) where they describe the world’s need for a “trustless” asset that is immune from debasement through inflationary central banking policies:
“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”
– Satoshi Nakamoto, February 2009
Gold has historically served this role as an immutable asset. But it has significant drawbacks in the digital age given constraints around portability, storage, security, divisibility and verifiability. Gold is also not hard to confiscate by any authority with the power and means to do so. Satoshi’s intention was to create “digital gold” rather than a mere transactional payment system. Those inclined towards trivia will note Bitcoin’s references to Executive Order 6102 dated April 5th, 1933, whereby Franklin D. Roosevelt forbade ownership of gold coins, bullion and gold certificates: (i) the pseudonymous author of the Bitcoin Whitepaper, Satoshi Nakamoto, states his birthday as April 5th, the same date as the Executive Order, and (ii) the ‘difficulty adjustment’ in the Bitcoin protocol adjusts every 2016 blocks (Order 6102 in reverse). Gold, or rather, digital gold, was unquestionably on Satoshi’s mind. And more crucially, the intention was to create an asset that is immune to debasement or corruption by any governmental or other authority, and which does not suffer the shortcomings of physical gold.
The feature most critical to any store of value is its scarcity. This fact is demonstrated throughout human history by what societies have attributed value to as ‘money’, be it salt, seashells, ivory beads, cattle or precious metals. The scarcer the asset, and/or the more work needed to produce it, the “harder” the asset and consequently, the greater its effectiveness as a store of value. Mark Twain described the relationship between scarcity and value when he observed: “buy land, they’re not making it anymore”. In the words of Nick Szabo, a good store of value should have “unforgeable costliness”. It is a misnomer that gold derives value from its use in making jewelry or industrial applications — in reality, its value is derived from its scarcity and market consensus of its role as a store of value.
The price of an asset over time, and consequently its effectiveness as a store of value, is a function of demand and supply. When demand increases and supply stays constant, that results in higher prices. The higher prices incentivize an increase in supply, which then balances out the price. The increase in supply could arise through greater investment in the supply of the asset, e.g., in the case of gold mining and exploration driven by demand for gold, or by the issuer of the asset simply opening the spigot at will, e.g., in the case of governments and central banks issuing more debt and fiat currency driven by political and economic incentives. Overall, there are varying degrees of ambiguity around the true level of scarcity of such assets.
Now let us consider Bitcoin which is an asset that is not backed by any physical commodity, stock or bond, nor any guarantee or assurance from a private or governmental body. Unlike stocks or bonds, there is no revenue stream on which a financial model may be prepared to calculate a present value of future cash flows. Similar to gold, what gives Bitcoin value is the consensus among the market participants of its integrity and ability to retain purchasing power over time. What imparts integrity to Bitcoin as a store of value is its scarcity, namely, Bitcoin’s hard cap of 21 million coins that is part of the Bitcoin protocol. Unlike with gold or any other commodity, no amount of investment can ever increase the supply of Bitcoin — it is thus the first and only known asset class whose supply is entirely unaffected by its demand. But this 21-million cap is meaningless if not immutable over time and space. How does Bitcoin achieve such incorruptible immutability? It is through the robustness of its decentralized consensus and governance.
Bitcoin’s Immutability
The global monetary system as we know it, is a product of the evolution of money over thousands of years. Today, the world’s banking system has made ledger entries the money of humanity. As a result, “wealth” today takes the form of ledger entries on electronic databases. These electronic databases reside at one’s bank (at a sub-ledger level) and ultimately at the relevant central bank (at the general ledger level). What we take for granted as our store of value is essentially digital entries residing on the server or cloud of a centralized trusted entity. The key element here is trust. If this trust were to ever evaporate for any number of reasons, so will those digits representing one’s wealth.
Bitcoin is originally a product of the cypherpunk initiative to separate money from governments, corporations and other central trusted authorities. In other words, the objective was to disintermediate central banks and the banking system from money by the creation of a peer-to-peer ledger entry system. In the existing monetary system, the trusted central party manages the central ledger and validates transactions for inclusion thereunder. Bitcoin’s solution was to create a decentralized network where all participants come to consensus on the state of “truth” with respect to the ledger at any point in time.
When people think of Bitcoin as “internet money” they typically imagine that Bitcoin’s ledger must reside on a cloud or database on some central server. However, there is in fact no central source of truth for Bitcoin. There is no centralized record where all transactions are posted. Instead, the ledger resides on thousands of personal hard drives of individuals scattered across the globe, known as “nodes”. This makes Bitcoin a decentralized public ledger. The primary technological achievement of Bitcoin was the creation of an incentive structure that ensures that all participants on the network are honest, without the need for a central trusted party to validate transactions. In other words, the protocol operates in a “trustless” manner.
Verification of transactions on the network is performed by thousands of “miners” around the world who anonymously verify transactions. Bitcoin transactions are submitted to the network on an ongoing basis and received by miners who then proceed to verify the transactions to make sure that the sender of bitcoin actually has the bitcoin, is the rightful owner, and is not double-spending the bitcoin. The miner then packages the verified transactions into a “block”. The block is then put through a cryptographical hashing process, and the first miner to complete that hashing process wins the right to add that block to the blockchain. To incentivize mining, such miner receives additional bitcoin once the block has been attached to the blockchain.
A verified and hashed block is published to the thousands of nodes across the world, validated by their software and then recorded on their ledgers. The key point is that no one trusts anyone — each node validates for itself every single transaction from the very first one in 2009, to the latest one today. As a result, if a node records a block that does not follow consensus rules, other nodes will reject it as invalid. It is through this process of independent individual verification and “distributed consensus”, that the Bitcoin network is able to dispense with the need for a central trusted party.
The Bitcoin software operating on these thousands of ledgers stipulates that there will only ever be 21 million coins created. Now consider the question: what would it take to change this 21-million cap, thus destroying the sanctity of Bitcoin’s scarcity?
The only way the cap may be altered is by the nodes updating their software to change the cap. Here, the Bitcoin incentive structure comes into play again. If a given node decides to change the cap to, say, 100 million bitcoins, the node would be free to do so, but that node’s software will no longer be compatible with the remaining tens of thousands of nodes. Therefore, the new coin with a 100 million cap would no longer be “bitcoin”. By analogy, if you were to change the rules of chess, you would be free to do so, but no one would play with you. Besides, by increasing the cap, a node would effectively be diluting the value of its own coins, and therefore, would have no economic incentive to take such an action. This powerful incentive structure forms the basis for Bitcoin’s incorruptible immutability.
Bitcoin’s Inimitability
Is it possible to improve upon Bitcoin’s system for achieving decentralized consensus? Experts in the field, such as Dr Adam Back, have noted that there is virtually no room for further improvement of Bitcoin’s fundamental design. According to Dr Back, “by curious happenstance, bitcoin exists in a narrow optima in the near infinite design space”. However, any open-source technology, even if perfect, is always open to being copied. Bitcoin would need to be a ‘once-in-history event’ to be truly inimitable. According to Jack Dorsey, founder and CEO of Twitter and Square, replication or replacement of Bitcoin is “extremely unlikely since the conditions needed to create and sustain it were very special”.
To understand the power of Bitcoin’s inimitability, it is necessary to appreciate Bitcoin as a “path-dependent one-time-invention”. Bitcoin is much more than the Bitcoin Core software that the protocol runs on, which is all too easy to copy. Bitcoin is the network of over 100,000 nodes, over 1,000,000 miners, over 100,000,000 users, and billions of dollars of mining equipment spread across the globe, built organically over 13 years, and now securing a trillion dollars of wealth.
As Robert Breedlove notes, path-dependency means that the sequence of events matter as much as the events themselves. Any new cryptocurrency trying to compete with Bitcoin today would have, by comparison, extremely weak security as its miner network and hash rate would be vastly lower than Bitcoin’s. Given the industry’s awareness of how blockchain technology works, the new coin would be attacked by incumbents if it ever threatened Bitcoin. Path dependency prevents Bitcoin from disruption as the organic series of events that led to its release and assimilation into the marketplace cannot be replicated.
Furthermore, network effects and Metcalfe’s law would make it impossible for Bitcoin to be dethroned from its current position. Investors would be incentivized to hold the asset with the greatest liquidity, security and network effects. Jeff Booth has argued that in order for an existing network to be disrupted, a new competitor must be 10 times better. Because the existing network gives the incumbent such a large entrenched advantage, a new network cannot just be a little bit better — it has to be an order of magnitude better to get users to switch over. When it comes to a store of value function it would be virtually impossible to improve upon Bitcoin’s scarcity, portability, verifiability, durability and divisibility to such an extent that it provides a 10 times improvement on Bitcoin in order to disrupt it.
A Comparative Analysis
Let us look at the primary features that contribute to Bitcoin’s immutability and inimitability and compare these aspects to other cryptocurrencies, and in particular, the second largest cryptocurrency, Ethereum:
ADecentralized Decision-Making:
The existence of a founder and leadership team are antithetical to decentralized governance. In light of this fact, the circumstances under which Bitcoin was conceived are remarkable. “Satoshi Nakamoto” is the fictitious profile of a Japanese male, born on April 5th, 1975 who claimed to be living in Japan at the time when the Bitcoin Whitepaper was posted on an online forum. On April 23th, 2011, the pseudonymous operator of the account stated he had “moved on to other things”, and shortly thereafter, disappeared. There has never been any reliable information about his/her/their whereabouts since. While this entire story might seem suspicious and dubious, the final result is what matters: Bitcoin has no founder or leader. It never has and never will.
Compare this to other cryptocurrencies including Ethereum, which has Vitalik Buterin, who commands a god-like status within the Ethereum Foundation (not to mention the self-contradiction of a “foundation” running a purportedly decentralized network). Virtually every single other cryptocurrency has founders, a leadership team, sponsors, seed investors and other key stakeholders. The absence of leadership matters for decentralization because leadership brings influence. Vitalik Buterin enjoys overwhelming influence over the future of Ethereum which detracts from the immutability of the protocol. He has changed Ethereum’s monetary policy multiple times within its short lifespan. On the other hand, Bitcoin has no specific individual(s) who can strongly influence its monetary policy, and in thirteen years of history, it has not been changed.
Bitcoin’s only decision-makers are the economic users of the network who maintain and validate copies of the entire Bitcoin blockchain, i.e., the nodes. It is estimated that there are over a hundred thousand nodes across the globe. The largest share of these nodes are in the United States (approx. 19%), followed by Germany (approx. 18%); China has a little under 2% of the nodes. The number of reachable nodes is estimated to be approximately 10,000, while the grand total of nodes globally is estimated to be in excess of 100,000. One feature of Bitcoin that has enabled such a wide distribution of fully validating nodes is the small size of Bitcoin blocks. When an individual sets up a node at home, they will be required to download the entire blockchain, which is currently in the region of 700,000 blocks. Each individual block is less than 1.5 megabytes in size. As a result, the entire blockchain is only about 350 gigabytes. This is a size that can be accommodated at home at a relatively low cost. Any individual with a basic internet connection and a laptop, located anywhere in the world, can download the entire Bitcoin blockchain, validate blocks, and have a stake in the protocol’s decentralized consensus. The trade-off in having small block sizes is that there is a limit to the number of transactions that may be processed. But Bitcoin’s nodes have made a conscious decision to prefer decentralization over transaction volume or speed.
By contrast, in the case of Ethereum, a regular cost-conscious individual would be unable to partake in the consensus process. With Ethereum 2.0, only “super full nodes” have the entire transaction history. A super full node will require a large amount of investment into computing and network infrastructure which will be beyond the means of most individual users. Smaller entities will have to trust that these super full nodes are acting honestly. Ethereum also places a large degree of reliance on third party large scale node operators like Infura. And Infura uses Amazon Web Services, which compounds the degree of centralization. This creates risks of single-point-of-failures. In November 2020, this risk played out when Infura faced a major service outage. The outage caused a delay in price feeds to Ethereum tokens. Many exchanges had to temporarily stop allowing withdrawals of Ethereum tokens. This sort of centralization also creates vulnerabilities whereby a powerful entity may attack, coerce or influence the network.
In an attempt to mimic Bitcoin’s 21 million hard cap and scarcity thesis, Ethereum 2.0 is expected to have a deflationary monetary policy whereby coins are removed from the system over time, thus making it increasingly scarce. Ethereum’s leadership, however, may be missing the central issue here — the hardness of an asset arises from its immutability. The fact that Ethereum is changing its protocol to this deflationary system does not help its case for being a ‘hard’ monetary asset, but rather, hurts it. Ethereum’s history shows several instances where the protocol was changed or influenced, including in 2016, when a large number of coins were invalidated in the aftermath of a hack, which resulted in the network forking to form Ethereum Classic. By definition, if you have changed your protocol even a single time, you cease to have the privilege of calling it immutable. There is no second chance. In the case of Ethereum, it has changed its monetary policy over a dozen times. Its case for immutability is consequently, beyond redemption.
Proof-of-Work Versus Proof-of-Stake:
As discussed, miners compete to verify transactions for inclusion on the blockchain. The incentive structure governing Bitcoin’s miners is referred to as Proof of Work (“PoW”). In order for the system to work in a trustless manner, this incentive structure needs to deter dishonest behaviour on the part of the miners and enforce the integrity of the network. How does PoW achieve this?
Firstly, miners must incur significant upfront cost to secure the network, and are only paid if the blocks they mine comply with the software on the nodes. If a block is invalid, the miner receives no reward and therefore would be out-of-pocket with respect to the expenses incurred in mining that block. This incentivizes the miner to only mine valid blocks.
Secondly, nodes still validate every block independently, and have the ability to invalidate blocks in the event of a theoretical coordinated attack by miners (referred to as a “51% attack”). It is thus said that miners do not control Bitcoin, but rather, are the paid servants of the nodes.
Thirdly, Bitcoin’s PoW mechanism fosters multiple layers of decentralization including, for example, on the geographic front and the temporal front:
(i) Since miners are always seeking out the cheapest sources of energy, and the best technology, there is invariable dispersion of miners across the world, i.e. geographic decentralization. Thus, even if miners were attacked in one jurisdiction, miners in other parts of the world will ensure that the network continues on unaffected. This scenario is currently playing out with China’s unprecedented ban and crackdown on mining operations located in the country (which at one point represented approximately 75% of global hash power, but has now dropped to below 46%). While such a large proportion of bitcoin miners were abruptly shutdown and forced to relocate, the network experienced zero downtime, only experiencing slightly delayed block times for the brief period until the next hashing “difficulty adjustment” on the network.
(ii) The ASIC computers used for mining Bitcoin are specialized hardware that is costly and limited in supply — it would likely take 2 to 3 years to set up a material mining operation anywhere in the world, and it would involve acquiring the equipment of existing miners since new supply is limited. This achieves temporal decentralization since in the event that a potential attacker (attempting a “51% attack”) started amassing the equipment over such a long period, network participants would invariably be alerted and put in place a defence plan. PoW introduces a mechanical and physical element into the digital asset. Mining is thus the connection Bitcoin makes from the digital realm into the real world.
Now let us turn to other cryptocurrencies. Firstly, while Bitcoin’s PoW requires ASIC computers which are costly and have physical limitations on supply, most other cryptocurrencies including Ethereum requires GPUs which are cheap, general purpose and abundantly available. It would be vastly easier for an attacker to buy an immense amount of cloud GPU power for a brief period, and carry out a 51% attack on Ethereum 1.0. Recognizing these limitations, Ethereum 2.0 is expected to move to a Proof of Stake (“PoS”) model sometime imminently, though a date is yet to be confirmed.
How does PoS work? While PoW rewards its miners for solving a mathematical hashing problem, in PoS, the entity that has “staked” the most Ethereum tokens on the network, gets to validate transactions. The stakeholders who stake their coins and validate transactions earn a transaction fee in the same coins. PoS randomly chooses the winner based on the monetary amount they have staked. The important point here is that your chances of earning transaction fees is linked directly to the percentage of coins you have staked, i.e. your wealth. So in other words, the “rich get richer”, and over time, the system will inevitably trend towards centralization.
Proponents of PoS would retort that Bitcoin’s PoW suffers a similar drawback since mining requires expensive equipment and expenditure which is concentrated among a handful of mining pools. However, this misses a critical nuance to the argument. For the incentive system to work effectively, it would need to discourage dishonest behaviour. As we have seen, with PoW, if there is a dispute about which block is the latest, a miner can only work on one of them at a time, and the longest blockchain ends up getting accepted by the majority. Where there are two competing chains developing, miners have to choose which chain to follow when they commit processing power to mine new blocks to add to it, and ultimately, the chain with the majority of miners contributing blocks to it will prevail. And the shorter chain will be discarded — miners that contributed processing power to it would have wasted their money. Thus with PoW, there is a cost to being wrong or dishonest. The problem with PoS is that there is no cost for simultaneously verifying transactions on multiple chains. Rather than contributing to one chain, someone with a stake can verify all splits on the chain simultaneously, since there is inherently no cost to being wrong.
In order to punish dishonest behaviour, Ethereum 2.0 is expected to have a mechanism whereby Ethereum tokens are removed from validators that acted dishonestly or improperly. However, as Andrew Poelstra has observed, the inherent problem with this system is that the penalty system depends on resources within the system. Unlike with PoW mining where a miner expends external costs in the form of mining equipment and energy spend, PoS depends on the very history it is trying to form to enforce loss of value. Even if stakeholders are staking coins with a large market value in a way that they will lose the coins if they behave dishonestly, this is only a deterrent to dishonest behaviour until they move their coins. And once they do so, they no longer have anything at “stake” in enforcing the truth of historical transactions. As soon as the staked coins are unbonded from the related keys, it would theoretically be easy to fork the network and create a new history.
PoS proponents argue that any such dishonest revision of history post facto is sure to contradict the history as remembered by participants in the system, and thus, such an attack would be detected, and the new dishonest history rejected. The problem here though, is that new users who encounter multiple histories are no longer able to distinguish them on their own — they need to ask existing participants in the network which history they know to be the true one. This is thus no longer a trustless system as Bitcoin is. New users and users that were temporarily offline will always have to trust others to get the latest record of transaction history. And since PoS by its nature enables multiple “cheap histories”, this creates significant vulnerabilities.
Another shortcoming in PoS that Andrew Poelstra has pointed out is that it provides a stakeholder the incentive and ability to pick transactions that direct or skew the history of transactions towards one which gives the same stakeholder more reward. This again causes the system to trend towards centralization. A dishonest stakeholder may skew the stake selection of future blocks or even worse, censor transactions which might have otherwise increased the set of stakeholders.
To illustrate the inherent flaws in a PoS system, a simple thought experiment is helpful. Imagine if you were launching a new coin. The main challenge would be in the dispersion of the coin as far and wide as possible, in a fair manner. If you utilized a PoS system, you would have to do a “pre-mine” and issue the coins to a select group of initial holders (who are invariably going to be the founders of the coin), who would then propagate the network by staking these coins. This is obviously a manifestly unfair system given the initial nepotistic coin allocation. In the event the coin gets traction in the market and there are secondary buyers at high prices, these initial holders will subsequently have a windfall when they sell their coins for cash. Aside from the inherent unfairness, it also potentially raises legal issues since its similarities to an illegal securities offering would be unavoidable. By contrast, in the case of Bitcoin’s PoW system, every single coin ever issued, was issued in exchange for the expenditure of energy in the mining process.
Finally, it should also be noted that PoS is still an experiment. With any new security model, it takes years to prove attack resistance. Further, the more complex a structure, the more potential surprises. It is thus virtually impossible to make a case that PoS is in any way superior to Bitcoin’s battle-hardened PoW system that has proved incredibly robust over a 13-year period (which is eons in the technology world).
Blockchain Fallacies
There is tremendous technological progress taking place around us and changing the world beyond recognition. However, where this innovation is taking place on purportedly decentralized blockchains by strapping on utility tokens with purported monetary value, it is necessary to stop and answer two questions: (a) does the project really require a decentralized monetary token, and (b) assuming it does, then is the said blockchain in fact truly decentralized.
Let us consider the first question. We know that decentralization is critical to Bitcoin’s value proposition as a monetary asset to prevent inflation of its supply. According to Parker Lewis, all any blockchain can offer in return for security is a monetary asset native to the network. Where the system depends on enforceable claims outside the network, in the physical world, a blockchain does not really help. That is why a decentralized blockchain is only useful in the application of money or as an immutable store of value, where the blockchain achieves nothing besides securing its own immutability.
We see application of blockchains in the video-gaming industry in the creation of virtual items or “skins”, for example, in the art world with non-fungible tokens, and most importantly, in the burgeoning field of decentralized finance (“DeFi”), attempting to replicate the financial system on a “decentralized” protocol. Blockchains supposedly provide censorship resistance and the ability to theoretically avoid KYC checks that centralized and regulated exchanges would require. Do these use cases, primarily around resistance to de-platforming and KYC-avoidance, justify a trillion dollar plus industry? Maybe they do or maybe they don’t. But the often overlooked aspect here is that due to their pseudo-decentralization, these purported benefits are actually a mirage. As we have discussed earlier, being built mostly on Ethereum, they are still subject to several single points of failure and are vulnerable to attacks by authorities seeking to censor or enforce KYC regulations, etc.
It is important to acknowledge that decentralization normally comes at a cost. One of the best kept secrets of the crypto industry is that putting something on a blockchain is typically much more inefficient than having it explicitly on a centralized database. A blockchain generally makes the service expensive (ETH gas fees are notoriously exorbitant), slower and with a worse user interface when compared to what is possible on a centralized system. It is more expensive to run a project on Ethereum than on, say, Amazon Web Services. Market participants and users are recently beginning to catch-on to this reality. For example, Binance Smart Chain, a centralized protocol, surpassed Ethereum in daily transaction volume and unique active wallets recently, given soaring transaction costs on Ethereum in early 2021. Besides, with any utility token, given switching costs are so low, there is always a risk of disruption. E.g., users of Tether are overwhelmingly switching to TRON recently from Ethereum, for cost reasons. Many utility tokens are analogous to casino chips: you might need them to play roulette while at the casino, but you would not take them out of the casino and store your wealth in them. What many crypto projects are attempting to do is akin to a casino claiming that their $10 chips from their roulette table are scarce monetary assets.
Why do projects continue to strap on blockchain-based tokens notwithstanding our conclusions from the prior sections? The main reason is essentially to free-ride on the success of Bitcoin as a scarce store of value. By associating with Bitcoin and pretending to be part of the same “blockchain space”, other cryptocurrencies get swept up by the engine of Bitcoin’s price action. Speculative manias across the entire industry are virtually 100% correlated with Bitcoin’s bull and bear market cycles. This is exacerbated by many large investors and asset managers having “crypto allocations” whereby they acquire other cryptocurrencies as a misguided means of diversification away from the primary investment target, which is Bitcoin. There is thus a huge incentive for crypto projects to jump on the decentralization bandwagon and “put lipstick on a pig” by dressing up their centralized project tokens as decentralized scarce assets. This strategy has proved stupendously profitable for founders and promoters of these tokens. The unfortunate consequence of this is that Bitcoin’s reputation gets tainted by the numerous scams and shenanigans across the industry. Consider Dogecoin, a cryptocurrency whose creator set it up over a few hours as a joke and shortly thereafter, completely abandoned the project. The coin nevertheless has a market capitalization in excess of $50 billion. It is all too easy for an outsider, looking at the crypto industry as a whole, to paint Bitcoin with the same brush as Dogecoin, i.e., as a joke and a bubble. As Alyse Killeen has commented, “if other cryptocurrencies succeed, it will be because of Bitcoin; and if Bitcoin succeeds, it will be despite other cryptocurrencies muddying the waters”.
The other reason is that many of these tokens aim to avoid registering as securities offerings by attempting to walk a blurry line in structuring the token as purportedly decentralized. Prof. Angela Walch refers to this as the “Veil of Decentralization” which, many token promoters believe, grants immunity from securities regulations. The reality is that most cryptocurrencies, beside Bitcoin, have a medium to high risk of prosecution by securities regulators, as illegal securities offerings. This determination in the U.S. is based on the “Howey Test” — in SEC v W.J. Howey Co., the U.S. Supreme Court held that an investment contract exists where there is “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter, sponsor or other third party”. With respect to most cryptocurrencies other than Bitcoin, there is always a blur around questions of the existence of an “investment” in a “common enterprise” with an expectation of profits from the efforts of “promoters, sponsors or other third parties”. Ethereum was “cleared” on this front in a speech by William Hinman, Director of the SEC’s Division of Corporate Finance, but in a somewhat backdoor way, which some commentators have referred to as the “Hinman puzzle”. Hinman’s suggestion was that Ether was initially offered as a security, but subsequently ceased to be a security. This analysis has come under a fair amount of criticism for its ambiguity. However, other tokens may not benefit from such a degree of leniency and there is always a risk of post facto recharacterization. Several crypto promoters have already been prosecuted and this may well continue. The most high profile of these prosecutions is the ongoing case against Ripple Labs involving their XRP token.
The Signal and the Noise
What is the value of an inimitably immutable monetary asset with absolute scarcity? Here is some food for thought:
On 8 November 2016, the Government of India announced that Indian bank notes of certain denominations would no longer be valid. Not only did the notes of those specific denominations become valueless, the very act of possessing them was criminalized. Holders would need to swap their invalid notes for new ones within a limited timeframe. In effect, the Indian Central Bank’s “Promise to Pay the Bearer” of the specific notes was invalidated and annulled unilaterally. The merits and demerits of this step taken by the Indian Government with the stated objective of combatting black money, are beyond the scope of this paper. But this incident is a stark reminder of the ability of not just the democratically elected Government of India, but any government or central bank, to invalidate over a televised speech, the asset where you might store your life’s savings.
In the United States, the Federal Reserve has printed approximately 70% of all US Dollars since 2008. In other words, each US Dollar we hold has been diluted to approximately 30% of its initial value in absolute terms, over the last 13 years. Debates over the true impact of increasing M2 money supply and disagreements between proponents of Austrian Economics and Modern Monetary Theorists are also beyond the scope of this paper. But this is just an objective description of how the United States central bank operates: a group of seven individuals appointed as Federal Reserve Governors meet in a private meeting room and make unilateral decisions to dilute, to a very substantial degree, the asset that currently serves as the world’s reserve currency.
Bitcoin’s inimitable immutability is an instrument of freedom offering an escape route or “hedge” against such actions by governments and central banks. The point here is that immutability is only achievable with the magic ingredient of truly uncompromising decentralization. If you have to rely on founders, foundations, centralized databases, or wealthy incumbent stakeholders who are able to skew the system in their favor, then the magic is lost. Anything short of uncompromising decentralization is a blockchain fallacy since what you are left with is a project that is not immutable, is slower, more expensive and less efficient than a centralized competitor. I.e., a project that may as well be, or rather should be, run out of a company with a formal management team, board of directors, shareholders and centralized databases. As Nick Szabo, observes, “if you’re going to invest in something centralized, you should invest in a financial system that has 100s of years of institutional history behind it [i.e. the stock and bond markets], not in centralized systems pretending to be decentralized, or in novel lord-of-the-flies governance notions”.
If we accept the inimitability of Bitcoin’s decentralization, then it would make sense to build the entire “digital economy” on the back of Bitcoin rather than have thousands of tokens masquerading as monetary assets. We are seeing strides on this front with development on Bitcoin’s “upper layers”. For example, RSK and Stacks are protocols built on top of Bitcoin that can bring smart contracts and DeFi to Bitcoin’s network, using Bitcoin as the settlement layer. In November 2021, Bitcoin will adopt a substantial software upgrade known as Taproot, which will significantly improve the malleability and programmability of the protocol, unlocking the potential for cheaper and more complex smart contracts. Bitcoin will thus be able to offer a lot of the functionality and programmability of Ethereum, for example. The main difference being that the former will be built on the rock of decentralized immutability and the latter built largely on the sands of decentralization fallacies.
Bitcoin’s immutability through inimitable decentralization is a democratic tool that takes power away from any central authority and disperses it across thousands of nodes and miners spread across the world, brought together by a unique incentive structure designed to preserve the security and scarcity of the asset. This is a paradigm shifting and path-dependent one-time invention that is more profound and far-reaching than the rest of the crypto industry combined. It would be a mistake to conflate them.
“And the end of all our exploring
Will be to arrive where we started
And know the place for the first time.”
- T.S. Eliot
At the start of this paper we discussed the perspective of an individual entering the crypto industry for the first time, starting with Bitcoin and then being distracted by other cryptocurrencies along the way. If such person were to continue with their journey, performing an honest inquisition at every stage, they will eventually come a full circle to arrive right where the journey began: Bitcoin.
*The views and opinions expressed in this paper are attributable to the author alone and not to any other party or organization that the author may be affiliated with.
** References to “blockchain” throughout this paper refer only to public blockchains using distributed ledger technology, and not to private blockchains which are not relevant to the subject matter.
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