The Centralization of Bitcoin
Over the last 3 years, Bitcoin has been centralising into the hands of a select few organizations. The use of Bitcoin for transaction settlement is also changing — Bitcoin is moving off-chain.
Summary
- Bitcoin’s primary use cases today point towards centralization
- More Bitcoin is now stored on centralized platforms than ever before, up 700% in less than 3 years.
- More transactions are completed off-chain than ever before. Exchange based volume is 300% greater than daily on-chain volume
- Bitcoin as a currency requires off-chain protocols and asset centralization with 3rd parties… and yes, you can buy coffee with Bitcoin
- The fate of Bitcoin as an institutionalized or decentralized asset may be decided by a race between technological development and mass public adoption
- Be wary of “promises to pay the bearer”!
The Centralization of Bitcoin
In “The Bitcoin Standard”, Saifedean Ammous talks to a future of Bitcoin used in inter-bank settlement. Saifedean notes Bitcoin’s suitability for this role due to its hardness of supply. No one can change Bitcoin’s extremely low inflation rate. Further, Bitcoin’s ability to settle international transactions with finality, in under an hour and at low costs is something no traditional settlement processes can achieve today. Saifedean’s argument is compelling.
He may well be correct.
Over the years, many use cases have been put forward for Bitcoin. This article explores two of the most popular use cases today and how current technology development and adoption is tending towards the centralization of Bitcoin for both. These are:
- Bitcoin as an Asset
- Bitcoin as a Currency
The era of Bitcoin institutionalization has begun.
Bitcoin as an Asset
Trend 1 — Off-chain transactions have outgrown on-chain transactions
Bitcoin’s Massive Volume Growth highlighted Bitcoin’s growing trading volume. That growth is more prominent when compared to the volumes Bitcoin's blockchain moves.
In 2017 Bitcoin’s daily average spot market transaction value represented just one quarter of the total on-chain transaction value.
Fast forward to 2019 and Bitcoin’s daily average spot market transaction volume has quadrupled in size relative to the on-chain volume. Daily spot transactions are now 10% greater than the daily average on-chain transaction value.
Add derivatives to the mix and Bitcoin’s total daily trading value is more than 300% larger than the total value transferred on the blockchain.
[Source: TradingView “Bitcoin Real Volume”]
We know the value of on-chain transactions has not dropped below pre-2017 levels. A higher relative portion of exchange-based transactions suggests Bitcoin is entering the era of high frequency trading. With traders moving in- and out- of Bitcoin positions many times per day.
Alameda Research, for example, has stated it is responsible for 5% of Bitcoin’s Global daily trading volume alone with just $100M of capital.
Off-chain trading volume today is magnitudes greater than on-chain volume.
Trend 2 — More Bitcoin is Centralising on Major Exchanges
Related to the rapid growth in trading and contrary to the Bitcoin Maximalist mantra of “owning your own private keys”, Bitcoin is rapidly centralizing on major exchanges.
Research by TokenAnalyst found that as of October 2019, 6.7% of Bitcoin is stored on the top 10 exchanges. This is just based on known Bitcoin address ownership, many other addresses cannot be easily linked back to a central owner/exchange, suggesting the actual figures are likely much higher.
In less than 3 years, Bitcoin stored on exchanges has grown over 700%. Through bull and bear markets, more and more Bitcoin is being concentrated on centralized platforms.
[source: TokenAnalyst.io]
Trend 3 — Putting Assets to Work
Most investors want to earn an additional rate of return on their assets by putting them to work. For a Bitcoin holder today, there are already over a dozen loan platforms offering the ability to earn a passive rate of return. Nexo, for example, has processed over $1B in crypto-backed loans in its short 18 month life.
With most of these loan platforms offering around 8% p.a. in 2019, it’s easy to understand the attraction and hand your Bitcoin over to an institution to manage.
Bitcoin as a Currency
Bitcoin’s strength in on-chain settlement immutability is also its weakness as a high-speed payment platform. Bitcoin’s blockchain processes just 5 transactions per second versus Visa’s 1700 transactions per second. However, novel solutions have been developed to enable a Bitcoin currency future.
So far, all involve the centralization of Bitcoin or use of off-chain protocols.
Trend 4 — Spending Bitcoin
Not all exchange volume is driven by pure investment and speculative motives.
Some of that volume may be from the person sitting across the table to you at the café — from consumer spending.
The old argument that it costs more in fees to buy a coffee with Bitcoin, than the coffee costs itself, is now redundant. If you want to use Bitcoin for everyday spending today, platforms such as TenX offer a feasible approach. With TenX’s Visa card, your Bitcoin is instantaneously converted into fiat currencies at the point of sale via interaction with spot exchanges. It is a gateway into our fiat world that enables spendability of Bitcoin (and other currencies) anywhere that accepts Visa globally.
While this might not be a Bitcoin Maximalist approach to solving spendability, until most retailers accept Bitcoin, it is extremely effective.
This is another example of the institutionalization of Bitcoin.
Trend 5 — The Lightning Network
The Lightning Network is Bitcoin’s answer to spendability.
Simply stated; the Lighting Network allows users to transact with one another at ‘lightning’ speed and at low fees. This is achieved by completing payment’s off-chain and only recording to the blockchain when final settlement is required.
With enough users, Bitcoin’s lightning network could be used to purchase anything, anywhere.
The Lighting Network is still in its infancy, with just around $10M locked up in Network Capacity (see below chart). However, despite recent growth reductions, the number of nodes, channels and network capacity are all up over 100% year on year.
[source: Bitcoin Visuals]
If Bitcoin sees widespread adoption as an everyday currency, it will be via applications such as the Lightning Network, OpenNode and other off-chain payment aggregators.
Bitcoin as a currency won’t be Bitcoin on-chain.
Trend 6 — Convenience is King
The above trend points to an interesting phenomenon, despite the industry’s historic risk of hacking and stolen funds, Bitcoin owners are increasingly favouring the liquidity, returns and ease-of-use that centralized platforms offer.
People like the easy user interface that these platforms offer, just like we like home delivered Uber Eats. It’s a much nicer experience logging into a slick website than it is scrambling for private keys or connecting to a Ledger cold wallet, regardless of the inherent risks. Who knows what that Uber driver did to your food anyway!?
The current institutionalization of Bitcoin could be history repeating itself.
Gold has a similar past. Gold is another great store of value through time due to its limited supply, low inflation rate and indestructibility. However, it is heavy, cumbersome and costly to secure and transport. Like Bitcoin private keys, a gold bar in the hand might give a sense of clearer ownership, but it is inconvenient. As a result, through history it made sense to centralize gold into banks and issue receipts and notes “promising to pay the bearer”.
Should Bitcoin achieve mainstream adoption as a store of value, it’s not unfathomable to imagine that many people would rather a “trusted”, insured institution manage their holdings at a secure premise which promises to pay the bearer on demand their Bitcoin.
Institutional Bitcoin backed stable coins, such as Wrapped BTC, should ring warning bells. If such coins were to gain traction in the future due to their 1-to-1 exchangability with Bitcoin, “greater utility”, and perhaps instantaneous transactions and zero fees; think twice. Especially if it is “backed by” a company, regulatory body or central bank.
The Counterargument — Decentralized Finance (DeFi)
In the shadows, there is a growing body of decentralized blockchain enabled financial applications. A new world of Decentralized Finance (DeFi).
DeFi’s purpose is to allow the core function of business interactions to be completed via trust-less and transparent protocols that run without intermediaries. One of the key cases for DeFi is that it allows you to keep your private keys and therefore maintain clearer decentralized ownership among the people.
The greatest use case of DeFi today is Decentralized Exchange (DEX) trading. While growing in use, DEX volumes still pale in comparison to centralized exchanges.
An argument against DeFi today is that none of the existing non-Bitcoin blockchains are truly decentralized. Ultimate power to alter their blockchains, change supply, or wind back undesirable events rests in the hands of centralized foundation team.
Further, while personal management of your Bitcoin private keys allows clearer ownership today, it could carry increasing risk with time. A world of mass Bitcoin adoption where everyone holds their own private keys has its own problems. Imagine if everyone kept cash under their mattress today.
The obvious solution here is personal insurance of Bitcoin private key management.
However, the risk of personal Bitcoin management, and the cost to insurance companies of managing a distributed network of people with Bitcoin, is likely to be greater than the cost of centralized custody in the near-term. This too would sway most people towards institutionalization of their Bitcoin.
DeFi might have great solutions to all of the above in the future. For example, a decentralized autonomous organization (DAO) insurance fund which operates on a blockchain with no central authority could be perfect. This would be a more advanced, trust-less version of NexusMutual. However, this is likely some time away.
While it is possible that today’s trends toward centralization of Bitcoin are just a fad, true decentralized offerings which compete with centralized platforms are some time away.
The Implications of Bitcoin Usage Today
What do all the popular use cases of Bitcoin today have in common?
What do each of the above six trends have in common?
The growing centralization of coins into the hands of a select few organizations and the growing use of off-chain transactions to settle balances of payment.
Centralized investment and trading of Bitcoin is growing strongly and the only solutions to Bitcoin as a currency today involves off-chain settlement or entrustment of Bitcoin with 3rd parties.
The Fate of Bitcoin
With only around 1% of the World’s population using Bitcoin today, the jury is still open on Bitcoin’s centralization. But as of November 2019, primary usage trends point towards it.
The fate of Bitcoin as a centralized asset may end up being a race against the clock. A race between technology development and mass-adoption.
What will come first? The functional development of (and widespread trust in) autonomous DeFi solutions enabling convenient management of Bitcoin privately? Or, will mass-Bitcoin adoption and centralization in existing institutions occur before the technology catches up?
If Saifedean is correct, and Bitcoin becomes the inter-bank settlement asset of the 21st century, we can expect to see a continued movement towards the institutionalization of Bitcoin and ultimately the emergence of the 21st century’s answer to the Gold Standard — The Bitcoin Standard.
It’s worth pondering on a not so distant past. Just over 80 years ago, in 1933, President Roosevelt made private gold ownership illegal. Gold was forced to be turned over to the Federal Reserve in exchange for gold backed paper money at a price of $20.67 per troy ounce. However, when gold ownership was re-legalized in 1974, the price of a troy ounce had risen to $154 and all that 1933 paper money was now backed by nothing.
US Investors who wanted to hold gold long-term from 1933 effectively saw an 87% destruction in their wealth by receiving “gold backed paper” over the following 40 years — all thanks to the US Government.
If Bitcoin does become an Inter-bank settlement asset one day, let’s hope things are different this time.
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CAPRIOLE INVESTMENTS
Quantitative Asset Management
www.Capriole.com
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