Bitcoin Network Analysis

P2P Money & Payment Network

TLDR: This is an excerpt from the book DAOs & Purpose-Driven Tokens where I analyze not only Bitcoin the currency but the whole Bitcoin payment network including its stakeholders and the power structures that emerged between the different network stakeholders over time. The focus of this analysis is less on the technical details, but rather on the social and economic dynamics of the Bitcoin network. For readability purposes I shortened the chapter. It is still very long, so take your time when reading it, or skip to sections you might find more interesting:

“Bitcoin Network” from DAOs & Purpose-Driven Tokens, Token Economy Series, Shermin Voshmgir

The analysis covers following topics:

• How the Bitcoin network started
• Political principles
• Functional design
• Stakeholders
• Token types & token properties
• Economic mechanisms
• Governance, protocol upgrades & network splits
• Power structures
• Purpose & reality of the network

PURPOSE & HOW IT STARTED

The original purpose of Bitcoin — as stated in the white paper — was to provide an P2P electronic cash system that resolved the double-spending problem over the Internet in the absence of traditional financial intermediaries and with lower settlement fees than the current financial system. The hard question that needed to be resolved was this: How can untrusted Internet actors collectively agree on the truthfulness of transactions in the absence of such intermediaries?

Many academics and practitioners had been working on this question for decades. Various forms of private digital money in general, and cryptographically secured P2P money in particular, had been publicly discussed or experimented with in different evolutionary stages since the 1980s. However, there had never been a practical implementation of a P2P network that actually managed to avoid the double-spending problem, without trusted intermediaries guaranteeing finality of payments.

On November 1, 2008, Satoshi Nakamoto appeared for the first time and published the Bitcoin White Paper on a cryptography mailing list, where the intention of Bitcoin was announced and outlined. The proposed solution to the double-spending problem was to (a) combine the concept of P2P networks with economic anti-spam mechanisms (“Proof-of-Work”) and digital signatures to coordinate payment verification in a fault-tolerant and attack-resistant way, and to (b) reward network participants for their network contributions with newly minted Bitcoins.

The released white paper immediately sparked many questions from the mailing list’s participants, and two weeks later, Satoshi distributed a preliminary source code that specified the applied solutions to selected individuals of that mailing list. From what is known today, these individuals started to contribute to improving this first version of the code behind the scenes. On January 3, 2009, the “genesis block,” was mined by Satoshi Nakamoto. It contained a special message in its first transaction (aka coinbase transaction): “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” This message was a reference to a headline from “The Times” newspaper on that day. The mining of the genesis block marked the official start of the Bitcoin network. A few days later, the version 0.1 source code was publicly released by Satoshi on the mailing list, allowing others to begin using and contributing to the network. A combination of timing at the peak of the global financial crisis, the groundbreaking innovation of Proof-of-Work, combined with the mystery around the true identity of Satoshi Nakamoto, probably led to the hype and traction that Bitcoin generated at that point in time and in the years that followed.

It seems that the initial launch of the Bitcoin network was intended as a testnet by Satoshi. At the time of deployment of version 0.1 of the Bitcoin protocol in 2009, it was still unclear whether the economic robustness assumptions — on which Proof-of-Work relied — would withstand manipulation attempts. It was expected that more research and development would lead to a refined Bitcoin protocol, and that a final network would eventually be launched. However, once the testnet went live and Satoshi’s economic assumptions proved to be stable, the Bitcoin network and the Bitcoin asset generated more interest and eventually also economic traction. While the protocol was improved over time, it never left this testnet stage. Eventually, protocol improvements became the subject of political ideologies of how to update the protocol. On top of that, vested economic interests started to emerge, which politicized network upgrades even more.

The innovation that Satoshi had envisioned for Bitcoin did, to a certain extent, unfold within the Bitcoin network itself, but it also started to unfold with every new blockchain protocol that was developed and deployed inspired by Bitcoin’s codebase. The open-source nature of the Bitcoin protocol allowed other innovators to copy and tweak the Bitcoin codebase and start their own public settlement networks for digital values, which had alternative scalability, privacy or versatility features. One can say that Bitcoin sparked a renaissance of research and development of alternative P2P networks, from which the concept of Web3 gradually emerged (read more on this topic in another book of the Token Economy Series titled “Web3 Infrastructure.”)

Satoshi Nakamoto’s online presence and contributions abruptly ceased in 2010. The exact reason why the pseudonymous creator of Bitcoin stopped contributing to the evolution of Bitcoin remains a mystery. The Bitcoin community took over the project’s evolution, leading to the vibrant ecosystem that has made a game-changing impact on the world of money, finance and technology.

POLITICAL PRINCIPLES

Since the identity of Satoshi Nakamoto is unknown, we can only speculate on the real motivation behind Bitcoin’s creation, based on the information trails available on the mailing list and similar online sources. The purpose of the cryptography mailing list, where the ideas were originally discussed, was to investigate the “technical aspects of cryptosystems, social repercussions of cryptosystems, and the politics of cryptography such as export controls or laws restricting cryptography.” When reading through the conversations on that list, one gets the impression that Satoshi’s motivation was more engineering-oriented and less dogmatic than one might expect.

What is certain is that many of those who eventually contributed to the improvement and evolution of the Bitcoin protocol had their own political ideologies, which were often rooted in the cypherpunk movement (which focuses on Internet privacy and Internet anarchy) and/or the libertarian movement (members of which often refer to Austrian Economics as an alternative form of monetary policy).

Today, the spectrum of political beliefs within the wider Bitcoin community varies: more or less libertarian, more or less privacy-oriented, and more or less dogmatic when it comes to interpreting the original intentions of Satoshi. Some dogmatic beliefs such as “immutability (of the chain)” became dominant in the crypto narrative only after Bitcoin was deployed, but were never explicitly mentioned in the white paper itself.

• Disintermediation, decentralization & censorship resistance: Disintermediation through decentralization of governance and operations seems to have been the core principle when conceptualizing Bitcoin. P2P maintenance of the network was considered a means of guaranteeing autonomy from state-based censorship (read more in the book).
• Open source, public & permissionless infrastructure: Satoshi created the Bitcoin protocol as open-source code to provide distributed control over protocol evolution. Maintenance and usage of the network was also designed to be public and permissionless. The idea was that anyone with the adequate skills can contribute to the protocol evolution in a public manner (i.e. become a developer), anyone can use the network as a payment system (i.e. become a user), or become mining node operator and write transactions to the ledger without needing to ask anyone else within the network for permission to do so.
• Irreversible transactions: The term “immutability,” which became a dogma among many early crypto enthusiasts, was not used in the original Bitcoin white paper. Satoshi only wrote about making transactions irreversible, which seems to have been a rather practical decision and not a dogmatic one, because reversing accidental transactions would not have allowed for maintaining a clear consensus on the ledger’s history in a distributed network. Making Bitcoin transactions irreversible was a highly contentious topic among early Bitcoin developers — the trade-offs were clear to everyone involved in the decision (read more in the book).
• Privacy: Privacy was seen as an important political principle. However, the act of publicly broadcasting all transactions — such that the network nodes can reach distributed consensus — was a crucial design feature that was needed to circumvent the double spending problem (read more in the book).

FUNCTIONALDESIGN

Though the concepts of Bitcoins blockchain architecture might sound intuitive in hindsight, this techno-financial system architecture was quite a game changer when it was first introduced. It took early contributors and early adopters some time to wrap their heads around the functional design of the system, and understand why it was necessary to design the system in this way.

The main function that needed to be collectively fulfilled by all participating nodes was to somehow reach consensus over truthful financial transactions in the absence of intermediaries checking privately maintained ledgers, all while avoiding the double-spending problem.

The question was: How can we functionally distribute the process of verifying whether a sender really owns the Bitcoins they want to spend and that these Bitcoins have not been previously or simultaneously spent? This required certain functional design choices to make distributed consensus possible:

• Money could not be represented by a digital file:
  (more details in the book).
• Identification of token holders & digital signatures:
  (more details in the book).
• Peer-to-peer distributed timestamping:
  (more details in the book).

The result of this functional design is a collectively maintained and collectively governed accounting network where all users have equal access to the same data set of all historic Bitcoin transactions in (almost) real time.

Contributions to the network are rewarded with newly issued Bitcoins. The issuance and distribution rules are encoded into the Bitcoin protocol. Bitcoin transactions are publicly verifiable, such that all historic transactions can be traced back to their origin by anyone.

“Bitcoin Stakeholder Analysis” from DAOs & Purpose-Driven Tokens, Token Economy Series, Shermin Voshmgir

Stakeholders

A range of stakeholders influence the Bitcoin network by contributing network services, consuming network services, offering external services, or by influencing the network from the outside. Not all the stakeholders that have materialized over time were envisioned from the beginning. As we will see, they emerged as the economic and political realities of Bitcoin adoption started to unfold.

Mining node operators (aka “miners”): Mining nodes participate in the process of Proof-of-Work, to execute the main function for achieving the network purpose: collective transaction verification and processing in the absence of trusted intermediaries. Mining node operators need to download the client software (or code their own client, given the specifications in the protocol), and install it on a computer (the client). They also need to download the dataset with all historic Bitcoin transactions. Once this is done, this computer/node/client can communicate and coordinate with other mining nodes via the process of Proof-of-Work, by competing for the right to create new blocks, adding transactions to the ledger and scooping the block reward. In addition to the block reward, miners can also earn transaction fees. Mining nodes are the only stakeholder group that can actively vote on changes to the network rules.

Full node operators (aka “full nodes”) were not conceptualized as an independent stakeholder in the white paper. They emerged over the years, as operating mining nodes became a profitable business and started to require expensive special-purpose hardware in the form of CPU, so one could compete in finding the pseudo-random number of the Proof-of-Work puzzle. More and more people started to operate Bitcoin clients that only contained the data-set with all historic Bitcoin transactions, but without participating in the process of Proof-of-Work. Operating a node with only the full ledger data does not require special-purpose hardware and can be done on any home PC with standard processing hardware. It allows the operators to verify the integrity of transactions when receiving Bitcoins and when they are being added to the ledger, without having to rely on any third-party service. Verifying transactions is an independent function from Bitcoin mining, but it is not independently incentivized with a network token, since such functional independence was not conceptualized when the Bitcoin protocol was being designed. Eventually, the number of full node operators declined, and only individuals and institutions that sent and received frequent Bitcoin payments started to operate their own full nodes for independence, security and quicker transaction verification. At the time of writing this book, operating a full node has become a software service, which is often outsourced to specialized service providers. Fewer and fewer people and institutions are managing their own full node anymore. This has reintroduced principal-agent problems, which Bitcoin’s creators wanted to eradicate in the first place.

Mining pools are another stakeholder group that were not envisioned at the inception of the protocol. They emerged over the years as individual miners began to collaborate. They pool their CPU (Central Processing Units) such that the collective of miners have more cumulative hash power than each miner participating in the pool would have on their own. This way, the pool participants can boost their chances at being the fastest entity to solve the puzzle and write a block of transactions to the ledger, all without needing to operate their own full node. Only the mining pool operator needs to maintain the whole data set of all historic transactions.

Light nodes (or SPV nodes): In the white paper, Satoshi envisioned that certain computers, such as smartphones and other small devices, would not be able to maintain the whole ledger and would only be able to participate in a process of “simplified payment verification” or “SPV.” Light nodes were designed to only store copies of the block-headers of all the transaction blocks. They cannot verify transactions autonomously and have to trust the information given out by other nodes who run the full ledger on their computers.

Users aka Bitcoin holders: Any individual or institution owning Bitcoin is a user of the Bitcoin network and can send and receive Bitcoin P2P, by using a Bitcoin client with a Bitcoin wallet. The act of sending Bitcoins requires the payment of a network transaction fee, which is conducted in Bitcoins and is directly paid to mining node operators. In the very early days of Bitcoin, all users operated full nodes and also participated in the process of Proof-of-Work. Eventually, some users stopped participating in the mining process and only operated full nodes for sending and receiving Bitcoins. As both Bitcoin and mobile phones became more popular, more and more Bitcoin holders started to migrate to mobile wallets (which are light nodes) or began to manage their Bitcoins over special hardware devices (hardware wallets). In all of these cases, they kept full control over their private keys, and therefore full control over their assets. Today, however, most Bitcoin holders have outsourced the management of their Bitcoins to third-party financial services providers and have no control over their private keys and therefore their Bitcoins. As a result, most Bitcoin payments today are not conducted P2P anymore. Bitcoins are predominantly sent and received using intermediary services — such as merchants, exchanges and banks — without the Bitcoin holder operating their own Bitcoin node.

Custodial wallet operators (exchanges & banks): When Bitcoin was conceptualized, it was assumed that everyone would operate their own Bitcoin client on their own hardware device. As previously mentioned, reality unfolded quite differently. Most Bitcoin owners today do not mine Bitcoin. Instead, they buy Bitcoins from centralized financial service providers, such as centralized exchanges or traditional banks, who manage the Bitcoins of their customers on their private servers. Unless these customers withdraw their Bitcoin into their own self-hosted wallets, they can only access their Bitcoins via custodial wallets operated by their service providers — without access to the private key and therefore without autonomous control over their assets. This defies the whole purpose of Bitcoin as P2P money. Adding insult to injury, these service providers very often do not operate Bitcoin full nodes to verify sending and receiving transactions anymore. Instead, they use the specialized services of companies such as “Blockdeamon” (a full node service provider) or “Fireblocks” (a wallets-as-a-service provider). Not only does this reintroduce the principal-agent problem — when exchanges and their service providers go bankrupt or are hacked — it also means that on top of the Bitcoin network transaction fees, the senders of Bitcoins now also need to pay additional management fees to the banks or exchanges managing their Bitcoins, who in exchange pay service fees to the full node operator and wallet as a service providers.

Software & hardware wallet developers: Wallets are Bitcoin applications that provide a user interface for Bitcoin users. These wallets can be software-based or hardware-based and charge a fee for their services. Software wallets can be downloaded on computers and mobile devices, while hardware wallets are special-purpose devices, in the size of a USB stick. Both software and hardware wallets act as a keychain for one’s Bitcoins (and other crypto assets). Hardware wallets are considered much safer than software wallets that are operated on a regular computer or mobile phone. The main purpose of any wallet is to keep one’s private keys — that allow access and control of one’s Bitcoin — offline and away from the Internet. In the early days of Bitcoin, people stored their private keys on their computers or mobile devices. This approach came with risks, as malware or hackers could potentially compromise these devices and steal the private keys. To resolve this issue, independent developers began creating hardware wallets for non-tech users. They empowered Bitcoin users to manage their Bitcoins in a sovereign and safe way. With the emergence of alternative cryptocurrencies, the need for wallets with multi-blockchain capabilities has grown, since users are not likely to use different applications for each different token they own. Today, wallet providers increasingly offer interfaces with exchanges and other DeFi protocols and CeFi services. They have also gained market power as an on-ramp and off-ramp to more traditional financial services. Wallet providers can influence innovation, industry standards and user adoption — shaping the behavior of users and the practices of other service providers.

Token exchanges & banks: When Bitcoin was first deployed for test reasons, many network functionalities were not conceptualized or implemented yet — such as exchanging Bitcoins for other currencies or assets. The original founders and contributors probably never expected that enough people would be interested in exchanging their Bitcoins or using it for payments, at least not for the foreseeable future. However, as more and more people started to experiment with the network — installing their own nodes, contributing to Proof-of-Work and mining Bitcoins — the demand for exchanging Bitcoins for other digital currencies such as Linden Dollar (the currency of the virtual reality platform “Second Life”) or fiat currencies grew. Second Life already had the means to exchange their virtual currency, the Linden Dollar, for U.S. Dollars. It soon became a gateway for Bitcoin holders to exchange their BTC to USD via Linden Dollars. Eventually, other websites that offered dedicated exchange services in one form or another started to emerge. They became the market makers for BTC, and for the first time, allowed outsiders with no technical know-how to buy Bitcoins without needing to operate a mining node to earn Bitcoin via the process of Proof-of-Work. The possibility of simply buying Bitcoin raised the demand for the asset and influenced Bitcoin’s price. Various forms of exchanges started to emerge — first centralized and eventually decentralized exchanges. Today, many traditional banks also offer custodial services for Bitcoins. Early 2024 Bitcoin-based Exchange Traded Funds were authorized and introduced in the U.S.A (read more about exchanges in another book of the Token Economy Series titled “Money, NFTs & DeFi”).

Merchants accepting Bitcoins: Any merchant accepting Bitcoins as a method of payment is a market maker for the adoption of Bitcoin for day-o-day payments. They have the power to make or break the market for Bitcoin as a medium of exchange. Today, these merchants can either operate their own full node and wallets, or they can use third-party service providers for full node operation and wallet management, in which case they lose autonomy over their Bitcoins. Merchant adoption also depends on the legal status of Bitcoins in the country where the merchant operates. Countries with a high inflation rate or state-based Bitcoin acceptance tend to have more merchant adoption — legally or illegally — than other countries.

External policymakers: Even though nation-state-based policymakers are external to the Bitcoin ecosystem, they regulate the market viability of Bitcoin within the boundaries of a nation state and can sanction Bitcoin developers, users, exchanges, merchants and other internal and external service providers. Policymakers make or break the local market for Bitcoin both through non-regulation (creating uncertainty for entrepreneurs), Bitcoin-friendly regulation or through prohibitive regulation. While it is true that the Bitcoin network is geographically decentralized, and cannot be unilaterally censored by nation state-based legislation in one country only, the users and service operators on the edges of the network can always be sanctioned by local lawmakers. Mining node operators, users, service providers and the market makers that interface with the real world are subject to nation-state-based regulation and can be coerced into not accepting Bitcoins as a method of payment, not exchanging Bitcoins for other currencies, not developing code, not operating a node or not buying Bitcoins.

Chain analytics companies: The emergence of blockchain data analytics services such as “Chainanalysis” has also changed the dynamics of the Bitcoin ecosystem. These privately-operated companies analyze all publicly available transaction data of the Bitcoin network and correlate it with outside data points. They can identify economic data flows, individual spending patterns and ultimately also the identity of special interest wallets that might be relevant under anti-money laundering regulation, etc. This has made anonymous transactions quasi-impossible. Using flagging techniques based on chain analytics, regulators can coerce banks and centralized token exchanges to freeze the assets under anti-money laundering and similar regulation, and impact the fungibility and general acceptance of Bitcoins.

Protocol developers are individuals who contribute to the improvement of the Bitcoin protocol. They are the internal policymakers of the Bitcoin network. Developers conceptualize the network rules in code, discuss them over various social media channels, and eventually make Bitcoin improvement proposals that can be adopted by the community of miners (or not). The Bitcoin protocol has no native reward mechanism for developer contributions, since it grew as an open-source project. The lack of direct incentives to develop the code has led to the situation that many Bitcoin developers are now funded by private individuals and institutions, who all have their own special interests. What once was a superpower of the Bitcoin network as it was still emerging, is becoming a serious challenge for decentralized Bitcoin development in the long run.

Hardware producers & chip logic: Satoshi expected that anyone could participate in Proof-of-Work (i.e. mine Bitcoins) using the central processing unit of standard computers, though it was anticipated in the white paper that the hardware requirements would grow over time. However, this happened much faster and differently than anticipated. The chip logic, as part of the hardware components necessary for operating mining nodes, interacts with the Bitcoin software, determines boundaries of the Bitcoin protocol, and influences the difficulty rate. Any progress in research and development of hardware chip logic impacts the costs and benefits of Bitcoin mining and therefore the Bitcoin ecosystem as a whole. Some node operators realized that the use of special gaming computers with better GPU and CPU gave them a competitive advantage in the race to create blocks. Specialized companies started to produce special-purpose mining rig hardware. Node operators started to use these special devices which were built around ASIC chips, which had greater hashing capacity at lower energy consumption. Today, people with normal computers have little to no chance of participating in Proof-of-Work. Mining rig producers have a lot of market power over the technical evolution of processing hardware and its cost, which ultimately has an effect on micro- and macroeconomic parameters of the Bitcoin ecosystem — the benefits of mining and the transaction costs that get passed on to Bitcoin users. As a result, these hardware producers also gained competitive advantage over other miners to operate mining pools, as they can do so at lower costs.

Electricity market: Similar to hardware producers, dynamics on electricity markets worldwide influence the micro- and macroeconomic conditions of the Bitcoin network. Availability, costs and the regulatory conditions influence the costs and benefits of Bitcoin mining. On the other hand, electricity providers can be affected by capacity issues related to Bitcoin mining. If managed wisely, Bitcoin mining operators can balance the excess loads of power grids while benefiting from lower energy costs. One possibility for mining pool operators is to collaborate with renewable energy producers (e.g. wind and solar) who typically create a lot of excess capacity and have a hard time adding their excess capacity to the power grids.

Second layer protocols such as the “Lightning Network,” the “Liquid Network” or “Roostock” are being developed to improve the capabilities of the Bitcoin mainnet. The Lightning Network is a network of payment channels that is being developed to allow for faster and lower-cost transactions off the main Bitcoin network where users can open payment channels, send multiple transactions without each one needing to be recorded on the mainchain. Liquid is a federated sidechain for Bitcoin — it offers faster confirmation times and confidential transactions, making it useful for high-frequency trading and inter-exchange settlements. Rootstock is a smart contract protocol that adds smart contract functionality to the Bitcoin network, allowing developers to build decentralized applications on top of Bitcoin. All these networks enhance the capabilities of the Bitcoin ecosystem and influence general Bitcoin adoption.

Alternative Web3 ecosystems: The emergence of alternative cryptocurrencies has created alternative systems that might be faster, more versatile or more anonymous than the Bitcoin network. More privacy-preserving currencies have stayed a fringe phenomenon, mostly because of regulatory sanctions against them worldwide. The Ethereum network and similar blockchain networks, on the other hand, have created a more versatile Web3 infrastructure for the settlement of a wide variety of token-based applications, which drove a certain amount of innovation potential away from Bitcoin. Stable tokens in particular — which are mostly issued on the Ethereum network — have the biggest market transaction and have therefore created earning possibilities for Ethereum miners. The emergence of a wide range of alternative blockchain networks has not only created competition for Bitcoin but also strengthened general crypto/Web3 adoption, as well as research and development. Any innovation in other networks can positively influence protocol development within the Bitcoin ecosystem, and vice versa.

Token Types & Token Properties

As opposed to many DAOs that emerged later, the Bitcoin network only has one type of network token. Originally, its intended purpose was to serve as P2P electronic cash with small transaction costs, to make micropayments feasible. While the Bitcoin network has proven to be a robust P2P settlement network for digital values, and paved the way for a renaissance of P2P network innovation, Bitcoins have not proven to be practical for everyday payments — both because of the relatively high transaction fees and also due to the fluctuating exchange rate vis-à-vis other currencies. As a result, many people today refer to Bitcoin as digital gold, rather than digital money. To understand why the original token did not fulfill the intended purpose, it helps to analyze the properties of Bitcoin:

“Bitcoin Properties” from DAOs & Purpose-Driven Tokens, Token Economy Series, Shermin Voshmgir

• Minted upon: Newly minted Bitcoins enter the ecosystem each time a new block of transaction is minted upon Proof-of-Work. As previously explained, they are attributed to the mining node that receives the block reward.
• Expiry date/event: Bitcoins never expire, and also have no automated event upon which they might be burned. Bitcoins can be endlessly stored and hoarded, and will only be unattainable under two circumstances: (a) If the user loses their private key to authenticate themselves as the owner and sign transactions, or (b) once they leave the blockchain network into custodial wallets of centralized service providers such as merchants, exchanges or banks, and if they are mismanaged by those custodial service providers or frozen due to government coercion. It is unclear what really happens to those centrally managed Bitcoins behind the scenes.
• Rights attached: Bitcoins represent a property right (network assets with certain aspects of currencies). Bitcoins also represent access and usage rights for network services, as they are the only accepted currency with which one can pay the transaction fees.
• Transferable: Bitcoins are designed to be unconditionally transferable.
• Privacy: As previously explained, Bitcoin has limited privacy by design due to a combination of factors: (i) It only exists as a string of digital signatures that can be traced back to the original transaction, (ii) because of the pseudonymous nature of Bitcoin identities, and because of (iii) the cryptographic primitives used. This pseudonymous nature of Bitcoin transactions is not at all comparable with the anonymous nature of cash, and also affects its practical fungibility (read more on the topic of privacy in another book of the Token Economy Series titled “Web3 Infrastructure”).
• Fungibility: In theory, each Bitcoin is designed to be interchangeable with any other unit of Bitcoin, and therefore fungible, which is a core prerequisite for any currency. In practice, due to the above-mentioned pseudonymous nature of transactions, Bitcoins (or to be more precise, specific unspent transactions aka UTXOs) can get sanctioned by custodial service providers at the edges of the network who are subject to regulatory pressure from nation state regulation.
• Stability: There are no provisions in the Bitcoin protocol to maintain price stability, which is why many stable token initiatives have emerged in recent years (read more about exchange rate stability and stable tokens in another book of the Token Economy Series titled “Money, NFTs & DeFi).

“Bitcoin Token Flow” from DAOs & Purpose-Driven Tokens, Token Economy Series, Shermin Voshmgir

Economic Mechanisms

Bitcoin’s token distribution and supply is regulated in the protocol and was defined by Satoshi before the protocol was first implemented and deployed. The first BTC were minted in the genesis block in 2009. All newly minted Bitcoins were and still are rigidly distributed via the Proof-of-Work process. No tokens were pre-mined or distributed to founders or investors, which is the case with many DAOs today.

• Monetary policy: The number of Bitcoin tokens was and still is limited to slightly under 21 million BTC. The number of BTC issued per block was designed to decrease by 50 percent every 210,000 blocks — approximately every four years. At the time of writing, the reward for successful block creation in the Bitcoin network is 6.25 BTC per block. The next “halving” of block rewards takes place in 2024. The last BTC is estimated to be mined and minted in 2140, when the block reward would drop below 1 “Satoshi” — the smallest denomination of BTC. It will be interesting to see how that will play out as from that point on, only transaction fees are paid to those providing network security. The combination of a fixed token supply with a decreasing issuance rate is often assumed to lead to deflationary price development, when demand surpasses the supply of new tokens, taking into account sunk tokens. Bitcoin’s supply is determined by the number of newly minted Bitcoins each year, minus the amount of all sunk or burnt Bitcoins.
• Network taxes: As previously elaborated, mining node operators also collect transaction fees, which can be described as network taxes that are not paid to a common tax pool, but to the winning miner directly. The fees collected are determined based on several network parameters: (i) urgency of the transaction, (ii) network congestion, (iii) transaction size and (iv) general market conditions such as Bitcoin’s exchange rate. The fees can be set by the user who initiates a Bitcoin transaction and is directly paid to the miner who creates the block in which the transaction is included. As a result, miners tend to prioritize transactions with higher fees, as this increases their potential earnings. When the Bitcoin network experiences high demand for transactions, the available space in each block becomes limited. If users want their transactions to be confirmed quickly, they can choose to pay a higher fee to incentivize miners to prioritize their transaction. The size of a transaction in terms of bytes also plays a role in fee calculation. Larger transactions with more inputs and outputs require more space in the block and thus incur higher fees. When the value of Bitcoin rises significantly, users might be more willing to pay higher fees for faster transaction confirmations for trading purposes. It is technically possible to send Bitcoins without paying a transaction fee. However, if users set a fee that might be perceived as too low by miners — depending on market conditions — their transaction might take longer to be confirmed, especially during times of high network congestion, or it could even be dropped entirely. In this case they end up in a waiting position in Bitcoin’s mem-pool (the memory pool of unconfirmed transactions) until network congestion subsides and miners are willing to include it. Many Bitcoin wallets and crypto-exchanges provide fee estimation tools that help users estimate an appropriate fee based on current network conditions. Wallet operators offer predetermined options to either set their own fee when creating a Bitcoin transaction, and/or choose from a predefined set of fees such as low, medium, or high. Their user interface option can influence the Bitcoin fee market.
• Monetary policy changes: There is no provision in the Bitcoin protocol for changing the monetary policy of Bitcoin. In fact, Bitcoin’s ideology prides itself on its scarcity and the “deflationary” monetary policy. While changing the monetary policy of the Bitcoin network is theoretically possible, it would require a social consensus of mining node operators, which is unlikely. A higher supply would very likely drive down the Bitcoin price and probably reduce miner profits — unless other unforeseeable factors come into play.
• Treasury & resource allocation: As we will see in the analysis of other use cases, many DAOs today collect network taxes in a treasury smart contract and redistribute them to various types of stakeholders who contribute to the DAO. The Bitcoin network never had anything like a centralized treasury to fund its ongoing operation, research or development. Bitcoin was built by community contributors for free — which, at the time, was standard practice for open-source and free software development. As a result, code development and maintenance was initially performed by voluntary code contributors only. Marketing services were conducted inadvertently for free over social media by a community of Bitcoin enthusiasts. Full node operators, who are also important to the system, never had direct financial incentives for the previously mentioned reasons, and would often operate full nodes out of intrinsic motivation. Resource allocation in the form of newly minted Bitcoin tokens and network taxes was only designed to incentivize mining node operators who contributed with Proof-of-Work, for network execution and network security. This created considerable power asymmetries in the network, favoring mining node operators. We will discuss this in more detail later on in this chapter.
• Proof-of-Work’s difficulty adapter: To compensate for increasing hardware speed and varying interest in running mining nodes over time, while deterring potential 51% attacks, the proof-of-work difficulty was “determined by a moving average targeting an average number of blocks per hour. If they’re generated too fast, the difficulty increases.”

Governance, Protocol Upgrades & Network Splits

The Bitcoin protocol defines all the computational rules of the network, i.e., how the Bitcoin nodes can coordinate with each other and reach an agreement over which Bitcoin transactions are valid or not. The protocol also defines the economic rewards for validating transactions, how they are generated and attributed to their owner, and the properties of the Bitcoin token, aka currency. It also defines how to reference identities and sign transactions, and who decides over network upgrades. Any change to these rules requires a social governance process, which are loosely defined in the protocol. As a result, a series of informal social practices have manifested over the years around the social governance process of the Bitcoin network.

The process is as follows: To initiate protocol improvements, developers coordinate via a mailing list, forums and a repository of improvement proposals, also referred to as “Bitcoin Improvement Proposals” or “BIP,” where anyone can contribute proposals for a protocol upgrade. They discuss these implementation proposals via closed and open social media channels, and anyone can contribute with opinions on discussion forums such as “bitcoin-talk” or Subreddits such as “r/bitcoin” and “r/CryptoCurrency.”

When the Bitcoin developer community has finished social debate around how to upgrade the protocol, all mining nodes running the protocol need to decide whether they agree to the upgrade or not. They can agree by adapting the protocol rules (updating the software to the new rules and running it on their computers), or disagree by continuing to operate the old protocol. The network with the most cumulative Proof-of-Work, also referred to as the “longest chain” which has more “hashing power” or “network power,” is always considered the valid one by the network nodes. This basically means that the winning ledger version gets determined by a majority “vote” of the network. Mining node operators vote by upgrading the protocol or not, where one vote equals one CPU.

Mining node operators are the only stakeholder group who gets to directly decide whether or not to actually adopt the new network rules. However, simple token holders are not completely powerless. They can revolt by selling their tokens. If they operate a node and have full control over their private keys, they could coordinate with other users and economically course miners via a “user-activated fork.” Some argue that user-activated forks reflect a strong user signal, whereas simply selling tokens reflects a signal with bigger time lags and may be weaker in the short run.

After its initial deployment in 2009, the Bitcoin protocol was upgraded several times, more so in the early years when the community was still small and the protocol still needed more fine-tuning. As the community grew, became more politicized, and participants had more stake or network power to lose, protocol upgrades became harder to implement. Instead, the majority of the network would agree to adopting the new rules — aka a “fork” of the protocol. As a result of some of these protocol upgrades, network splits occurred at several points in time.

In software engineering, the term “fork”’ refers to copying and modifying an existing codebase into a different version. While any codebase can be forked, the term is often used in the context of free and open-source software development where forking does not need prior permission of the original development team without violating copyright law. The term sometimes also refers to a split in the developer community of an existing project, rather than only the code. The Bitcoin community uses the term fork in various contexts:

External forks are forks where people take the Bitcoin codebase, with the intention to create their own community. They copy and mofify the code with the aim to deploy their own network with their own values, priorities and a completely new community from scratch. Examples of this are “Zcash” or “Litecoin.”

Internal forks are a result of protocol changes with the aim to improve network functionalities, without creating a new community. In this case, two types of protocol changes are possible — “soft forks” and “hard forks” — though network splits into two different communities can be a consequence of such forks.

In the Bitcoin network, a “hard fork” refers to a type of protocol change that is not backward compatible. The existing community of node operators are typically split into two different communities — one operates the old ledger (those who did not accept the upgrade), and the other takes over the new protocol (those who accepted the rules). The ledger history on both chains is the same up to the block where the vote happened, from then on, the network history takes separate paths. Nodes that don’t update to the new version of the protocol won’t be able to process transactions on the new ledger. All nodes that validate transactions according to the old protocol will treat the blocks produced according to the new protocol as invalid. Nodes that want to adopt the new protocol will therefore need to upgrade their software.

In the Bitcoin network, a “soft fork” refers to a type of protocol change that is backward compatible. Nodes that didn’t update the protocol are still able to process transactions if they don’t break the new protocol rules. Blocks produced by miners running the upgraded protocol are accepted by all nodes in the network. Blocks produced by miners running the old version can still produce blocks, which will just not include features that were introduced with that soft fork. If old-version miners get their blocks rejected by part of the network, they might be inclined to upgrade, too. Soft forks are, therefore, a bit more gradual in their voting process than hard forks and take several weeks.

Since hard forks require all miners to upgrade their clients to the new protocol immediately, this can lead to sudden splits in the network. As a result, many protocol upgrades were designed as soft forks. In the case of a hard fork, anyone who owned tokens in the old network will also own an equivalent number of tokens in the new minority network, which they can then sell or hold on to. This, however, requires at least one token exchange to list the new token of the minority network; otherwise, there is no market, and the network fades into oblivion. Deliberate secessions for political or economic reasons are another example of forked networks. They are often disguised as political secessions, when in fact are just designed to extract economic value (as was the case with “Bitcoin Gold,” “Bitcoin Diamond,” and “Bitcoin Platinum”). Such forks are usually undesirable events, as they split the user community and the developer power of each network. Miners also have to choose which network they continue supporting with their hardware.

In the early years of Bitcoin, technical protocol updates were conducted quite frequently. They did not create too much controversy — the shorter chain eventually died due to lack of support, and the token had no market value. More politicized decisions on protocol changes sometimes led to a split in the network, if the minority chain had enough followers, or when a political narrative strong enough to maintain an economy of its own. Examples such as the “Bitcoin Block Size Debate” resulted in heated and prolonged discussions in the community, giving rise to several hard forks of the chain that resulted in dissident chains such as “Bitcoin Cash.” Such a politicized hard fork is a black swan event that can create unexpected market dynamics and influence the value of one’s tokens, depending on which network gains more traction in the long run.

Temporal splits in the network can happen accidentally, due to network latencies. If two miners find two different valid solutions for the same block at the same time, it is possible for the network to temporarily split. When this happens, the nodes in the network have two alternative versions of the ledger on different parts of the network. This creates two parallel blockchain networks. The Bitcoin protocol has a provision to resolve these temporal splits so that only one branch of the network survives: It always recognizes the chain with the most computing power spent on it as valid, where one of the two chains eventually becomes “longer.”

Power Structures

To grasp the dynamics of the Bitcoin network, it helps to understand the different interests stakeholders pursue, as well as the realities of the power structure within the network. As for different preferences and interests: Token holders and developers might prefer upgrades that result in lower transaction fees. Miners, on the other hand, will most likely find such a proposal unattractive, since transaction fees are a source of income for them. They might favor protocol upgrades that would yield larger block rewards, which would increase the supply rate of Bitcoin per day and thus would probably not be in the long-term interest of any of the other stakeholders involved. The following aspects need to be considered when we talk about the realities of the power structure in Bitcoin today:

Executive power: As opposed to other Web3 network or application level DAOs, the Bitcoin network has very limited functionalities, which are predominately executed by individual miners and mining pools according to the computational rules defined in the protocol. They execute Bitcoin transactions by co-validating them and adding blocks of transactions to the ledger. As opposed to other DAOs, there is no executive day-to-day management of the network via a foundation or other special-purpose incorporated entity and subcontractors that work for them.

Policymaking power: While in theory, anyone can make Bitcoin Improvement Proposals, only relatively few people globally have the know-how to understand the intricacies of the current code and propose rule changes. Full-time protocol developers are the only ones who can juggle the complexities and understand the cryptoeconomic intricacies of Bitcoin enough to make meaningful proposals to change the rules. At the time of writing this book, according to the commits on GitHub, around 300 protocol developers are more or less actively contributing to Bitcoin’s improvement. Given a global population of several billion people who can use this infrastructure, the level of decentralization of policymaking is questionable. Inclusion is only possible on a theoretical level. The fact that Bitcoin has no native mechanism to incentivize developers creates further power asymmetries. Personal ideology and reputation were reasons to contribute to the code in the early years of Bitcoin, but today, private companies such as mining pool operators and big Bitcoin holders have the economic power to fund protocol developers and pursue their own best interests. This puts a lot of policymaking power in the hands of this small group of “techno-priests,” at least until coding skills, higher mathematical skills and financial market know-how are taught across schools globally, so that real inclusion in policymaking is not only a shallow narrative. An index for comprehensibility of the code would be necessary to measure the actual level of political inclusion.

Voting power: As previously mentioned, only mining node operators can directly decide over protocol changes in the Bitcoin network. Only people who have the know-how and who can afford to operate mining nodes can influence the political fate of the network. Since their voting power depends on their hashing power, their voting power is directly correlated with the amount of money they are willing to invest in hardware and energy. In the case of mining pools, the case is a bit different. While anyone can become a co-investor of a mining pool and participate in the profits, these co-investors may or may not be included in the decision-making process by the mining pool operator, depending on the contractual agreement between pool operators and CPU contributors or co-investors. Users, on the other hand, have no direct possibility to vote over protocol changes, but they can use their market power to collectively coerce mining node operators into accepting a protocol upgrade, which they otherwise would not accept. Such coercive tactics via collective market power are referred to as UASF (User-Activated Soft Fork) or UAHF (User-Activated Hard Fork). This process requires a lot of coordination between users and a certain degree of technical know-how. To engage in a UASF or UAHF, users need to operate a full node or a light node, to be able to technically and therefore politically coordinate. Users who have their tokens managed by custodial service providers (such as exchanges or banks) cannot participate in a UASF or UAHF. Due to the increasing dominance and market concentration of mining pools, mining pool operators have a better ability to politically coordinate than individual users, since they are a smaller and more concentrated group. This gives mining pool operators disproportionate power compared to simple Bitcoin users — who are more scattered and are usually not as well coordinated.

Market power: Any Bitcoin holder has market power by entering or exiting the system. By selling their Bitcoin holdings, users can potentially influence the market price via a mass exodus. This means that those who own more Bitcoins have more proportional influence over the market price. As previously explained, they can also exercise indirect voting power via a UASF or UAHF, which might have market implications. Both mining node operators and wallet developers have market power over transaction fees: Mining node operators have the power to accept or decline transactions depending on the amount of fees users are willing to pay. Wallet providers control the user interface that gives the users the option to choose between fees or to set their own fee. Even though Bitcoin transactions can be theoretically sent without a fee, in practice, most wallets and exchanges have default fee policies that automatically attach a small fee to outgoing transactions. While some wallets and exchanges allow users to set their own custom fees, not all do. This means that wallet providers can collude with miners to make it harder for technically unskilled users to avoid paying fees. Merchants make or break a market via acceptance of Bitcoins as a medium of exchange. The same applies to exchanges, which can list or delist Bitcoins. External policymakers have ultimate coercive power over their citizens, residents, and companies that fall under their jurisdiction through regulation — and make or break the Bitcoin market within their jurisdiction. Hardware producers influence the market dynamics via the capacities and prices of input factors that miners need, as do electricity markets. Second-layer protocols and applications that complement the Bitcoin network can make the Bitcoin ecosystem more attractive. Competing Web3 protocols can drain the Bitcoin network from developers, node operators and users.

Information & coordination power: Experience has shown that the community dynamics that unfold in the process of protocol upgrades are quite similar to the public discussions in traditional media or on social media in the context of regional or national elections. The question is whether the Bitcoin community has enough institutionalized mechanisms to make sure stakeholders’ voices are heard, while balancing the interests of everyone. Information and know-how are key to practical inclusion in policymaking and to controlling the execution of policies. If a certain group of stakeholders can coordinate better than others, this could result in information asymmetries and power imbalances. From what it seems to me, information dissemination and coordination in the Bitcoin community is dominated by a Wild West culture predominantly driven by those who have the tech know-how, the financial power or the loudest voice in the chatroom. For example, there are many outspoken ideologists in the Bitcoin community — who are often referred to as “Bitcoin Maxis” or “Bitcoin Maximalists” — a very loud minority which influences the political discourse within the community and also externally. Information in Bitcoin is also relevant in the context of all historic ledger data. Since most users use hosted wallets or light nodes for managing their Bitcoins, they always rely on third-party servers to broadcast transactions to the network. These third-party services know the entire transaction history of their clients or the light nodes they relay. This situation not only creates information asymmetries, principal-agent issues, and policymaking asymmetries — it also creates privacy issues. Whether or not Bitcoin holders and wallet services providers operate their own full nodes (or any node at all) influences the information flow, coordination power and potential control.

Purpose & Reality

• Double spending challenge: The Bitcoin protocol absolutely nailed this purpose. It achieved what many researchers and developers had not achieved before. It resolved the double-spending problem over the Internet in the absence of centralized trusted authorities. The Bitcoin protocol also sparked a renaissance of P2P network development.
• P2P electronic cash: While the protocol resolved the double-spending problem, Bitcoin has not proven to be practical for everyday payments because of the constant and relatively high price fluctuations. At least, it is not an attractive option in economies that have relatively moderate inflation rates and currency stability. Satoshi did not provide a stability mechanism in the protocol, just a scarcity mechanism. Since exchange rate stability is a classic feature for money to serve as a medium of exchange, Bitcoin has become a digital asset that is more similar to scarce commodities such as gold — which is why some people refer to it as digital gold.
• Fees: The aim of the Bitcoin protocol was to reduce the transaction costs of sending money, especially for international transfers and micropayments. Due to the unexpected level of Bitcoin adoption and Bitcoin speculation, and in the light of the rudimentary monetary and fiscal policy mechanisms, the average transaction fees have become much higher than originally anticipated. They do not allow for cheap day-to-day remittances or micropayments. This might change if second layer protocol solutions — built on top of the Bitcoin protocol — would manage to provide more transaction bandwidth at much lower costs. At the time of writing this book, the Bitcoin ecosystem still has a long way to go to meet this original value proposition.
• Privacy: As previously explained, Bitcoins can be sanctioned at the edges of the network, where the permissionless Bitcoin network intersects with centralized exchanges and merchants who can be sanctioned by governments. Through the backdoor of these centralized institutions, Bitcoin (and similar cryptocurrencies that followed) have lost their pseudonymous features, and therefore also their censorship resistance and their fungibility. But even without exchanges and merchants, there are many ways to inadvertently unmask oneself with BTC, for example, if one’s address has been previously published as a donation address on social media or other public communication channels. Satoshi addressed these privacy issues and expected people to create a new wallet and thereby a new public key for each Bitcoin transaction. Creating a new wallet for each transaction was impractical, so Bitcoin wallet developers started to implement this as a feature. However, this turned out to be an insufficient privacy strategy, as even less sophisticated chain-analysis can quite easily reveal the identity of most users, not to mention governmental institutions with access to other associated data sets. The lack of fully autonomous privacy features in Bitcoin sparked an innovation cycle around privacy-preserving P2P payment solutions — both within the Bitcoin community and with Bitcoin forks that were more privacy-preserving from the get-go (read more on token privacy in another book of the Token Economy Series titled “Web3 Infrastructure”).
• Economic assumptions: The economic assumptions upon which Proof-of-Work was conceptualized seem to have built on simple game theory, not collaborative game theory. As a result, the Bitcoin network has become a much more centralized system than originally intended. Some people therefore argue that the reality of Bitcoin’s consensus mechanism can be described as a “delegated Proof-of-Work,” and that it has become an oligopoly of a handful of mining pools, which might not reflect the original intentions of Bitcoin’s creator, Satoshi Nakamoto.
• Stakeholders & power structures: The historic evolution of the Bitcoin protocol is the best proof that, due to the complex nature of socioeconomic networks, it is hard to foresee their future development. The assumptions under which one designs a DAO must always be considered incomplete. As previously discussed, the Bitcoin white paper only envisioned two types of node operators who would participate in maintaining the network: mining node operators and light node operators (aka SPV-nodes). Full node operators and mining pool operators only emerged after the protocol was deployed, but were never accounted for in the economic calculations outlined by Satoshi. The same was true for exchanges, chain analytics companies, full node service providers or wallet-as-a-service providers. The emergence of all these unanticipated stakeholders changed the political and economic dynamics of the network and greatly influenced the power structures within the network.

REFERENCES

This link will lead you to a website that contains all the references to the source materials used for the research of the chapters, and should also provide a reading list for those who are interested in a deeper dive into the topics presented in this chapter.