Bitcoin’s future is fractional reserves: unless we do something

What began as a single transaction from Satoshi to Hal Finney has evolved into a complex system of industrial-scale miners, evolving meta-protocols like the Lightning Network and Fedimint, and fully embracing institutional investors with a record influx of new acceptances. Spot ETF.

Bitcoin has come a long way dramatically, and that has created a certain sense of optimism for those who have invested the time, money, and energy into it.

Unfortunately, this optimism and the sense of “inevitability” I wrote about previously has contributed to creating a culture of complacency. This is characterized by a narrative that early Bitcoin protocol ossification is acceptable or even desirable, and is highlighted by the implicit assumption that the biggest risks to Bitcoin at present are potential changes to the protocol and Trojan horses.

This belief is clearly false.

The biggest risk with Bitcoin is that it is actually guaranteed a certain future if it is effectively “hardened” today. Specific regulatory capture, unlimited fractional reserve supply, censored and monitored transactions.

old news

If this sounds extreme, you haven’t been paying attention. The problems facing Bitcoin that lead to this inevitable outcome are nothing new. In fact, this issue was addressed by Hal Finney himself 14 years ago.

“There is actually a very good reason why Bitcoin-backed banks exist that issue their own digital cash currency that can be exchanged for Bitcoin. Bitcoin itself cannot scale to the point where every financial transaction in the world is broadcasted to everyone and included in the blockchain.

Bitcoin-backed banks will solve these problems…

Most Bitcoin transactions take place between banks to settle net transfers. Bitcoin transactions by individuals will become as rare as Bitcoin-based purchases are today.”

From the beginning, many of Bitcoin’s early adopters clearly understood its limitations and its downstream implications. What has changed since then? It’s not math.

Even with the Lightning Network, an innovation that Hal Finney cannot see coming, the upper limit on the number of regular users that Bitcoin can use in its current state is optimistically 100 million. These numbers don’t take usability/user experience into account at all. This is an inherent challenge for the Lightning Network due to the very new way it operates compared to other financial systems.

In the Lightning Network white paper itself, authors Joseph Poon and Thaddeus Dryja make it clear that this alone is not any kind of panacea to enable global scale.

“If all transactions using Bitcoin are performed within a network of micropayment channels, then 133MB blocks would be needed to enable 7 billion people to create two channels per year and make unlimited transactions within the channels (500 bytes per transaction, per year). (assuming block 52560). )”

Today, restrictions on who can leverage Bitcoin in their own sovereign way without using a trusted third party present obvious problems. Especially if we assume adoption and usage will continue to grow.

Saifdean Ammous wrote “The Bitcoin Standard,” a book that received much fanfare by making a compelling economic case for Bitcoin as the ultimate expression of “hard money.” He claims that the Bitcoin standard will surpass the current fiat system thanks to hard supply. Likewise, in 2014, Pierre Rochard popularized the idea of ​​a “speculative attack” when he argued that the adoption of the Bitcoin currency unit would be gradual at first and then very rapid.

In our future projections, we will assume that both schools of thought are correct, and that demand for Bitcoin as a unit of currency will drive increasingly greater savings as network effects further accelerate widespread global adoption.

However, this “HyperBitcoinization” scenario presents an impossible challenge due to the current constraints of both the Bitcoin core protocol and the Lightning Network. So what does it mean that hundreds of millions and billions of people are running away with confidence in a fixed supply of Bitcoin, as the mainstream Bitcoin community believes they will?

Quite simply, if they can’t be able to afford Due to strict scalability limitations, using the core protocol or the Lightning Network (no need to even discuss usability or UX here, that’s a separate big challenge) You must use a centralized managed service provider.. Even if they don’t want to.

There’s nothing around this bush to beat or wish would go away.

If you accept the premise that Bitcoin is a superior currency and understand the practical limitations of today’s protocols, this is a clear outcome that Bitcoin can currently reach.

Gold Standard 2.0

It’s a fair question to ask why this might cause problems. Hal Finney certainly didn’t seem to imply so in his aforementioned post.

Returning to the Bitcoin standard, Ammous devotes a significant portion of the first chapter of the book to discussing the history, strengths, and most importantly, weaknesses of the gold standard. Crucially, he identified the Achilles heel. Gold was too expensive to secure and difficult to trade in meaningful quantities.

As a result, paper money technology first began to be used as a convenient IOU for gold, stored in centralized locations specialized for protecting and moving large quantities of gold as needed. Over time, as technology improved and commerce became more global, these centralized custodians continued to grow. Eventually they were all captured by the state through their regulatory powers, and later until new fiat currencies were completely decoupled from their underlying gold backing.

As we predict the future of Bitcoin in its current state, we can see very similar outcomes unfolding. Cost may not be an issue save We encrypt Bitcoin using a private key and a mnemonic phrase, but in our HyperBitcoinization scenario, Do business with With self-governed Bitcoin, even with Lightning, the fees quickly evaporate for all but the very wealthy and institutions that can afford them.

The results are much the same as under the gold standard. Platforms like Coinbase or Cashapp will take center stage, given that transactions within their custodial platform have zero marginal cost because they are tracked in a central database. Cross-platform payments can also be aggregated across these platforms via lightning channels or on-chain payments, very cost-effectively. The result is a situation not so different from the gold standard of the early 20th century, where most of the supply is held by large administrative institutions that the state can trivially influence, coerce, and capture.

Going back to the question of the biggest threat to Bitcoin, there is absolutely no need to attack the base layer if the only one that can really use it is a large known entity that could lose everything.

Certainly there will be significant differences in practice from the original gold standard. Transactions are fundamentally digital, reserves can be proven, and supply is fully transparent – a notable improvement over the gold standard. Nonetheless, none of these differences affect our self-custody conundrum in any way. According to the vision of Bitcoin as a censorship-resistant currency, once a majority is held by trusted third parties, there is nothing to prevent states from monitoring transactions, seizing assets, and strictly enforcing capital controls. Nor is there anything to prevent us from activating and encouraging fractional reserve policies for prudent economic management.

Crucially, if these actions occur, the majority of users will not be able to opt out by withdrawing funds under their control.

It’s not all bad. In this scenario, the value of Bitcoin as a unit of currency would still increase dramatically. Everyone who has taken interest and entertained me so far will likely benefit enormously financially in the future.

But is that it?

Is the vision of Bitcoin as a fundamental tool for censorship resistance and separation of money and state dead?

There is no doubt that this is true if we continue to reject or, worse, encourage the current trajectory. But it doesn’t have to be that way.

false fears

Fortunately, there is no reason or dominant claim that the Bitcoin network is already solidified. It remains firmly in the hands of the core community to continue to drive research, discussion, and proposals to further improve the underlying protocol to increase the scale and usability of solutions like the Lightning Network and enable entirely new potential configurations such as . Ark protocol, advanced state chain, etc.

However, it is important to acknowledge how we got to the point where “ossification” became a serious problem. prescriptive Rather than a pure story descriptive This is the idea of ​​the final end-state of the widely adopted Bitcoin protocol. These prescriptions are inevitably rooted in the assumption that Bitcoin’s biggest attack vector will come from future code changes.

This way of thinking is not unfounded. It is true that protocol changes can be an attack vector. After all, we saw these attacks in action on Segwit2X when a consortium of large Bitcoin institutions and miners orchestrated a unilateral hard fork on the Bitcoin protocol in 2017 to increase the default block size. I did.

But we must also acknowledge that Segwit2x failed miserably. Worse, they completely misjudged the dynamics involved in introducing changes to a decentralized P2P protocol, so the futility of the attack was obvious before its final collapse.

The participation of many individuals and companies involved in Segwit2X, which in many cases suffered lasting reputational damage, was not only a failure but also a costly one. It will be abundantly clear to an enterprising attacker seeking to permanently compromise Bitcoin that attempting to repeat this approach or any variation of it would be foolish.

A much easier and cheaper approach with a much higher chance of success would be to invest in slowing down the already difficult task of building consensus to introduce beneficial extensions to the Bitcoin protocol, thereby ensuring that the experiment in sound, censorship-resistant money is ultimately successful. This is to ensure that you can do so. A victim of his own success. Whether you believe this is actively happening today or not, the steps you need to take are the same.

What now?

Ultimately, where we are now and what we need to do is not much different from when Hal observed in 2009. We must continue to critically examine the limitations of the Bitcoin protocol and ecosystem and push as a community to address these shortcomings.

Fortunately, numerous research advances and proposals have been made to further increase scalability without requiring larger block sizes. Core Bitcoin contributor James O’Beirne published a blog post last year containing a sobering technical analysis of Bitcoin’s immediate scalability prospects and provided good context for some of these proposals, and more recently Mutiny wallet developer Ben Carman took a critical look at the surrounding issues. More specifically, the Lightning Network.

Amidst all the noise, there are constant strong signals, and the best we can do is put in the individual work to identify and amplify them, while also actively countering counterproductive narratives that do not contribute to meaningful improvements for Bitcoin.

In doing so, perhaps we can find a way to extend the vision of truly peer-to-peer and sovereign currencies to every individual on the planet.

We may still fall short and there are no guarantees at all.

But it’s worth a try.

This is a guest post from Ariel. Deschapel. The opinions expressed are solely personal and do not necessarily reflect the opinions of BTC Inc or Bitcoin Magazine.