Bloomberg’s Joe Weisenthal permitted the fintwitterati to discuss Bitcoin’s existential problem: no one is using it. What exactly does he mean by this?
The Bitcoin blockchain’s purpose is to enable users to send transactions that third-party entities, miners, process as financial intermediaries. The compensation incentivizes enough competition among intermediaries to prevent monopolization and fraud. These miners are compensated through an automated reward hard coded into the network software and a variable fee based on supply and demand. Bitcoin’s network software is designed to inevitably reduce the automated reward to zero in increments occurring about every four years. This makes the miner revenue generated from the variable fee component that much more important.
Although the entire system is dependent on fostering high transaction levels, as Weisenthal pointed out, no one is “actually using the network.” He cited Bitcoin researcher Zack Voell’s data that showed Bitcoin’s variable fee revenue, as a percentage of total miner revenue, is not growing like it should and instead is quite dismal. Almost all the growth in miner revenue has come from price appreciation. The automated reward occurs independent of supply and demand, so miners are effectively getting subsidized to operate while the market says otherwise. You may be asking yourself, how is there no demand to actually use the much-hyped Bitcoin network? Simple. Let me explain.
To kick us off, what makes Weisenthal think Bitcoin is made to be used in the first place? He also wrote, “Bitcoin’s adherents are into holding (HODLing) it, and if anything they argue that holding and saving it is, in fact using it.” Nic Carter, Bitcoin pundit and Partner at Castle Island Ventures, wrote that the consensus view of Bitcoin is that it’s meant to be a store of wealth like gold and thus not to be used for everyday commerce that would generate high transaction volume. The foundation for this economic narrative was laid by the academic Saifedean Ammous who wrote the popular book: The Bitcoin Standard. He claimed, “Bitcoin’s value proposition is not in making the small consumer purchases, but in making large and important payments…Bitcoin can thus best be compared to settlement payments between central banks and large financial institutions…They would settle payments between their own customers off of Bitcoin’s blockchain, and then perform final daily settlement between each other over the blockchain.” Ammous further explained that low value but high volume transactions should “not happen on Bitcoin’s ledger.” Dan Held, Kraken Exchange Growth Lead, affirmed the above with an appeal to the authority of Satoshi Nakamoto’s original vision. This is the definition of Bitcoin by its alleged experts that the mainstream absorbs downstream. So, we return back to Weisenthal and see his questioning as odd. Low transaction volume is normal. That’s how Bitcoin works. The exploitation of the proletariat will hasten the social bitcoin revolution leading to high fees…
Yea that’s stupid. Yea that sounds a little like Marxist gobbledygook. Weisenthal is right to be skeptical. The answers, to why the mainstream view of Bitcoin is self-defeating, lie in common sense and history.
Bitcoin was meant to be a store of value AND a medium of exchange. The original vision considered both use cases interdependent. A good medium of exchange needed a stable store of value, that didn’t fluctuate, to transact. A good store of value needed a viable medium of exchange to preserve its centrality and prevent derivatives. The logic follows the problem with the gold standard. Gold was a bad medium of exchange, so paper currency took its place. Eventually, paper currency completely removed gold from the monetary system.
The first word in Satoshi’s whitepaper introduction is “commerce.” He then goes on to describe the problems of “merchants”, “buyers”, and “sellers”. Satoshi certainly expressed belief in goldbug ideology in other places but never saw that as prohibitive to the medium of exchange use case. In the P2P Foundation forum post, where he announced the whitepaper, he criticized central bank currency debasement and fractional reserve banking. He also opined that the current system makes “micropayments impossible” and that his system would make money “secure and transactions effortless.” In a BitcoinTalk forum post in 2010 he wrote, “Bitcoin is practical for smaller transactions [that] are practical with existing payment methods. Small enough to include what you might call the top of the micropayment range.”
We have now established that bitcoin as defined by its creator, Satoshi Nakamoto, was conducive to high transaction volumes. This is important to the overall and current topic of the miner fee crisis because high transaction volumes would be the solution. It’s the simplest equation in all economics: Price x Quantity = Revenue. If quantity goes up the fee crisis can be mitigated. Reliance on high fees making up for that missing quantity growth is a self-defeating solution. The high fee strategy has diminishing returns to scale. For every additional [x] of fee price, [y] transactions are decreased. One might wonder, why such a strategy was taken, and that’s a very good question. That lies in the history of the bitcoin scaling war.
The bitcoin scaling war occurred roughly between 2014 and 2019. The two sides were split along the lines of transaction capacity on the network. On the blockchain, there are blocks. Blocks are like container ships that carry transactions. As described previously, miners compete for every potential block every 10 minutes. Once a miner wins, they are awarded the right to process a block. They will search for transactions from users and include them inside the block for a fee. The miner will then process the block into the blockchain. The key thing about blocks is that they have a size. Their size is directly related to how many transactions they can contain. Originally there was no size constraint. Satoshi thought it would not scale with a limit. Only after deliberation did Satoshi and other early developers decide on a safety constraint of a max block size value of 1MB in 2010. They considered it necessary to avoid spam transactions in the early days. Once enough scaling had occurred, they believed that this limit could be removed. Satoshi explained on October 4, 2010, how one could go about phasing in increases in the block size limit.
As one can observe from this objective account of the history of bitcoin development, the original debate around block size was an adult conversation. It was not mired in polemics of extremes. It was nerds determining the optimal parameters at the optimal times to scale…well optimally. Satoshi’s disappearance left a void of leadership and direction for the project. As the scaling challenges metastasized, the two sides of the scaling war became visible. Big blockers were defined as those who desired an increase in the block size in line with Satoshi’s earlier idea as explained above. Small blockers were defined as those who desired no increases in the block size (some even preferred a decrease).
The small blockers argued that bitcoin would centralize under miner control if block sizes were increased. According to them, smaller miners wouldn’t be able to compete and an oligopoly would form. They also peculiarly argued that listening nodes (nodes that only view the blockchain and don’t contribute computing power to processing transactions) would have trouble downloading the blockchain. The emphasis on listening nodes being vital components of the bitcoin system was a new innovation. It ran perpendicular to Satoshi’s miner emphasis because the contribution of computing power was the crux of sustaining an honest blockchain. The absence of computing power from listening nodes made them inferior in that sustainability optimization. Cheap listening nodes could be spammed while costly mining nodes could not. However, these positions that feared mining centralization led small blockers to the conclusion that bitcoin must be scaled with a hard block size limit.
In order to scale under that condition, especially with the expectation of small and high quantity transaction volume, off-chain solutions were needed. Off-chain obviously means transactions that occur off of the bitcoin blockchain and thus don’t interact with the system of bitcoin. These solutions also were coined as layer 2s. Bitcoin was layer 1 and layer 2s would connect to it. Bitcoin would be used as a final settlement layer. We now begin to see the antecedents that generated the current ideological underpinnings justifying bitcoin in this way.
Small blockers had a well-reasoned argument against the big blockers, however, inversely so did the big blockers against the small blockers. Big blockers argued that the creation of layer 2 off-chain scaling solutions was inherently a greater risk as they were entirely new systems. A fine point must be made that their argument wasn’t that these layer 2s should never be tried or destined to fail, but that they were being made the exclusive and only option rather than as a voluntary add-on. Big blockers worried that a small block size would lead to a supply shortage of block space for user transactions. As demand increased, the only logical conclusion would be that users would bid up transaction fees. These high fees would be prohibitive to low value transactions and eventually diminish demand.
This dynamic can be analogized to St. Matthew Island’s reindeers. Reindeers were imported to an isolated island. With no predators and plenty of grass, their numbers grew exponentially. However, at a certain point the amount of grass to sustain the population dwindled and the population declined extremely and rapidly. This is to illustrate the dynamic that bitcoin users would at first enthusiastically transact bitcoins in a similar exponential curve, that would produce high fees, and then rapidly disincentivize adoption of bitcoin. This was the risk the big blockers were trying to avoid.
You can find a variety of historical blog posts and other literature on this subject. I recommend Jonathan Bier’s book, “The Blocksize War”, and Daniel Morgan’s article, “The Great Bitcoin Scaling Debate — A Timeline”. The former leans towards a small blocker perspective and the latter leans towards a big blocker one. The prime importance of each work is on establishing the key players, events, and most importantly the timeline. Both do a fair job in constructing each of these aspects. I reviewed Bier’s book and discussed where some great information is illuminated as well as where it suffered from inaccurate analyses.
A general summary from both works (and the myriad of others floating around the internet) is that big blockers were mostly comprised of miners, bitcoin-centric businesses, and heterodox developers while small blockers were comprised of mostly orthodox lead bitcoin developers. The big blockers had profit-incentives to increase the block size while the small blockers didn’t. However, small blockers were also attached to for-profit layer 2 projects whose business models were dependent on there being a block size limit. As the debate continued into 2015, 2016, and 2017, the two sides jostled back and forth as to the future direction of bitcoin. Eventually, a compromise was reached for an upgrade in the fall of 2017 that satisfied both sides. However, social media activity, certain exchange trading dynamics, and alleged listening node voting all resulted in the cancellation of the block size increase portion of that upgrade.
In the aftermath, much of the big blocker energy was dissipated or siphoned away into competing cryptocurrencies. The most rivalrous competitor was bitcoin cash (BCH). It had many defectors from bitcoin (BTC) and represented a unique challenge. As a software fork of bitcoin, was it possible for it to be conferred the title of bitcoin if most to all the activity switched to it? After two years of testing this hypothesis, the bitcoin cash alternative did not gain enough adoption to prove it. Its diminished status in comparison to bitcoin’s growth reinforced the success of the small blockers’ perspective.
Returning to Weisenthal’s questioning, we can now better answer him. Bitcoin’s miner fee crisis was caused by the split in direction of the bitcoin community. It is a crisis of the miners because the winning side of that debate deliberately reduced the technical and ideological position of miners. This is a significant departure from Satoshi’s original design for bitcoin. By going over the history of bitcoin, we can better see that the crisis wasn’t as baked into the cake as it now might be suggested. There was an internal logic to the original bitcoin strategy that accounted for this miner fee crisis through larger block sizes that would enable higher transaction volumes while keeping fees relatively inexpensive. It is an entirely separate debate to argue if this original theory would be successful in the real world. The main point is that it didn’t suffer from the logic gap of the new theory.
Miners were to be demoted (if not made eventually obsolete) in favor of the new layer 2 off-chain systems. Motives and intentionality are perhaps indeterminable; however, the effect of such developments is relevant. Layer 2s promise low fee transactions and thus suck away transactions from bitcoin. If layer 2s are marketed as just as good as bitcoin (like substitutes) then demand should shift from bitcoin to them. If this happens, miners will eventually not have enough transaction volume to generate enough revenue. Regardless of the advantages of settlement layer theory, this balancing act can obviously not be maintained. Eventually, the system would totally collapse or one layer would need to be abandoned. Considering what happened to gold vis-à-vis paper money, it’s curious to ponder the outcomes.
Weisenthal mentioned some solutions such as emulating the token and DeFi capabilities on other cryptocurrencies. He also mentioned that perhaps skyrocketing price will be able to offset any problems. These are generally fine points. Once upon a time, I analyzed these issues and came to similar conclusions. For every halvening or reduction in hard coded miner rewards from the system every four years, the price of bitcoin needs to double to offset the reductions. However, while this solves the immediate shortfall in miner revenue, it doesn’t solve the transaction quantity issues related to block space shortages due to block size limits and the balancing act between layer 2s and bitcoin’s blockchain. A solution, while unpopular to the current bitcoin regime, that seems viable is to, yes, raise the block size limit to accommodate for more transactions. However, as I mentioned back in 2019, bitcoin would have a very hard time acquiring the necessary transaction count growth to satisfy miner revenue needs.
Although similar to Weisenthal’s suggestion, token capability could be simply added to induce transactions not just for straight monetary exchanges. Transactions could incorporate other assets and instruments. Ethereum founder and lead developer, Vitalik Buterin, left the bitcoin project because these capabilities weren’t enabled. There is a circular nature to: his departure rationale, enablement of new features on ethereum, and now Weisenthal’s recommendation of those very features for bitcoin. Buterin has even stated, “for example I continue to believe that Bitcoin’s *failure* to raise its blocksize by a significant amount in 2016–17 was a travesty and a great violation of many people’s expectations of the protocol.” Ethereum’s departure from bitcoin has revealed its own challenges of scaling and development of unproven systems. It’s amazing to consider that if the block size issue and its tangential elements were better and earlier compromised on, ethereum and its resultant token and DeFi dynamics might never have been actualized. Instead, Buterin might have added a much leaner version of ethereum into bitcoin.
Although while operating within the logical framework of bitcoin’s theories and axioms we can arrive at these potentially viable solutions, from an outside framework we can evaluate bitcoin agnostically. Bitcoin failed its most basic test: to prove that decentralized market-driven anonymous individuals can build, sustain, and grow a global monetary and payment system. The centrality and anti-centrality of Satoshi revealed the reality of hierarchy. Rather than a 21st-century crypto-version of Mr. Smith Goes to Washington (Blockchain), elite leaders and groups within the bitcoin community use their leverage to decide matters in obscure ways. Centralization of miners, businesses, investors, and developers is a feature not a bug of bitcoin. The mixture of a decentralized theory with a hierarchical reality is the real problem. Hierarchies aren’t themselves problematic as they exist in almost every human organized institution. The problem is that the hierarchies are hidden by the veil of decentralization. This obscurity fosters corruption and fraudulent behaviors.
As a disclaimer, bitcoin is bad. No one should invest in bitcoin. I, in no way, support bitcoin or any other cryptocurrency.
Rather than us concentrate on a solution for bitcoin, why don’t we ask what solution the massive phenomenon of bitcoin’s decade points us to? If there’s one significant positive outcome of bitcoin, it’s that it got many people discussing esoteric monetary economics. This confrontation provoked investigation and a demand for change. Perhaps bitcoin was never the destination but the journey. Other economic theories are coming to the floor that have powerful theoretical, empirical, historical, and rhetorical arguments. I recommend evolving past bitcoin and wider cryptocurrency theory towards specifically Modern Monetary Theory and generally National Political Economy.