The Bitcoin Cash Panic

bitcoin cash

Bitcoin has dropped significantly in the past few hours after the announcement of the release of Bitcoin Cash on August 1st which was supposed to be a contingency release, as announced by Bitmain, in case the UASF went into effect on August 1st. Many people are scared and confused thinking that the scaling debate was put behind following the BIP 91 lock in. Although most people nowadays are aware of Bitcoin few are aware of the several Bitcoin forks in existence (i.e. Bitcoin XT, Bitcoin Classic). The scaling debate of the Bitcoin network is not a new issue. It’s been a contentious issue as far back as 2013. In order to solve those issues several Bitcoin hard forks have been attempted ever since. However, none of these bitcoin forks gained enough traction to rival the main network in terms of hashing power. This is not surprising since a hard fork of Bitcoin is essentially an altcoin. As an altcoin what significant features would it offer to users that other altcoins like Ethereum or Ripple do not offer? The answer is not much. Since they fail to garner user interest, they also fail to garner miner interest, since miners live of fees generated by users, and hence they never gain traction beyond being interesting ¬†experiments for what features could be adopted in the main Bitcoin protocol.

Bitcoin Cash vs UASF

Although the current news outlets are comparing the Bitcoin Cash release as a fork to the UASF issue. The two events are not comparable. First of all there are already a few popular bitcoin forks out there (i.e. Bitcoin Unlimited, Bitcoin Classic) and more will come out over the years. They just don’t draw enough hash power at launch to become significant threat to the stability of the network. The recent UASF scare was because segwit only had 40% support of the miners, support level for segwit had been in the 30% to 40% range for months, and it was mid July already with the deadline being August 1st due to the UASF. Therefore the hashing power could have been split in half on August 1st had BIP 91 not locked in. The problem with the hashing power being split in half all of the sudden is the instability that it would create within the Bitcoin network. In order to find a new block a puzzle has to be solved, there is a difficulty level for this puzzle that is set approximately every two weeks that depends on the amount of hashing power within the network. If that hashing power all of the sudden drops to half, the difficulty level may still be too high for transactions to validate on time. Leading to long delays in block confirmations that could severely impact the user experience. Sudden drops in hash rate while the difficulty level was too high was a common cause of death of many new altcoins launched in early 2014. Now long delays would not be the only problem. An additional problem is the emergence of two blockchains with approximately equal amounts of hashing power. Most miners and users would have a hard time figuring out which blockchain is the right blockchain that users should be following and miners should be validating. This could lead to loss of funds if users are using the wrong blockchain, since the two blockchains will have different histories starting at the point in time of the fork. Although I have trust that the problems could have been solved in the event this worst case scenario happened, the bad user experience could have scared away new and potential users of Bitcoin and damaged Bitcoin’s reputation as the most stable network among cryptocurrencies.

On the other hand the release of Bitcoin Cash does not pose an immediate threat to the stability of the main Bitcoin network upon release. There are several miners supporting Bitcoin Cash but they are not the majority and although the user base would be an exact copy of the current user base of Bitcoin, the bitcoin cash client has not yet been released and therefore almost no one will be using Bitcoin Cash upon release. Since almost no one will be using Bitcoin Cash upon release, miners who decide to validate Bitcoin Cash transactions will not be receiving much in fees, but mostly units of a new coin with an uncertain future. It will be an opportunity cost to them that once they start they cannot abandon for causing a sudden drop in hashing power in the Bitcoin Cash network. Therefore, those miners that are claiming they will mine in the Bitcoin Cash network, if they do, they will most likely be diverting an insignificant percentage of their hashing power to the Bitcoin Cash network, thus leaving the main network essentially unscathed.

What is Bitcoin Cash?

The main feature of Bitcoin Cash is the much larger block size of 8 megabytes as opposed to Bitcoin’s 1 megabyte. The reason for increasing the block size to 8 megabytes is to solve the scalability issue that has plagued Bitcoin for years. Every transaction is stored in a block, given that the block size of Bitcoin Cash is eight times the size of Bitcoin’s, it can hold eight times the number of transactions as Bitcoin. At plain sight this seems like a more sensible solution than the harder to understand segwit solution, however, like every other solution it has its drawbacks, which had been considered in the past too significant to ignore. Mainly, the fact that the block size is bigger also means that more information can be put inside each transaction, leading to further uses of transactions within the Bitcoin network. One of these uses was the colored coins concept, which was implemented by MasterCoin and Counterparty within the Bitcoin network. Both projects attempt the creation of smart contracts with more functionality than what the basic Bitcoin protocol provides but at the expense of larger transactions and larger fees. Bitcoin core developers were opposed to these types of implementations because they clogged the network with transactions which Bitcoin was not intended for. Counterparty developers had long pushed for increasing the Bitcoin block size since the seemingly arbitrary 1 megabyte limit also limited the possibilities of their platform. Projects like Ethereum were created as a result of these limitations within the Bitcoin protocol.¬†However, the invention of segwit along with concepts like state channels and side chains address the issue of limited functionality of the Bitcoin protocol by creating a separate layer between users and the blockchain where more powerful smart contracts can be created in addition to greatly increasing transaction throughput by relying on this layer between users and the main network to aggregate transactions before publishing to the main network. Users therefore would cease to interact directly with the main network and instead interact with these other networks that pass the final result of users’ actions to the main network.

Who is Bitcoin Cash For?

Since Bitcoin was born on ideological grounds the idea of being dependent on a third party or intermediary to interact with the main network does not sit well with many Bitcoin users, hence the opposition to segwit and solutions like the lightening network and support for solutions like Bitcoin Cash which simply increase the block size. This opposition still exists despite the fact that the intermediary between the main network and bitcoin users in most cases will still be some type of trustless blockchain that just runs as a side chain to Bitcoin. From the perspective of miners increasing the block size is a preferred solution due to the greater number of transactions they can validate in each block, and therefore larger number of fees they can charge, however, this view is myopic. Although it is true that the implementation of something like the lightening network would lower the number of fees miners can charge validating the main bitcoin network since most transactions hitting the main network would just be aggregated transactions, new opportunities would open up in validating transactions in the layer between users and the main bitcoin network which would come from added services to the Bitcoin protocol built on top of this new infrastructure, services that have not yet been imagined.

Outlook

Most of the price action over the last two weeks seems to have been driven by news events shaking new investors and speculators off their seats. However, most of these news events are exaggerations of what’s to come in the short term. Although my general outlook on the entire cryptocurrency market is that the bubble will keep deflating until it reaches near parity with the rate of growth of its user base and network activity, the hypes and panics created by the news events are opportunities to enter or exit the market in the short term. Bitmain was playing a game of chicken with UASF, they were not going to fork the network and lose money. It was in their best interest to comply with BIP 91. BIP 91 does not fully solve the scalability issue. The debate whether to increase the block size has still not been solved and will be revisited in three months after Segwit activation since Bitmain along with a significant percentage of the network are supporting Segwit2x, which increases the block size to 2 megabytes, not Segwit, which is the preferred upgrade by the Bitcoin core developers. Bitcoin Cash will not bring down the Bitcoin network. Bitcoin Cash is not the first fork to increase the block size to 8 megabytes. That title goes to Bitcoin XT. The ideologically biased community that supports Bitcoin Cash was a significant percentage back in the early 2010s, nowadays that community is small compared the rest of the cryptocurrency community. Bitcoin Cash like Bitcoin XT and other Bitcoin forks, will simply be another altcoin copy of Bitcoin like the many forks that already exist.

What Kind of Assets are Cryptocurrencies?

cryptocurrencies

In the previous post I claimed that cryptocurrencies, at least most of them (including bitcoin), are not currencies although they are assets. Therefore, from now on I will stop referring to them as cryptocurrencies and call them cryptotokens, since I think the word token describes better not only their utility but also their properties as an asset class and does not exclude other projects that can actually perform as currrency.

Many people have pointed out how bitcoin, ethereum, ripple, etc. have equity like properties. For example, if bitcoin gains mass adoption, the price is expected to go up to match the price required to satisfy its utility with its user base. This is analogous to the price of a stock going up as a company’s earnings increase which usually require an increase in their customer base. However, the flaw in this analogy is that ownership of a cryptotoken does not provide any of the legal rights that are often afforded to the owners of equity in a company. To make matters worse for investors concerned on the legal ramifications of their investments, cryptotokens exist outside of any regulatory environment. While there have been efforts by several countries to pass laws to limit their citizens’ use of cryptotokens to avoid currency controls, such as in China, the fact that there is no actual legal entity standing behind cryptotokens other than the entire user base makes cryptotokens impossible to regulate without the state cracking down on its population in a manner reminiscent of a dystopian novel. While an argument can be made for the development teams behind a project as holding legal accountability for investors in their projects, once the project is live and the cryptotokens are being traded, the development team is not as relevant anymore, a different development team can fork the project and take the development of the cryptotoken in a different direction as it happened with Bitcoin Unlimited and Ethereum Classic. It is really up to the user base to decide which blockchain they will support. Therefore, the user base is the ultimate holder of leverage in the life of a cryptotoken and for that reason the user base is the ultimate holder of legal accountability regarding the value of a cryptotoken. Although, there may be in the future regulations introduced that afford some legal rights to owners of cryptotokens issued by a company where such company exists outside of the blockchain where the cryptotoken exists and those rights make the company legally accountable for the investments of cryptotoken owners thereby turning said cryptotokens into securities, until then most cryptotokens in existence are not securities and for that reason cannot be considered equity.

Detractors of cryptotokens have often pointed out the fact that cryptotokens lack legal backing despite performing like equity in a company as evidence that they are a scam since as the user base grows they become more valuable solely for the sake that there are more users. However, this type of thinking is due to a failure to understand what cryptotokens really are and the utility they provide. A better description of what cryptotokens represent are rewards points like those issued by credit cards or the loyalty programs of some businesses that can be used to pay for products or services offered by a business. In the case of cryptotokens however the business is not a brick and mortar entity but the network on which the cryptotokens exist whose service is provided through the algorithm within its blockchain. This company does not have any legal persons working in it and therefore it is considered a Decentralized Autonomous Corporation/Organization (DAC or DAO for short). The value of the service that this DAO provides to the public is measured in the value of its cryptotokens which go up in value as its services become more valuable to the public at large since you need the cryptotokens to access the DAO’s services just like rewards points offered by a small business would also become more valuable if the value of their services increases in US dollar terms but not in terms of their rewards points. Therefore, according to this terminology Bitcoin is the first DAO ever created with its service being the most basic of services possible with a blockchain, that is transferring information securely and with guarantees that it is not forged without the need of a middleman. Effectively solving the Byzantine’s General Problem.

While blockchain technology can be used to represent national currencies, or other well known assets like stocks, real estate, commodities, etc. it is currently being used to represent rewards points used to purchase the services of DAOs which are not much different than using rewards points to purchase products or services at your favorite shop. As a matter of fact rewards points of existing companies themselves are arising as a new asset class independently of the advances of blockchain technology with an expected value of $500 billion by 2019. There are even institutional investors such as hedge funds seeking exposure to them through new exchanges like the Affinity Capital Exchange (ACE). ACE is even planning to use blockchain technology to trade the products listed in its exchange. However, the difference between the majority of cryptotokens such as Ethereum or Bitcoin and the rewards points of loyalty programs of existing companies is that the companies behind the majority of cryptotokens are supranational decentralized entities called DAOs, that are virtually impossible to regulate. Therefore if one wants to classify cryptotokens as an investment vehicle, that investment vehicle is rewards points which has been in existence prior to the invention of Bitcoin, although not previously available to retail investors. However, the technology behind cryptotokens has actually created a new asset class, the DAO. One can seek exposure to DAOs, through cryptotokens that function as loyalty programs or mining equipment that verifies transactions in a DAO’s network, the latter being similar to fixed income products like preferred shares that pay out in the loyalty program tokens of the DAO while given the owner control over the network proportional to his ability to verify transactions.

Therefore, despite there being new blockchain projects every day, it is important to distinguish whether the cryptotoken being offered is giving exposure to a new DAO or the services of an existing physical company or companies (i.e. potcoin), because the latter would just offer exposure to loyalty programs of old fashioned companies, an asset that has already been in existence, whereas the former is giving exposure to a completely new asset class that has only been possible thanks to the internet.

Cryptocurrencies are not Currencies they are Something Else

cryptocurrencies

Back in 2013 when I first started investing in bitcoin and other blockchain projects many people including myself referred to all blockchain projects as cryptocurrencies. However, most blockchain projects that are referred to as cryptocurrencies (including Bitcoin) are not currencies. Most of them perform a terrible job as currencies, even the ones that are actually meant to work as currency such as Bitcoin. An agreed upon definition of currency by most economists is an object that is fungible (all unites of the currency are the same), transferable (can be easily interchanged), can serve as a unit of account (you can price goods and services with it), and serve as a store of value (the price tomorrow relative to everything else will be about the same as today). Unfortunately for most supporters of Bitcoin and other projects as a replacement of national currencies, Bitcoin and most similar projects fail to have all of these four properties of currency. Although Bitcoin and its brethren are fungible and divisible that they can be used as a unit of account they are as volatile as a penny stock, being subject to massive spikes and crashes sometimes simply due to unfounded rumors.

However, that doesn’t mean that all blockchain projects cannot function as currency. There’s a project called Tether which has tethered the price of the USD and EUR to its token by backing it with actual USD and EUR deposits. That project and similar others like Gatehub USD and Bitstamp USD which exist within the Ripple network deserve the term cryptocurrency since they are actually performing the job of currency by fulfilling the requirement of day to day price stability. However, they do not exist as separate from the national currencies they represent, and they are still not completely safe forms of currency as they are very dependent on the credit of the organizations supporting the tokens with USD and EUR funds as has been seen at times when insolvency rumors in the Bitstamp exchange or Tether affect the price of their respective currency tokens. Although the frequency of such rumors is rare and the price volatility of such tokens is small compared to those of Bitcoin and other blockchain projects.

If most cryptocurrencies are not currencies then what are they? It has been noted that the price variation of bitcoin and similar projects is similar to those of commodities. In the commodities world, sudden changes in demand due to weather or geopolitical events significantly affect the price of commodities due to their finite supply. With bitcoin and its brethren sudden changes in demand from speculators is often responsible for the sudden significant changes in prices due to the scarcity ingrained in the algorithm of most of these projects. The proof of speculators being responsible for the sudden spectacular price movements in bitcoin and its brethren can be seen in the fact that average transaction rates in their respective networks have been growing at a steady rate, signifying a steady rate of adoption due to its discovered utility among the people transacting in them, while the actual price has often been spiking multiple 1000% in short periods of time with massive volume and crashing down soon afterwards. Therefore, since bitcoin and its brethren have utility to the people that use it, as is evident by the steady growth of average transaction rates in their respective networks, they can definitely be categorized, just like natural commodities, as assets, as has been the position of the Internal Revenue Service in the United States, that is subject to significant spikes in volatility due to perceived scarcity among speculators.

A better and more important question that is yet to be answered is what kind of asset is Bitcoin and its brethren?