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.

The Great Cryptocurrency Bubble of 2017

Bitcoin Bubble

Another year and another bubble in the cryptocurrency market. As I explained towards the end of a previous post the the cryptocurrency market is in the middle of another bubble of epic proportions. The chart above shows the price of bitcoin compared to the normalized average transaction rates (averaged over five days to smooth it out). Transactions here refer to transactions within the Bitcoin network, transactions that have to be validated by miners, this excludes transactions within centralized exchanges that typically use an order matching engine. The normalized average transaction rate was calculated by first calculating a moving average of daily transactions over a period of five days and finding the daily growth rate of the moving average. Afterwards starting from a value of 1 and multiplying cumulatively by calculated growth rates. The end result is what would the value of $1 be had it been invested in an asset whose value appreciated locked in step with the growth of its network, in this case the growth of the network is estimated using the average transactions over five days. The time period covers from August 28th, 2010 to July 14th, 2017. The data was obtained from Blockchain.info.

Impressive Network Growth

The purpose of calculating the normalized average transaction rate was to estimate how much has the network growth relative to the price of Bitcoin. As the chart shows above the average transaction rate, the orange line, has grown quite impressively. If it had been a security, $1 invested in August 28th, 2010 would be worth approximately $644 today. That’s an astounding 64,300% return over almost seven years or approximately 154% yearly return. While the price of Bitcoin has offered a similar rate of return one thing to note is the considerably lower volatility of the rate of growth of the network compared to the price of Bitcoin. The network has been steadily growing year over year despite the spikes and crashes of Bitcoin. Although there are other factors that also have to be considered when estimating the health of a blockchain project, such as the number of active wallets in the network, the average price of transaction fees, etc. the average transaction rate encapsulates the more important question of how much is it being used?

Bitcoin is in a Bubble

As is also obvious in the chart there’s a poignant discrepancy between the price of Bitcoin and its normalized average daily transactions. Starting in Februrary 2017 the price of Bitcoin started to grow at a much faster rate than the average transactions per day of the network. This spike happened as positive news coming from Japan and Korea made headlines increasing demand from speculators. It is quite obvious that the surge in prices is not justified by the growth of the network. A similar event happened towards the end of 2013. While many people blamed the collapse of Mt Gox for the crash of 2013 and now probably the potential fork as a result of segwit activation, it is clear that in both cases the stream of bad news only served to remind investors to come back to their senses regarding the price of Bitcoin relative to the size of its network.

Cryptocurrency Market ins in a Bubble

While my analysis is only applied to Bitcoin, it extends to the entire cryptocurrency market. The great majority of cryptocurrencies are valued in Bitcoin, therefore a surge in the price of Bitcoin means a surge in their prices as well. To make matters worse, the relatively small trading volumes in other cryptocurrencies make them more vulnerable to spikes and crashes of much larger proportions than what is being experienced in Bitcoin at the time. While there are other projects that are also priced independently of Bitcoin, such as Ethereum and Ripple which are also possible to analyze, it is not necessary to analyze them to conclude that they are also in bubble territory when looking at their price gains in the past two months. Ethereum and Ripple, despite having grown tremendously in terms of popularity, funding, expertise of their respective teams, and utility of their tokens, their networks are still much younger than Bitcoin’s with a smaller number of participants, yet their current market capitalizations have been increasingly nearing that of Bitcoin despite Bitcoin being in a bubble itself.

The Bubble is Crashing but Another will Come

As I write the cryptocurrency bubble seems to be bursting, with Bitcoin being more than $1000 away from its peak at $3000 and Ethereum under $180. Many people in the past have claimed every time a bubble bursts in the cryptocurrency market that it is the end of the cryptocurrency market. Do not be alarmed as you can see in the chart above that despite there have always been bubbles and bursts, Bitcoin’s network has kept growing, as has been the case for the most established cryptocurrencies in the market that offer something innovative. As I explained in a previous post, every time there’s a surge in speculators (usually due to some significant positive news) the price of cryptocurrencies may experience parabolic growth, but be aware that these price spikes are never sustainable as the growth of their networks do not justify such sudden price gains.

Bitcoin Maximalism is Rubbish

bitcoin

Ever since the the launch of the first altcoin (alternative coin, as in alternative to Bitcoin), prior to the invention of the label “Bitcoin Maximalist,” there have been people opposed to the idea of multiple blockchains. At first they claimed that there can only be one blockchain. Their argument usually was that the invention of the Bitcoin protocol was analogous to the invention of the TCP/IP protocol which is the backbone of the internet. Therefore, just as TCP/IP was the first and only protocol to be used in what later became the internet, despite there being superior protocols invented afterwards, bitcoin will be the only protocol that will be used because, like TCP/IP, it had first mover advantage.

The first mover advantage would help the Bitcoin protocol achieve such a large network effect that it would make other blockchain projects redundant. If someone had to use a blockchain, that someone would use Bitcoin because it was the most widely used blockchain and blockchains are only meaningful if other people use them. It does not matter that competing blockchains may offer superior technological innovations because those innovations could be incorporated into the Bitcoin protocol thus rendering the competing project redundant.

The problem with this argument is that it’s based on an incorrect analogy. The Bitcoin protocol does not provide a service analogous to the TCP/IP protocol. The TCP/IP protocol is generic and trivial to use. Meaning that it can be used to transfer any type of information and no single transfer of information is significant to the network, thus not having any value. The cost of changing to a new protocol is higher than the cost of developing better hardware and software to work with the current protocol. On the other hand the Bitcoin protocol is very specific and its use nontrivial. One can only transfer bitcoins through the network and each transfer is significant enough that it requires other users to validate that network event (the bitcoin transaction). Thus every event is costly to the network and it may be cheaper to use a different protocol. In addition the fact that Bitcoin’s protocol is specific opens Bitcoin to competing projects with different protocols that satisfy users’ needs that Bitcoin cannot satisfy.

Although, there have been efforts to make the Bitcoin protocol more generic, such as the Mastercoin project and the Counterparty project, the Bitcoin protocol has been proven to be highly inefficient in performing the types of transactions a more generic project could offer. On the other hand were a more generic protocol be created to serve primarily to transfer tokens, as Bitcoin does, it would pale in comparison to Bitcoin. The network would be clogged with the amount of information having to be processed with every transaction, not to mention the rapid growth its blockchain would experience in terms of memory, i.e. Ethereum. For this reason it is not sensible for Bitcoin to adopt features offered in other blockchains, as Bitcoin’s performance limitations are not an accident but intentional by design.

When encountered with these facts some of the proponents of Bitcoin Maximalism argue that some of the features offered by other blockchains should not even be used by any blockchains at all. Their argument is that if a feature cannot be adopted by the Bitcoin protocol, it does not make sense at all in the realm of blockchain technology. Therefore, it cannot be considered an improvement on blockchain technology. The problem with this argument is that it assumes knowledge of the full impact of blockchain technology on society. It assumes full knowledge of the future, something no one is capable of. Prior to the creation of Google, searching the internet was considered a solved problem. In the 1990s no one had envisioned the rise of online social networks or the sharing economy. Microsoft was expected to rule the world. Therefore, while someone can make educated guesses on what is or what isn’t an improvement on blockchain technology, no one really knows what it is. Only the market will tell which features of new blockchains are improvements because they fulfill a need among the people that use them. This is evident in Ethereum’s rise as the default funding platform for new blockchain projects, overtaking Bitcoin’s place through the Counterparty and Mastercoin platforms back 2014.

Although no one can really tell what the future will be like, given the large potential impact blockchain technology can have on society, one thing is certain, Bitcoin will not be the only widely used blockchain in existence. In addition it is most likely that Bitcoin will not be the most widely used protocol given the limitations of its design. At this point in time Bitcoin is ancient technology with even Litecoin (a long time competitor) being significantly ahead of Bitcoin technologically, having already implemented Segregated Witness, something that may or may not happen for Bitcoin. A most likely future scenario is one of multiple blockchains specializing on different services with some competing against each other in the same service space and some dominating their service space. Bitcoin, however will no doubt remain as one of the most well known blockchains in existence for being the first of its kind, and therefore may still be widely used.