Why Bitcoin May Not Stand Up To The Bitcoin Standard

Bitcoin provides an opportunity for its users to store and transfer assets without the needtrust and involvement in the process of anythird parties. However, such guarantees apply only to 4400 transactions per block (possibly more, provided that payments are made from one sender to many recipients). All things being equal, the transaction capacity in the Bitcoin network is limited by the block size. The current block size limit exists for technical reasons and because of restrictions imposed by incentive compatibility that are unlikely to disappear any time soon.

Some people claim that you canScale Bitcoin by increasing block size. Although this would allow an increase in the number of transactions, at the same time sacrificing security guarantees for transactions. Thus, Bitcoin provides protection of its properties, excluding any use in excess of a safe bandwidth limit. Over time, the limit of safe capacity can be increased, for example, using additional layers, such as Lightning.

I would like to challenge this traditional notion by saying,that Bitcoin’s ability to limit the number of users is actually less than is commonly believed. While Bitcoin can controlthe number of users within the network, it has no control over the number of users accessing the network through custodial banks. The increase in this banking layer is beyond the control of the protocol, and this situation may escalate into a systemic risk for Bitcoin.

Users choose custodial banks, becausethat they offer lower transaction costs in various directions. The benefits of custodial services may be a greater network effect, faster payment clearing, legal protection offered to clients, lower fees charged for transactions, or access to financial services such as the exchange or money markets.

Today, there is a popular opinion thatthe future “Bitcoin stack” will consist of various layers representing unique points on the trust / value diagram. If the functioning of higher levels is interrupted for any reason, users will be able to retreat to lower layers.

In this article, I'll showhow the custodial banking layer creates a systemic risk for Bitcoin. After that, I'll tell you thatdriven by the growth of the custodial banking layer, and finally,how could the negative consequences for Bitcoin be prevented.

How the custodial banking layer creates a systemic risk for Bitcoin

Imagine a future in which 200 millionpeople use bitcoins, and most do it through the custodial banking layer. These banks use the core chain as an interbank settlement network. Users trade bitcoin bills, which are deposits in bitcoins.

The long-term stability of this mechanism dependson who has leverage and on whom. If users can leave the system at any time and go to a competitor (including system layers that do not require trust), the depository banking system remains under control. But if users are locked inside the system, then the power belongs to banks (and therefore to governments) Whether users will be blocked or not depends on the cost of logging out.

Manual exit cost

When governments can step in and revoke the ability to redeem Bitcoin, such an action couldgovernments can increase the infinite cost of exiting the system.It is difficult to control the network layer itself, but in this context it is not necessary at all.Banks are already under their control.

This is exactly what happened in 1933 with the gold of US citizens, and in 1971 - with the gold of other national states located in the United States.

If the buyback option is canceled, Bitcoin completes the switch back to fiat money, exactly as it is shown on the Dalio long-term debt cycle diagram.

: https://www.linkedin.com/pulse/money-credit-debt-ray-dalio/

It is noteworthy that this is not the scenario withwhich users could make “UASF” (user-activated soft fork) or react in some other way at the protocol level, since the rules of the Bitcoin standard are still subject to the rules of the Bitcoin protocol. The users themselves allowed this situation to grow into a political problem, which now requires a political solution.

Organic Cost

In practice, governments may not even have to cancel the possibility of buying out bitcoin, because the cost of withdrawing can rise very naturally.

Take the scenario of mass withdrawal of deposits frombanks, when all 200 million people, or at least a significant part of them, would like to leave this banking system and move down the stack to a level that requires less trust. Some of them would succeed in making such a transition, but they would be the winners of the auction, which raises transaction fees to several thousand or tens of thousands of dollars. All the rest would remain on the same higher layer.

If the taller layer becomes too large compared to the capacity of the lower layer,people lose the ability to move back down the stack. Since users are permanently blocked at a higher level, governments can safely implement various taxes or rule changes in the system.

What drives the growth of the custodial banking layer

People use higher levels becausethey offer them better positions in the trust / cost spectrum. Remember that “value” includes many things, not just transaction fees. It also includes network effect, estimated time, reversibility, privacy, etc.

I'm afraid that there isfeedback loop, which makes the custodial layers more attractive, the larger they become, thereby attracting even more new users to them.

This scenario can be illustrated first.turn by example from the "gold standard". Each user of gold competes in the market with other such users. The sooner they can pay off their debts, the more willing suppliers will do business with them. If custodian banks can provide them with lower commission fees, then they can redirect this savings to the price of their trading partners. The result is a feedback loop in which users switch to the cheapest solution over time.

The advantages of using a bank ledger are local and immediate, while the disadvantages are global and often manifest with a delay of decades.

The same feedback loop exists inBitcoin, but perhaps in an even stronger version. If the level of custodial banking services will be significant success, we can assume that all these settlement transactions will lead to an increase in operating fees at a basic level. Suddenly, more and more people will generally be squeezed out of non-trusting layers due to high fees. Custodians will be able to afford to pay more for the space of the base layer, since their operations represent the aggregate interests of thousands of users outside the chain.

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As a result, consumers who did not usepreviously custodial services, they may face the problem of choosing between switching to the use of custodial services and the complete cessation of the use of bitcoins. This also applies, to a slightly lesser extent, to the Lightning network, where you cannot securely make payments that are less than a 3.5-fold commission limit on the network.

It’s noteworthy that the feedback loop is everythingcan still continue to operate, provided that transaction fees remain at a very low level. The reason again is that commission is just one aspect of the total transaction costs. If the security budget of the main chain is very small, this threatens with excessive terms for settlement of transactions. Which ultimately further increases the relative advantage of off-chain custodial solutions, such as banks.

How to Prevent Negative Implications for Bitcoin

From my point of view, there are two ways to minimize systemic risk from the custodial banking layer.

First, the Bitcoin community candissuade users to accept debt on a large scale. It is about creating such an understanding, withwhich new users will still have financial involvement in Bitcoin, but they will not use it in such a way as to give banks the opportunity to have more advantages than layers without trust.

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It is possible that this has already happened inthe past couple of years and shows how well the Bitcoin community instinctively understands that the confidence in the guarantees provided by Bitcoin weakens for everyone if too many people use it incorrectly.

Secondly, we must continue toto innovate and expand Bitcoin's capacity at levels that do not require trust in order to support a larger number of users.More specifically, we need to develop methods that allow multiple users to share a single UTXO, so that they can also pool their interests to survive in the on-chain market of block spaces with custodial banks.

There is an implicit assumption in Bitcoin thatusers will agree to pay more for using a basic layer or its non-trusted add-ons such as the Lightning Network. In practice, Bitcoin competes not only with fiat money or even other cryptocurrencies, but also with custodial Bitcoin banks.

I would still consider myself confidently“Adherent of small blocks,” but the analysis does raise some doubts as to whether maintaining low data verification costs is as effective as is commonly believed. You may have low validation costs, but you will be forced to switch to custodial levels due to high transaction fees, very long settlement times, or other factors that increase costs.

Many proponents of Bitcoin believe that moving too fast is a significant risk, unlikeThis would be true if Bitcoin could stick to its own growth rate, but it doesn't.We areshould do everything possible so that sufficientthe volume of market demand could be satisfied with the help of levels without trust, otherwise there are all risks that the custodian banking system will forever hang ballast on the base layer.

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