This is a followup to my recent post on the True Cost of Bitcoin Transactions. A legion of Twitter trolls has been yelling at me, proclaiming that “since people are willing to pay higher prices, that proves Bitcoin’s value is growing.”

This is actually a common sentiment among those who believe that blocks filling up is “no big deal.” As space gets tight, the argument goes, the transaction fees rise and this balances out supply and demand. This is referred to as the “fee market” where fees determine who gets into a block, and it has become a way to dismiss anyone raising concern about network congestion on Bitcoin.

As with all good rhetorical distractions, it has some truth to it. Indeed, as blocks approach capacity, fees rise, and only those transactions willing to pay the most will be included. Sounds very “market-esque” doesn’t it? You have to pay to play, after all. You shouldn’t expect to “freeride” on the Bitcoin blockchain.

There is a really serious problem with this mentality, however…

Here is a point of economic truth: If Bitcoin blocks fill to the point where prices are rising, utility at the margin falls.

What does this mean?  It means that of the universe of potential uses of Bitcoin, the subset of uses which makes sense is diminished by rising costs. If it costs $0.10 to send a Bitcoin transaction, X number of use cases are theoretically practical. But if it costs $100 to send a Bitcoin transaction, X-Y use cases are theoretically practical (a smaller amount). Thus, the higher the cost of transactions, the fewer the applications. For a technology that relies on network effect, this is very important.

Regardless of this truth, some people point to the increasing transactions we see on Bitcoin today, notice that the blocks are filling up, and proclaim that this is sign of success because “lots of people are finding the system useful.” Yes, that’s true. Bitcoin is increasingly finding use among people, and this should be celebrated, to an extent.

But this is the “seen,” as Bastiat would say. What is “unseen” is that as transaction costs rise, potential transactions that would otherwise occur, no longer do. Thus, as the actual transaction count on the network increases, and prices rise, the theoretical transaction count (ie – the sum of all potentially useful transactions) falls.

To illustrate this principle, and why it is existentially important for Bitcoiners to understand, let’s consider a hypothetical situation with an imaginary cryptocurrency, AlphaCoin.

AlphaCoin has ten potential Use Cases around the world (Use 1, Use 2, … Use 10).  Each Use Case has up to 200,000 transactions per block of potential demand based on adoption and price. Thus, a fully-realized AlphaCoin could enable theoretically 2,000,000 transactions per block.

The Parable of Alpha

Assume that each AlphaCoin block can fit 20,000 transactions, on average. And assume that, on Day 1, there are 15,000 transactions per block happening per the below Use-Cases. Thus, blocks aren’t totally full, and let’s assume fees are $0.10 per transaction under these circumstances.

Day 1 – AlphaCoin

  • Use Case 1 = 3,000 txs per block
  • Use Case 2 = 5,000 txs per block
  • …Use Case 3-10 = 7,000 txs per block
  • Capacity =  15,000/20,000 txs per block
  • Fees = $0.10 per tx
  • Total Revenue to Miners = $1,500 per block

Next, assume that on Day 100, there are now 20,000 transactions per block happening in AlphaCoin. Use Case 1 and Use Case 2 have grown considerably, and the users are happy to pay the now higher ($2.00) transaction fee, for it’s still well worth it to them.

Day 100 – AlphaCoin

  • Use Case 1 = 10,000 txs per block
  • Use Case 2 = 10,000 txs per block
  • …Use Case 3-10 = 0 txs per block
  • Capacity = 20,000/20,000 txs per block
  • Fees = $2 per tx
  • Total Revenue to Miners = $40,000 per block

Use Case 1 and 2 grew, and the AlphaCoin system itself grew (20,000 transactions per block now, nice!) Clearly, AlphaCoin is providing more value to users and is succeeding.

But wait… what has happened to Use Cases 3-10? They’ve been priced out. $2 per transaction is too expensive for those Use Cases. They’ve left AlphaCoin. Maybe they went to another crypto platform, and maybe they just don’t happen at all anymore.

Should AlphaCoin advocates be happy about the above situation? Well, it depends. If the goal was to build a network that supported a limited number of Use Cases, then yes they can celebrate, for those Use Cases have grown to the max and are fully and adequately served by AlphaCoin.  Transactions have grown 33%, fees are up 2,000%, and miners are earning $40,000 per block so hashrate security is higher. Clearly the world is finding AlphaCoin increasingly useful and AlphaCoiners are going to the moon.

That’s the seen. What about the unseen?

What if the goal was to support many other Use Cases? What if the goal was to change the global financial system, with all its myriad users and demands, for example? In this case, celebration may not be as warranted, for all those other Use Cases, finding previous utility with AlphaCoin, have now left.

In the noise of aggregate transaction growth, the potential Use Cases and marginal utility of AlphaCoin fell. Maybe when transaction quantity rose, and especially when AlphaCoin price increase, AlphaCoiners don’t realize what has happened.

And let’s ponder how this could play out a little further…

Fast forward to Day 1,000, Use Cases 3-10, priced out of AlphaCoin, gradually migrated to BetaCoin (all the AlphaCoiners confidently proclaim BetaCoin a scam, of course), and it looks like the below…

Day 1,000 – AlphaCoin

  • Use Case 1 = 10,000 txs per block
  • Use Case 2 = 10,000 txs per block
  • …Use Case 3-10 = 0 txs per block
  • Capacity = 20,000/20,000 txs per block
  • Fees = $1.50 per tx
  • Total Revenue to Miners = $30,000 per block

Day 1,000 – BetaCoin

  • Use Case 1 = 15,000 txs per block
  • Use Case 2 = 15,000 txs per block
  • …Use Case 3-10 = 1,000,000 txs per block
  • Capacity = 1,030,000/2,000,000 txs per block
  • Fees = $0.05 per tx
  • Total Revenue to Miners = $51,500 per block

That’s interesting… By pricing out Use-Cases 3-10 from AlphaCoin, a competing platform (BetaCoin) that permits more transactions per block has earned those users. Has AlphaCoin failed? No, it’s still “hugely successful,” for it’s running at capacity, with fees 1,500% higher than on Day 1. Clearly, “users are still finding huge value with AlphaCoin.”

But look what else happened: BetaCoin now has 1,030,000 transactions per block, serving not only Use Cases 3-10, but actually 1 and 2, as well. In fact, it has more transactions from Use Case 1 and 2 than does AlphaCoin even! And while fees are cheaper, only $0.05 per tx, it appears that BetaCoin is actually more secure than AlphaCoin, for it’s paying miners $51,500 per block vs AlphaCoin’s $30,000 per block.

In other words, BetaCoin now enjoys a higher hashrate, and much higher use, than AlphaCoin. Not only that, but BetaCoin’s existence with lower fees has made AlphaCoin less competitive, and thus fees on AlphaCoin itself have fallen, from $2 per txs on Day 100 to $1.50 on Day 1,000. AlphaCoin’s own security is now lower and it is, by far, less successful and widely adopted than BetaCoin.

The lesson…

Transaction costs matter, and as costs rise, marginal utility of a platform falls. We should not be so blind to think that just because transaction count is rising, and fees are rising alongside, that a platform is “getting better.”

If fees are rising because we are truly at a technological capacity limit, then fine. But if fees are rising because we are at an artificial/arbitrary limit, then that should be examined. If such limits encourage other Use Cases to explore other platforms, Bitcoin jeopardizes not only its continued adoption, but in fact its very security.

The Parable of Alpha isn’t a guarantee of what will happen to Bitcoin. Rather, it’s an example of a real risk of lost users to the extent transaction throughput is throttled and transaction costs artificially heightened.

For a community that weighs very heavily the risk of any marginal loss of decentralization, there is a disturbing tendency to wholly discount the risk of any marginal loss of actual users. A network with a hundred nodes and a hundred users is perfectly decentralized, while the network of 20,000 nodes and one billion users is proportionally less decentralized. Yet, which would should be the goal for Bitcoin? Perfectly relative decentralization on a small network, or significant decentralization on a globally used network? The benefit to academics may come from the former, but the benefit to humanity comes from the latter.

The Bitcoin community should be embracing more use cases, and more users, by advocating and working toward lower transaction costs as a fundamental goal. If it doesn’t, another platform may.

 

Tags: ,
Erik Voorhees
Erik Voorhees
http://www.ShapeShift.io
Erik Voorhees, CEO of leading digital asset exchange ShapeShift.io, is among the top-recognized serial Bitcoin advocates and entrepreneurs, understanding Bitcoin as one of the most important inventions ever created by humanity. Erik's former project, the groundbreaking gaming phenomenon SatoshiDICE, was, at its peak, responsible for more than half of all Bitcoin transactions on Earth and popularized the concept of "provable fairness." Having been a featured guest on Bloomberg, Fox Business, CNBC, BBC Radio, The Peter Schiff Show, and numerous Bitcoin and industry conferences, Erik humbly suggests that there is no such thing as a “free market” when the institution of money itself is centrally planned and controlled. This blog is about the human struggle for the separation of money and state, and about Bitcoin as the instrument by which it will happen.

Comments are closed.