Frances Coppola spent many years working in banks and IT, and now writes and speaks about finance, banking and economics.
Bitcoin has proven unable of satisfying growing demand without deflecting noticeably from Satoshi Nakamoto’s initial vision of a “peer-to-peer electronic cash system.”
It was intended to provide a quick, secure and cheap means of making payments without using the traditional financial system. Today it still only manages a wee proportion of the traffic of, say, Visa or Mastercard, yet has become terribly slow and very expensive.
Solving bitcoin’s scaling problem has become a main concern of developers. But the problem has proved unsolvable.
Now, making a virtue out of necessity, the buzz is that bitcoin is “digital gold.” Its built-in limit of 21 million bitcoins makes it an ideal anchor for a hard-money financial system similar to a strict gold standard. A new payment system could be built on top of it.
The problem is, it’s impossible to have total decentralization, a fixed money supply and adequate liquidity for an effective payments system. This is bitcoin’s “trilemma.”
Motionless money
There was no trilemma in the gold standards of old. They were always centralized.
For instance, the “classical” gold standard of the 19th century was the blossoming of the British Empire, which at that time covered a third of the globe. The pound was the currency of international trade, and it was backed by gold.
Countries of the empire were forced on to the gold standard by the British government; countries outside the empire joined the gold standard, or even acknowledged the pound as their currency, because it made trade much simpler.
In the center of the web, the Bank of England managed both the price of gold and pound issuance. It was the most centralized financial system since the Roman Empire.
But for bitcoin, the fact that it is designed as a decentralized system means something else has to give. And the clue is its rapidly rising price.
Bitcoin is becoming illiquid.
Bitcoin’s growing illiquidity is due to a toxic combination of high demand, hoarding and designed-in scarcity. The rapid price rise indicates that purchases have increased much more than sales. More and more people are buying bitcoin hoping to cash in as the price rises, while those who already own bitcoins are Holding On for Dear Life for the same reason.
People are averse to spend their bitcoins, because that rapidly growing price means that they face huge opportunity costs.
And although bitcoins are still being produced, the rate at which they are mined is nowhere near enough to meet demand – and anyway, miners too can HOLD their bitcoins.
In the meantime, growing transaction volumes are causing network overwork. Bitcoin has no facilities of adjusting capacity other than rationing verification. Miners check transactions with higher fees faster than those with lower fees. Those who want fast verification (which is almost everyone, since bitcoin’s price is growing so quick) will pay higher fees. Those who don’t want to pay higher fees must wait longer for their transactions to settle.
Bitcoin’s popularity means both higher transaction fees and slower settlement times. The design feature intended to prevent it coming to a hyperinflationary end is driving it towards deflationary gridlock. As Business Insider asked, what on earth is the point of money that you can’t spend and can’t convert to anything else?
But is there a method to solve this problem? The clever folks working on the Lightning Network think so. Their solution is to take most transactions off-chain, and to share liquidity across the network.
Supply deficit
Lightning is a decentralized network of pre-funded, bilateral bitcoin payment channels off the bitcoin blockchain. Lighting transactions are typically small, and most are not broadcast to the blockchain. So they should be cheaper and much more quickly than on-chain bitcoin transactions.
Supposing enough people open Lightning payment channels, there will eventually be a sizable bitcoin liquidity pool distributed across the network. The question is, how to enable it to be shared.
Lightning developers are designing a routing facility that identifies which network nodes have enough funds to make a payment, calculates the shortest vital route to
the payment destination across those nodes, and sends the payment. If this works, it would resolve the bitcoin trilemma.
However, there are no guarantees that this will work.There are 2 potential problems.
The first is that Lightning’s pre-funded channels tie up funds that could be used for other aims. Because of this, people may choose to keep very low balances in their Lightning channels, topping them up frequently rather than making infrequent balance adjustments.
And the second is that channel funding changes permanently. Typically, people would fund their channel, then pay the balance down gradually. Soon after funding, there could be quite a big balance, but only a few days later, the balance might have reduced noticeably.
If a lot of people fund their channels at around the same time – for instance, if people fund their channels on payday, then pay them down over the next month – liquidity across the network could vary noticeably. This would mean that, at times, particularly for bigger payments, it could be hard or even impossible to find a payment route.
Howbeit, Lightning could prove as illiquid as bitcoin.
Lightning’s illiquidity problem could be resolved by creating big payment channels kept open and totally funded at all times, so that they were always available for payment routing. But this would mean Lightning was not fully decentralized.
Such “hub” channels would be more effective for payments, but they would be a magnet for burglars and a point of weak point in the network. If one went down, an awful lot of payments could be broken.
The alternative would be to allow channels temporarily to go into deficit as a payment passes through. This would guarantee that payments always settled.
However, since it is effectively fractional reserve lending, it would breach the “gold standard” principle of bitcoin. If gold is needed to settle payments, and you haven’t got enough gold, you can’t settle payments. This is how it works. It is also why it fails.
Lightning is still in progress, of course. But now, it is difficult to see how it can solve bitcoin’s three-pronged problem.
