Bitcoin… is it failing?

Good morning everyone, and welcome to my first actual post of 2016. I’ve been away on holiday – which meant that I happily bypassed all the Penny Sparrow drama, and neatly avoided getting Gareth-Cliffed by the Twitterati (although it could still happen).

Anyway, because the Rand and Emerging Market currencies in general and the oil price and global stock markets have continued to take a beating (as expected, mind), and because local politics and global politics are so depressing (#NotSoRainbow and #Trump/#Cologne respectively), I thought that it would be a relief to talk about some news that doesn’t impact many of us too much. So I’m starting the year with Bitcoin.

There is an article that is doing the rounds on Medium. I took a time-out from the sight-seeing to read it when it showed up in my inbox – and quite a few of you sent it to me as well, so thanks for that! Here is the link: The Resolution of the Bitcoin Experiment. And basically, it reads like a Shakespearean political tragedy: the once noble ideal of Bitcoin had this fatal flaw that could so nearly have been fixed, but wasn’t, because of the idealistic clashes of guardians who were committed but divided, and now that fatal flaw is being exploited by a nefarious Dark Lord (China), and so doom.

But first, here is a quick Bitcoin refresher.

A Beginner’s Guide to Bitcoin

Bitcoin was created/invented by the mysterious Satoshi Nakamoto, who is still at large. It was intended to be the world’s first decentralised currency, as well as a digital gold standard.

It works something like this:

You have people like you and me, who want money to pay for things.
But perhaps we don’t want to go through international banking systems because Visa charges are expensive, or because we live in China and have awkward exchange controls that prevent the payment, or because we’re the kind of people that get paid in Bitcoin (for doing who knows what).
So we have bitcoin exchanges, where you will find other people who want to swap your centralised currency for Bitcoins (the decentralised currency), and vice versa.
Finally, there are the bitcoin miners (computers), who are also the processors of any bitcoin transactions. And to be clear, the Bitcoin miners are basically every computer with the Bitcoin mining software installed on it.
Okay, so, if I want to pay for something in Bitcoin, I would first have to have a Bitcoin wallet, with Bitcoins put in there after I purchased them on the Bitcoin exchange.
I could then go to my online retailer and buy something.
At that point, the transaction to move Bitcoins from my wallet to the online retailer’s wallet would go into a transaction block that needs to be cleared by the Bitcoin miners.
WARNING: it’s about to get a bit technical. But I’m doing my best.
The Bitcoin miners are furiously engaged in a kind of mathematical scavenger hunt: trying to solve what I like to think of as a massive Sudoku puzzle (where at the beginning of each block, the code shuffles around a few of the indicator numbers, and demands that the computers employ massive amounts of processing power in search of a fresh solution). The moment a single computer (or node) happens upon what it thinks is the solution, it broadcasts it to the rest of the network. If more than 50% of the computers in the network agree that the solution is correct, it gets added to the code of all the bitcoins in the outstanding transaction block, the transaction block gets processed, bitcoins are transferred, the finder-node gets a little bitcoin reward for finding the solution, and everyone moves on to the next block of outstanding transactions (and the next re-shuffle of the puzzle).
At which point, I now have fewer bitcoins in my wallet, and the online retailer has more bitcoins in theirs. And the bitcoins in their wallet have some shiny new numbers tacked onto the end.

The process sounds complicated. But basically, the Bitcoin software is meant to be an elegant mathematical solution to prevent bitcoin duplication. The difficult part of a decentralised digital currency is making sure that the bitcoins can’t be pirated, or re-used multiple times like a Big Bang Theory episode downloaded from a torrenting site.

The Potential Flaws

Right, so that’s the solution. What are the problems? Well, there are a few:

Firstly, the system requires that the network of bitcoin miners be well distributed. If more than 50% of the bitcoin miners are controlled by one person (or group of people), then that person/group would theoretically be able to reject any solutions broadcast by a node outside of their network, and thereby control the entire system (and earn all the future bitcoins). I think there was the assumption that this possibility would grow increasingly less likely as the number of mining computers increased in the network. Unfortunately, this wasn’t quite the case. For example, people panicked big time in July 2014 (I wrote about it here), when the GHash.IO group of miners briefly controlled just over 50% of the mining computers on the network.
The second flaw seems like a weird one: the initial code developed by Satoshi Nakamoto arbitrarily limited the transaction block size to 1 megabyte per block. There is (apparently) a fix to this – the code can be changed to allow larger transaction blocks. Which is exactly what you need when more people start to transact, otherwise the blockchain gets overwrought and payments become unreliable once people get caught up in blockchain queues and such.
The third flaw is basically just that humans are humans, and humans are in charge of the code (and of changing the code); so when you get independent idealistic thinkers having different idealistic opinions, then things get rocky. Which is exactly what you don’t want in a monetary system.

And the Bitcoin experiment is now stymied by all three of those issues at once. There are probably more flaws that we haven’t quite identified as yet – but I feel like those three are enough to be getting on with.

The Flaw Trifecta

So here is the opening number of article auther and now ex-Bitcoin core developer Mike Hearn:

If you had never heard about Bitcoin before, would you care about a payments network that:

Couldn’t move your existing money
Had wildly unpredictable fees that were high and rising fast
Allowed buyers to take back payments they’d made after walking out of shops, by simply pressing a button (if you aren’t aware of this “feature” that’s because Bitcoin was only just changed to allow it)
Is suffering large backlogs and flaky payments
… which is controlled by China
… and in which the companies and people building it were in open civil war?

I’m going to hazard a guess that the answer is no.

Spicy! And could his tone be any more dry? It’s like all of my favourite things.

Here is the summarised story:

The Bitcoin network is on the brink of collapse because the blockchain keeps getting full.
You’d think that the Bitcoin folk would decide then to lift the 1 megabyte limit that’s causing the problem.
But no.
According to Mike, this is “because the bitcoin mining network is controlled by Chinese miners, just two of whom control more than 50% of the hash power. At a recent conference over 95% of hashing power was controlled by a handful of guys sitting on a single stage. The miners are not allowing the block chain to grow.”
Why?
My favourite reason: Chinese government firewalls mean that China’s internet connection to the outside world is basically at mobile data speeds.
“Imagine an entire country connected to the rest of the world by cheap hotel wifi, and you’ve got the picture. Right now, the Chinese miners are able to — just about — maintain their connection to the global internet and claim the 25 BTC reward ($11,000) that each block they create gives them. But if the Bitcoin network got more popular, they fear taking part would get too difficult and they’d lose their income stream. This gives them a perverse financial incentive to actually try and stop Bitcoin becoming popular.” ~ Mike Hearn
So that’s a problem. Actually, that’s problems one and two combined.
Now for that human issue.
When Mr Nakamato abandoned Bitcoin back at the turn of the decade, he essentially handed control of the code over to a group of core developers. I’m not sure if that’s what he intended – but like all noble founders/leaders, he couldn’t control what happened to his legacy after his departure.
Around this block size issue, the core developers have essentially split down the middle. One side (Mr Hearn’s) felt that the block size should increase in order to keep the system workable; the other side wanted to keep the block size as is, concerned that allowing larger transaction sizes would allow Bitcoin to become too corporatised, and risk becoming less decentralised.
So Mr Hearn’s side of the team decided to follow the spirit of Mr Nakamoto, and develop a Bitcoin code that allowed for larger transaction blocks. They called it BitcoinXT, and the general idea was: “Instead of trying to settle this between ourselves, let’s allow the bitcoin users to vote for which version of the code that they’d prefer.“
The other side treated this as a massive betrayal, and immediately banned all discussion of BitcoinXT on the forums (not sounding too decentralised at this point, amirite?).
This led to lots of banning of people from the Bitcoin forums for mentioning BitcoinXT.
And now there is no BitcoinXT (or so I understand).
So the Bitcoin network is rapidly approaching breaking point, and any discussion of this fact does not really take place in public (and is thereby mostly hidden from investors). Except for this article, obviously.

So that’s the story. And I think it’s interesting because it takes me back to the question that I was asking two years ago:

Here’s a theory: free markets contain within them the seeds of their own destruction, because the rise of a dominant player is simply an inevitability of time?

The Bitcoin story certainly seems to be headed in that direction. All those attempts to maintain the decentralisation of the Bitcoin network seem to involve some very interventionist-type moves. And awkwardly, there are clearly some special interest groups in play: groups that are powerful, and with money in the game.

It’s just a thought.

Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.