Austrian Economist: Availability and volatility prevent Bitcoin from becoming a medium of exchange


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Due to volatility and usability issues (for example, confirmation time, handling fees, transaction throughput, available wallets and custody, etc.), it now makes little sense to try to use Bitcoin (or any other cryptocurrency) in everyday business. Usability issues can be solved through technologies, including better software, applications, payment protocols, and second-tier extension solutions. The volatility issue requires time accumulation to bring more awareness and wider adoption.

Bitcoin’s availability as a medium of exchange

First, let us understand availability with a focus on capacity.

Bitcoin’s base layer protocol cannot be expanded exponentially. Linear and incremental expansion is possible, and it will continue to be upgraded to accommodate more throughput and other optimizations. However, if Bitcoin wants to carry billions of users, it must expand exponentially, and blockchain is not suitable for this demand. Any cryptocurrency that claims to be possible sacrifices some key features of the blockchain to achieve this goal, and its creators often fail to disclose or even realize this. The exponential scalability on the chain with the highest security and decentralization is not feasible, and there must be engineering compromises.

Similar to the Internet protocol stack, many blockchain projects strive to avoid layered protocol development at all costs. Although this article is not a technical discussion about scalability, it cannot be avoided because the concept is closely related to the dispute between the store of value and the medium of exchange.

A reasonable solution to the problem of technical limitations on the Bitcoin chain is based on the Bitcoin construction protocol. So far, the Lightning Network (Lightning Network) is the most promising second layer solution, which can increase transaction throughput and reduce confirmation time. It is not the only or last hierarchical solution for decentralization and trust minimization to solve scalability problems. What most people cannot understand is that the Lightning Network is not a currency network, so the Lightning Network Protocol will not create a new currency. It is just a payment network, no currency is issued on it, and no currency is transferred through it. The Lightning Network implements payment routing by transferring ownership of on-chain balances, which are linked to specific “unspent transaction outputs” (UTXO) on the Bitcoin network using encryption technology.

The Lightning Network is built on pioneering ideas like eCash, which allows private, untraceable payments via the native currency in its system (known as “CyberBucks”) or national legal tender. In this way, the payment network can provide greater capacity and better privacy.

Layered development will make Bitcoin similar to the current financial system, but this similarity is only from a functional point of view. In terms of security, the two are very different, because there will be fewer trusted third parties (if any) in the Bitcoin monetary order.

The legal currency of each country is not scalable by design. Including gold itself cannot be expanded. The bank is essentially a payment network based on legal tender, which can realize the exponential expansion of legal tender. PayPal is another payment network that allows fiat currencies to be used more widely in the digital world.

Although economists believe that commercial banks created money out of thin air, this is not the case. On the one hand, banks issue liabilities or deposits that can be exchanged back into legal tender (base currency) at any time. These liabilities are a payment commitment (similar to off-chain transactions) and are only settled when the paper currency is redeemed (on-chain transactions).

Bank deposit is a promise that it can be exchanged back to legal currency (base currency) at any time

On the other hand, assets held by banks. These assets have varying degrees of liquidity, maturity and default risks. Banks must use market-acceptable tools such as cash, securities, loans, etc. to manage their liquidity in order to fully and prudently meet their debt repayment obligations. Therefore, although individuals use demand deposits to conduct transactions in economic activities, demand deposits themselves are not currency. Bank deposits may be used as currency, but it is essentially a promise of payment. Therefore, it is ridiculous to grant this privilege (legal currency status) to commercial bank debt (current deposits).

Therefore, our current financial system has a variety of payment networks (hierarchical, parallel, subordinate, and, often overlapping), which are filled with (for better or worse) trusted relationships. The “need for trust” is exactly what makes Lightning Network different, because its payment channel is not a payment promise, but a kind of bilateral contract driven and protected by clever encryption technology. These contracts are similar to specific UTXOs on the Bitcoin chain. Bind.

When envisioning the development of the Bitcoin stack protocol, from a functional point of view, its similarities with the current financial system include:

1) Basic layer protocol (or strong currency, base currency and external currency): gold, legal paper currency and bitcoin.

2) Secondary and outer protocols (or payment networks): banks, financial institutions, PayPal, ApplePay, WeChat Pay, and Lightning Network.

The difference between a fiat currency (or gold)-based financial system and a Bitcoin-based financial system lies in the security model, that is, the trusted interconnected party security model vs. the network security model with minimal trust, or in other words, centralized Trusted security model vs. distributed security model without trust. This distinction is true for both the basic layer protocol (fiat currency and Bitcoin) and the outer layer protocol (bank and Lightning Network). However, gold’s “basic agreement” is more similar to Bitcoin because it is not a debt of anyone.

Therefore, the statement that Lightning Network uses encryption technology to replicate the traditional banking system ignores the most significant difference between the two. The former is an open bilateral contract network with the lowest level of trust, and no one party unilaterally keeps basic assets. The latter is a closed and trusted network in which centralized institutions and customers contract the transfer of ownership, control of underlying assets, and the promise of instant payment (in short, the relationship between banks and depositors). Therefore, the lightning network payment channel is a contract between two parties with equal rights, and the nature of the contract between the bank and the depositor is the relationship between the debtor and the creditor.

Now that we have understood the similarities and differences between the two financial systems, we will answer the question of how to use Bitcoin as a medium of exchange.

Consider the following: Today, when you pay via bank or PayPal, is it correct to say that you are using U.S. dollars? Are U.S. dollars in wire transfers used as a medium of exchange? The paper money is not actually handed over to the other party, right? We can conclude that the US dollar is not the medium of exchange in this transaction. This transaction is a transfer of the ownership of the “Instant Payment Banknote Commitment”.

The above statement is technically correct, but it has no practical significance. However, Bitcoin Cash proponents use this method of reasoning, that is, Bitcoin’s off-chain transaction means that it is not used as a medium of exchange.

In fact, currency is indeed a medium of exchange, and the US dollar is indeed a medium of exchange, but this does not mean that every transaction in an economy should be done directly with paper money (or gold, or bitcoin on the chain). This approach cannot be extended, so we need to use payment networks, and these payment networks must be linked to (or supported by) legal tender. In other words, it does not matter whether we use physical currency or the payment network for payment.

If only when the two parties actually transfer paper money (or gold) can the function of the medium of exchange be manifested, then we can think that money is rarely used as a medium of exchange, especially in developed economies where cash payments are becoming less and less. At present, the basic currency is so separated from daily economic life that it lacks practical significance to explore whether the function of the medium of exchange exists from the perspective of the basic currency. Most payments are not made in currency, but are denominated in currency, and payment commitments are settled in currency.

Paper money forms the basis of our current financial system (ie, currency standards), and the payment network (ie, off-chain) runs on this and settles payments through it (ie, on-chain). In this system, the dollar is a store of value (although very unstable in the long run), but also a medium of exchange and a measure of value.

The same model applies to the Bitcoinized financial system. Bitcoin can be used as a store of value, a medium of exchange, and a measure of value (at least theoretically possible). However, this does not mean that every transaction must be carried out on the chain. Bitcoin can (and will) be used as a medium of exchange. But in the long run, a large number of transactions may occur on the payment network, and these transactions transfer the ownership of the balance on the chain. These ownerships may or may not be payment commitments (that is, there may be both Lightning Network and traditional banks-just like the current centralized exchanges), and then these ownerships are settled on the Bitcoin chain through the transfer of UTXO.

At present, Bitcoin is already a very safe and smooth global transaction method. For large and medium-sized transactions, borrowing from Szabo’s terminology, Bitcoin is an excellent “wealth transfer medium.”

But frequent and small payments may eventually be made mainly through payment networks. They do not need to use actual bitcoins, but use bitcoins for pricing and use bitcoins as settlement assets for bilateral contracts (such as Lightning Network or other trust-minimizing third parties) or payment commitments (trusted third parties).

In this sense, the basic protocol can be regarded as the final settlement layer, where only large transactions are often carried out, while the second layer can satisfy regular payments and smaller payments.

Therefore, in this way, we answer the question of how to use Bitcoin as a medium of exchange.

Liquidity, store of value and transaction costs

Let us now discuss another fundamental issue, volatility.

From 2012 to 2015, the number of merchants accepting Bitcoin as a payment method continued to grow. Bitpay and Coinbase initially acted as intermediaries or payment gateways, allowing customers to use bitcoin to pay, and merchants can choose to receive local fiat currency or bitcoin. Of course, most businesses prefer to use local currency.

I appreciate the actions of these two companies very much. However, objectively speaking, no sane merchant will take the daily business risks to hold cash that may fluctuate greatly within a few minutes. Although Bitcoin price volatility has declined in recent years, its volatility is still an obstacle to traditional commercial acceptance and holding of Bitcoin.