Bitcoin and Decentralization

There is a robust debate going on within the Bitcoin community right now.  I don’t particularly have an opinion, but reading posts from both sides of the debate are insightful.   I am not a coder, but I have a very visceral understanding of markets, marketplaces and economics.

Yesterday, I read these two posts Here and Here.  My friend William Mougayer weighed in with a comment here.

The crux of the debate is over block size.  How big should the block size be?  If you are a student of business, this is a debate to pay very close attention to.  You are seeing a real life business school case study happen in real time.

Industries cannot scale unless some sort of standard is agreed upon.  At early stages before extreme growth, there is always a fight over standards and there is a winner and loser.  Betamax vs VHS is the classic one but there are certainly plenty of other examples.  On Reddit, people against larger block sizes deliberately eliminated and censored comments in favor of larger block sizes.  Censorship is not helpful.

Without getting into the weeds on Bitcoin, block sizes and block chain, I think it’s instructive to think about Bitcoin differently than the community is currently thinking about it.

One thing that never occurred to me is that because Bitcoin is computer code, it has inherent limitations.  The code is going to have to consistently be updated so it works.  Fiat money isn’t that way.  A dollar is a dollar is a dollar and it’s always going to be a dollar.  As long as there is confidence in the US government, people will use it as a medium of exchange.

First, thinking about Bitcoin in terms of a payment system is too narrow.  Bitcoin is a decentralized medium of exchange.  Bitcoin has a value.  That value is determined by a community, and the markets that trade it.  For an example of how a community can determine value without currency being present, I would suggest reading the essay on The Economic Organization of a POW Camp.  Markets are core to humans, and they don’t need fiat currency to form and operate them.  Centralized control, and price ceilings/floors cause markets to break.

What humans have always had in the past is a fiat currency that had centralized control, but humans were able to act in decentralized ways to utilize that currency.

Bitcoin can be used any time one entity exchanges something with another entity.  In the future, it might be artificial intelligence exchanging things-or robots.  There are millions of ways Bitcoin could be used and that is what is both intoxicating and daunting about it.

Bitcoin is not a democracy.  It’s a market.  It should be administered as a transparent marketplace, not like a democratic republic.

That framing opens Bitcoin up to a significantly broader universe of things.

Currently, I see a lot of the Bitcoin community focusing on things like VISA, Banking and other pure financial transactions.  That’s too narrow a focus for bitcoin.  Instead, the focus should be on whenever things of value are exchanged.

Second, Bitcoin consistently runs into a headspace problem.  Every time they create a bigger block size, it fills up.  The average block size that is hashed and put out on the blockchain gets bigger and bigger.  This reminds me of a problem we had at the CME when the Emini was launched.  Initially, the Emini could only do a certain volume of transactions per second(TPS).  Every time CME rolled out new software that could process more TPS, the headspace was immediately filled up.

The difference between the two is CME was operating a closed network and Bitcoin is wide open.  But, like Professor Ron Burt‘s research in closed corporate social networks and today’s open social networks I think there are some things that can be learned and are similar.

It seems to me that there should be a way to arbitrage between block sizes and create a marketplace.  If one group wants to go one way, and another group wants to go another, as long as they agree to bargain using the same unit of value there is an arbitrage opportunity.  That would make the entire blockchain more valuable and bring more value to the nodes on the network.

One criticism of increased block sizes is that every time they increase the block size, there is a decreased number of nodes that can process that block size.  The fear is that Bitcoin nodes will become too centralized.  This fear is not unfounded, because miners can potentially exert a lot of control over the network.  This also illustrates the law of diminishing marginal returns, and the importance of marginal costs versus marginal revenue.

Fear comes from lack of trust and the lack of transparency.  I don’t know the answers to these questions and I don’t know if they have been asked.  What can make the activities of miners more transparent so the community builds more trust?  In turn, that transparency and trust will help Bitcoin get a toe hold in broader communities.  Whatever it is should become part of the core values of the Bitcoin community which are still being developed.

What are the checks and balances over the community?  This also is still unclear to me, but might be in place.  How does the community operate and is their a process to get things done?  A process to air grievances?  An arbitration process?  Getting these sorts of things down and being transparent at how they were arrived at, and how they operate will grow the community.

Brian Armstrong of Coinbase writes, “It’s remarkable that in bitcoin, of all places, some people are hesitant to embrace free market competition (hard forks) in favor of a centrally planned committee.”

I find this ironic too, but it is not surprising.  It happens all the time.  A fight over standards is setting the ground rules over how that competition is going to play out.  What might help is recognizing some core concepts that won’t change.  Of course, they are microeconomic core concepts too.

  1.  Humans act in their own economic self interest.  They are rational.  They try to maximize their utility. Markets are also rational.
  2. There is a cost/opportunity cost to every standard.  As long as the community is willing to accept the cost along with the benefit of standardization, it should move forward with the standard.
  3. Markets allocate resources better than any centralized entity.  When possible, always create an opportunity for a market to develop to solve problems.  We might not like what the market decides, but a free market decides better than anything else.  Markets are also messy, and can take time to come to a decision-there are a lot of false decisions that could pre-date the actual decision.  Standards will influence the free market.
  4. The more actual participation a market has (liquidity), the better it allocates the resource.
  5. As long as property rights are clearly assigned, and transaction costs are zero, entities will bargain with one another to create the same allocation of resources, regardless of the way a  centralized committee might rule in disputes.

The development of Bitcoin should be governed by pure microeconomic principles.  When the marginal cost of development exceeds the marginal revenue, a new fork will start up that changes the equation so MR>MC.

These are first world problems for the Bitcoin community.  It’s important to focus on the fact these problems would not exist if the adoption of Bitcoin wasn’t growing.

 

  • We are witnessing an extreme form of decentralized decision-making. What happens next will have a significant effect on the future of Bitcoin.

    • As long as they use principles of the free market, and true microeconomic principles to make the decision, whatever decision that’s reached is best for everyone-assuming transaction costs are zero and people are free to bargain.

  • CliffElam

    The real reason I’m ignoring Bitcoin as a medium of exchange is that I believe that countries will outlaw it as a threat to the power of the central bank.

    Blockchain as a transparent anti-corruption anti-authoritarian devices to manage title to transactions, on the other hand, is terrifically interesting. If I were DocuSign or something like them I’d be trying to get way out in front of that.

    -XC

    • I don’t think it matters if countries outlaw it as currency. People will use whatever they feel confident in. If they have more confidence in Bitcoin, they’ll use it. Do we think that Argentinians have real confidence in their local currency? Or, would they prefer US dollars? Room for Bitcoin there. The other point I think that needs to be stressed is what if Bitcoin is a replacement for all kinds of things when assets are transferred? For example, non-cash transactions within internal supply chains. What if a market could be created over cost accounting transfer prices that replaces the hierarchy that oversees it? Would companies be more efficient and would supply chains be more efficient?

      • CliffElam

        Well, that’s why I was splitting out bitcoin from blockchain. I think the really important thing is a stable/secure public records mechanism.

        If the US/UK/EMEA governments use bitcoin as a presumption of illegal activity then people like you and I (me?) will avoid it like the plague – who needs the hassle. But they will have to move soon-ish or the problem will be much bigger.

        -XC

        • Tyler

          Just curious, but how do you split out bitcoin from the blockchain?

          • CliffElam

            Ah, well, blockchain holds digital data in a secure and untamperable (so far) way and can be maintained in a distributed fashion. Keep the agreement for a bet on the superbowl in it if you like. Blockchain transactions are locked until a digital key is supplied to unlock the transaction.

            Bitcoin is essentially a form of public/private key pairs that people use as currency. If you used the serial numbers on dollar bills and held the bills at a trusted third party you could trade dollars just like bitcoin. That’s why I find it relatively uninteresting.

            There are beaucoup articles on this. Here is one with a good picture: https://www.linkedin.com/pulse/whats-difference-between-bitcoin-blockchain-david-everett?articleId=5991950108973940736

            -XC