In 2008, the Global Financial Crisis and subsequent bailouts fostered an eave of mistrust and resentment towards Wall St and the wider financial system.
Many people felt the moral hazard, the idea that overleveraged institutions could be bailed out by governments for reckless lending, meant the system needed a fundamental rethink.
One of those people was Satoshi Nakamoto, who developed Bitcoin on the idea that the control and ownership of money shouldn’t be centralised.
Fast forward 12 years and the DeFi revolution continues to challenge the centralised control of currency, slowing pushing it into the mainstream. As of writing, 1 Bitcoin is worth almost $60,000 USD because of fiat currency devaluation, the COVID-19 pandemic and stock market FOMO¹.
If Bitcoin aims to become a complement or a supplement the centralised production of money, instead of being ‘virtual gold’, it will succeed by providing the right incentives for blockchain and lightning node owners.
This articles examine the how the two tiers of the bitcoin economy operate, the Blockchain and the Lightning Network, and considers what influences could impact Bitcoin’s future.
Blockchain Tier (Tier 1)
The Blockchain uses miners (blockchain servers) to record Bitcoin transactions and group them into blocks.
When a Bitcoin user wants to send money to someone else, they choose (manually, or as the wallet suggests) how much to give the miner to process the transaction. This is known as the transaction fee.
When a Bitcoin user wants to send money to someone else, their wallet sends the transaction to a waiting queue to be processed by miners. Once confirmed, the transactions waits in a queue to be processed by miners.
Although miners do not specify exactly how they choose transactions, one provable consideration is the size of the transaction fee.
When a miner fills a block of transactions, they validate the block by playing a computationally expensive game of chance. The first miner to validate a block adds it onto the blockchain, which approves and settles the transactions in the block.
The miner then claims the transaction fees and an additional reward for validating the block (called the block reward), which is designed to happen every 10 minutes on average. They are also the mechanism to release new bitcoins into the economy, which is how inflation is determined.
When mining the first block in 2009, the reward was set at 50 BTC and is designed to halve every 4 years (it’s now 6.25 BTC). Rewards will be issued until 21 million Bitcoins are released, which is expected to occur 2140.
So far 18 million bitcoins have been mined, leaving 3 million bitcoin to be mined for the next 120 years.
Eventually miners will only earn income from transaction fees.
The Lightning Tier (Tier 2)
The Lightning Network is a layer above the Blockchain which runs Lightning Nodes (advanced wallets) that connect to each other using payment channels.
The network run smart contracts called Hash Lock Time Contracts (HTLCs), which facilitate a stream of transactions between 2 parties. The Funding (start) Transaction and Settlement (end) Transaction are still required to be recorded on the blockchain and incur transaction fees.
The Funding Transaction provides the liquidity required for the smart contract while the Settlement Transaction confirms the payment and refunds unspent bitcoin.
The transactions in between, called Commitment Transactions, are validated outside the blockchain within seconds. Because they aren’t bound by block limits, the network can theoretically handle millions or billions of transactions per second².
If two nodes aren’t directly connected by a payment channel, they can route transactions through the payment channels of other nodes. Those intermediary nodes require enough money to be reserved for transaction to be facilitated.
For each node that provides this service, a Fixed Fee (the median price is 1 satoshi) is charged as well as a Fee Rate, a percentage of the money going through the network (the median price 0.000001)³.
This makes bitcoin more feasible for smaller transactions to occur, like a cup of coffee, provided the Funding and Settlement Transactions aren’t required for each purchase.
Factors That Affect Bitcoin’s Future
A large component to Bitcoin’s success is enough people believing it has current and future value. When people believe this, they buy it and tell others about it, causing some of them to also buy it.
It was also the first mainstream cryptocurrency to be developed and has 12 years of adoption and development behind it, meaning it is a ‘stable’ choice of cryptocurrency. If you bought 1 bitcoin 5 years ago and held onto it, it would have increased 13,929.2% relative to the US dollar¹. This is despite the 2017/2018 bull run and subsequent crash.
In 2021, Bitcoin now has the attention of institutional investors, who are using it as a speculative store of value to counteract low interest rates and the widespread devaluation of fiat currency. This differs from the 2017 bull run which composed mainly of retail investors who were driven by pure speculation.
From a miner’s perspective, the sharp increase in Bitcoin’s price increases the potential for profit, but could bring new miners which increases the computing power of the network. This means less chance of validating a block, because bitcoin increases the difficulty to ensure blocks are mined every 10 minutes on average, regardless of computing power.
This may increase the chance of mining pools earning more rewards if more miners join the pool, but less profits for the individual miners in the pool, who share them with more people.
In addition to this, the block reward continues to halve every 4 years, making this revenue stream less profitable. Despite the increasing interest in Bitcoin, there is no guarantee it will double in price to make block rewards consistently profitable.
If this happens, miners will seek other ways of generating income, leaving them with two main options. They can pick transactions with higher fees attached to them, driving up prices, or pursue more profitable uses for their computing power.
A prolonged increase in transaction fees could also decrease usage of the network and persuade users to use other currencies, which would in turn drop prices to attract them again. Without a quick and low cost method of transacting with Bitcoin, it can only remain a store of value, likely to be held by institutional investors and wealthy individuals who can influence its value.
That said, the Lightning Network also has the potential to decrease the cost of individual transactions and processing times on the Bitcoin network, but its adoption has been slow.
This is because running a node is not profitable, and there aren’t enough nodes to facilitate the network. The current network capacity is only 0.006% percent of all possible bitcoin². This has given competitors such as the Matic Network and StarkPay more opportunity to compete for market share.
The slow adoption of the network has been a technical bottleneck to the widespread use of Bitcoin, Then again, so is price volatility.
From an environmental perspective, Proof of Work is seen as a less favourable option of validating blocks, with some people sharing concerns about its environmental impact. Bitcoin is currently estimated to have annual energy usage the size of the Philippines⁴.
Conclusion
It’s hard to tell where the future of Bitcoin is headed, because there are so many factors to consider.
I personally bought bitcoin six months ago and have seen some investment success, but recognise a number of long term risks and uncertainties associated with it.
Despite the fact it is relatively mature and has a significant market share, it struggles to implement important features, in part due to its decentralised nature.
Maybe it will be like the Yahoo of the dot com era — popular, useful and first, but unable to focus and maintain relevance over time. It might be an intermediary currency that last a few more years and becomes the inspiration for many future projects.
I hold onto Ether, Litecoin and Ada just in case.
Sources
- Google. (n.a.). Bitcoin to USD. Retrieved from https://www.google.com/search?q=bitcoin+to+usd (last accessed 3rd April 2021)
- Skalex. (n.a.). How Does the Lightning Network Work & When Will It Go Live? Retrieved from https://www.skalex.io/lightning-network/#networked-transactions (last accessed 3rd April 2021)
- 1ML. (n.a.). Real-Time Lightning Network Statistics. Retrieved from https://1ml.com/statistics (last accessed 3rd April 2021)
- Digitconismist. (n.a.). Sustainability. Retrieved from https://digiconomist.net/bitcoin-energy-consumption (last accessed 4th April 2021)
Coinsmart. Beste Bitcoin-Börse in Europa
Source: https://medium.com/geekculture/a-guide-to-bitcoins-two-tier-economy-836a20c85698?source=rss——-8—————–cryptocurrency
