Bitcoin’s Future Is Fractional Reserve: Unless We Do Something About It

What started as a single transaction from Satoshi to Hal Finney, has evolved into a complex system of industrial scale miners, evolving meta-protocols like the Lightning Network and Fedimint, and a full embrace of institutional investors with the record breaking inflows into various newly approved spot ETFs.

Bitcoin has come a dramatically long way, and with that comes a somewhat earned sense of optimism for those who have invested their time, money, and enthusiasm.

Unfortunately this optimism, and sense of “inevitability” I have previously written on, has contributed to a culture of complacency. This is hallmarked by a narrative that early Bitcoin protocol ossification is acceptable or even desirable, itself underscored by the implicit assumption that the largest risks to Bitcoin now are potential changes and Trojan horses to the protocol.

This belief is categorically false.

The greatest danger to Bitcoin is the certain future it has if it were in fact to effectively “ossify” today: Certain regulatory capture, an uncapped fractional reserve supply, and censored and monitored transactions.

Old News

If that sounds extreme, then you haven’t been paying attention. The problems facing Bitcoin that lead to this inevitable result aren’t remotely new. In fact it was touched on by Hal Finney himself 14 years ago:

“Actually there is a very good reason for Bitcoin-backed banks to exist, issuing their own digital cash currency, redeemable for bitcoins. Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain…

Bitcoin backed banks will solve these problems…

Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin based purchases are today.”

From the very beginning, many of Bitcoin’s earliest adopters clearly understood its limitations and the resulting downstream implications. What has changed since then? Not the math.

Even with the Lightning Network, an innovation that Hal Finney would not be around to see, the upper limit for the number of regular users Bitcoin can onboard in its current state is optimistically 100 million. That number does not factor in usability/user experience whatsoever, which is an inherent challenge of the Lightning Network due to the very novel way in which it works compared to any other financial system.

In the Lightning Network whitepaper itself, authors Joseph Poon and Thaddeus Dryja make it clear that alone it is not any kind of silver bullet enabling global scale:

“If all transactions using Bitcoin were conducted inside a network of micropayment channels, to enable 7 billion people to make two channels per year with unlimited transactions inside the channel, it would require 133 MB blocks (presuming 500 bytes per transaction and 52560 blocks per year)”

The resulting cap on users who can leverage Bitcoin today in a self sovereign way without the use of a trusted 3rd party presents an obvious problem. Especially if we assume adoption and usage will continue to grow.

Saifdean Ammous authored “The Bitcoin Standard”, a book which received much fanfare for making the compelling economic case for Bitcoin as the ultimate manifestation of “hard money”. A Bitcoin standard, he argues, will out-compete the current fiat money system by virtue of its hard supply. Similarly, in 2014 Pierre Rochard popularized the idea of the “speculative attack”, arguing that the adoption of the bitcoin monetary unit would happen first gradually, then extremely rapidly.

In our projection of the future, we will assume both lines of thinking are correct, and that demand for bitcoin the monetary unit will attract an increasing amount of savings as its network effects only further accelerate its own widespread global adoption.

This “hyperbitcoinization” scenario however presents an impossible challenge for the current constraints of both the Bitcoin core protocol and Lightning Network. What will it mean then when hundreds of millions, and then billions, flee into the confidence of Bitcoin’s fixed supply as the mainstream Bitcoin community believes they will?

Very simply, if they can’t afford to use the core protocol or even the Lightning Network (no need to even discuss ease of use or UX here, that’s a separate sizable challenge) due to hard scalability limits, they will be forced to use centralized and custodial providers. Even if they don’t want to.

There’s no beating around this bush or wishing it away.

If you accept the premise of bitcoin as a superior money, and also understand the practical limitations of the protocol today, then this is the certain outcome Bitcoin is currently on track to reach.

Gold Standard 2.0

It’s a fair question to ask why this might pose a problem at all. Hal Finney certainly didn’t seem to imply so in his own aforementioned post.

Returning to the Bitcoin Standard, Ammous dedicates a significant amount of the book’s opening chapters to discussing the history of the gold standard, its strengths, and most importantly its weaknesses. Crucially he identifies the Achilles heel: Gold was simply too expensive to secure and difficult to transact with in meaningful quantities.

As a result, paper money technology first came to be used as convenient IOUs for gold, which itself was stored in centralized locations specialized to the task of guarding and transferring large amounts of gold as needed. Over time as technology improved and commerce became more global, these centralized custodians only continued to grow, until they were all eventually captured by States through regulatory power and later outright fiat, which completely severed the new fiat money from the underlying gold backing.

In projecting the future for Bitcoin in its current state, we can see a very similar outcome unfolding. There might not be a cost issue with the storage of bitcoin using private keys and mnemonic phrases, but in our hyperbitcoinization scenario the ability to transact with self custodied bitcoin quickly evaporates for all but the institutions and the super wealthy who can afford the fees, even when using Lightning.

The consequences are much the same as they were under a gold standard. Platforms like Coinbase or Cashapp will take center stage, given transactions within their custodial platforms have zero marginal cost as they are just tracked in a central database. Cross platform payments can also be aggregated between these platforms with Lightning channels or on-chain payments extremely cost effectively. The result is a landscape that is not all too dissimilar from the state of the gold standard in the early 20th century, with most supply held by large custodial institutions which States could trivially influence, coerce, and capture.

To return to the question of the biggest threat to Bitcoin: In this future, there’s zero necessity in attacking the base layer if the only ones that can actually use it are large known entities with everything to lose.

To be sure, substantial differences from the original gold standard would in fact exist. Transactions being natively digital, proof of reserves being possible, and the supply being completely transparent are notable improvements over the gold standard. Still, none of these differences impact our self custody conundrum in any way. As far as the vision of Bitcoin being a censorship resistant money, once the vast majority is held by trusted third parties, there is nothing stopping States from strictly enforcing transaction monitoring, asset seizures, and capital controls. There is also nothing stopping them from enabling and even encouraging fractional reserve policies in the interest of prudent economic management.

Crucially, in the event of these actions, the vast majority of users would have no ability to opt out by withdrawing funds to their own custody.

It’s not all bad. In this scenario, bitcoin the monetary unit still appreciates by leaps and bounds. Everyone who’s humored me this far with their attention will still likely stand to financially benefit immensely in this future.

But is that it?

Is the vision of Bitcoin as a foundational tool for censorship resistance, and separating money and State, dead?

If we continue to deny, or worse encourage, the current trajectory, then there’s zero doubt that it is. But it doesn’t have to be.

Misplaced Fear

Fortunately, there’s no reason or prevailing argument for the Bitcoin network to have already ossified. It remains firmly within the grasp of the core community to continue to push forward research, debate, and proposals for further improving the base protocol to increase the scale and usability of solutions like the Lightning Network, as well as enable whole new potential constructs such as the Ark protocol, advanced statechains, and more.

It’s important however, to acknowledge how we’ve reached such a point that “ossification” became a significant prescriptive narrative, rather than a purely descriptive idea of the eventual end state of a widely adopted Bitcoin protocol. Such a prescription is necessarily rooted in the assumption that Bitcoin’s largest attack vector comes from future code changes.

This line of thinking isn’t baseless. It is true that protocol changes can be an attack vector. After all, we’ve actually seen that very attack play out before with Segwit2X when a consortium of large Bitcoin institutions and miners coordinated a unilateral hard fork to the Bitcoin protocol to increase the base block size in 2017.

However we must also acknowledge that Segwit2x failed in a miserable fashion. Worse still, the futility of the attack was obvious before its eventual collapse as it entirely misjudged the dynamics involved in introducing changes to a distributed peer to peer protocol.

The participation of many of the individuals and companies involved with Segwit2X suffered lasting reputational damage in many cases, making it not only a failed effort, but a costly one. For any enterprising attacker looking to compromise Bitcoin for good, it would be abundantly clear that attempting to repeat this approach or any variation of it is a fool’s errand.

A much easier and cheaper approach with a much higher likelihood of success, would be to invest in slowing the already challenging work of building consensus to introduce beneficial extensions to the Bitcoin protocol, ensuring that the experiment in both sound and censorship resistant money is ultimately a victim of its own success. Whether or not you believe this is actively happening today, the actions that need to be taken are identical.

So What Now

Ultimately, where we are now and what we must do is not so different from the time Hal made his observation in 2009: We must continue critically examining the limitations of the Bitcoin protocol and ecosystem, and push forward as a community to address these shortcomings.

Thankfully a number of research advancements and proposals have been made for further increasing scalability that don’t require larger block sizes. Bitcoin core contributor James O’Beirne released a blog post last year with a sober technical analysis of Bitcoin’s immediate scalability prospects and gives good context to some of these proposals, and more recently Mutiny wallet developer Ben Carman has taken a critical look at the issues surrounding the Lightning Network more specifically.

There has never ceased to be a strong signal amidst all the noise, and the best we can do is put in the individual work to identify and amplify it, while actively pushing back against counter productive narratives that do not contribute to meaningfully improving Bitcoin.

By doing that, perhaps we can find a way to scale the vision of truly peer to peer and sovereign money to every single person on the planet.

We may very well still fall short, and there’s absolutely no guarantees.

But it’s worth a shot. 

This is a guest post by Ariel Deschapell. Opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.