Murat Karamüftüoğlu
18.04.2024
Use Case 1. Peer-to-Peer Value (Money) Transfer
This is the basic problem bitcoin solves, and arguably the foremost. Peer-to-peer means there is no intermediate agent, be it a person, bank, or another kind of organization between the sender and the receiver of the transaction. Both ends of the line are free in their monetary expression; they can put their money where their mouth is, so to speak. Self-custody is the keyword here, i.e., holding one’s funds in a personal wallet that can only be spent by the holder of the wallet. This way sovereignty, that is, full control and ownership of the funds is ensured. It is important to note that bitcoin is a commodity, not a “I-owe-you” promise that involves a counterparty. There is no counterparty risk associated in transferring bitcoin between two peers.
Bitcoin is the only “open” and permissionless monetary network, all other money rails used in banking, including, SWIFT used international financial transactions, as well as point of purchase payment processing networks used in retail shopping, are all propriety, in other words, private, therefore, “closed”.
Peer-to-peer, i.e., decentralised nature of bitcoin, makes it the only censorship and sanction resistant monetary network. Think of the freezing of bank accounts of the Canadian truckers and their supporters by the Canadian government, who were protesting Covid-19 restrictions, and you would appreciate the freedom of transacting empowered by bitcoin. Many people, companies and even nations are sanctioned for various reasons, often political, and one would agree the vital importance of an open permissionless monetary network that protects the freedom of how one uses his/her money.
Another real life example of this use case is the US gold confiscation bill of April 5, 1933 signed by President Franklin D. Roosevelt during the Great Depression. It required all individuals and entities in the United States to turn in their gold and gold certificates to the Federal Reserve in exchange for paper currency.
This much should be enough, but one can go on to mention of the plight for financial inclusion of the “unbanked”, who are as obvious beneficiaries of a permissionless peer-to-peer monetary network which enable them to become their own personal banks. As anyone could be the target of corporate or government sanction or cancellation, everyone is a potential beneficiary of bitcoin.
Use Case 2. The Cantillon Effect
The Cantillon effect is an economic concept named after the 18th-century economist Richard Cantillon. It describes the observation that when new money is injected into an economy, prices change unevenly rather than propagating uniformly throughout the economy. This phenomenon occurs because the new money does not reach and affect all individuals and sectors equally. Instead, its effects ripple through the economy in a non-uniform manner, impacting different groups and sectors at different times and to varying degrees.
In the context of today’s economics, the Cantillon effect describes the phenomenon where those who gain access to cheap money earliest, benefit the most from its injection into the system. Companies and individuals who can borrow cheaply, often for extended periods at near-zero rates, tend to use these funds to purchase assets like stocks and real estate, thereby inflating their prices disproportionately. Conversely, those who access the money later and at higher interest rates lose out the most.
Most arguments in favour of a fixed money supply regime, such as that of bitcoin, emphasise the undesirable inflation of highly sought-after assets, such as stocks, caused by the Cantillon effect. When a company buys back its own stocks, it typically does so by borrowing money. Stock buybacks using inordinately cheap credit lead to an artificial increase in the company’s stock price, effectively boosting stock prices without necessarily improving their underlying fundamentals or profitability. It is estimated that most of the investments into big tech companies, in some cases, as much as 9 dollars in every 10, came from central bank money printing spree during the great monetary easing program started in the aftermath of the financial crisis of 2008-9.
Use Case 3. Triffin’s Dilemma
This is one of the most fascinating economic phenomena. Named after the Belgian-American economist Robert Triffin who described the phenomenon in the 1960s, it refers to the inherent conflict of interests faced by countries whose national currency serves as the global reserve currency. The conflict arises because the country serving as the global reserve currency must supply enough of its currency to international markets to meet global demand, which can lead to devaluation of the value of its currency and domestic economic instability.
There are two main ways for a currency to become an international reserve: Overseas military expenditure and importing more goods than it is exporting. This is because a country who aims to dominate money markets has to find a way of supplying its currency, in the present case, the US dollars, to other national markets by running a trade deficit with them.
The US did this first by spending cash in wars fought in Vietnam and elsewhere, and maintaining hundreds of military bases around the world. Following the Vietnam War, it shifted focus by offshoring its manufacturing sector and importing significant quantities of goods, particularly from countries like China. Military expenditures and trade activities contributed to the integration of the US dollar into global financial systems and transactions, solidifying its status as a dominant reserve currency. The offshoring of the manufacturing sector also served the interests of large corporations, who sought to save on labour costs. However, it resulted in the devastation of the US industrial base and its social fabric. Michael Hudson’s book “Super Imperialism: The Origin and Fundamentals of U.S. World Dominance” delves into the complexities of this phenomenon.
The best candidate for a new international reserve currency is bitcoin, as it is politically neutral and mathematically guaranteed to be secure, unchangeable, and uncensorable. For this reason, it is a perfect “peace” currency that eliminates the need for trust between international actors, potentially helping to mitigate militarism and conflicts. Furthermore, neither the US nor any other country possesses the economic capacity required to serve as the world’s reserve currency any longer. Natural selection will inevitably propel bitcoin into the position of the world’s reserve currency eventually. The only positive future prospect for the Americans, and indeed everyone else, lies in the hope that bitcoin will replace the USD as the reserve currency sooner rather than later. This shift would help restore peace and prosperity to the US in the long term, contrary to the propaganda spread by bankers and the military-industrial complex.
Use Case 4. Energy Optimisation and Management
One criticism levelled against bitcoin is that it consumes too much energy. However, this assertion is baseless for several reasons. Firstly, anything that performs useful work requires energy, and bitcoin indeed fulfils a useful purpose, as outlined briefly in the use cases in this section. Bitcoin does not use excessive energy; rather, it uses precisely as much as necessary to maintain a secure, permissionless monetary network.
Moreover, an increasingly larger proportion of bitcoin’s energy consumption is sourced from renewable, underutilized, or untapped and wasted sources. This trend is not driven by a moral imperative but rather stems naturally from the competitive nature of bitcoin mining. Miners are incentivized to seek out cheap energy sources, leading them to gravitate towards renewable and underused sources as they offer a competitive advantage. Note that energy constitutes over 80% of the cost of mining operations.
Bitcoin mining is filled with ingenuity and creativity. Miners, driven by profit motives, are finding new ingenious ways of tapping into cheap off-grid energy sources, such as methane emitted by landfills and water treatment plants, and produced as a by-product of oil extraction. . Note that, methane is more polluting than that of CO₂. When crude oil is extracted and refined, gas builds up and pressurizes the processing equipment. This “flare gas” is usually directed to a facility where it can be repurposed for generating electricity to be used in bitcoin mining
Bitcoin mining operations can be quickly turned on or off, enabling them to assist in balancing the load on the power grid, which is a considerable problem. They can shut down during periods of high demand and resume operations during times of lower demand and prices. This is especially useful in balancing load from renewable sources such as wind and solar.
Use Case 5. Eliminating Boundaries and Increasing Transparency in Financial Intermediaries
Bitcoin’s removal of intermediaries has profound implications for the financial system. Traditionally, financial transactions require intermediaries like banks or payment processors to facilitate and validate transactions. These intermediaries not only add costs but also introduce complexities and vulnerabilities such as censorship, delays, and security risks. With bitcoin, transactions occur directly between users on a decentralized network. This decentralized nature ensures that transactions are peer-to-peer, transparent, and resistant to censorship or control by any single entity.
The transparency aspect needs to be emphasised. All transactions are logged in immutable bitcon ledger. All transactions have associated public keys of the senders and receivers, which provides transparency while maintaining a degree of anonymity. No other identification is used in the transactions apart from the public keys of the users. This ensures a level of privacy while also maintaining transparent accountability for the funds available in the system. This property of bitcoin not only makes it an honest accounting ledger but also reduces the likelihood of its use in illegal activities, contrary to portrayals often propagated by the media.
Many aspects of finance, including loans and credit, have the potential to become fully decentralized, automated, and transparent by adopting a decentralized base layer of money. Transparency here is also of paramount significance. Bitcoin transactions settle approximately every 10 minutes on the base asset layer. This means that settlement is final, and there is no counterparty risk because bitcoin is not an “I-owe-you” promise; it is a commodity. In the fiat money world, base layer settlements take days or weeks. This delay is often due to the need for multiple intermediaries, regulatory requirements, and batch processing. There is no way for general public to know exactly how much asset a bank or a traditional finance institution holds. Bitcoin provides a transparent and publicly verifiable ledger of transactions which removes uncertainties stemming from lack of transparency and slow settlement rates. I encourage interested readers to explore this topic further, as it is a vast and diverse subject and abundant online resources are available.
Use Case 6. The Internet of Things
There is also coming of age of the Internet of Things (IoT). In such a scenario where avatars, robots, self-driving cars, and other autonomous agents interact and transact independently, there will be a growing need for frictionless cross-border money systems tailored to their unique requirements.
IoT has seen significant development and adoption in recent years. Industries such as healthcare, manufacturing, agriculture, transportation, as well as smart city concepts, have embraced IoT enabled technologies to improve efficiency, productivity, and decision-making processes. National currencies are cumbersome to use over the borderless Internet, and physical gold cannot be transmitted digitally. Bitcoin, therefore, emerges as a natural and native currency for such purposes. This alone is enough to make bitcoin indispensable in future world economy.
The Current State of Affairs
We could say that the current state of the art has fully solved only the peer-to-peer money transfer problem, with the exception of cases when the fiat value of the transferred bitcoin is very small, leading to prohibitive network fees, and the network is congested. At various points in bitcoin’s history, we have witnessed double-digit network fees in USD. Second and third layer technologies like Lightning, Liquid, and Fedimint that dramatically reduce transaction fees and increase the network throughput are promising solutions. However, it appears that any solution that increases the throughput depends on striking a balance between decentralization and efficiency. Increase in one leads to decrease in the other.
As many in the space rightly point out, a layered approach where bitcoin serves as the base money layer with full decentralization is fundamentally the correct approach. Layers built on top of the bitcoin network do not necessarily need to be as decentralized. However, there are still many discussion points that need to be settled for a layered architecture to fully take off.
As a summary, it can be concluded that while use case 1, which involves peer-to-peer money transfer, is fully realized for most practical purposes, use cases 2 to 6 above are realised to varying degrees. The successful realisation on these use cases depends on the future level of adoption of bitcoin, specifically, the size of the user base of the bitcoin network.
How Does Bitcoin Do The Above?
To maintain a decentralized ledger of transactions that does not depend on any central or external mechanism is a tremendous challenge. In computer science, this problem is referred to as the Byzantine Generals’ problem, alluding to the battlefield dilemma of how to organize a unexpected coordinated attack and ensure that the coordination does not require trust between the participating parties. In other words, it’s about ensuring that none of the participants can leak information to the enemy, betraying the others taking part in the operation.
In the case of a public ledger, the challenge is how to ensure that transactions between two peers are recorded in a common ledger, and that both parties agree that the transaction took place and cannot be altered once recorded in the ledger, thus solving the “double spending problem”, i.e., the risk of spending the same digital currency unit more than once. This is akin to the generals’ problem above in that no trust should be required between the participants in the system. Certainly, delving into the complete technical details of how bitcoin solves the Byzantine Generals’ dilemma would necessitate a separate paper or book. Here, we’ll provide a brief overview of some of its fundamental features.
One of the mechanisms for maintaining a trustless consensus is to require participants to invest physical resources (computing power and energy) to undertake the task of bookkeeping. In return for their work, the bookkeepers or “miners”, are rewarded with the native unit of value of the system, i.e., bitcoin. This is known as “proof-of-work”. Proof-of-work ensures that the miners have a strong incentive to remain truthful and not manipulate the ledger arbitrarily. Investing physical resources is essential for decentralization and security, as no other form of investment would provide the same level of protection against centralization and manipulation.
In proof-of-work, miners use specialised chips optimized to solve a cryptographic puzzle that demands significant computing power, energy, and technical expertise. To overtake or hack the system, a malicious actor would need access to a substantial number of physical chips and energy, resources that are not readily available to anyone at a moment’s notice, even if they had the financial means to acquire them. This is why the alternative mechanism of “proof-of-stake,” where participants lock in a substantial amount of monetary funds, is not as secure or decentralised. Financial resources can be mobilized at a moment’s notice, whereas physical chips and the energy to run them cannot. In other words, the security of a decentralized ledger cannot be guaranteed with fiat currency but relies on physical resources like computer chips and energy.
One fascinating aspect of bitcoin is that by design it does not rely on any external source of information, including, a clock to keep time. This poses one of the greatest design challenges for any computer system: how to divide work in time. In the case of a ledger like bitcoin, this means to how to divide transactions into blocks of time. It is likely for this reason that, in the latest published Satoshi emails, Satoshi seems to prefer referring to the underlying architecture as a “timechain” rather than a “blockchain.”
The way bitcoin ensures that timechains, or blocks of chronologically ordered transactions, are created at regular intervals is by adjusting the total computing power amassed by the system in relation to the cryptographic difficulty. In the context of bitcoin mining, cryptographic difficulty refers to the level of complexity involved in solving the cryptographic puzzle required to add a new block of transactions to the ledger. This difficulty is adjusted periodically by the protocol to ensure that new blocks are mined at a relatively constant rate, of every 10 minutes on average.
The difficulty level is dynamically adjusted based on the total computational power (hash rate) of the network, ensuring that blocks are neither added too quickly nor too slowly. When the total hash rate of the network increases, the cryptographic puzzle becomes more difficult, and vice versa; when it decreases, it becomes easier. In this way, bitcoin maintains a slightly variable pulse, resembling more to an organic heart than a mechanical clock. This dynamic pulse ensures the steady creation of new blocks, embodying the decentralized and organic nature of the bitcoin network, all without the need of an external clock.
What Bitcoin Is Backed With?
Bitcoin’s security and value are backed by the energy and computing power expended in its mining process, that is, by real, physical resources that contribute to the network’s decentralised nature and security.
The current (as of 6 April 2024) Bitcoin Network Hash Rate is about 640 Ehash/s, that is 640 exahashes per second. An exahash represents one quintillion (1018) hashes per second, a tremendous amount of computational work performed by mining hardware within a single second. Assuming a high-end laptop computer can do 10 million hashes/s, to match the current hash rate of the bitcoin one needs to put together 64 trillion laptops. To give an idea, it is estimated that there are around 2 billion desktop and laptop computers in the world today.
In 2023 annual energy consumption of the Bitcoin network is estimated to be 120 terawatt-hours (TWh), that is, 120 trillion watt-hours of energy over the course of a year. This is roughly equivalent to the annual energy usage of 11.27 million US households.
Ultimately, however, bitcoin’s value is in its utility, particularly, in its ability to facilitate permissionless, transparent and decentralized peer-to-peer money transfers. All of the use cases discussed above contributes to its real value, and I may have missed quite a few others. It must be said however that above all bitcoin’s value stems from its dedicated community of developers, users, and node operators that run the bitcoin protocol on their local machines.
Game-Theoretic View of Bitcoin
Bitcoin revolves around the competition for value. On an individual and corporate level, miners compete for rewards by investing in more computing power at lower energy costs, developers compete to offer new use cases and improve user experience, and investors compete to accumulate bitcoins. These competitions often constitute a zero-sum game, where one person’s loss translates to another’s gain. This is all possible as bitcoin offers real utility and real-world use cases.
At the country level, various countries have attempted to ban bitcoin mining and trading for various reasons. Some of these reasons were related to the financial situation of a given country and its foreign trade regime. Others attempted to ban bitcoin because it upset the existing financial status quo, threatening established privileges.
In almost all cases, the bans were only partially enforceable, as it takes two parties to engage in a bitcoin transaction. As long as there are individuals willing to trade, bitcoin provides a solution that no other monetary network can, making it virtually impossible to prevent a bitcoin transaction from occurring. At the international level too, the name of the game is zero-sum. Since, bitcoin provides real value to people and businesses, if one country bans it, another country takes advantage of the situation. One country’s loss becomes another’s gain, as evidenced by China’s ban on bitcoin mining in 2021. Within weeks, mining operators packed up their machines and relocated to new bitcoin-friendly jurisdictions with plentiful energy resources, and paid their fees and taxes there.
What Are The Threats?
Arguably, most of the potential existential threats have been left behind after 15 years of uninterrupted operation of the bitcoin network. No major economy has managed to completely ban it, although there have been various attempts to restrict its use through regulatory measures or by defaming it. However, both legal and media attacks so far have not caused major damage other than slowing its wider adoption. With Wall Street investment in Bitcoin via Exchange-Traded Funds (ETFs) since 2024, various other ETFs already trading around the world, and a Hong Kong ETF on the horizon, a blanket ban is practically out of the question.
There are, however, still various legislative efforts in the US and elsewhere aimed at restricting bitcoin use, including proposals for KYC-type requirements for miners and bitcoin-related software developers, a proposed 30% tax on bitcoin mining, and the possibility of a ban on private bitcoin custody, i.e., personal wallets.
More concerning is the reported cases of legal action taken against software developers for the type of software they create. This is alarming to say the least, and raises important questions about freedom of speech and expression in the digital realm. Historically, software development has often been considered analogous to speech, enjoying certain protections and freedoms from direct interference by regulatory authorities in many parts of the world. We cannot, therefore, rule out the possibility of regulatory attacks directly aiming to change or regulate the bitcoin protocol itself in the current political climate worldwide. That would be the ultimate existential threat to bitcoin.
The bitcoin phenomenon is primarily a social one, which makes it exceedingly complicated not only on technological but also cultural and political levels. Political attacks don’t just come from external sources or governments; they can also originate within the community itself.
The famous block size war of 2016 is a notable event within the bitcoin community, characterized by significant debate and conflict over proposals to change the size limit of blocks on the bitcoin blockchain. One side advocated for an increase in block size, comprising major players such as miners and exchanges. On the other side were core developers and node creators, responsible for running the bitcoin protocol and validating blocks. Initially, it appeared that the side favouring an increase in block size would prevail due to its support from most miners and exchanges. However, the seemingly weaker side of developers and tens of thousands of node operators ultimately emerged victorious, thanks to the decentralized nature of bitcoin, which empowered the defenders of the bitcoin protocol—the node operators.
The bitcoin community has moved beyond the first major civil war, but now faces another conflict, though arguably at a less than existential level. This time, the conflict centres on whether non-monetary data should be allowed to be recorded in the blockchain, considering the ongoing need to optimize the total size of the bitcoin blockchain — welcome to “Bitcoin NFTs or Ordinals”: The Bitcoin Ordinals represent a concept similar to non-fungible tokens (NFTs) that exist on Ethereum and a number of other blockchains. The Ordinals utilises satoshis, which are the smallest units of the currency to embed digital content such as artwork onto the bitcoin blockchain. Supporters view it as a meaningful application that could facilitate broader adoption, whereas detractors see it as a form of spam.
This recent incident underscores the social aspect of bitcoin. Like any social phenomenon, bitcoin is a dynamic living system shaped by the collective actions and interactions of individuals, not a lifeless machine. Consequently, both internal conflicts and external attacks are likely to persist as long as it remains alive. In my view, the detractors of the ordinals are essentially right. The primary purpose of bitcoin is to facilitate monetary transactions. Recording art or whatnot on the blockchain can, therefore, be viewed as, at best, noise and, at worst, a form of covert sabotage.
Let me rewind from the far future to the recent past. The risk of a 51% attack, popular idea until a few years ago, has become unrealistic given the current hash power of the network. Bitcoin operate on a decentralized and distributed basis, the integrity and security of transactions rely on a majority consensus among network participants. In the 51% attack scenario, a single entity gains control of more than half of the network’s mining power. With this majority control, the attacker could potentially manipulate transactions or prevent new transactions from being confirmed while they have control, or even reverse past transactions to rewrite the history of the blockchain. However, executing a 51% attack on bitcoin is extremely difficult and would require a massive amount of computing power and resources given the current hash rate of the network discussed earlier.
Even if an attacker were to amass enough computational power to control the majority of the network’s hash rate, they would still face significant challenges. While the attacker may have majority control over the network’s computing power, they do not necessarily control the majority of the network’s nodes. Nodes are operated by various individuals and organizations, and if they recognize the attack and refuse to accept the altered chain as valid, they can collectively reject it, since a compromised ledger is a useless one, and node operators would not, in all probability, choose to let their assets become worthless. In other words, in all likelihood majority of the nodes would reject the comprised blockchain and stick with the original. This scenario is referred to as a “fork” in the blockchain, where the network splits into two separate chains, one following the attacker’s altered chain and the other sticking with the original chain. Undoubtedly, rational bitcoin investors would do the same – rejecting the comprised chain and accepting the original as true bitcoin.
The fear that quantum computers could break the cryptographic security is similarly unrealistic, as quantum computers are many years, if not decades, away from practical deployment. Furthermore, such an advancement would threaten not only bitcoin but also all civilian and military systems, including traditional banking and nuclear power plants, as well as nuclear arsenals. Undoubtedly, new cryptographic measures are being developed to counter such future risks.
The transaction throughput is another area of concern. As discussed earlier, there are solutions already in place to help scale bitcoin to hundreds of millions of daily users. However, as mentioned, these solutions may not satisfy all bitcoiners who would like to see more decentralisation on all levels. While not existential, this is an area that needs to be monitored closely.
According to most experts, one possible black swan event is the appearance of an unforeseeable bug in the core bitcoin code during its future development. While Bitcoin development is extremely cautious and conservative, and the code is open-source, being meticulously checked by hundreds of software engineers, a bug is always a possibility in any software development process. Though it is a very small probability, should such a bug occur, it is likely that it would not be irreversible. Bitcoin could even reboot itself from ground if no other solution could be found in the case of such an event.
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