This article is based on a Twitter conversation with Adrian X and Tao Jones, two of my favorite Bitcoiners.
I am consistently impressed with their creativity, open-mindedness, and articulation of arguments; they are worth following.
Transaction Volume and Decentralization
Each of Bitcoin’s three major forks can be summarized by their ideological preference for these two characteristics: transaction volume, and decentralization.
All of Bitcoin’s forks agree that censorship resistance is desirable. However, Bitcoin, Bitcoin Cash, and Bitcoin Satoshi Vision have different ideas of how to achieve it.
Bitcoin started as a way to make payments which couldn’t be censored. We call this quality ‘censorship resistance.’
Censorship resistance is achieved through Bitcoin’s incentives, which encourage a level of decentralization.
Bitcoin (BTC)
The fork of Bitcoin which kept the BTC ticker is mostly focused on decentralization.
BTC achieves decentralization at the base layer, but the community has become so fixated on decentralization, it’s forgotten the original goal.
Rather than peer-to-peer electronic cash, BTC is becoming a settlement layer – too expensive to use in daily transactions.
While the main chain is still ‘decentralized,’ using BTC for payments will soon require the trusted third parties Satoshi sought to eliminate.
The BTC community’s fetishizing of decentralization keeps forcing it further and further from its original purpose as a permissionless medium of exchange.
Bitcoin Satoshi Vision (BSV)
Bitcoin’s latest incarnation, Bitcoin SV aims for censorship resistance of everything.
BSV doesn’t limit censorship resistance to just transactions. It wants to include all types of data – photos, videos, documents – the whole internet on BSV.
This is entirely possible, but at the cost of significant levels of decentralization.
Bitcoin SV advocates frequently and aggressively assert that BSV can scale.
Of course it can – as can Facebook Coin, JP Morgan, and Hashgraph.
They all sacrifice decentralization.
Decentralization
Decentralization is necessary to offset systemic risk.
Unfortunately, in the hostile environment of the modern world, incentives within the protocol are not enough deter bad actors from outside it. Because all BSV miners will be known at scale, they could be forced to censor transactions.
Bitcoin Cash (BCH)
BSV sacrifices decentralization for censorship resistance of increased transaction volume.
BTC sacrifices its utility altogether.
BCH strives for sufficient levels of each in order to maximize its utility as a medium of exchange.
Decentralization exists on a spectrum; transaction throughput is high enough when all demand for payments is filled.
BCH is not perfect – it suffers from the same governance problems as the other forks.
But it’s the only fork of Bitcoin which has its priorities straight.
For different reasons, BTC and BSV miss the forest for the trees.
BCH is solving for Bitcoin’s intended use, as a medium of exchange.
Valuing Cryptocurrencies
BTC and BSV advocates also rationalize that their use cases will give their coin value.
These are topics for another post, but utility as a data store doesn’t make BSV very valuable, and Metcalfe’s Law is mostly relevant to BTC because it’s a pyramid scheme.
This is not a unilateral endorsement of BCH; each of these three currencies could succeed in their own way.
However, BTC and BSV don’t create futures worth supporting.
I’m with you, any of them could succeed but BTC is just a cosmetic upgrade of the status quo and BSV far too easily lends itself to an Orwellian dystopia.
A case can be for the success of other coins, but the cryptocurrency that dominates the market in the future will be the one which is used as a medium of exchange.
Mystery miner ‘Satoshi Nakamoto’ appeared on the Bitcoin Cash (BCH) network and has amassed ~37% of total network hash in the past several weeks.
The appearance of this unknown miner is concerning to Bitcoin Cash community members particularly because Bitcoin Cash has its first planned hard fork since the BSV split in November coming up on May 15th.
The timing, and the moniker itself have some speculating that Calvin Ayre and Craig Wright are behind the hash power and planning to disrupt the fork.
We’ve examined data from the BCH chain and compared it with circulating theories behind the miner’s identity and intentions.
BCH vs BSV Hash Rate
We first wanted to know where the hash was coming from.
One theory which surfaced on Reddit was that hash from BSV had moved over to BCH.
This doesn’t necessarily mean BTC.TOP’s miners went to the Satoshi pool, but it’s one possibility.
Varying Bitcoin Cash Clients
Varying version numbers indicated in the block headers of blocks mined by ‘Satoshi Nakamoto’ indicate varying clients and suggest that this is a mining pool, not a single entity.
The pool’s hash rate as a percentage has remained relatively constant, which suggests it’s profit-oriented, not malicious.
Bitmain
A rumor has been circulating that this pool is operated by Bitmain, testing new equipment.
The version numbers in some block headers of ‘Satoshi’s’ blocks bear exclusive similarities to version numbers of the BTC.COM pool’s blocks, namely in the fourth through sixth characters: fff.
BTC.COM is owned by Bitmain. Still, the rumor remains just that.
Conclusion
‘Satoshi Nakamoto’ appears to be a standard pool pursuing profit, not a malicious entity.
We hope this analysis puts the issue to rest so the Bitcoin Cash community can continue promoting BCH as an optimal medium of exchange, fulfilling Satoshi’s true vision of peer-to-peer electronic cash.
Leave your thoughts in the comments section and discuss ‘Satoshi Nakamoto’s identity with others in the Bitcoin Cash community, and share this article on social media via the icons below.
Binance was founded in 2017 by Changpeng Zhao. A newcomer to the Bitcoin space, the Binance exchange quickly became popular for its customer focus, and later for its native token, BNB.
Binance has also been working on a second exchange – one that is decentralized. The Binance “DEX” which will go live on or around April 23rd, 2019.
.@Binance Chain launches its mainnet and plans to execute Mainnet Swap on Apr 23, 2019.
As of April 20, 2019, not much is known about the Binance DEX. In this article, we include as much information as possible in our analysis.
Updates to this article and accompanying model will follow.
BNB Token
BNB is an ERC20 token hosted on the Ethereum blockchain. Holding BNB in a Binance account gives users a 25%+ discount on trading feeswhen paid with BNB.
The Binance exchange also has BNB base pairs, as will the Binance DEX.
BNB is not used as a medium of exchange (MoE) for goods per se; it’s used as an MoE for other currencies.
The popular narrative about BNB is that it resembles an equity and should be valued according to traditional formulas – a DCF model or similar. Adherents to the theory point to BNB’s correlation with Binance’s revenues, which are based on trading volume. The venture capital firm Multicoin Capital based their investment thesis on this heuristic.
Using Binance’s revenues as a proxy for BNB’s price assumes perfect value capture by the BNB token. The Binance team understands value capture, but based on observations, they are far from perfect at it.
More to-the-point, since Binance Coin is a currency whose variables can be identified and modeled, it makes more sense to value BNB as a currency, not as an equity, or a “store of value.”
For this reason, our analysis focuses on these factors: the circulating supply of BNB, and the variables in the equation of exchange, MV = PQ, which expresses the equivalence between the supply and demand of a currency.
Equation of Exchange Variables
In this article, we’ll abbreviate circulating supply to S.
In the equation of exchange, M represents the value of the circulating monetary base – all BNB in circulation.
V represents the velocity of those BNB. Velocity is the average number of times each unit is exchanged.
On the other side of the equation, P stands for purchases – the average value of a purchase made with BNB. Purchases with other currencies are of goods and services. Purchases using BNB are of other cryptocurrencies.
And Q is the quantity of purchases.
We model the future of each variable with adjustable assumptions in the Investor Series BNB model.
Supply and Demand
Fundamentally, currencies are subject to the same factors as any goods – supply and demand.
There are two sides to the equation of exchange; each side corresponds to supply and demand.
MV represents the supply side of the equation, while PQ represents demand.
Supply
Binance issued 200 million BNB as ERC20 tokens. Of these, 48 million are frozen, pending release according to Binance’s vesting schedule for employees’ tokens (found on page 9 of the BNB whitepaper). Over 11.6 million BNB have been burned by Binance in quarterly “coin burns”.
Due in part to Binance’s engineering the BNB supply, many of Binance’s supporters believe that Binance Coin is a “store of value.” It’s an somewhat irrational conclusion which becomes a self-fulfilling prophecy.
Most of BNB’s perpetual increases can be attributed to trading volume, with which it’s highly correlated.
The perception of BNB as a “store of value” disorients investors unfamiliar with currency valuation, especially since BNB is more frequently affected by changes in supply than other currencies.
Factors which primarily increase supply
Vesting of employees’ tokens
Tokens given as part of employees’ compensation are governed by a vesting schedule, found in the Binance Coin whitepaper.
Each year, 16 million BNB becomes available for employees.
Based on chain analysis and price history, we believe employees’ BNB vests in July each year. Employees appear to have sold their BNB within months of receiving it.
The BNB model includes an adjustable assumption for the percentage of employees’ BNB which enters the circulating supply the same quarter.
Factors which primarily decrease supply
Binance’s quarterly BNB burns
In a direct effort to reduce the total supply, Binance burns 20% of their profits in BNB every quarter.
Binance’s 7th quarterly burn included 829,888 BNB – around $15,600,000 USD at the time. Burns will continue until the total number of BNB tokens reaches 100 million.
Staking requirements for Binance Chain
The Binance Chain which supports the DEX uses a Delegated Proof of Stake (DPoS) consensus algorithm to keep the network safe from malicious actors.
As a result, the Binance DEX looks almost identical to BitShares (BTS). Difference are mostly superficial; the Binance DEX uses BNB instead of BTS, and its blocks are every second instead of every 1.5.
BNB holders elect block producers – one vote per BNB. Block producers can either campaign to receive votes from existing BNB holders, or buy BNB and vote for themselves.
Since it’s cheaper to buy votes than BNB, block producers will do this instead of hoarding BNB. This leaves circulating supply unaffected.
Under a pure Proof-of-Stake system, Binance DEX would require a significant percentage of total BNB, which could decrease the circulating supply. Some DPoS-based blockchains require stake as well; we’ll find out this week what the staking requirements for Binance Chain are.
If the Binance Chain requires a fixed BNB stake per validator, the circulating supply may be reduced by stake amount * number of validators.
Binance Launchpad
Binance Launchpad is an ICO platform that accepts BNB for ICO tokens.
BitTorrent accepted BNB for the first round of their ICO. BNB raised through ICOs stays out of circulation as long as BitTorrent’s treasury chooses to hold it.
BNB locked up for the DEX
BNB locked up via transactions on the Binance DEX is the most interesting way BNB supply is reduced; it’s also unexplored.
The Binance DEX doesn’t exchange other blockchain assets. Buying one BTC/BNB pair on the Binance DEX is actually a purchase of a BTC’s worth of BNB tokens.
When the BTC/BNB pair is purchased on Binance’s centralized exchange, BNB goes to one party, BTC to the other.
Both coins remain in circulation.
On the Binance DEX, it is just BNB being exchanged, except one party holds some number BNB in place of another asset.
This takes a disproportionate amount of BNB out of circulation, while increasing the demand for BNB on the other side of a trade.
The net effect of this is yet to be seen, but if the Binance DEX were to fully displace Binance’s centralized exchange, it would move the speculative value from other cryptocurrencies to the BNB token.
Unfortunately for BNB holders, the Binance DEX is quite limited in scope – requiring a Ledger to sign on.
We will reevaluate this possibility once the Binance DEX gains traction.
Factors which increase demand
Trading volume
BNB can be used to pay Binance trading fees at a discount. Increased trading volume on Binance brings more demand for BNB.
BNB is somewhat correlated with overall crypto trading volume, but not entirely. There are no major uses for BNB outside of holding a balance to pay for fees.
The Binance DEX, Launchpad, and future Binance endeavors may change this.
Factors which decrease demand
Regulatory crackdown
Regulatory action against Binance make BNB less valuable to the extent it restricted Binance’s users or operations.
Because Binance a) moves quickly and b) operates in several supportive jurisdictions, it is unlikely regulators will catch up to the company.
KYC is one of Binance’s concerns, however, and this may take a toll on their user base. It may also have inspired their DEX.
BNB Investor Series model
Now that we’ve reviewed factors which affect BNB’s value, we’ll construct the model.
First, the supply inputs.
The Binance exchange’s current wallet contains just over 91 million BNB.
Since there are no real off-chain uses for BNB, this is the circulating supply. 48 million BNB are frozen; 11.6 million are burned.
The rest are trading on other exchanges, or held by large investors and Binance employees.
Each quarter, we factor in employees’ tokens which enter circulating supply after vesting, and the number of tokens burned.
Based on chain analysis, employees’ tokens appear to vest in Q3 each year, and there are roughly 1.5 million tokens burned each quarter.
Aside from speculation, demand for BNB comes from trading fees on the Binance exchange.
We assume all trading fees are paid in BNB at 0.075% of trade value.
There are two sides to each trade, and each is paying fees, so we multiply the fee rate by 2 and apply it to volume.
Growth rate
Binance is already one of the largest exchanges, so its growth would come from cryptocurrency price increases rather than competitors’ volume.
Assuming increased trading volume is driven by cryptocurrency price increases, all else being equal, the default assumption of 50% quarterly growth reflect a $75,000 BTC price at the end of 2020.
Velocity
Velocity is the number of times each unit is transacted in a given time frame, on average.
We imagine Binance users refill BNB balances every two weeks, on average, which would give us a quarterly velocity of 6.5.
To solve for the value of circulating coins, we rearrange the equation of exchange to isolate M:
M = PQ/V
In our example, where each BNB circulates 6.5 times per quarter, the required value of circulating BNB is 20.7 million.
Divided by the circulating supply of 89,500,000 gives us a per BNB fair value of around $0.35 in Q2 2019.
Conclusion
Unless we drastically overestimated circulating supply and/or velocity, this analysis suggests BNB is 70x overvalued for its use case – paying Binance fees.
This does not necessarily mean BNB’s price will fall.
Although cryptocurrencies trend toward their fair value, BNB is very popular with speculators. With no way to short, price discovery is difficult.
BNB has consistently traded above its fair value for most of its existence. Due to its noncorrelation with other cryptocurrencies, speculators treat BNB as a hedge. This drives demand up on exchanges while locking up supply.
It makes perfect sense that BNB would be uncorrelated while trading at 70x its value – it’s barely tied to fundamental drivers of value.
An informed bet on BNB is a bet on the Binance team or community to create more uses for the token.
The Binance DEX could give BNB fundamental value if it locks up enough either as stake on Binance Chain or as collateral for pegged-assets.
A second round of ICO mania centered around Binance Launchpad could also bring fundamental value to BNB.
At Eat Sleep Crypto, we prefer cryptocurrencies with fundamental support from real use-cases.
These currencies have less downside and often more upside from less speculation. Maximizing upside potential while minimizing downside risk is key.
We’ll be talking about this concept in the coming week at Eat Sleep Crypto – look out for more email updates on BNB as we hear more information about Binance Chain and the Binance DEX.
Bitcoin Satoshi Vision is a fork of Bitcoin Cash. Like Bitcoin Cash, BSV intends to scale on-chain with large blocks.
The difference between Bitcoin Cash and BSV is ideological. Where the BCH community is distrustful of government, BSV is not.
The leads to a different scaling approach. Since BSV proponents are not worried about government surveillance, the Bitcoin SV chain has no need for decentralization. It can be hosted by as few or as many miners as will compete to build the chain.
The name ‘Satoshi Vision’ is partly indicative of this approach as Satoshi said Bitcoin would eventually be hosted in large data centers.
Fee Market Solutions
Cryptocurrencies are intended to be means of payment. Bitcoin SV recognizes this, but BSV’s scaling approach is different than other cryptocurrencies.
Bitcoin SV is increasing block size to allow a true free market between miners and users via miners’ fees. Instead of payment transactions, BSV will charge fees for storing data at first.
Because centralization is no threat per Bitcoin’s incentives and BSV’s love of transparency, only miners which are able to store large volumes of data will remain on the network.
To promote this data storage fee market, the Bitcoin SV community developers are creating applications that use the SV blockchain as a data storage layer.
Immutable data storage is not in high demand, and currently prohibitively expensive on BSV for traditional storage. Timestamping data to create an immutable record is a valuable application of blockchain, but there’s not enough demand to make it worthwhile.
However, use as a traditional server is a good fit for a centralized blockchain like Bitcoin SV.
Storage on BSV
SV fans are calling this data storage layer Metanet and have started to build on it.
Bitcoin SV is technically capable of being the data storage layer of the internet. The question is can BSV compete with traditional storage providers?
Short of illegal applications which the BSV community is opposed to, there are few use-cases for this immutable storage at fees of 1 satoshi per byte.
However, at a lower fee per byte of data, Bitcoin SV might be able to undercut competitors.
As an example, we’ll use Google Cloud’s price per GB of storage and compare it to BSV miners’ costs. If BSV can undercut Google at any price point, it will slowly steal market share while accruing economies of scale. Economies of scale would afford miners lower costs and enable continual undercutting of competitors with large overhead costs.
Before modeling BSV’s price under these circumstances, we must see if it’s economical for BSV to provide this service.
Bitcoin SV vs. Google
The use case we’re examining is the most basic that Bitcoin SV can provide – cold storage of data.
A quick note: this means infrequent or no retreival of data. Thanks to public block explorers with limited API calls, this is about what we have.
The price of data retrieval is a different issue, but we assume a specialized node could provide the service more cheaply than large data centers like Google or Amazon.
Coldline storage with Google Cloud costs $0.007 per GB with a minimum of three months. To determine whether BSV miners could compete with this, we can approximate the costs incurred by the network.
Most BSV miners are profitable at present, and the cost of including a transaction into a block is negligible, so we assume the only additional costs are storage space in the form of HDD disks.
The cost per GB of storage is $0.016 and halving every 18 months or so according to Moore’s Law. A user deciding between Google Cloud and BSV at-cost would see the Bitcoin SV chain is cheaper than Google at their 3-month minimum.
But we can’t compare the costs of just one miner – since storage is redundant, the cost to the network is at least the cost of required hard drives for each miner.
We’ve included an adjustable assumption for the number of miners in the model which you can follow along with.
At scale it would be quite costly and likely unprofitable for smaller miners which would keep this number down. Consensus seems to be that about three miners would maintain the network.
This would be sufficient for the decentralization required by redundant data storage, or transparent cash transactions.
The cost of storage would also increase as more miners entered the network if they tried to pass these costs on, which limits the viability of the network for storage in the first place.
Assuming three miners providing data storage at or close to cost, the price of data storage on BSV would be a one time fee of 4.8 cents per GB.
A user comparing prices with Google would see a breakeven at 7 months.
Global Data Storage
The internet is growing at 70 TB per second.
We’re using gigabytes (GB) as a common denominator – 70 TB is 70,000 GB.
10% of that would allow everyone on Earth to upload a few photos to Facebook per day and create some short videos to upload as well.
In the model, we also include an assumption that this user-generated content suitable for immutable storage doubles in size every year.
With our default assumptions, the cost of storing all this data would be $10.6 billion in 2019, and around $135 billion in 2030.
All of this would be paid in BSV.
Using the circulating supply of BSV and the equation of exchange, we can calculate what each BSV would be worth in this system.
Simplified, the equation of exchange shows that the circulating supply of a currency is worth what that currency is used to purchase, divided by the velocity of that currency – the average number of times each unit circulates.
In the model, we estimate the circulating amount of BSV based on bitcoin issued, the number of lost coins and an adjustable ‘hodl’ percentage.
We estimate velocity at 12 to simulate users refilling their balances once per month.
Combining all of our factors into the equation of exchange yields a value of $84 for 2019, and $869 in 2030 with our default assumptions.
At the time of writing, the price is $83.18 – this is purely coincidental, as our assumptions are simulating massive amounts of on-chain storage when in reality there is very little.
If you do adjust the assumptions of the model, you’ll find that that no matter what constraints you include, BSV simply isn’t that valuable as a medium of exchange for just data storage.
However, if the Bitcoin SV blockchain actually became the data storage layer of the internet, it would likely be used for other things.
First on that list would likely be payments for data retrieval i.e. internet service – this would add some value to BSV.
It’s the BSV community’s hope that as the currency native to the internet, BSV would be adopted for all payments.
It’s possible, but because BSV is highly traceable and lacks anonymity, it’s not a given. Some private citizens care about their privacy, but more than this, governments and politicians value the ability to transact anonymously.
The dystopian median between governments’ conflicting interest in surveillance and politicians’ desire for anonymity of transactions would be a mandate that private citizens use BSV for payments while governments and politicians use some other anonymous currency like Monero (XMR).
Short of a government mandate, though, it seems unlikely BSV will be adopted for all payments, but not impossible.
With the way the BSV community is ingratiating themselves to governments by proactively designing legally compliant applications, a bet on BSV is a bet on government endorsement. It’s not necessarily a misplaced bet, but seems likely to lead to dystopian outcomes.
BSV proponents imagine citizens keeping politicians accountable using this system. This seems unlikely – surveillance doesn’t tend to work two ways. Beyond that, this could also legitimize redistribution schemes and create mob rule.
In conclusion, if miners lower the satoshi per byte fee, BSV can become the data storage layer of the internet. It could also be adopted for payments in the future, but not a future we’d support.
Over the past week, Eat Sleep Crypto subscribers received the first four parts of the Cryptocurrency Price Floors series.
Price floors can be used to predict what technical analysis experts call “support.”
In part three of the series, I described how I used price floors to predict Bitcoin’s fall from $5600 to $3170 almost to the dollar.
You can access the full article by signing up. It’s less than $5 a month, and the insights you’ll get will more than pay for themselves.
This is part five, on the price floor created by denomination of goods and services in a currency.
Price Denomination
The denomination of goods and services in a currency provides the sturdiest price floor for a currency.
We haven’t seen this yet in cryptocurrencies on large scale, but it’s starting to happen in Venezuela through sites like Freelance For Coins.
Denomination of goods and services in a currency inevitably follows the adoption of cryptocurrencies as payments in a local, closed-loop economy, or in economies with no imports and exports. Without products priced in other currencies on either end of a supply chain, the relative price of a currency becomes irrelevant.
Native denomination of goods and services has a ripple effect. Through social pressure, this ripple effect might extend outward, but through economic forces it extends downward in a supply chain.
For example, a merchant pricing sandwiches at ₿.001 might see his competitors adopt a similar rate, but a farmer selling chickens at a fixed ₿0.001 enables his whole supply chain downstream to start pricing products in Bitcoin with an absolute reference to their costs.
This relative valuation of goods and services is the principle behind the Big Mac Index, which values goods and services of a country relative to the price of a McDonald’s hamburger in its currency.
In the same way, we can start to value a cryptocurrency with reference to what it buys.
Cryptocurrency Adoption In Venezuela
This hasn’t happened on a large scale yet, but it may be the next step for third world countries using cryptocurrency.
I’ll be discussing the ways this might play out in Venezuela and modeling the Venezuelan economy with Dash and Bitcoin Cash to show the effect this would have on these currencies in the Eat Sleep Crypto newsletter later this month.
In the Dash and BCH articles this month, we will discuss the practical application of this framework as well.
Dash and BCH models will be available exclusively for subscribers of Eat Sleep Crypto.
Sign up for just $5/month to receive articles like this one delivered Monday through Friday every week, and exclusive access to other articles on the site including the full Cryptocurrency Price Floors article where I explain how price floors can be used to predict prices.
I don’t like technical analysis. It’s imprecise at best, and I prefer to base my investments in sound reasoning.
I can tell you that if it is in a bull market, BTC won’t be there long. It doesn’t take TA or reading tea leaves to figure this out.
The Finger Trap Effect
Bitcoin is in a perpetual bull trap. Actually, it’s more like a finger trap – the further BTC goes, the deeper it gets stuck.
Here’s the cycle:
Price increases attract speculators
Speculators create transactions
Transactions fill blocks
Full blocks cause high fees
High fees alienate speculators, and merchants leave
When speculators sell BTC, its price declines. When merchants leave, BTC’s value declines. A currency’s value comes from its use as a medium of exchange.
Devoid of actual use, BTC trades even lower. Once it goes down, it can’t climb back up through speculative transactions without triggering panicked buys that set off the same cycle.
This continues with BTC in a death spiral and no fundamental value to bring its price up.
It ends once Bitcoin scales. That could be on-chain or off-chain, but right now it doesn’t look like BTC will do either.
Adoption’s Effect on Price
While Bitcoin Core developers actively advocate for less transaction space, other cryptocurrencies’ communities are focused on adoption as currency.
This is the focus cryptocurrency communities should have. Used as a medium of exchange, cryptocurrencies must increase in price – over time, the market demands a higher value for these currencies.
We see this through the equation of exchange. Don’t worry – it’s not complex. I explained it to my grandma over Christmas.
The equation of exchange is the most important equation for cryptocurrency valuation. Eat Sleep Crypto’s public articles on cryptocurrency valuation are a good intro, but we explain the applications of this framework and many others for valuing cryptocurrency in the Eat Sleep Crypto newsletter.
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For the past several years, the Bitcoin block size has been the biggest controversy in the space. The debate surrounding the issue started around 2013, and in 2015, the Lightning Network was announced as a possible solution.
Despite four years of development on a 6-month project, Lightning employees still haven’t answered the question the Lightning Network was designed to address: how will it scale and remain decentralized?
In this article, we discuss five reasons the Lightning Network can’t scale and remain decentralized.
1. The Lightning Network is too expensive
One of the proposed benefits of the Lightning Network is low fees. It’s not really the case. Lightning transaction fees are low, but only relative to Bitcoin’s. It still requires an on-chain transaction to open one Lightning channel, which is not supposed to be enough to route payments anywhere else in the network. The optimal number of channels per user is around 14.
Bitcoin fees have been hovering around $0.10 for some time now, but even this amount is enough to price out third world users. Venezuelans making a dollar a day can’t afford to open 14 channels just to get paid, let alone the $50, $100, or $1,000 transaction Bitcoin maximalists want to see on-chain.
That the Lightning Network can’t cater to Venezuelans, Zimbabweans, and other marginalized 3rd world users severely limits its target audience. These are the people who need Bitcoin the most, and adoption must begin with the people who need it.
2. Lightning has terrible UX
One of the components to using the Lightning Network as envisioned by the developers is running a Lightning node. Lightning nodes require connection to a Bitcoin node, and additional hardware to make sure they never go offline. Downtime for a Lightning node can mean complete loss of funds.
Short power shortages don’t affect LN channels unless the outage messes up your node and causes irrecoverable channel state data loss!
PLEASE be sure to use an external UPS battery wherever you plug in your node hardware!
Despite Lightning advocates’ insistence that the technology is still in its early years, a technology as clunky as this isn’t even being adopted by tech enthusiasts, let alone the average person in the US, or Venezuela.
3. Lightning has a low ROI
On the demand side, Lighting prices out users by keeping fees high. On the supply side, Lightning is equally impractical. Besides the requirement for nodes to be live 100% of the time lest users lose all their funds, the Lightning Network is impractical for liquidity providers.
Insufficient returns are the greatest antagonist to meaningful investment in the Lightning Network. This may change in the future, but at the cost of decentralization, as a high ROI would attract competitors and eventually spawn large hubs as are already being formed.
4. Lightning’s Network Latency and the Routing Problem
The aforementioned problems are mostly economic obstacles facing the Lightning Network. There are equally damning technical hurdles LN faces.
Network latency refers to the time it takes to send messages across the network. In Bitcoin, this is done through block propagation, with game theoretical incentives to ensure the entire network can quickly come to consensus.
In the Lightning Network, nodes must find a path to send payments before sending. The problem is, every time a payment is sent, the balances of each channel must be updated. Nodes have to always remain aware of the channel balances, learning about updates almost instantaneously. Lightning payments have a high frequency of failure now, and this problem will be even worse at scale (without centralized hubs) due to the volume of payments.
To ensure successful payments, users are incentivized to open channels with nodes which have lots of BTC available to route. This leads to a “hub and spokes” (centralized) network topology.
5. The Lightning Network is easy to censor
Because the Lightning Network naturally tends toward a hub-and-spokes model, it’s very easily disrupted. If a node with large balances were taken down, it would disrupt the network immensely.
Furthermore, if the identities of Lightning Network nodes operators are known they can be easily censored through the same KYC restrictions which are placed on exchanges today.
In Bitcoin, this censorship is impossible because of the incentives of the system, but Lightning has no such incentives to prevent centralization.
Closing Thoughts
Because of its high costs and highly technical UX, Lightning appeals to a small subset of people – skilled developers in first-world countries who already hold BTC.
Without custodians to take on these issues, further adoption is inhibited. With custodians, the Lightning Network becomes a recreation of the existing banking system, entirely defeating the purpose of Bitcoin. This means that the Lightning Network can’t scale and remain decentralized.
Thankfully, there are alternative approaches to scaling that may remain decentralized. Bitcoin Cash and Bitcoin SV have interesting approaches to this problem.
We write about these and other cryptocurrencies, analyzing them using their fundamentals and incorporating the technical viability of their solutions into our projections of their future value.
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In How to Value Cryptocurrency: The Equation of Exchange, we walked through the steps to valuing a currency based on its utility. Eat Sleep Crypto tries to be as straightforward as possible, but valuing cryptocurrency based on utility is a paradigm shift from the still-speculative market.
I may have overestimated the article’s clarity, but I passed it to my grandma, who’s very sharp and capable of understanding the subject. This was her actual response:
Nate
I sort of understand your article. But why is another valuation method needed? Isn’t the value what someone will pay? I.e. what the coin will purchase?
Love,
Grandma
Disclaimer: My grandma is more well-versed in politics, economics, and business than most people I’ve ever met. I hope my response is concise enough for all grandmas, but your mileage may vary.
Cryptocurrency Price Factors
Grandma,
You’re thinking of it correctly. The ‘valuation’ is a loose price floor created by demand for goods in that currency.
For example, say Ford wants to buy $1000 worth of parts from China. Chinese manufacturers demand payment in a new currency, the Gold Yuan.
If there is only $500 worth of Gold Yuan in circulation, Ford can’t pay. However, by buying Gold Yuan – assuming there is some outside demand for the currency, Ford raises the price of Gold Yuan until their holdings are valuable enough to pay the manufacturers.
The principle here is that the money supply of an economy must be valuable enough to support purchases in that economy. In the absence of market-makers, volatility may push the price under this price floor temporarily.
Speculators can push the price infinitely high, but as long as commercial transactions exist, there is a loose price floor waiting at the bottom.
Market Demand For Cryptocurrency
I sent the first email. I tend to realize what I left out after sending an email – a terrible habit, not unlike leaving the house without your keys – my other favorite. So I quickly sent the following:
As it relates to cryptocurrencies – online merchants demand them.
Some demand cryptocurrencies on principle, more demand them for privacy, and half the world demands crypto because they don’t have access to traditional finance.
I write about cryptocurrencies which are adopted for the latter two reasons. Eventually they will become the standard.
Thank you for sending the previously linked article, and thanks for asking these questions.
Conclusion
This is a lightly edited version of an actual exchange between my grandma and I. She’s sharp, but anyone understand cryptocurrency when it’s explained in common terms.
Fostering understanding is Eat Sleep Crypto’s mission. We detest the deviations from utility-based investing principles. Speculation delays adoption and doesn’t work. The sooner the market gets on board, the quicker cryptocurrencies will be adopted by the world – particularly by those with no alternatives.
We write about valuing cryptocurrencies using each cryptocurrency’s utility a medium of exchange to mirror Warren Buffett and Benjamin Graham’s style of value investing, and have created several articles on individual cryptocurrencies with this lens.
Though you may not be familiar with the term, you’ve almost certainly been exposed to the ideology.
Bitcoin maximalism is the belief that Bitcoin, and only Bitcoin must succeed in the market. This belief stems from a faulty understanding of the role of social consensus in currency markets, and belief in myths about the origins of money.
A Collective Memory
Through centuries of cultural conditioning, money has been elevated to a special place in the public’s mind. People cannot imagine what money might look like in a free society.
In a free market, money would be a good just like any other – cryptocurrencies included. Demand for goods stems from the value those goods bring to consumers. Money is not unique in this sense.
Good money has distinct qualities, which Bitcoin maximalists like to list. Scarcity, portability, and fungibility are among them. However, Bitcoin maximalists are working from a different paradigm. They don’t recognize the ordinary status of money.
Due to unconscious conditioning and reasoning by analogy, maximalists imagine money has special properties which make it act differently than ‘ordinary goods’. In a sense, Bitcoin maximalism is only a step removed from existing arguments for fiat currency.
Fiat currencies remain popular through the threat of force. In Bitcoin maximalist circles, it’s the threat of ostracization. Insults are not violence, but they’re hardly a competitive strategy.
Benefit of the Doubt
Unlike policymakers of the past century, Bitcoin maximalists are not malicious. Bitcoin maximalism stems from a genuine desire for Bitcoin to succeed, coupled with a faulty understanding of the interactions between technology and economics.
Maximalists believe that money is purely a social construct, that its value is subjective. Bitcoin maximalists are afraid that if Bitcoin fails, there will be no reason for people to agree on any one cryptocurrency. They see Bitcoin’s failure as driven by speculation on other coins, and reason that, because code is adaptable, any currency can copy the properties of any other.
While it’s true that code is adaptable, the network effects of currencies are much more robust than maximalism implies. Among other reasons, these network effects remain because infrastructure is built around them. And infrastructure is an objective reality, not a social construct.
Another reason for Bitcoin maximalists’ fervency is that they believe money must be (or must be made) valuable before its use. This line of reasoning comes from their reasoning by analogy, and uses few examples.
Bitcoin is compared to gold ad nauseam, but there are other non-fiat currencies circulating today which should be considered. Drawing insights from a sample size of one is bad practice.
The currency of choice for drug users, and hungry millenials.
Cigarettes, Food, and Tide laundry detergent are still used as currencies in distinct niches. Bitcoin maximalists tend to ignore these examples and decline to consider what makes them valuable.
Why Are Currencies Valuable?
On a high level, these currencies are accepted because of their near-universal utility in their target markets. For that matter, even gold has utility, supremely in the ability for owners to flaunt their wealth.
The utility of a currency is its usefulness as a medium of exchange. Currencies are affected by supply and demand just like any other good. Assuming stable supply, currencies appreciate with demand. And the best way to create demand for goods is through utility.
As explained in How to Value Cryptocurrency: The Equation of Exchange, utility drives adoption; adoption drives price. The next time cryptocurrencies spike, it will be due to utility. Unfortunately, utility has been masked while most new money to cryptocurrency comes in through Bitcoin.
Bitcoin is the dominant base pair on most exchanges. Because buying other cryptocurrencies typically requires BTC, the BTC price stays up, even without Bitcoin’s utility.
A currency’s utility is in its use as a currency. This is axiomatic. It’s self-evident, implied by the very name crypto-currency.
At Eat Sleep Crypto, we focus on utility rather than speculation. Gambling is fun, but it’s not a sustainable investment strategy.
We’ve been creating models in the Investor Series which tie cryptocurrencies’ utility to real-world use cases. Models are created with comprehensively-sourced data and adjustable assumptions for you to see the effects of individual factors on the value of each cryptocurrency.
The Monero Investor Series article is in its final stages, and you can get a discount on it by subscribing to the Eat Sleep Crypto newsletter for FREE. As a subscriber, you’ll also get access to articles like this one in advance.
If you enjoyed this article, or even if you disagree completely, we’d love to hear your thoughts on Twitter @officialESC and in the comments below.
Cryptocurrency investment has been almost entirely speculative. In 2017, anyone with a half-baked idea could write a whitepaper, create a token contract, and raise $50 million in a week-long ICO.
Besides Joe and Jane Sixpack, participants with larger allocations were BTC early adopters and Silicon Valley veterans who should have known better. Then again, everyone is a genius in a bull market.
It wasn’t until the bear market struck that these investors started second guessing their positions. Fundamentally, investors failed to understand that cryptocurrencies (and tokens) should be valued not as stocks or commodities but as currencies.
The Bitcoin model yields a $50 million dollar per BTC value in 2030 with default assumptions.
Fortunately, it’s not only possible to value cryptocurrencies on a fundamental basis, this type of appraisal delivers more accurate valuations than speculative targets, and fortune awaits those who identify these investment opportunities.
The Equation of Exchange
The equation of exchange is used by economists to model currencies. It has four variables which describe the relationship between purchases made in an economy and the amount of circulating currency. We can use this equation to assign a value to a currency based on its utilty…that is, its fundamental usage as a medium of exchange. This, after all, is what the genesis of cryptocurrency was all about.
The equation is
MV = PQ
M represents the units currency actually circulating in an economy. Hodl’d units don’t count.
V is for velocity. Velocity is the number of transactions an average currency unit will encounter, per year.
P stands for purchases. Its value is the average price of purchases in an economy.
Q is the quantity of these average transactions.
Given any 3 of these variables we can determine the 4th. Now for some application.
In the US, M1 is the term for all dollars circulating in the economy. According to the St. Louis Fed, dollars are used an average of 5.5 to 6 times per year so we’ll use a V of 6.
Suppose that the average purchase in the US is $50 (P=50), and that the yearly quantity of these purchases is 20 (Q=20).
Therefore, PQ is $1000 and through the equation of exchange must be equivalent to MV. (MV = PQ)
So, what we know is:
P = $50
Q = 20
PQ = $1000
MV = $1000
V = 6
Given a velocity of 6, we can solve for the remaining variable M, the monetary base. To do this, we divide both sides by 6.
This leaves us with M = $1000/6 = $166.67.
And voilà, with only three variables, we’ve just calculated the total monetary base of an economy.
This can be solved for any size economy, but the relevance to cryptocurrency is that the equation of exchange can be applied to specific use cases targeted by niche cryptocurrencies. Let’s look at one now.
Example B: WidgetCoin (WGC)
Imagine WidgetCorp sells widgets for an average of $20. Five hundred of them are purchased per year for an annual volume of $10,000.
Q = 500, P = $20
Now suppose as the sole manufacturer of widgets, WidgetCorp decides to create WidgetCoin (WGC) and require payments be made in WGC. WidgetCorp also has a monopoly, (state-sanctioned of course).
Because it’s a closed system, the new currency has its own velocity. Some speculators are reluctant to spend their WidgetCoins, so we’ll estimate a WGC velocity of 4.
Now we can solve for the monetary base required to support purchases, M, i.e. the value of circulating WidgetCoins.
M * 4 = $20 * 500
4M = $10,000
M = $2,500
So we’ve figured out that the total value of circulating WGC is $2,500, but what is one WidgetCoin worth?
We could simply look at the market price, but price won’t tell us what the actual value is. WGC could be fairly valued, overvalued or undervalued, and as investors this is what we want to determine.
We seek the intrinsic value of a WidgetCoin. To calculate that, we need a critical piece of information – the circulating supply of WGC.
There may be a thousand, ten thousand, or millions of WGC but let’s imagine WidgetCorp was conservative in determining token supply. WidgetCorp wanted each widget to cost 100 WGC, and they issued 12,500 coins.
With the known dollar-value of the monetary base, we can factor in the coin supply to calculate the expected market value of each coin.
In this case, $2,500 divided by 12,500 coins is $0.20 per coin.
Now pretend WidgetCorp instead decided to create 1 million coins.
The same $2,500 divided by 1,000,000 coins is $0.0025 per coin – a quarter of a penny.
If WidgetCorp had ICO’d WGC for 20 cents each, they’d have made a killing. Unfortunately, early investors would have seen the value of their WGC fall by 98.75% as the market adjusted.
Wittingly or not, this is what happened in 2017 with ICOs.
It’s also the reason behind Bitcoin volatility. The market price strays from Bitcoin’s intrinsic (i.e. utility) value.
With largely speculative transactions, Bitcoin’s economy has no fundamental drivers of value – no necessary purchases (PQ). Eventually, the market catches on and adjusts the price accordingly.
For a more in-depth exploration of Bitcoin’s intrinsic value, go to Investor Series #1. (At this point, you’re well-equipped enough to skip the first part and go straight to the calculations.)
Implications
The equation of exchange is not only relevant to ICOs, or Bitcoin. The equation of exchange is the single most important equation in the industry, and yet it’s been largely ignored. Eat Sleep Crypto applies it, and you should too.
As the bear market eats weaker currencies, we focus on the value propositions of utilitarian coins in niche markets. Hope is not an investment strategy.
These currencies are the subject of our Investor Series. Our next edition is due this week and will be offered at a discount exclusively to subscribers of Eat Sleep Crypto. We’re covering Monero, one of our favorite coins, and the determined value will shock you.
Keeping with the “utility determines value” theme, free analysis is readily available on Reddit and Facebook, and is worth exactly what it costs. However, if you want to know what we know, it’s going to cost you something.
Right now though, you can get a preview for free.
Sign up for a 5-day free trial of the Eat Sleep Crypto daily newsletter and send us a message to receive a notification when we release Investor Series #3 – Monero.
