Trade-offs and risks

The move toward second layer scaling is one that involves risk for users individually, as well as systemic risk for the network. The first and most obvious trade-off is in the network's censorship-resistance. Bitcoin has produced the only reliable technology for transferring value without reliance on intermediaries, and it only manages to do a few hundred thousand of these transactions per day. As demand for bitcoin transaction increases, and individuals resort to second layer solutions that rely on third parties to clear their payments, these parties will be able to censor their transactions and possibly confiscate their coins. One of the main advantages of the Bitcoin network is thus lost for individuals if they choose this type of second layer scaling.

The second risk is more systemic to the network overall, and involves alterations to the network's protocol or consensus parameters. If bitcoin transactions move to second layer solutions where many individuals are trusting third parties to validate their transactions and enforce network consensus rules, Bitcoin deviates from being a peer-to-peer system, and the risk of collusion between nodes processing transactions rises. One can think back to the Segwit2x attempted upgrade and imagine that in a world where far fewer individual users ran their own full nodes, that businesses wanting to change Bitcoin's consensus parameters might have actually gotten away with it had users been reliant on them to enforce consensus rules. If the number of nodes declines, the remaining nodes become more influential and easier to co-opt by attackers or governments. A Bitcoin network with a few hundred nodes is a far less immutable and secure network than one with tens of thousands of nodes.

The risk of losing censorship-resistance is one that each individual needs to assess in contrast to the convenience and cost of other payment and custody options. The other risk is not directly the result of second layer processing itself, but rather a reduction in node count to the extent that jeopardizes the decentralized nature of Bitcoin. However, the Schelling point of Bitcoin nodes agreeing on the main consensus parameters does not require every user to run their fully-validating node, it merely requires that enough independent full nodes exist to prevent any one particular party from altering the code in a direction it chooses.

What is essential for bitcoin to survive is that the main consensus parameters, particularly the economic parameters, remain immutable, and for that to happen, bitcoin needs a large number of independent nodes unable to coordinate. The larger the number of nodes, the less likely that subgroups will collude. It is not strictly necessary that every individual is able to verify their every transaction on-chain for bitcoin to survive. If the growth of second layer solutions results in a larger liquidity pool for bitcoin, and operating bitcoin full nodes becomes a profitable way to provide banking services, it would financially incentivize the growth of independent nodes, thus making the bitcoin protocol more ossified and harder to change. Not only does the increase in the number of nodes make coordination more difficult, but the profit motive would likely make nodes conservative.

As Bitcoin scales, the challenge will be to introduce second layer solutions that minimize both the trust in third parties and their ability to censor transactions. Yet one must be realistic, and Bitcoin's trustless transactions are not something that can be easily scaled. As discussed above, those priced out of them have no alternatives with the same guarantees. Altcoins have nowhere near the liquidity of bitcoin in the real world, and exist mainly as trading pairs with bitcoin on exchanges. As I have traveled around the world and met many bitcoin brokers, I always ask what percentage of their business is in bitcoin; the answers I have gotten range from 90% to 99% to 99.9%. Altcoins are thus useful for speculating on exchanges, but not so much for the transfer of large sums of money across the world. Most importantly, no altcoin can possibly be viewed as decentralized. Whereas bitcoin is a neutral protocol that only has users, altcoins are subject to small, centrally controlled groups that face no significant barriers to changing consensus rules; this renders altcoins lousy substitutes for Bitcoin's use case as a a long term store of value and a neutral protocol for international payment settlement. Even if an altcoin were to copy Bit coin's code, it does not follow that it can access the same liquidity and network effects. If bitcoin continues to grow in value due to its hardness as a money, then demand for accessing it as a store of value and for using its large pool of liquidity in trade will mean that second layer solutions on top of it are also likely to be more popular than base layer payment solutions of altcoins. The lesson of the demonetization of silver is again relevant here.

As discussed previously, if demand for bitcoin transactions increases and on-chain transaction fees rise, smaller transactions will be priced out. In my essay from TBSRB3 on the Economics of Mining, I talk about how Bitcoin block space is scarce, and that price is the only way to allocate it. Any approach to scaling will never alter this fundamental reality. The block space can increase, or it can be used more efficiently, but it will always remain scarce and will never be able to accommodate every transaction in the world. This is the reality of how Bitcoin will operate, and nobody benefits from hand-waving away these trade-offs and limitations, or pretending that they will be solved completely.

If Bitcoin continues to survive and generate increased demand, smaller transactions will find ways of settlement that are not as secure as on-chain transactions. We can imagine a world in which transaction fees continue to rise to the point that only the 1 million transactions that are most willing to pay high fees will be settled on-chain, and everything else will be transacted through less secure means.

Off-chain transactions will never be as safe as on chain transactions. It took ten years and millions of hours of software development, Satoshi's inimitable genius, and the daily consumption of about as much electricity as Ireland to find a way of doing half a million digital cash transactions daily. We may be able to increase this number marginally over the coming years, but there are no easy ways to increase that number to a global scale, and any one pretending there are is not being realistic.

The good news is that Bitcoin does not need to be scaled globally on-chain. Bitcoin doesn't have any competitors for trustless, automated, and censorship-resistant global clearance, and the only other asset that comes close to it is gold, whose movement is far more expensive and subject to confiscation, as discussed in TBSRB1. Bitcoin needs to be secure and decentralized enough to resist control and capture, and to establish a very clear, broad, and immutable consensus around network rules and money supply considerations. It does not need to accommodate your coffee transactions on-chain.