Unit 10 Lecture Notes

Just as transactions with financial instruments based on gold displaced silver coins, it is my contention that second layer bitcoin transactions will in the long run displace transactions that currently take place with easier forms of money. Bitcoin purists may complain that second layer bitcoin transactions will never have the equivalent of chain transaction security and certainty, but that misses the point. Second layer bitcoin transactions do not compete with first layer bitcoin transactions, they compete with second layer transactions on inferior moneys.

The scaling limitations for bitcoin's on-chain volume discussed above make it clear that Bitcoin will probably not scale past a few million on-chain transactions a day, nowhere near the number needed for all individual consumer payments. Bitcoin itself on its base layer will never be able to handle all of that volume. Further, transactions need about 10 minutes to get a single confirmation on the network, which is highly unsuitable for individuals who expect their consumer payments to complete much more quickly. The level of security and certainty Bitcoin provides for a transaction after it has received a few confirmations is also wasteful overkill for small purchases. For individual small payments, Bitcoin's security is too expensive and wait times are too long. In the same way that payments with gold were standardized and more convenient through banknotes backed by gold, second layer solutions will make bitcoin more predictable, faster, and cheaper, but in the process incur a trade-off of security, liquidity, and censorship-resistance.

While the purists will complain that these kinds of transactions will never have the same level of security as real bitcoin transactions, they cannot do anything to stop the economic reality of individuals preferring these second layer payments with hard money as the base layer to second layer payments on easy money. The limitations that exist will also be present in second layer payment solutions for other types of money. The main difference is that the payment solutions on hard money are likely to allow holders to retain value better into the future. Given the choice between payment solutions on a hard money and payment solutions on an easy money, salability across time dictates that the harder money will inevitably win.

The common mistake that many bitcoiners make when assessing second layer solutions on top of bitcoin is to compare them to bitcoin transactions, but the more accurate comparison is to consumer payment technologies on other forms of money. Conceptually, Bitcoin could scale to handle all of the world's transactions by next week if central banks replaced all their reserves with bitcoin this week. Hypothetically, if the Bitcoin blockchain were only used to settle large transactions between central banks (while they issued currencies fully backed by bitcoin), then all of the world's transactions would effectively be bitcoin second layer transactions. Your government paper money, your checking account, your credit card, and your PayPal account would all become second-layer bitcoin payment solutions in that scenario. Of course, this is not to say that I think such a scenario is likely or even in any way politically feasible; this is just a thought experiment to drive home the parallels between bitcoin and settlement layers.

In the world of national moneys, we cannot really expect central banks to move to bitcoin, as I had discussed in TBSRB1. There is nothing wrong with bitcoin that fundamentally prevents its adoption as a reserve asset for central banks. The problem rather lies in the incentives of central banks themselves. I expect that bitcoin is far more likely to grow as an apolitical system independently of the national central banking system, and that this will be healthy for bitcoin in the long run.

As the number of bitcoin holders grows and more people demand payment solutions, there will be an incentive to provide them; the solutions will be optimized and tailored to work best with bitcoin as it is. This will likely lead to a reinvention of most of the mechanisms we use today for payment. Secondary layer transactions do not share the same level of security as on-chain transactions, but it is not clear why that level of security is needed at all for such transactions. When a customer has an account with an exchange or online casino, they are already trusting that party on many different levels; allowing that party to record transactions on their own ledger, after they've received the deposited customer funds, adds no risk whatsoever. If they choose to exit a scam, they could do so regardless of whether their internal transactions were recorded on-chain or off-chain (since funds are only truly under the control of the user after withdrawal from the third party service).

As demand for bitcoin increases, these second layer solutions for scaling will only proliferate, and different levels of risk and safety will emerge for different use cases. Opendimes are another good example. These physical usb keys are made to be tamper-proof, and the bitcoin balance inside them can be verified very quickly. For small sums and transactions between people with a sense of familiarity and trust with one another, this is a very useful mechanism that allows for in-person transactions without needing to be registered on the Bitcoin blockchain. While clearly unsafe for larger sums, it can nonetheless handle a very high number of small transactions and allow for more liquidity in bitcoin transactions.

Multisignature custody solutions will likely also play a role in allowing for cheap second layer payments. Holders could deposit their coins in multiple accounts, such that the coins can only be moved on-chain with both the private keys of the holder and the bank. That bank could then create a payment network for holders of such accounts on its own internal databases to allow individuals to transfer ownership to each other, which would only be settled with on-chain transactions at the end of the day, week, or month.