Unit 10 Lecture Notes

So far we have examined how the scarcity of the block size necessitates off-chain scaling, but there is another reason why second layer scaling is inevitable: demand for legitimate banking services will continue to exist under a bitcoin standard, just as it has existed under any form of money. Bitcoin block space does not replace the essential functions of banking. There is a lot that is wrong with crony capitalist modern banking, but this is primarily the result of government protection of banks that allows them to profit from unproductive practices and offload the downside risk of their activities to taxpayers.

There are two core functions of banking: holding deposits and allocating investments. The need for these two specialized services is not the result of technical shortcomings of government money that bitcoin could improve upon. They are demanded in a free market for the same reason any good is demanded: consumers value it, and producers specializing in it can provide it at a lower cost and higher quality than individuals could provide it for themselves.

The majority of people with any appreciable liquid savings prefer to have most of their savings deposited with a specialized service that can provide better security. Individuals do not want to have physical possession of their entire life savings at all times because of the risk of loss or theft, and the stress that comes with it. Homes are not designed to optimize for securing large amounts of money, but bank vaults are. It is an inevitable part of human trade and specialization that enterprising individuals would take the initiative and build a facility optimized for securing large amounts of money and employing the kind of security that is unsuitable for a residential home. Individuals would then benefit from paying a small cost to have their money secured at that facility. The benefits are not just that their money is less likely to be stolen, but perhaps more importantly, banking makes it common knowledge in society that anyone with serious money will have it locked up in a safe vault and will not be carrying it on them or storing it at their homes. Even if a criminal were to abduct or extort a millionaire at gunpoint, they would be unlikely to get significant amounts of money from them because most of their wealth would be stored away in a bank, and not immediately available to its owner. This common knowledge is a significant contributor to individual safety, as it severely decreases the likely pay off from violent crime, extortion, and kidnapping.

While bitcoin allows people to send money globally without censorship, it cannot possibly offer them safe and reliable self-custody, as that is inescapably a real world flesh and bone problem. The same censorship-proof nature of bitcoin that allows the sender to irreversibly move money across the world can be utilized by a thief to steal some one's bitcoin. The nodes of the Bitcoin network have no way of distinguishing between different people wielding a private key, and no notion of legitimate or illegitimate ownership of these keys.

No matter the scale at which Bitcoin operates, it is entirely unreasonable to assume it can eliminate the demand of humans to avoid self-custody. That view is built on the naive assumption that people only use banks for payment processing, and so they store their wealth at banks because they need the bank to spend the money. This ignores the demand for storing money for safekeeping and for personal safety.

Importantly, it is also inaccurate to assume that the continued existence of banking will necessarily result in censorship, inflation, and fractional reserve banking. The systematic lack of economic freedom enabled through banking censorship and inflation is the result of the monopolies that governments grant to their banking systems. There is no inherent reason why banking cannot be a normal business where providers strive to please their consumers (think warehouses). Neither is there anything inherently wrong with banking that prevents it from building trusted relationships. People will every day trust strangers to deliver them safe food, drink, and critical tools like cars and airplanes. These industries will function well and consumers will be safe only when a free market exists in these goods, and when consumers have a choice in their providers; this choice forces providers to either care for their clients or suffer the penalty of lost customers and potential failure. As seen in many industries, anytime a government monopoly provides these goods, consumers are in trouble. The problem with banking, then, is not the nature of banking itself, but the fact that it is a government monopoly. In a free market, banking would continue to exist, but would be subject to consumers' choice and their satisfaction. The freedom to choose forces providers to behave their best and swiftly punishes any deviations.

While many bitcoiners themselves have a very strong anti-bank sentiment, and a desire to hold their own money, it does not follow that newcomers entering Bitcoin will necessarily have the same desire or need to follow these ideals. In fact, to impose this model on everyone flies in the face of bitcoin's permissionless nature. Many Bitcoiners may want a world in which everyone gets to be their own bank, but the vast majority of people don't want this anymore than they want to be their own butcher, builder, or baker. There is nothing old-time bitcoiners can do to stop new bitcoiners from banking with bitcoin, if that is what they choose. It is also inaccurate to assume that the benefits of bitcoin are lost to those who choose to deal with custodian services. One may lose the censorship-resistance and permissionless control of owning their own bitcoin private keys, but they nonetheless benefit from holding a hard asset that cannot be inflated away. While there is definitely demand for a permissionless way to send value worldwide, that use case is without a doubt dwarfed by the potentially universal demand for the hardest money. Not everyone has a pressing need for making payments their government does not approve, but everyone will inevitably be compelled by economic reality to converge on the hardest money in the market. As time goes by, and if current trends continue, we can expect demand for holding bitcoin as a hard money to increase even while more transactions are priced off-chain.

The second core function of banking is the allocation of capital through credit and equity investments. The demand for this function is also not something bitcoin can possibly eliminate. The development of banking institutions is an advancement in the process of capital accumulation, allowing for a much more sophisticated division of labor and higher productivity. Because bankers specialize in the deployment of capital, they allow individuals to specialize in their respective fields and focus on being as productive as they can. The individual is freed from the labor of analyzing various investments and assessing their likely returns and risks, since the task is delegated to professionals who specialize in matching individuals' investment goals and risk tolerance with suitable investment projects. The allocation of investment is an act that cannot benefit from the automation and immutability that bitcoin provides to financial transactions. These are activities that require human judgment of factors outside of the Bitcoin blockchain, in relation to subjective individual preferences and desires, and they would exist in any sufficiently advanced capitalist economy.