Unit 10 Lecture Notes

A look at the ten years of Bitcoin's existence shows these trends unmistakably. As the chart below shows, while the number of daily transactions has grown, it is far outpaced by the increase in the value of these transactions. By comparing averages for the most recent three months of data to the first three months of data from 2010 (the first available price data), we find that daily transaction value has increased by roughly 250,000-fold, while transaction count has increased by about 800-fold. In 2019, the value of the average bitcoin transaction is around 300x the value of the average transaction in 2010. In fact, the number of daily transactions has largely remained in the range of 200,000 to 400,000 transactions from 2016 until 2019, while the value of transactions has increased roughly 7x over the same period.

As its demand has increased, Bitcoin has not scaled through a larger number of on-chain transactions, but rather by increasing the value of these transactions. Should its demand continue to increase, I expect this trend to continue. With a fixed block size, there is a hard limit to how many transactions can be done on-chain. Even assuming non-contentious forks can increase the block size, they will not be adopted unless they come nowhere near compromising average users' ability to run their own nodes; this means that any block size increase will likely be slow and gradual. Growth in demand for holding bitcoin, on the other hand, does not have the same hard limit. Should bitcoin continue to maintain its core value proposition as a hard money whose supply is perfectly predictable, the growth rate of demand for it will far exceed its ability to handle individual on-chain transactions.

The economics of Bitcoin's block space are a beautiful illustration of market dynamics at work. Its scarce nature necessarily means that a bidding war will ensure only those who value block space the highest will get it. Over time, this pressure has priced out many types of transactions from being registered on-chain, and now more and more are settled off-chain. As was the case with gold and silver, the inability of individuals to use the harder money directly and without intermediaries was not a deal breaker for them to hold it over the easier money.

Today, many bitcoin-based businesses conduct a majority of their transactions in bitcoin on their own internal databases, and only use the Bitcoin blockchain for final settlement to and from the business. Gambling websites, for instance, will record all bets and winnings on their internal ledgers, and will only use the Bitcoin blockchain when a user deposits or withdraws bitcoin from the website (the same is true for exchanges, where traders speculate on bitcoin and digital currencies). For each on-chain transaction, many thousands of bitcoin-denominated transactions can occur and settle on internal and private ledgers.

This is in contrast to the situation in the earlier days of Bitcoin when betting services such as Sa toshi Dice would record thousands of transactionsdaily on the Bitcoin blockchain. As transaction fees on the network have risen, these models are no longer sustainable and have changed to rely on the Bitcoin blockchain for settlement only.

Should demand for bitcoin increase significantly, many more uses like this will inevitably be priced out. Because there is no hard limit on its demand, its total daily transaction value can rise to many multiples of today's daily transaction value. If it does, the pool of liquidity for transacting bitcoin will grow, allowing for more valuable purchases and sales to be conducted in bitcoin; this will inevitably price out the transactions of smaller value, as they will not be able to match the transaction fees of these larger transactions.

When considering the types of transactions that will remain on the Bitcoin ledger, it is instructive to think of the alternative avenues available for such transactions. By determining the opportunity cost of not using Bitcoin on-chain for various use cases, we can see which ones can afford to bid the highest for block space. Assuming market participants desire superior security and hard monetary policy, they would be willing to use bitcoin even if transaction fees are significantly higher than alter native payment solutions that rely on trusted third parties and inferior security.

Conversely, if users are not as concerned with superior security and a hard monetary policy for a given use case (e.g. involving smaller value transactions), the opportunity cost of not using Bitcoin is lowered. Currently, individual consumer payments are processed with fees of 0-3% over various payment processors. Given that market participants are less concerned with Bitcoin's value propositions for these use cases, it would only make sense to use bitcoin for these payments if a bitcoin transaction fee were in the cents or at most single digit dollars. Similarly for international remittances, transaction fees are usually tens of dollars, which suggests that as a potential cost ceiling for bitcoin in this use case. If the use of bitcoin for these uses takes off, transaction fees will eventually rise past the cost ceiling, and it would be no longer economical for the users.

This feedback mechanism will continue to price out all manner of uses of Bitcoin's blockchain and will reserve block space only for transactions that need Bitcoin's guarantees the most. As it stands, bitcoin on-chain transactions are a tiny fraction of total bitcoin-denominated transactions, if one were to count trades on exchanges and casinos, as well as all manners of second layer transactions. As bitcoin transaction fees increase, one of the use cases likely to be the most willing to pay will be international final settlement payments between large financial institutions. These are by their nature the most valuable and most security-sensitive transactions today, and the closest thing to a bitcoin transaction currently, in terms of their finality. They currently require days (or even weeks) to complete. Bitcoin is barely beginning to acquire the size and liquidity to allow it to conduct such payments with confidence and security. As it grows it will likely attract more and more of these transactions, which will crowd out many other use cases and push them off-chain. For some of these crowded out use cases, second-layer solutions will inevitably emerge that retain some of Bitcoin's guarantees while relieving users of its on-chain fees.