Bitcoins challenges and potential solutions.

Satoshi Nakamoto’s paper

“Bitcoin a Peer-to-peer electronic cash system” is one of the most influential contributions in monetary economics of the past fifty years. Bitcoin technology is fascinating, but there are many challenges. For some observers, these challenges are unsurmountable. For example, Stephen Williamson argues that “bitcoin’s future seems dismal. It represents a poor payment system, the ability to replicate it means that it cannot survive as a safe store of value like gold, and it may even provide poor services for criminals” he concludes that “most likely, the value of bitcoin is going to zero”

We are more optimistic about the future of bitcoin. That being said, we do not want to neglect the fact that bitcoin faces some severe challenges. In this article we take a closer look at some of those challenges and discuss potential solutions. These issues include high price volatility, scalability, regulatory uncertainty, and low levels of adoption.

Price volatility

First we look at bitcoin’s predetermined supply path and the claims that bitcoin is a deflationary currency. This section will help us understand the origin of bitcoins price volatility.

Bitcoins supply path

The supply path of bitcoin is predetermined and converges to 21 million units, after which no additional bitcoin units will be created. An interesting question to study is how the predetermined supply path for bitcoin units affects monetary policy in a current competition model.

Is bitcoin deflationary

The limit of bitcoins quantity makes it a scarce resource and a potentially interesting store of value. It could lead to situation where an ever increasing aggregate demand for bitcoin units will meet a constant supply. This could in theory cause a substantial increase in the value of bitcoin and is the reason why bitcoin could be deflationary in the long run.

Consequently, many users are convinced that bitcoin’s value will increase forever. This belief needs to be challenged. Bitcoin has no intrinsic value. It cannot be consumed or used in production, nor does it generate cash flow. The price of an asset without intrinsic value is determined solely by expectations about its future price. A buyer is willing to buy a bitcoin unit only if he or she assumes that the unit will sell for at least the same price later on.

Is bitcoin digital gold?

one potential use case for bitcoin is as a safe haven asset. In this context bitcoin is often referred to as “digital gold”. Many economists oppose this view and argue that bitcoin is not scarce because it is straightforward to create a new crypto asset. If anyone can easily create copies, then how would bitcoin be able to serve as a store of value? This concern has been raised.

It is impossible to copy bitcoin units, it is only possible to copy the bitcoin software and then to launch a new blockchain with an entirely new crypto asset. This new crypto asset can be easily distinguished from bitcoin. In fact, identifying bitcoin copies is much easier than in the art market where sometimes even experts are tricked into believing that a copy is the original.

Volatility analysis

For an asset to be useful as a medium of exchange or unit of account, it needs to have a low price volatility. A low price volatility, in turn, requires that its supply is elastic. Central banks in developed countries stabilize the value of their currencies by adjusting elastically the supply to accommodate changes in aggregate demand. In fact, the federal reserve system was explicitly founded “to provide an elastic currency” to mitigate the price fluctuations that arise from changes in the aggregate demand for the US dollar.

What distinguishes bitcoin from these government currencies is the absence of a stability mechanism. Bitcoins aggregate demand is driven by price expectations, and these expectations react in unpredictable ways to news, sentiments, and rumors. These highly volatile expectations affect aggregate demand, and since the bitcoin supply path is fixed, bitcoins price volatility is high.

Stablecoins the quest for low volatility cryptocurrency

A stablecoin is a crypto asset that is developed with the aim of minimizing price volatility by embedding a stability mechanism.

There are three types of stablecoins that differ mainly in terms of the stability mechanism and the form of the collateral. The stability mechanism either is algorithmic or uses collateral. Collateral can be either off-chain or on-chain.

Let’s have a look at how central banks stabilize their currencies

Central banking

There are two broad models of how central banks stabilize their currencies. Most central banks define a basket of goods and announce an inflation target with respect to this basket. Typically, the inflation target is around 2 percent inflation per year. Interestingly, there is no scientific evidence that a 2 percent inflation target is optimal, but most central banks nevertheless use it.

Algorithmic stablecoins

The defining characteristic of a pure algorithmic stablecoin is the absence of collateral. Instead , the designer issues two assets (sometimes even three). One asset is the stablecoin, which we assume is pegged to the US dollar. The second asset is a bond that is redeemed for stablecoins at a future date. We call this bond the “stablecoin bond”.

The basic stability mechanism of an algorithmic stablecoin works as follows. If the demand for the stablecoin increases, its price also increases. To maintain the peg to the US dollar, the issuer creates additional stablecoins. These additional stablecoins are either airdropped or used to redeem any outstanding stablecoin bonds. Increasing the supply of an algorithmic stablecoin in such a way will eventually reduce its price.

If demand decreases, the issuer creates additional stablecoin bonds and sells them against the stablecoin to reduce the quantity of stablecoins in circulation. The stablecoin bond is a promise to future stablecoins; that is, algorithmic stablecoins attempt to stabilize a falling price by promising to increase the stablecoin supply in the future to incentivize agents to buy the stablecoin bonds, they are sold at a discount. The discount is determined by market forces.

Collateralized stablecoins: on chain

The working of a collateralized stablecoin with onchain collateral is best explained by the DAI stablecoin, which is pegged to the US dollar. The DAI stablecoin is an ERC-20 token and is based on a set of smart contracts on the ethereum blockchain. Everyone can generate new DAI tokens. To do so, a user must send ether the native crypto asset of the ethereum blockchain-to one of the smart contracts. These funds serve as collateral for a loan in DAI. The interest rate is called the stability fee and DAI loan is called a collateralized debt position (CDP).

Supply and demand in the DAI stablecoin system

fundamentally , agents with different risk attitudes are at the origin of the aggregate demand and the aggregate supply of the DAI stablecoin.

Aggregate supply for DAI: agents who want to increase the risk of their portfolios of crypto assets can use the DAI stablecoin to leverage their portfolios as follows. They can borrow DAI stablecoins and sell the newly created DAI for ether or any other price volatile cryptocurrency (leverage), This increases risk exposure.

Aggregate demand for DAI: agents who want to reduce the risk in their portfolios of crypto assets can sell any price volatile cryptocurrency for DAI stablecoin. This decreases their risk exposures.

Thus, transfer of risk at the origin of the aggregate demand and the aggregate supply of DAI stablecoin. Since demand and supply can shift in unpredictable ways, there is a need for a mechanism that stabilizes the DAI price.

Collateralized stablecoins: off-chain

Stablecoins based on off-chain collateral use, regular bank accounts or other forms of centralized custody to hold the collateral. By far the largest and best known stablecoin using off-chain collateral is tether, which is pegged to the US dollar. Tether was founded in 2014 and is associated with the hong kong based exchange bitfinex. The history of tether stablecoin reveals the main issues that arise with off-chain collateral: namely the lack of transparency, absence of censorship resistance, and lack of profitability.

Stablecoin outlook

Collateralized on-chain stablecoins such as DAI offer many benefits. They are useful for machine to machine payments, in smart contracts, and in some cases even atomic cross-blockchain transactions. Currently, we can see the first designs, and it is possible that many of them fail. However, because a price stable crypto asset has so many benefits, blockchain enthusiasts will keep innovating relentlessly until they find a working design.

Scalability

The bitcoin network can currently process fewer than ten transactions per second. Sometimes this bottleneck expresses itself through high bitcoin transaction fees and large pools of unconfirmed transactions, leading to an intense and fierce debate on how to scale bitcoin and other crypto assets. It is important to note that this debate has been ongoing for many years and that there are dozens of proposals on how to improve the overall performance of cryptocurrencies. For many of these solutions there are existing packages, and some of them have already been implemented.

The crypto community has been working on many solutions to these scaling problems, some of which have already been in practice. We discuss some of the most popular scaling approaches.

Block size limit increase

Increasing the block size limit requires only small changes to the bitcoin software, and it immediately increases the number of transactions per second that can be processed by the network. The change could be implemented through a one time permanent increase, a predetermined growth path, or a dynamic block size where the blocksize limit changes over time depending on the size of the last few blocks.

Payment channels and the lightning network

so-called payment channels enable off-chain transactions; that is, transactions that are not propagated to the bitcoin blockchain. They are shared exclusively between the two parties involved and later added to the bitcoin blockchain in aggregated form. In this respect , off chain transactions benefit from the security of the blockchain without burdening it.

Payment channels are based on multisig (pay-to-script-hash) unlocking conditions and allow two parties to perform almost any number of (micro) transactions. Such payments are secure and immediately valid and can be made between parties without an established relationship of trust. An additional advantage is that only two blockchain transactions are required to process any number of off chain transactions. In the following, we describe different types of payment channels.

Undirectional payment channels: In the simplest case, all payments within a payment channel are made in the same direction. If tamara wants to make multiple payments to the brain over a period of time, they can open a z-of-z multisig address. Tamara creates a funding transaction in favor of the multisig address, which provides the bitcoin balance for the payment channel. The higher the balance, the greater is the capacity of the payment channel.

Bidirectional payment channels with timelocks: payment channels can also be used directionally. However, once funds can flow in both directions, additional security measures need to be put in place. In particular, the goal is to prevent a person from publishing an old commitment transaction that was partially signed by the other party but no longer reflects the current state of the distribution of bitcoin units.

Bidirectional payment channels with asymmetric revocable commitments: The remarks in the last paragraph suggest that in practice payment channels based on time locks are inefficient. A much better approach would be to invalidate old commitment transactions as soon as a newer commitment transaction is generated. This would prevent participants from propagating an old commitment.

Lightning network

Payment channels allow a very large number of (micro) transactions between two parties. The lightning network is a so-called “second layer solution”, that is, an additional network on top of the bitcoin system that benefits from bitcoins security. Lightning allows payments to be routed through multiple payment channels. It allows tamara to transfer bitcoin units to emanuel without opening a payment channel with emanuel. She could simply use an indirect connection through other payment channels.

In conclusion the lightning network is a young but very promising technology that could make bitcoin suitable for adoption. One side effect is that lightning transactions are much harder to track. Depending on your political views this may be a selling point or cause for concern.

Adoption

bitcoin units can already be exchanged for numerous goods and services. The market acceptance of bitcoin, however, is nowhere near that of traditional government-issued fiat currencies. We already discussed the high price volatility and scalability issues that hold back bitcoins adoption as a medium of exchange.

Bitcoin inflation and transaction fees

Transaction fees are a potential reason why people are reluctant to use bitcoin. For the first few years of bitcoins existence, low transaction fees were one of the main arguments in favor of using bitcoin for payments.

Denomination

People may have difficulties reading decimal numbers and interpreting the information correctly. The high price of bitcoin enails that the prices of many goods and services have to be expressed in fractions of a bitcoin unit and that users are therefore forced to use decimal places.

Confirmation time

A further issue is the time it takes for transactions to get confirmed. Since new blocks are usually generated every ten minutes, the average time it takes to confirm a transaction will also be in this range. Further, the probabilistic nature of block generation makes these waiting times unpredictable. It is therefore possible that confirmations are received almost immediately or only several hours later.

Political challenges

Bitcoin faces only technological and economic challenges but also political challenges. The main critique is the large use of electricity for mining, its potential use for illegal activities such as money laundering and tax evasion, and regulatory uncertainties.

Conclusion

We are more optimistic about the future of bitcoin. That being said, we do not want to neglect the fact that bitcoin faces some severe challenges.we took a closer look at some of those challenges and discussed potential solutions. These issues include high price volatility, scalability, regulatory uncertainty, and low levels of adoption.

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