FUD for Thought

For all the certainties that it offers and all the FUD that it can destroy through its continued existence, Bitcoin is still not perfect. Users and programmers must still deal with some of the system’s design choices that leave room for speculation.

For instance, the single biggest bet in Bitcoin is that the network will one day benefit from the same security incentives while only paying miners with transaction fees. The diminishing block subsidy is an essential part Bitcoin’s economic system: every 210.000 blocks (approximately 4 years), the mining rewards get cut in half. Back in January 2009, it was established that the mining reward would be 50 bitcoins per block. Then it got reduced in half in November 2012, and once again in July 2016, and May 2020.

As of May 2023, miners receive 6.25 bitcoins + transaction fees. And sometime next year, this reward will get reduced to 3.125 BTC per block. This halving trend will go on until the year 2140, when the entirety of the 21 million coins will have entered circulation. After this point, Bitcoin will be an entirely deflationary monetary system.

But what’s also worth mentioning is that, by May 2024 when the next block reward halving should take place, 93.75% of all bitcoins will already have been mined. So most of the supply is in circulation, the costs to produce 1 BTC are higher, and therefore only the most efficient miners will survive. The only winning combination involves affordable and abundant electricity (nuclear, solar, wind, and/or hydro) accompanied by high throughput mining hardware which produces more hashes per kilowatt. If mining remains stagnant across halving cycles, then the game theory becomes more complicated.

This issue is generally referred to as “the Bitcoin security budget”, and questions to which extent existing subsidies will be able to keep the miners profitable in the future. It’s estimated that, by year 2032, the transaction fees will already pay the miners better than the block reward of 0.78125 BTC. But some analysts are uncertain whether or not Bitcoin users are willing to constantly pay high fees.

There are 6 main ways to fix the security budget issue, which I will present from the most popular to the least supported:

A. The bitcoin price doubles every 2 years, so that the diminished BTC reward is worth just as much in US dollars. Though this scenario is the most popular, we’ve reached a point where it takes half a trillion US dollars to double today’s price and it will take another trillion dollars to make the same successful transition in 2028 (then two trillions in 2032, four trillions in 2036, and so on). For reference, Apple and Microsoft have a cumulated market capitalization of $5 trillion, while gold is at $13.36 trillion. Even if we assume that inflation through money printing goes on and gets worse over the years, a bitcoin price that doubles every 210.000 blocks still requires a lot of liquidity that may not always come.

B. With help from merge-mined sidechains such as RSK and Drivechains that get a lot of traction, Bitcoin miners manage to collect more transaction fees across multiple parallel chains. The main chain fees don’t increase too much, as most of the activity takes place on second layers. But the increased number of transactions in the ecosystem will compensate.

C. The bitcoin transaction fees will perpetually double after every halving cycle, to make up for the diminishing revenue. This is a social solution, as it relies on the good faith of others and their willingness to voluntarily pay higher transaction fees to keep the current miners running. Also, the fees don’t have to double – they can increase proportionally with the price, so that miners get paid an amount which incentivizes them to keep going.

D. Do nothing and let the miners lose money until they find cheaper energy sources, improve their equipment, or else give up. This solution incentivizes efficiency and innovation in terms of hashes per watt, but also completely takes out miners that don’t keep up. If the consequence of this purge drastically affects the hash rate, then all Bitcoin users will probably wait for more than 6 confirmations until they establish that a transaction becomes final.

E. Increase the block size, hoping that more transactions will come. This is difficult to pull off because it requires a hard fork (all users abandon the chain and move to an upgraded one), it negatively affects the miners’ revenue during times of low demand, and it centralizes the network much more during and after times of high demand. Also, this type of scaling doesn’t guarantee anything in terms of users and adoption – Bitcoin Cash, the big block clone of Bitcoin, didn’t manage to get traction in commerce in spite of aggressive marketing campaigns in 2017 and 2018.

F. Change the monetary policy to add inflation/tail emission. This is, by far, the most unpopular approach – and the one that will only be taken seriously if Bitcoin finds itself in a phase where the fees don’t make up for the declining block subsidy. It implies expanding the 21 million bitcoin cap in order to pay the miners, thus creating the type of inflation and central planning that bitcoiners sought to escape. Probably the most interesting proposal belongs to Peter Todd, who suggested that adding a small annual tail emission for the security budget might work.

In principle, this security budget FUD won’t become an urgent discussion subject until sometime around 2032. By then, it’s expected that a lot of innovation will happen in all fields – just like Bitcoin’s first decade was filled with discoveries and new research. Nonetheless, it’s good to know what’s going on and what the options are – the more time we spend thinking about the problem, the higher quality debates we’re going to have in the next decade.

Another source of legitimate FUD is the fungibility of the currency and the privacy it requires. When we deal with gold coins or banknotes, we don’t have to care too much about the origins. At a convenience store, a $10 bill that was once owned by Brad Pitt should not be more valuable than another one which previously belonged to an obscure car mechanic from the suburbs. The money is fungible – meaning that one currency unit is equal with any other one which bears the same nominal value.

But in the case of Bitcoin not all coins are created and transacted equal. As a matter of fact, unless you buy the freshly-mined coins directly from miners, it’s impossible to find two bitcoin units that carry the same history. The difference between cash and Bitcoin is that the former is great for local in-person transactions because it’s instant, private, and has the best finality… while the latter is designed for internet payments and it’s somewhat easy to track on the public ledger.

Bitcoin has 4 main types of privacy:

A. Network-level privacy, which protects users of light wallets (those that run on other people’s nodes and Electrum servers) from having their IP address registered. If someone can associate your Bitcoin transactions with a real IP address, then they can make use of social engineering to find out where you live. Thankfully, this issue can easily be mitigated with Tor routing (Tails OS on desktop, Orbot on Android phones, or specific wallets which have a Tor integration: Blixt, Blockstream Green, Phoenix) or a good VPN service (IVPN and Mullvad are both excellent because they require no e-mail address and accept BTC payments).

B. Public key privacy, which prevents other people’s servers from associating transactions from one UTXO with the rest of your wallet (and potentially identity). Your wallet’s xpub (extended public key) contains information about how much bitcoin you have, which addresses belong to you, and which addresses your wallet will generate in the future if you continue using it. To remove this risk, users run their own full nodes, or else install wallets that run a BIP157/158 implementation (Neutrino). Managing your own node comes with great privacy benefits, and it’s certainly something that everyone should learn.

C. Sender privacy, which is Bitcoin’s weakest spot. When you send someone some bitcoin, they can take a look on a public blockchain to see from where the transaction comes and where the funds have been before. After you withdraw from a KYC exchange which works with blockchain analysis services, someone will most likely track your funds across transactions in an attempt to know to whom you are sending bitcoin and from whom you are receiving. CoinJoins (Wasabi, JoinMarket, Samourai) offer a reasonably good workaround: you enter a collaborative transaction where, even if the entrants (inputs) are known, it’s difficult to tell who is who after the outputs get generated. CoinSwaps (MercuryWallet) are also great at exchanging your UTXO with somebody else’s, but they pose the risk of receiving the identity of someone who’s way more tracked than you may be. Using both tools in conjunction is the best solution so far.

D. Receiver privacy, which is Bitcoin’s strongest spot in terms of privacy. As long as you use addresses only once, nobody will be able to determine how much money you have or with whom you have been previously transacting. Your sender will only be able to see that your balance went from 0 (as all new addresses) to the amount that he or she transacted in your wallet. They can see, however, how you transact your funds afterwards. On the other hand, if a third party node owns your public key (described at point B), then your receiver privacy is nullified – they can see your transaction in every new address you may generate from the same wallet.

E. Amounts privacy, which is about being able to see how many bitcoins are being transacted across addresses. Bitcoin is an open ledger, so you can see how much money is being sent even if you don’t know who the sender and the receiver are. In principle, this is a matter of monetary policy transparency – you can always see that the amount of coins in circulation doesn’t add up to more than the amount of coins that have been mined, of which there will never be more than 21 million. However, there is some interesting ongoing research in the field and zero knowledge proofs or some other type of technology may mitigate the need for auditability and amounts privacy.

The issue with Bitcoin is that Big Brother caught up and figured out how it works. On-ramps and off-ramps are regulated in most countries, so the only truly private transactions are the ones that take place between someone who bought directly from a miner and his trading partner, CoinSwappers, or full node wallets that also went through a couple of CoinJoin rounds. Of course, there are off-chain solutions that offer better privacy: Lightning network, Liquid sidechain, statechains, drivechains, and other existing or proposed sidechains. But the base layer also needs improvements.

For now, privacy is costly. But it’s important to not let Bitcoin get captured by nation states that surveil – or else it turns into a financial panopticon. Nation state adoption is also a bad idea, as citizens benefit from even less privacy while transacting. Last but not least, the core argument is simple: sound money requires fungibility and Bitcoin has yet to acquire it.

Another legitimate piece of FUD concerns wealth distribution inequality. Mainstream economist Nouriel Roubini repeatedly pointed out in 2018 that Bitcoin has a terrible Gini coefficient. Bitcoiners suggested that the mainstream financial system also has most of the wealth concentrated in the hands of a few elites and their families, but academic economists ignore this issue because they are can’t bite the hand that feeds them.

Nonetheless, it’s true that almost 93% of the supply has been mined over the last 14 years and it’s in the hands of a few millions of users. This isn’t an argument for redistribution, but one for fairness: if Bitcoin is about being a better form of money, then it should be about more than replacing the financial elites of the industrial age with a new class of computer geeks.

Bitcoin can’t be the currency of the entire world unless it can serve 8 billion people. To achieve this milestone, early adopters need to be more generous and sometimes charitable by allowing others to earn more bitcoin than their equivalent in government money in exchange for their goods and services. Tipping and gifting are also ways to onboard others and make them willing to participate in the network.

But for as long as Bitcoin gets treated as a collectible, it can’t be money for the entire world – and this argument goes beyond the scaling debate. On a Bitcoin standard, all transactions are voluntary. So we should try to be voluntarily generous to prevent others from becoming envious or miserable to the point that they resort to violence. If we are truly building a better form of money, we must learn from some lessons from the issues of fiat money and try to do better.

ChatGPT apparently wasn’t smart enough to present these three pieces of FUD. But I think they are much better than the stuff that it presented and I’m glad that I had the chance to explain them. They are FUD for thought, as we all have a voice and the ability to contribute to the Bitcoin project. Unlike the fiat system which has its own hierarchies that revolve around an official narrative and a system of trust, Bitcoin is voluntaryist: anyone can join, anyone can learn to code and try to bring improvements, anyone can educate others about it without requiring a license from an authority, and everyone can run a node or mine. In other words, we are all in charge and we can make a significant difference. Now that we know the FUD in theory, let’s also break it in practice.