The original purpose of banks was to safeguard their depositors’ assets. Plain and simple. This was a “Free Banking System”. A simple contract between 2 parties, the depositor and the bank. In my last debate regarding the Lightning Network, I asserted the best comparison with what’s going on now in Bitcoin is the transition from a free banking system to one where the bank starts to add more “financial services” on top of the original relationship. I got some push back on this comparison. So, I will expand on why this comparison is very important.
In explaining, it is very important to know what the current state is and what events led us here. For that, I invite you to read this article. If you have done this, you know that the Bitcoin Core protocol is destined to have no new features added and no consensus changes after a certain amount of time. There will only be bug fixes. Instead, innovations will be made on new networks that are intended to be directly tied to the mainnet of Bitcoin.
My contention is that, all things considered, this plan will lead us down a very similar path that the free banking system underwent in recent history. Not only that, but it doesn’t even matter the details surrounding these new networks. Given the effective inability to transact on mainnet and only on these new networks, we are destined for fractional reserve banking, fiat currency and creation of the next central bank and its constituent banking cartel.
Before I go any further, I was also accused of nay-saying popular ideas while contributing no ideas myself. In other words, because I criticize one side of the scaling debate, it must mean that I am exclusively in support of the other side. This is just not true. Although, I think raising the block size in 2017 was the right way to go, I also think this approach was not a long term solution. So then, you might be thinking, why wouldn’t I support scaling via these layer 2 networks? Well, during the block size debate there were dozens of excellent ideas on how to scale bitcoin without resorting to an entirely new network. Stephen Pair and I even wrote a BIP on this very thing. But, the very best idea was swept under the rug and dismissed by the Core team. The idea was MimbleWimble.
MimbleWimble was anonymously presented and took the cryptocurrency world by storm. Nothing short of the invention of Bitcoin itself was more important to this space. It came at the exact right time and solved the two biggest problems in Bitcoin; fungibility and scaling. It was truly manna from heaven. I truly hope that this event will be remembered by historians. Consequently, it is the core technology that is used in the leading privacy coins, Grin and Beam. If Bitcoin had incorporated this technology, we would not have a fractured coin today.
So here were are. We still have a progressing Bitcoin, but the mainnet is not destined to scale. If things go right for Bitcoin, it will continue to gain users. It is not controversial to say that these users will not be transacting on Bitcoin’s mainnet. Even if they wanted to, there just isn’t the space for them. There are plenty of players that will gladly pay thousands of dollars in miner fees per transaction. When you are sending a hundred million dollars cross-border, paying a $3000 transaction fee is dirt cheap compared to the traditional banking system. The vast majority of transactions involving Bitcoin will happen off-chain. I should admit that I’ve changed my mind about fees when it comes to these layer 2 networks. Earlier, I thought that transactions on the layer 2 networks would be very inexpensive. This isn’t true. They will not only be inexpensive, but these layer 2 networks will pay for transactions to be sent through them.
In studying the business models of the layer 2 network operators, I learned that the current startup costs and regulatory frameworks are in a state that allow for many competitors. The revenue models for a modest investment is extremely favorable. This is good news for the customers of these new networks, but unfortunately, the benefits for customers will decay to zero and beyond. The name of the game, right now, for network operators is to attract as many active users as possible, as quickly as possible. The quickest ways to do this is to pay people to transact through your network, acquire your competitors, perform industrial espionage on your competition and bribe governments through campaign contributions to steer regulations in your favor.
But let’s get back to the comparison of 19th century banking to modern day Bitcoin infrastructure. One of the promises of Bitcoin was “be your own bank”. For me, this was very alluring. If I was a prospector in the second half of the 19th century, the idea of panning for gold and then saving that gold in a secret cache is also equally alluring. I was directly creating real value for myself without the need of an unpredictable third party.
The problem back then was thieves. Unfortunately, we needed to contract with a trusted third party to safeguard our gold. When Bitcoin asserted “be your own bank”, it did so with the implicit assumption that the lay person would be able to safeguard a set of 32 byte numbers, either by studying how to do this or waiting until enterprising software companies built tools for this.
10 years into the formation of Bitcoin, sadly, the market for Bitcoin banking is still a reality. It doesn’t seem like most people trust themselves to hold their own cryptocurrency. I have seen countless examples of intelligent people losing their private keys, mostly because of a lack of a simple hard disk backup. One painful story was the loss of funds because one member of a 4 of 4 multisig wallet lost their keys. The other 3 people didn’t, but it only took one person to sink the entire wallet. Other stories involve criminals calling a telecommunications company and social engineering their way into resetting a victim’s account to a phone number the criminal controls. The criminal then requests the email provider send a email password reset code to this new number via SMS. The criminal then has control over the victim’s email and mines it for information as well as a establishing base for resetting other passwords such as cryptowallets. Millions of dollars in crypto have been stolen in this way.
So, it is clear that a market exists for firms to take custody of their customers’ crypto keys. It is this business model that new cryptobanks will use to build products and services similar to those built in the 19th century after specie was deposited in banks. The first product is the first derivative. In the case of a 19th century bank, this was a slip of paper acting as a receipt for deposit. This was the predecessor of fiat money when the Fed was concocted in 1913. It is pretty easy to see the parallel to today’s cryptobanks. These banks will gladly issue receipts so that their customers may transact without withdrawing their funds. These receipts, will of course, be digital in nature. They may even call the receipts the same name as the underlying cryptocurrency. But what allows the cryptobank to do this? Wouldn’t the recipient of such a receipt also need to be the cryptobank’s customer in order to take advantage of this transfer? No! This is what is so unscrupulous about what’s happening with the Bitcoin infrastructure right now.
With layer 2 networks and no ability of most parties to ever interact on the layer 1 network, the party receiving these funds cannot, ever, turn around and spend the real cryptocurrency on the layer 1 network directly. So, even though he knows the incoming funds are not “the real thing”, he knows the incoming funds are spendable some where under some circumstances -and- the real cryptocurrency isn’t spendable except as a deposit into some layer 2 service. The derivative is more convertible in the short term. This is analogous to someone attempting to pay for merchandise with a chunk of gold. Unless Ron Swanson is the clerk, you ain’t walking out of the store with your stuff. You need to first go into a shady “We Buy Gold” store, take a giant haircut on your gold, then go back with fiat currency. We are at the start of this whole conversion in the cryptocurrency space right now (March 2019). It is high time that cryptocurrency HODLers realize that they are being led down the same primrose path that the people in the 19th century were led down. The only way for to prevent this is to reject the new layer 2 networks and insist on transacting on “the real thing” with the cryptocurrency you decided to hold in the first place.