The Power of the Invisible Hand

As an armchair economist, my hero is the father of economics, Adam Smith. I have gleaned much from his teachings over the years, but the most interesting for me is the notion of an “Invisible Hand”; a concept which has not only transcended the realm of Economics, but is now also seen as a force within mathematics and game theory.

I’ve often said that I believe the Bitcoin market is the only true, global, free-market economy in the world today. For the most part, it sits outside of government regulation, and continues to function, by and large, as an economy created by the people and for the people — governed not by rule of law, but by mathematics, economics, technology, and psychology. Supply is known, demand is clear and has continued to grow over the years. The price of Bitcoin follows suit, and has recently traded at record highs.

Since the SEC declined the application for the Bitcoin ETF just over a week ago, we have sunk back to reality that the elephant in the room is not going away. The scaling debate is still ongoing, with no resolution in sight. Then, this tweetstorm from Andrew DeSantis on Friday night opened up even more questions about the intentions of the largest Bitcoin mining company, their CEO Jihan Wu and his recent alliance with Roger Ver and John McAfee.

The goal of this post is not to get to the bottom of Andrew’s tweets or discuss the details around it. I’ll leave that up to the community to figure out. I want to instead focus on answering just 2 questions — “How did we get here?!” and “Where do we go from here?!”

The reality in the Bitcoin world, is that after 9 years we’ve seen it all. Bitcoin has “died” over 100 times & Fear Uncertainty & Doubt (FUD) has become the norm and so now we’re highly desensitized to it. Therein lies the rub. We’ve gotten to the point that even if barbarians are at the gate, we’d probably dismiss it as FUD.

Without contention, I’ve been a Bitcoin bull for most of the past five years that I’ve been in the industry. Sometimes I’ve called the price down or sideways, but I’d always been a bull for the long term and dismissed FUD for years. For the past couple of weeks, since the Satoshi Roundtable conference in Mexico at the end of January, my mood slowly been changing. Bitcoin is no longer on the right path and we either need to fix it, or hope the invisible hand will do it for us.

Now, before we all start blaming Roger, Jihan, John or anyone else for the current situation we’re faced with (an impending hard fork), let’s look inward. How did we get to the point where just a handful of players in a $20bn ecosystem could plausibly derail a peer to peer, globally distributed and seemingly decentralized network. It shouldn’t be possible. But it is. Even if their intentions are being misunderstood, and they mean well, the fact that it’s possible means that if it’s not them, it will just be another group in time trying to achieve the same outcomes. We need to fix this, but it’s not a short term fix.

To a large extent, Bitcoin has been a victim of its own recent successes. Since the recent halving event in July last year, Bitcoin has already doubled in price. This has resulted in miners earning larger transaction fees and demanding larger blocks, which will result in more centralization as it gives larger mining pools an edge. The higher the price goes, the less likely we are to get to an agreement with miners. The market keeps rewarding them for keeping the Bitcoin network secure, because the price keeps rising? Or is it.

When I posted my last post just days ago, A Fork in the Road, it was met with a lot of cynicism and skepticism — partially due to the insensitivity to what the community believes is ongoing FUD about a Hard Fork. Jihan didn’t waste time confirming his intentions. At some point, we need to take notice. My post was written while the Bitcoin price was flying high at $1260. Less than 5 days later, today, it broke below $1,000 and dipped to around $970. I believe the market is finally waking up to the reality of situation.

It’s important before proceeding to understand a basic set of assumptions that the broader market has about Bitcoin, which has led to its rise:

1. Bitcoin is currently in the hands of the Core Development team who have guided it through many challenges over the years. They are not perfect by any means, but they are a known entity. The broader community is invited to make proposals and even contribute code, but the Core team has the final say on roadmap and direction of the codebase for Bitcoin.
2. Bitcoin has formed the backbone for a number of commercial companies backed by $billions of venture capital, including companies such as Abra, Bitgo, Civic, Coinbase and many others and these companies will continue to participate and help in its development.
3. Bitcoin has a global network of exchanges, $billions of free media, millions of consumers using it and brand recognition in cryptocurrencies which is second to none.
4. Miners are accepted to be largely based in China for cost reasons and 2 companies, Bitfury & Bitmain operate a duopoly to supply hardware to mining operations who will secure the network as long as it makes financial sense for them to do that. Miners adopt the code that the Core Development team produces and in some cases, such as Segwit, may decline to accept it given perceived negative short term financial impact for them. We trust that this duopoly serves the best interests of everyone in the ecosystem, given the high cost of investment required for mining Bitcoins.
5. There are thousands of independent nodes operating around the world confirming transactions and ensuring that double spends do not happen — the key problem that Bitcoin solved with its entry into the market.

Bitcoin has been criticized for a lack of governance or the ability to break a deadlock. So, in the example of the scaling debate, a group called Bitcoin Unlimited broke away to create what they believe to be true to the founding principles of Bitcoin.

Unlimited wants to have larger block sizes, and this means that larger pools will benefit more, leading to more centralization of Bitcoin mining and higher fees for them (more transactions per block). Their argument is that block sizes were never meant to be constrained. Arguably, they’re right, but mining centralization with ASICs has meant that this is not an option right now. If we were to revert to another Proof of Work algorithm that was more decentralized, then I would be very supportive of larger block sizes.

The rising price of Bitcoin the past 18 months has actually been its downfall. The higher the price, the higher the miner fees, the more the miners want more transactions per block and this effectively reinforces an unwillingness to look at options such as Segwit.

So now, we have a standoff. Core is not willing to compromise on larger blocks, given further risks of centralization and miners are not willing to adopt Segwit and impact their fees.

This week, the market is slowly coming to this realization. A Hard Fork is imminent because the Bitcoin price remains high — now this is causing deadlock, which is forcing the hand of the miners, in that they want to take 80% network mining capacity and create their own version of Bitcoin- Bitcoin Unlimited, which must be avoided. I go into detail about that here.

Fundamentally, one of the demand generating assumptions listed above has changed, at least probabilistically. The separation of Church and State. If miners perform a Hard Fork to Bitcoin Unlimited, they will have control over both the ability to centralize mining operations further and act in their own interests and power to make code changes which further entrench them and control the economics of the network. The assumption that Core is in control of the code that runs on all of the network is now being challenged and the market is beginning to factor that in.

I published a series of tweets on Friday, the key conclusion being this:

In response to the concerns from the community over my tweets, Chris Burniske from Ark Research published the following information:

I’m a big believer in Free Markets. The market will decide which flavor of Bitcoin it wants to back. Right now, I think the market is just waking up to the reality that high prices will ultimately result in a hard fork. Conversely, if the miners realize that the market doesn’t believe that the current path they are taking is acceptable, they will be punished by the price.

I think there are a lot of lessons that we can learn from, and as a community we need to be more inclusive of other to prevent ourselves from fracturing, as has been the case with Classic/XT but not Unlimited. These problems can, and must be solved. A contentious Hard Fork probably can’t result in us fixing the other problems, and therefore we must avoid it at all costs. Bitfinex has announced Chain Split tokens that will simulate the trading of both coins today. I’m keenly interested to see how this plays out.

So here is both the experiment and the market theory I’m suggesting with this post:

Let’s make the assumption that if the miners get 80%+ of the network to fork, BTC will quickly become an altcoin (i.e. the smaller coin) and BTU will become Bitcoin by default. The market right now is saying that it’s pricing BTU at $800 & BTC at $200, effectively (I’ve argued that diminished network effects actually make it lower, but for simplicity, let’s ignore that for now).

Assuming this is the path we’re on (and it sure looks that way), does the market truly value the BTU version of Bitcoin at $800? I don’t.

Assuming post fork, we believe the BTU version with 80% of the network hash capacity is equal to BTC with 20% (in other words, a 75% discount), the combined value of both coins should be $400. This might be a more reasonable price for Bitcoin today, as the current price needs to reflect the future combined split price as the network splits, because that’s what you will be left with (Current Price = Future BTC + Future BTU)

As of a few days ago, the price assumed that Bitcoin wouldn’t Hard Fork. If indications from the miners are accurate, this assumption is being eroded by the day. As a result, the market is now buying coins that are likely to be split and needs to make an assessment as to whether or not the future combined valuation of those two coins are greater than or less than today’s price.

I think we’re all about to see the Invisible Hand enter the market. I suspect that if the price drops low enough, it may force the hand of the miners. If the market price stays high, it’s really saying that we don’t trust Core, and that everything will be fine. Markets are only efficient if people understand the nuances.

Let’s assume that the market adjusts, and the price plummets — how do we get it back up? If 80% of the miners responded to a massive decline in the price and their profitability, by signalling for Segwit — Core could reduce the threshold to 80% and proceed with Segwit, which would effectively end the scaling debate. I believe if this happened, the price would surge almost overnight to over $1,500, in anticipation of the end of this debate.

Again, my goal for this post is to educate the market so that it can provide the checks and balances that the Bitcoin economy needs to function within. I believe that if this subject is better understood, then Bitcoin can truly prove that the economic forces that hold it together today, will also protect it too in the future for years to come.

If I’m right, the market is going to begin to recalculate the price of Bitcoin being traded today as a function of the post split price and effectively punish the price if the current path we are on will result in a split and a dilution of the effects of Metcalfes law. If that happens, I cannot see how the price goes above $875 during the interim period, based upon the numbers presented by Chris. If sentiment diminished along with demand, $337 will probably be the maximum trigger point where miners will start calling uncle and signalling for Segwit.

Regardless, the logical behavior is if the market believes there is no risk of a fork, the price should be a premium to $875, and as the risk of a fork increases, the price should drop steadily…that’s how I read the tea leaves anyway.

In times like these, I look to the wisdom of people like Adam Smith who understood human behaviour & economics on a level I hope to one day achieve, even fractionally, and today I pray he is right about the Invisible Hand…

For full disclosure, I have sold the majority of my Bitcoin holdings (90%) earlier this month and I do not intend to repurchase any Bitcoins for long term holdings until there is clarity on a path forward.

Edit March 21, 20017: Please see this follow up post, where I will be donating any proceeds from any personal benefit I get of a lower Bitcoin price to charity. Details here.