One year ago when we formed the Bitcoin Consultancy, we formulated a theory that encapsulated our view of how bitcoin would grow. All of our decisions and action has been congruent with this theory and underlies our reasoning about the bitcoin world.
It is a pyramid of dependency. Growth in bottom layers feeds into growth at higher layers. Trying to effect growth in a later layer is immature without building the foundational infrastructure necessary first.
Compilers have improved software development a huge amount. Languages that computer programmers write in are approaching English! This makes the whole process of creating new software much easier, and empowers programmers to write better software. Programs that were immensely difficult to write in the early 80s, are now trivially easy (borderline boring).
I mention compilers because it is worth recalling history. Bitcoin now lies at that same juncture today. It is a very fringe and undeveloped market that is rough around the edges – analogous to the early web or internet.
As we develop more foundational parts of the system, this unlocks the potential in the higher levels so bitcoin can progress towards our proliferation singularity (I made that up; bite me).
In a simple model we can say that one level must be developed before the level above can become realised. In actuality it’s like the spread of warm colours into cold like in a heatmap that visualises the seeping of heat as it permeates objects.
As an example take overlay networks and merchants. Development in overlay networks allows merchants to integrate bitcoin more seamlessly and with less effort into their shopping carts. This means bitcoin integrates with more merchant software to a higher quality and so leads to more merchants accepting bitcoin.
Levels depend on the existence of lower levels. Growth in lower levels feeds into growth at higher levels.
Core system code
The code that runs the infrastructure is vital.
It’s what keeps the money circulating and allows all this to work. Thanks Satoshi. I hope we live up to your good name.
If any of the higher levels in the pyramid such as exchanges were to become impossible, or if clearing systems never appear then bitcoin will still function, albeit to a lesser degree.
During the cold war, the military worried about a nuclear attack sought to invent an intelligence network which could not be destroyed. This network had to be robust and resilient to attack.
The military developed TCP/IP as a decentralised system. Networks without any central point survive attack by drawing on the resources of participants, rather than authority. Today TCP/IP underlies the internet as a resilient system against attack – this time by governments.
If at any one time, one of these nodes is attacked, the network can rely on the strength of the other nodes. It is only when a sufficient number of these nodes that make up the network are attacked, that the network will start to break-down.
This is called graceful degradation. In the bitcoin ecosystem, if higher levels are destroyed or prevented from coming into existence, then it won’t shutdown. It will simply degrade and function to a lesser degree.
If bitcoin (the core system) shuts down – that’s it. Pack your crap and go home. The bitcoin ecosystem could not work without the blockchain and the core bitcoin settlements system.
Exchanges are highly important and critical for the bitcoin ecosystem. The bitcoin first gained value when the first exchanges came about. This ushered in the real development and growing professionalism we’re seeing today.
Whereas the core system is responsible for money circulating within bitcoin, exchanges allow money to enter and exit from the bitcoin system. Giving people the confidence they can leave bitcoin anytime they want, rather than feeling locked in, oddly makes them want to stay and play ball. Making it easy to acquire bitcoins is the flip side and also important. Exchanges are central to this. We call this providing market liquidity.
Nothing backs a bitcoin. It’s another unique currency. People trade them amongst themselves or with third parties. The value of a bitcoin comes from the willingness of people to buy and sell bitcoins for euros, dollars and sterlings. Due to the pressures of supply and demand, bitcoins reach a gently fluctuating equilibrium of people entering and exiting the bitcoin economy, through buying and selling bitcoins.
This is where bitcoin gains its value: as a mechanism of transfer. You value the cash in your pocket but not because the central bank decided to withdraw currency from the market or the government issued bonds. You value the cash because you can buy things with it. That you can go to the shop and purchase food or other essentials for cash means you value it. And if you can do that tomorrow, a week from now and so on, you are even more confident in that currency. Likewise people feel confident enough in the bitcoin marketplace to use it as a means for wealth transfer, to purchase goods online and to exchange it for conventional currencies.
Exchanges make the bitcoin have value by making it easier to transfer bitcoins between currencies which increases people’s confidence in bitcoin.
Exchanges allow a big selling point of bitcoin to exist: remittance. In the UK, we have an immense number of migrants from other countries. I remember at one time in my life living in a UK city where my girlfriend was Polish, my friends were Polish, the shops were in Polish, my flatmates were Polish and my wrestling partner was Polish. Migrants come to the UK to work, and need to transfer money abroad to family. This is a huge money maker for the finance industry and overhead that bitcoin can cut by destroying middlemen. The banks call this disintermediation.
An overlay network is an intermediary between front-end clients interacting with users and back-end servers that manage the bitcoin blockchain.
Overlay networks like Electrum are needed to deal with all the huge usability issues that exist in bitcoin currently. With a rapidly expanding and bloating blockchain that is unwieldy for new users and becoming a huge resource hog, we need to assemble bitcoin along specialised roles.
This specialisation of the bitcoin ecosystem is a new recent thing. When Satoshi first created bitcoin we mined inside the clients using our CPUs and used the GUI client to buy things from people selling goods.
Inevitably, as the bitcoin economy grew, merchants started running specialised bitcoin server nodes and mining has become a very professional field with advanced calculations and knowledge.
Likewise it is inevitable that we will see the peer to peer network of nodes fracture along specialised lines as the bitcoin economy expands and becomes more mature.
Computer systems often are designed in layers. A layered system is easier to grapple by a team. Each developer works his own turf in graduation from systems developers programming hardware, to application developers programming user software. People have diverse skills and propensities. This alignment permits coders to choose their layer and tend his turf to perfection without concerning himself with the neighbours.
We will see an explosion in client development as overlay networks provide an easy to use API for people to build user facing software. This alleviates the effort of having to create core bitcoin code which can take months. Because you lower the barrier for developers to create clients this leads to much better and more usable bitcoin clients built by designers, not programmers.
Merchants can use it for checking bitcoin balances and deposits, but they need some small code or a thin layer to manage their user’s keys.
Miners can use it. There are multiple applications of this concept as yet unrealised.
We are already seeing the development of markets which depend on some property of bitcoin to exist. These fringe markets rely on some aspect of bitcoin to make them a possibility.
In the future we will see more markets which maybe rely on the low cost of bitcoins to be barely profitable, their irreversibility to sell high risk goods, or their lack of regulation.
There are several examples of those. Sites which rely on micro-transactions like Ogrr would otherwise not be profitable with the huge fees of PayPal or other services.
Sites like the Silk Road and donations to Wikileaks depend on bitcoin’s lack of control for how money is spent. I’m confident in bitcoin’s future because no matter what happens – even if all exchanges are shut down – these kind of transactions will always have a demand for which only bitcoin can fill the role. Bitcoin’s future is pretty secure and it is never going away.
The SEPA (Single Euro Payments Area) initiative for European financial infrastructure improves the efficiency of cross border payments by consolidating fragmented banking systems into a single standard. This system is implemented by all banks within the SEPA region.
The Clearing and Settlement Mechanism (CSM) underlies SEPA payments. Clearing is a contractual obligation to fulfill a trade. The bank commits to a transaction until it is ‘settled’. Clearing is necessary because the speed is much faster than the cycle time for completing the underlying transaction (settlement). If bank A sends 20 EUR to bank B, and bank B sends 10 EUR to bank A, then during the settlement process 10 EUR will be settled from bank A to bank B. In practice the volumes are much higher.
Bitcoin is a settlement system. We need clearing systems. Systems like Electrum/Stratum will allow the network to scale, while clearing systems will fill in bitcoin’s blanks. Instant anonymous small micropayments at no or low fees. Currently bitcoin transfers are fast but not instant, private not anonymous, cent-value not micro-transactional, and low fees not no-fees. A good clearing system will connect those final dots.
Bitcoin’s future clearing system has no defined spec. Quite how it will look is not known. Could it be a third party service or a p2p system? Would the adopted clearing system be based on a first-mover advantage entrenched by the pull of network effects, or one that arises out of a competitive market based on its merits? Only Nostradamus knows.
Payment gateways, interfaces
It’s difficult to predict the final stages. It is so far off into the future that you’ll always be wrong. But by drawing some analogies and guessing, we can say that payment gateways which allow merchants to offload the processing of bitcoin payments and improved interfaces to the bitcoin system (better software or savings accounts for users) will be high on the list.
Late adopter stage, classic markets
If bitcoin can reach the 10% permeation of early adopters, then empirically by looking at similar technology adoption cycles, we are pretty much guaranteed adoption by the masses.
Success at later stages of the bell curve are self-perpetuating as the network effect of friends, family and your favourite merchants accepting bitcoins kicks in.
Right now we are seeing a premature realisation of classical markets. Six months ago, people were rushing in a desperate land grab to duplicate the most popular sites like Kickstarter or eBay in the bitcoin ecosystem. But they didn’t draw on bitcoin’s strengths in any meaningful way and failed to do anything new or creative. Ultimately these sites always fail as it is too early in bitcoin’s life for these sites to exist and be sustainable.
“Because of the lower costs in Second Life, it suffers from a greater level of irrational economic behaviour than real economies. A business using a model which has proven economically unviable may be kept open for months or even years using the owner’s real money, because the cost of doing so is so low and some business owners are more motivated by a sense of “winning” than monetary profit. (For example, some businesses spend more on marketing than they earn.) These businesses compete with, and potentially damage the market for, other businesses that are striving for economic viability.”
The late adopter or classical markets stage is the final step of victory. It’s when the currency of resistance has won the revolution.
It will be fabulous.