Emerging Technologies Law is a blog by William Ting which examines 21st century legal, business & Social tech issues.

What the Fork is going on?

What the Fork is going on?

Bitcoin splits ( licensed by Getty Images )

Bitcoin splits (licensed by Getty Images)

          With the mining of block 478,558 yesterday at 6:14 p.m. UTC by mining firm ViaBTC, the new crypto-currency dubbed Bitcoin Cash emerged from the battle of the forks splitting off from Bitcoin. Unlike the battles of old, no actual blood was spilt. Instead this battle fought on the global scale raged on digitally. How and why did it all start?

          Come take a look at the implications of the increasing influence of virtual currency miners (some of whom pushed for the adoption of SegWit 2X which has split Bitcoin). Is their influence a positive or negative factor in the development of cryptocurrencies? Is the battle more than just about which computing code should prevail? Lastly, let's examine the risks associated with a system of valuing the exchange rates of multiple cryptocurrencies relying on actors and forces that are completely different from those used in the valuation of real world currency exchange rates.

Reasons for splitting

          The cause for the split of Bitcoin was sowed years ago when transactions were intentionally kept small (up to 1MB) to hedge against the risk of cyberattacks. However just as bitcoin transactions have been gaining in popularity over the years, the limited number of transactions that may be recorded on a page or “block” undermined the speed and cost efficiency of Bitcoin transactions. 

          For example, at any moment during a day there may be about 10,000 transactions pending to be recorded on a register or “chain” forming part of a distributed ledger chain. Those who are sending Bitcoin need to pay a transaction fee in order to entice “miners” to process their transaction. The user is free to set this fee at any amount, however, in order to incentivize miners to process one’s transaction more quickly, the user typically sets a higher fee. Sure you may set the transaction fee at $0, but good luck waiting for your transaction to queue for days.

          So the “pay to pay” under-side of Bitcoin slowed its wide adoption over time, given its slow and cumbersome nature, that’s why you see most consumers using other forms of payment.

emerging tech: cryptocurrency ( licensed by Getty Images )

emerging tech: cryptocurrency (licensed by Getty Images)

The battle of the forks: soft fork vs. hard fork

          Like any splits caused by a civil war, the underlying reasons are political and financial. 

          On one side, a loose association of developers (helping to keep Bitcoin’s software hack-proof) began advocating for a solution (known as SegWit, BIP 148 or UASF (User Activated Soft Fork)) that would reduce the amount of data required to be present within a transaction before it may be duly registered onto a chain. They proposed to cut out the witness/signature data (which takes up 65% of the 1MB transaction data limit) so that more transactions can fit onto a block. This has the effect of benefiting users of Bitcoin because it reduces transaction fees because users will no longer have to compete to get their respective transactions processed by miners. This solution is also known as a “soft fork” because miners do not need to upgrade their hardwares and softwares to continue to operate. The systems that do not upgrade can simply ignore the witness/signature data included in a transaction when they process it. 

more money, less competition? ( licensed by Getty Images )

more money, less competition? (licensed by Getty Images)

          But the solution proposed was not kindly accepted by the mining community, the vast majority of which are based within China. Think of Bitcoin as being created or "mined" via computer codes run by server farms. Miners maintain a digital ledger or blockchain, that keeps a record of transactions recorded. So if your transaction is not recorded, your Bitcoins will not exist. These folks obviously do not like seeing transaction fees being driven down. After all, they are the ones who spent significant sums of money in building up massive server clusters.

          So the miners proposed a counter-arrangement known as SegWit 2x, MASF (Miner Activated Soft Fork) or BIP 91. Essentially, the miners proposed to double the size of a block (or page on which transactions are recorded) to 2MB (which can hold roughly over 7,000 transactions).  But this is not all that the miners want. The real kicker is that the new solution proposed would require the general mining community to use a new software code that is incompatible with existing hardwares and softwares used in mining Bitcoin proper. In essence, the more powerful miners advocate a “hard fork” because those who do not spend the time and money to upgrade their infrastructures would be left out of the mining business.

          In other words, the new code cuts down on competition amongst miners to favour those miners that are well financed and resourced. So if you hold any Bitcoins before August 1 (“pre-August 1 Bitcoins”), its wise to seek consultation on whether your pre-August 1 Bitcoins can be spent on the new network based on Bitcoin Cash. One thing is for sure, the virtual coins that will be traded on the new Bitcoin Cash network will be fundamentally different in quantity and value than Bitcoin. 

Should we care who wins?

          As in anything commercial, some say that the market will determine the loser and winner of the battle of the forks. They point to the market value for Bitcoin today which is a little over US$2,750 (per internet search) still double the value of an ounce of gold. Bitcoin reached its all time high of US$2999.97 in June 2017 which represents a whopping 222% rise from the start of 2017!  A quick internet search revealed that Bitcoin Cash is trading at about US$300 in the futures market.

It seems ironic that a digital system of micropayments originally intended to be open and decentralized may become dominated by a minority of powerful miners in the bitcoin space who are unregulated by national governments and relatively immune to pressures for reform emanating from within the bitcoin ecosystem.

          But there is a normative problem with allowing "market forces" to decide the winner because the battle of the two forks is fundamentally a battle of principles that are not amendable to being assessed mathematically or balanced by the cold dispassion of computing logic.  We should care about who wins or loses because we may all have alot more to lose. 

to the victor go the spoils. whose spoils? ( licensed by Getty Images )

to the victor go the spoils. whose spoils? (licensed by Getty Images)

Rise of the digital currency miners

potential for abuse? ( licensed by Getty Images )

potential for abuse? (licensed by Getty Images)

          In Bitcoin talk, "everyone owns the network, but nobody owns the network." Sounds like a fortune cookie saying, right? By its communal decentralized nature, a digitally distributed ledger system is above ownership. However, such a system is still vulnerable to abuses in the market perpetrated by dominant actors who in the context of Bitcoin Cash are some of the more influential miners.

          This is not a widely reported topic, but the increasing influence of the miners deserve closer scrutiny. During the battle of the forks, the mining community (which has about three-quarters of its computing power set up in China) played a pivotal role in its outcome. On the one hand, miners invests time and money in setting up server farms that process and records bitcoin transactions and register them on the chain. Without the miners, no bitcoin would ever exist. They know this, but not all of us know it. The battle of the forks that caused the splitting of Bitcoin is an example of growing miners' influence within this space. Will it be the only example going forward? 

          In many ways the battle of the forks is a battle of principles and ideas. Advocates of the soft fork believe in the principle that the bitcoin ecosystem should be as inclusive and decentralized as possible being true to the libertarian nature of bitcoin. They hope to keep block size as small as possible so that smaller scaled miners may participate in processing transactions and prevent the larger miners from dominating the system with their big investments in advanced computing power to process bigger blocks.

          But to many miners the majority of whom are based in China (according to Forbes magazine), they may not be interested in discussions about decentralization. As the CEO of one of the biggest bitcoin exchanges indicated recently, “this kind of stuff, the Chinese people don’t care about. It’s not in the vocabulary. Chinese people don’t grow up thinking about democracy and decentralization and individual freedom and liberty."

          So should the vocabulary of cryptocurrency revolve around libertarian principles of decentralization, liberty and democracy? Or, should the dialogue be just about bitcoin ASIC mining chips, computer assembly, data centers, machine ownership and pool operators all looking to make a buck? If the results of the recent battle of the forks is any indication of the future direction of this policy debate, our future looks more utilitarian than humanitarian.

More splittings in the horizon…

If the results of the recent battle of the forks is any indication of the future direction of this policy debate, our future looks more utilitarian than humanitarian.

          The same reasons for causing the current split may cause more splittings in the future. The more established miners are economically incentivized to favor increases in the data size of a transaction to be recorded in a block because it lowers competition and increases their transaction fees. After all, the solution proposed by the mining community during the battle of the forks undercuts the ability of smaller less financed miners to compete against their larger cousins. The fact that Bitcoin Cash is emerging is a good indication that there are some key players out there looking to cut competition and increase transaction fees.

          Either somebody from within or outside of the bitcoin ecosystem may stop this situation from happening. 

          Bitcoin operates on a public distributed ledger system that is decentralized with no principal authority. Given the decentralized nature of bitcoin, no external regulator would have jurisdiction (if we can call it that) to assert law and order over the ecosystem. It would also be hard for internal actors to stop abuses because the smaller miners have next to zero recourse in the courts or national governments. Instead, they are entirely at the mercy of private market forces caused by the actions of the dominant miners some of whom as reported in the media "didn't grow up thinking about democracy... freedom and liberty." Bleak prospects indeed?

          It seems ironic that a digital system of micropayments originally intended to be open and decentralized may become dominated by a minority of powerful miners in the bitcoin processing space who are unregulated by national governments and relatively immune to pressures for reform emanating from within the bitcoin ecosystem.

will history repeat itself in the crypto space? ( open source image )

will history repeat itself in the crypto space? (open source image)

          Before the United States created the Federal Trade Commission (to enforce the anti-trust laws) the American public had to endure the abuses perpetrated by the robber barons of the 19th century who engaged in unscrupulous unethical monopolistic practices.  It remains to be seen whether some of the more dominant miners may become the robber barons of the 21st century… 

         Will we be reading more about SegWit 3x, SegWit 4x and SegWit 5x in the coming years? It is too early to tell whether the dominant miners will continue to exert their influence or whether serious mining abuses will indeed occur.  The lack of a centralized authority to keep an eye on maintaining fair competitive practices amongst bitcoin (used in the general sense) miners is a significant hurdle towards the establishment of fair trading practices in the bitcoin space. 

Competing virtual coins?

          But there may be light down the tunnel. Prior to the split, Bitcoin has been in competition with competing virtual currencies like ethereum and zcash. One of the goals that the "soft fork" advocates wish to achieve is to make Bitcoin more accessible to being used by smart contracts to better compete for use against ethereum, which some consider to be more smart contracts and corporate-world friendly. It may be that users of bitcoins may start voting on the eventual outcome of the existential principle-based debate by switching out of the bitcoin system. But there is no guarantee that other virtual coin systems would be free from potential abuse or whether the same powerful miners in bitcoin also operates there in some form as well. (That is for another article.) It will be interesting to see how the relationship among the various virtual coins develop and whether such competition will be able to temper market excesses. 

Rise of cryptocurrencies

          The recent split of Bitcoin added a new cryptocurrency into the virtual coin mix. There are over 900 types of virtual coins in existence but experts have listed six of the more important ones by the size of their market capitalization. This is similar to a relative few number of real world currencies (like the US$, Yen and Euro) attracting more global use and interest compared to hundreds of other sovereign currencies. Decades ago, economists debated on the advantages and disadvantages of having a common currency for the European Union. Hundreds of years ago, the founding fathers of the United States also engaged in this debate for a currency for the new union. Will concepts about the pros and cons of unifying currencies also apply to cryptocurrencies? Before the economists figure that one out, we need to live in a world in which multiple cryptocurrencies exist.

          But having multiple cryptocurrencies raises the issues of: (i) how to set exchange rates among them; and (ii) whether these valuation would be affected by real-world political and economic factors. 

(i) Who sets crypto-exchange rates?

pure market forces in play to set crypto-currency exchange rates ( licensed by Getty Images )

pure market forces in play to set crypto-currency exchange rates (licensed by Getty Images)

          There may be instances when virtual coin users may need to find the exchange rate between Bitcoin versus Bitcoin Cash or find the value of Bitcoin Cash compared to zcash. How widely this will be done depends on the degree of adoption of cryptocurrencies. If they become more adopted, a merchant or service provider for a particular good or service in the future may need to denominate the transaction in terms of multiple cryptocurrencies. 

          Since no sovereign government issues or maintains these currencies, it is up to private decentralized (potentially unregulated) exchanges, traders, or broker-dealers to determine the relative value of these currencies. In light of the various digital currency exchanges being established, it's a matter of time for a mature market to develop in the trading of cryptocurrencies to exploit arbitrage opportunities existing within the digital currency medium. 

          When the market is watched over by keen regulators, it has an incentive to conduct self-policing and keep its excesses in line. But think of a world when exchanges and actors operate in a “Wild Wild West”-like environment when the only forces at work are those driven by the market. What sort of safeguards will exist to protect national economies from systemic shocks like those caused by market excesses and over-speculation during the Great Depression and in 2008? The degree of disruption to the real world economies depends on how far cryptocurrencies have penetrated into real world economies. 

virtual coin value unaffected by real world events? ( licensed by Getty Images )

virtual coin value unaffected by real world events? (licensed by Getty Images)

(ii) Crypto-valuation divorced from real world factors?

real world events matter ( licensed by Getty Images )

real world events matter (licensed by Getty Images)

          Traders of real world currencies buy and sell the currency of a national economy or union based on an analysis of various factors that result from its domestic economic situation like its unemployment rates, number of new mortgages, businesses going bankrupt, the interest rates and monetary policies of its central bank. Traders also review a national currency's political situation such as its military, defense and diplomatic postures in the global economy. For example, the U.S. dollar generally is seen as a "safe haven" currency given its military and cultural dominance.

          Yet the valuation of cryptocurrencies does not seem to be affected (positively or negatively) by any economic or political factors or developments of any national government. This is because no central bank of a sovereign nation supports, circulates or maintains any cryptocurrency which exists independently of any nation state. In theory, cyrptocurrencies are immuned to the effects of any rise of U.S. unemployment figures or terrorist attack. Instead, cryptocurrencies are valued in a political and economic vaccum divorced from any real world discounting factors. Commentators have noted that cryptocurrencies are value by their respective network value, contract and application value, and their transmission and storage value.

          What are the risks associated with a system of valuation that is not discounted by real world economic and political factors? It is uncertain which factors will be the primary influencer of cryptocurrency valuations, but I suspect that private virtual currency exchanges, virtual fund managers and investors and the financial deals they make or break will play a key role. No valuation for an asset can be valued purely based on mathematics. There is always a human element that drives supply and demand. If real world economics or politics will not drive crypto valuation, then market forces will. But we have seen what happens when any field of human endeavor is opened up exclusively for the unadulterated interplay of privately driven market forces: market abuse and excess leading to market concentration.

meet your new central bankers of the future... ( licensed by Getty Images )

meet your new central bankers of the future... (licensed by Getty Images)

          Another risk associated with crypto valuation is the effectiveness of the system's cybersecurity.  The value of virtual currencies is at the mercy of cyber-attackers who have been increasingly active in hacking into various digital currency exchanges.  The value of any digital coin often drops significantly following an adverse cyber-attack on its network. Since attacks are unpredictable and quite damaging if successful, risks associated with cyber-attacks will become (if not already are) more systemic and disruptive. It's likely that cyber-attackers, whether working alone or in collusion with other private deal-makers or breakers, will play an integral part (unwelcomed as they are) in setting cryptocurrencies values to achieve their illicit purposes (whether for ransom, deal manipulation or disruption). So in contrast to a national currency that rises or falls in value depending on rampant unemployment or economic stagnation, the value of the digital currency of the future will rise and fall depending on the egos, greed, bad habits and other life vicissitudes of cyber-punks.

         The battle of the two forks is more about computer codes. Underneath the dispute lies an existential question for all to think about: is our future utilitarian or humanitarian?

          This is part 1 to a long series of articles on #virtual coins. Stay tuned.

#Fintech #blockchain #banking #insurtech #IoT #P2P #bitcoin #bitcoincash #ethereum #cryptocurrency

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