Translation | Austrian economist: Usability and volatility prevent Bitcoin from becoming a medium of exchange

Only technology and time can change .

Original author: Fernando Ulrich | Austrian economist, Brazilian cryptocurrency expert

Authorized translation: Carrie | Chain Hill Capital

Original title: Usability and volatility prevent Bitcoin from becoming a medium of exchange

Original link: https://medium.com/@Ulrich_98986/why-money-has-value-and-spending-bitcoin-is-senseless-d2390127dc34

Chain Hill Capital (Qianfeng Capital) has been authorized by the original author to translate and reprint, and the first release in China is on Babbitt. The following is the translation:

This is the second of five articles in a series.

The first article in this series introduced monetary economics and the stages of monetary evolution. It also explained why the value of money comes from the willingness to hold cash. However, this does not mean to oppose the use of Bitcoin for commerce, nor is it a defense of its use as a store of value rather than for exchange.

However, I do think that it makes little sense to try to use Bitcoin (or any other cryptocurrency) in everyday commerce right now due to volatility and usability issues (e.g., confirmation times, fees, transaction throughput, available wallets and custodians, etc.). Usability issues can be addressed through technology, including better software, applications, payment protocols, and second-layer scaling solutions. Volatility issues, on the other hand, will take time to gain more awareness and wider adoption.

Usability of Bitcoin as a Medium of Exchange

First, let's look at availability with a focus on capacity.

Bitcoin’s base layer protocol cannot scale exponentially. Linear and incremental scaling is possible, and it will also be continually upgraded to accommodate more throughput and other optimizations. However, if Bitcoin wants to host billions of users, it must scale exponentially, and blockchains are not suited to this need. Any cryptocurrency that claims to be able to do so has sacrificed some key blockchain feature to achieve this, often without its creators disclosing or even realizing it. On-chain exponential scalability with the highest security and decentralization is not feasible without engineering compromises.

Similar to the Internet protocol stack, many blockchain projects strive to avoid protocol layering at all costs. While this article is not a technical discussion about scalability, it is unavoidable as the concept is closely tied to the debate between value storage and medium of exchange.

The logical solution to the technical limitations of Bitcoin’s on-chain technology is the Bitcoin protocol. So far, the Lightning Network is the most promising second-layer solution that can increase transaction throughput and reduce confirmation times. It is not the only or last decentralized and trust-minimized layered solution to solve the scalability problem. What most people fail to understand is that the Lightning Network is not a currency network, so the Lightning Network protocol does not create new currencies. It is just a payment network, and no currency is issued on it or transferred through it. The Lightning Network enables payment routing by transferring ownership of on-chain balances, which are linked to specific "unspent transaction outputs" (UTXOs) on the Bitcoin network using cryptographic techniques.

The Lightning Network builds on pioneering ideas like eCash, which allowed private, untraceable payments through its native currency (called "CyberBucks") or national fiat currencies. In this way, the payment network can provide greater capacity and better privacy.

Layered development will make Bitcoin similar to the current financial system, but this similarity is only from a functional perspective. In terms of security, the two are very different because there will be fewer (if any) trusted third parties that are inevitable in Bitcoin's monetary order.

Every country's fiat currency is designed to be non-scalable. Even gold itself is not scalable. Banks are essentially payment networks built on fiat currencies, which can enable exponential expansion of fiat currencies. PayPal is another payment network that makes fiat currencies more widely used in the digital world.

Although economists believe that commercial banks create money out of thin air, this is not true. On the one hand, banks issue liabilities or deposits that can be redeemed back to legal tender (base money) at any time. These liabilities are a payment commitment (similar to off-chain transactions) that are only settled when the banknotes are redeemed (on-chain transactions).

Bank deposits are a promise to be redeemed back to legal tender (base currency) at any time

On the other hand, banks hold assets. These assets have varying degrees of liquidity, maturity, and default risk. Banks must manage their liquidity using market-accepted instruments such as cash, securities, and loans to fully and prudently meet their debt obligations. Therefore, although individuals use demand deposits to conduct transactions in economic activities, demand deposits themselves are not money. Bank deposits may function as money, but they are essentially a promise to pay, so it is ridiculous to grant such a privilege (legal tender status) to commercial bank debt (demand deposits).

As a result, our current financial system features a variety of payment networks (layered, parallel, subordinate, and, often, overlapping) that are full of trusted relationships (for better or worse). The “need for trust” is exactly what makes the Lightning Network different, because its payment channels are not payment promises, but bilateral contracts driven and secured by clever cryptography that are tied to specific UTXOs on the Bitcoin chain.

When envisioning the development of the Bitcoin stack protocol, similarities to the current financial system from a functional perspective include:

1) Base layer protocols (or strong money, base money, and external money): gold, fiat paper money, and Bitcoin.

2) Secondary and outer layer protocols (or payment networks): banks, financial institutions, PayPal, ApplePay, WeChat Pay, and the Lightning Network.

The difference between a financial system based on fiat currency (or gold) and a financial system based on Bitcoin is the security model, i.e., a trusted interconnected party security model vs. a trust-minimized network security model, or a centralized trust security model vs. a distributed trustless security model. This distinction is true for both base layer protocols (fiat currency vs. Bitcoin) and outer layer protocols (banks vs. Lightning Network). However, the "base protocol" of gold is more similar to Bitcoin in that it is not anyone's debt.

Therefore, the argument that the Lightning Network is a cryptographic replication of the traditional banking system ignores the most significant difference between the two. The former is an open, minimally trusted bilateral contract network where no party has unilateral custody of the underlying assets. The latter is a closed and trusted network where centralized institutions and customers contract for the transfer of ownership, control of the underlying assets, and the promise of instant payment (in short, the relationship between banks and depositors). Therefore, the Lightning Network payment channel is a contract between two parties with equal rights, while the contract between banks and depositors is a relationship between debtors and creditors.

Now that we understand the similarities and differences between the two financial systems, we can answer the question of how Bitcoin can be used as a medium of exchange .

Consider this: Today, when you pay someone through a bank or PayPal, is it correct to say that you are using USD? Are the USD in the wire transfer used as a medium of exchange? The paper money is not actually transferred to the other party, right? We can conclude that USD is not a medium of exchange in this transaction. This transaction is a transfer of ownership of a “promise of instant payment of paper money”.

The above argument is technically correct, but has little practical significance. However, Bitcoin Cash supporters use this line of reasoning, namely that Bitcoin being transacted off-chain means it is not used as a medium of exchange.

The fact that money is indeed a medium of exchange, and the dollar is indeed a medium of exchange, does not mean that every transaction in the economy should be conducted directly using paper money (or gold, or Bitcoin on a chain). This does not scale, so we need to use payment networks, and these payment networks must be pegged to (or backed by) fiat currencies. In other words, it does not matter whether we use physical currency or payment networks to make payments.

If money’s medium of exchange function is only realized when two parties actually transfer paper money (or gold), then we can assume that money is rarely used as a medium of exchange, especially in developed economies where cash payments are becoming less and less common. Currently, base money is so separated from daily economic life that it is meaningless to discuss whether it has a medium of exchange function from the perspective of base money. Most payments are not made in money, but are denominated in money and payment promises are settled in money.

Paper money forms the basis of our current financial system (i.e. the monetary standard), and payment networks (i.e. off-chain) run on top of it and settle payments (i.e. on-chain). In this system, the dollar is a store of value (albeit a volatile one in the long run), a medium of exchange, and a unit of value.

The same model applies to a Bitcoinized financial system. Bitcoin can be used as a store of value, a medium of exchange, and a unit of value (at least in theory). However, this does not mean that every transaction must be on-chain. Bitcoin can (and will) be used as a medium of exchange. But in the long run, it is possible that a large number of transactions will occur on payment networks, which transfer ownership of on-chain balances. These ownerships may or may not be payment commitments (i.e., there may be both Lightning Network and traditional banks - just like centralized exchanges currently), and these ownerships are then settled on the Bitcoin chain through the transfer of UTXOs.

Bitcoin is already a very secure and seamless means of global transactions, and for medium to large transactions, borrowing Szabo’s terminology, Bitcoin is an excellent “wealth transfer medium.”

But frequent and small payments may eventually be made primarily through payment networks. They need not be made in actual Bitcoin, but rather denominated in Bitcoin and used as the settlement asset for bilateral contracts (such as the Lightning Network or other trust-minimized third parties) or payment commitments (trusted third parties).

In this sense, the base protocol can be thought of as the final settlement layer, on which only large transactions tend to take place, while the second layer caters to recurring and smaller payments.

So, with this approach, we answer the question of how Bitcoin can be used as a medium of exchange.

Liquidity, Store of Value, and Transaction Costs

Now let's discuss another fundamental issue, volatility.

From 2012 to 2015, the number of merchants accepting Bitcoin as a payment method continued to grow. Bitpay and Coinbase initially served as intermediaries or payment gateways, allowing customers to pay with Bitcoin and merchants to choose to receive local fiat currency or Bitcoin. Of course, most merchants preferred to use local currency.

I highly appreciate the actions of these two companies. However, objectively speaking, no sane merchant would risk daily operations to hold cash that may fluctuate greatly within a few minutes. Although the volatility of Bitcoin prices has decreased in recent years, its volatility is still a barrier for traditional businesses to accept and hold Bitcoin.

Bitcoin volatility has decreased but remains significant relative to fiat currencies

If merchants do not hold Bitcoin because they lack trust in it and are unwilling to endure its unpredictable short-term price fluctuations, then they will not have demand for Bitcoin and will not be able to promote its price stability. Instead, they will quickly put Bitcoin back on the market as soon as they receive it, which actually means less demand for Bitcoin.

This is why forcing merchants to adopt Bitcoin at this stage is futile and should not be a priority for the Bitcoin community. Focusing on promoting Bitcoin for transactions right now is putting the cart before the horse. First, we need to establish Bitcoin as a good store of value. Then, medium of exchange adoption will soon follow naturally. Therefore, we cannot simply ask merchants to allow customers to pay in Bitcoin, but to make them want their customers to pay in Bitcoin and want to hold Bitcoin as a cash reserve.

So how do we escape the cycle of merchants not holding Bitcoin due to volatility, and the lack of stable demand causing volatility? The answer is through education and understanding, solid protocol development, and most importantly, time. Below, we discuss this.

All other things being equal, people will always prefer a more universal (liquid) medium of exchange. Only if Bitcoin significantly reduces transaction costs, or merchants understand the potential of the technology and want to gain future appreciation by holding Bitcoin, will they be willing to accept Bitcoin over USD (or local fiat currency).

Borrowing Peter Šurda’s analysis, there are three factors that influence the choice of medium of exchange: in a narrow sense, liquidity, store of value, and transaction costs. But in a broad sense, all three factors can be considered transaction costs.

First, let's understand transaction costs in a narrow sense, which include handling fees, storage and transportation costs, verification costs, censorship resistance, counterparty risk, and compliance costs. Currently, Bitcoin has significantly improved over existing base currencies in many aspects, which reduces transaction costs in a narrow sense for its users. This is particularly evident in cross-border payments, where Bitcoin is a better medium of exchange than paper money or gold. In cross-border payments, paper money or gold use payment networks (off-chain), while Bitcoin uses base currencies (on-chain) for cross-border transactions.

But in many everyday payment scenarios, Bitcoin has no comparative advantage, whether using base currency (on-chain) or through payment networks (off-chain), because in the vast majority of jurisdictions, domestic transactions can be accomplished frictionlessly and almost instantly through cash, the banking system, or other methods (such as credit and debit cards or mobile payments).

As cryptocurrencies and blockchain technology bring more competition to the financial world, it is only a matter of time before the existing financial infrastructure improves significantly. Although the transaction costs may still not be as low as Bitcoin, it should be enough to reduce the gap.

However, in other ways, Bitcoin is likely to continue to maintain its superior position. No other financial system is so open and inclusive, as anyone with access to the network can start a transaction in seconds, and is resistant to censorship, which is true for both the base currency and the payment network (i.e., on-chain and off-chain).

Reducing transaction costs alone, in a narrow sense, can influence the choice of currency. However, its effect is limited and short-lived in the face of fierce competition. Although Bitcoin’s narrow transaction costs are lower than the base currencies of paper money or gold, when overall (broad) transaction costs are taken into account, the digital currency has little appeal in daily transactions.

Let's get back to liquidity and volatility. Bitcoin's price remains volatile and unpredictable, which is a major impediment to its becoming widely accepted as a daily medium of exchange and held by businesses and individuals. Currently, only those who expect Bitcoin to maintain or appreciate in value over the long term will accept Bitcoin as payment and hold it as a cash reserve. These people do so because of its attractive store of value properties, not because it is a highly liquid commodity. Bitcoin is currently accepted and held not because it is a more "universal medium of exchange", but because it can better maintain value and become a more universal medium of exchange in the future. Therefore, for the current stage, value storage is more important than liquidity.

As Bitcoin's value proposition gains traction, demand for it as a cash reserve grows, and more people observe and emulate these behaviors, Bitcoin's liquidity will increase and volatility will decrease. The network effect will create a positive feedback loop, with increased Bitcoin liquidity further promoting price stability, reducing overall transaction costs, and increasing its use as a medium of exchange.

So the answer to when Bitcoin can become a medium of exchange is that it is still early, but it will happen over time. We are not there yet at all. To get there, Bitcoin will need time and, most importantly, remain a good store of value.

About Chain Hill Capital

Chain Hill Capital has been focusing on value investment in global blockchain projects since its establishment in 2017. It has created a crypto asset investment matrix of VCPE, Beta passive investment strategy, and theme Alpha investment strategy, built a complete global resource relationship network, and strategically deployed city nodes such as Chicago, New York, Tokyo, Beijing, Shenzhen, Hong Kong, and Xiamen. It is an international blockchain venture capital fund with a wealth of overseas investment institutions and a global high-quality project resource library.