Litecoin founder: Sharing the Bitcoin pie

Author: Charlie Lee , founder of the cryptocurrency Litecoin and current head of engineering at Coinbase.

I first learned about Bitcoin in early 2011. Like many people, I thought it was a great creation. Bitcoin transactions are decentralized, secure, convenient, low-cost, and unlimited.

Let me explain what they mean:

Decentralization: Thousands of nodes verify and relay all Bitcoin transactions.

Security: The Bitcoin network is protected by extremely secure computer hardware.

Convenient: The authentication process is very fast. Transactions without authentication are also quite secure because double-spending attacks are impractical.

Low fees: You only need to pay little or no fees. And your transaction can also be queried in the next block.

Unlimited: At the time, the size of Bitcoin blocks was very small relative to the overall block size limit. Transactions were delayed by the unheard of block size limit. Therefore, there was no real limit on transaction throughput.

This is the case because of Satoshi Nakamoto’s brilliant design. Bitcoin bootstrapped itself like a startup: initially paying employees equity until it made enough money to pay higher salaries, thus reducing the equity ratio.

In the case of Bitcoin, the initial block rewards were used to pay for the cost of the decentralized network, and then slowly the users of Bitcoin paid for this part of the cost. Just like a startup company, Bitcoin producers pinned their hopes on the success of Bitcoin. Basically, the early Bitcoin users got the cake and tasted the sweetness.

Unfortunately, this thing was not to last.

By design, block rewards are cut in half every four years and will gradually approach zero.

When this happens, we must choose which of Bitcoin’s five core characteristics (decentralization, security, convenience, low fees, and no restrictions) we are most willing to sacrifice.

I will use an analogy to illustrate this situation.

Satoshi Castle

King Satoshi built a castle for his peasants. He decided to spend 50 gold nuggets a day to hire soldiers to protect his castle and peasants. His wealth was not infinite, so the plan would reduce the subsidy by half every four years.

So starting from the fifth year, he will only pay 25 gold bars a day.

After about 100 years, he would stop paying the soldiers any subsidies. His idea was that the farmers would begin to appreciate living in the safety of the castle, and they would eventually be willing to pay the soldiers themselves.

The security of Satoshi Castle was so good that many farmers from other castles began to move to Satoshi Castle to live.

King Satoshi was very hospitable and let everyone in. Everything was going well until one day the castle started to get very crowded and could no longer accommodate all the peasants who wanted to come in.

What can King Satoshi do? He can:

1. Expand the castle and continue to welcome everyone

2. Start collecting taxes from farmers to pay the soldiers. Poor farmers who can't pay taxes can't live in Satoshi's castle.

Of course, no farmer wants to pay taxes. They want Satoshi Castle to remain the utopia it was meant to be. As a result, the outspoken majority will support the decision to expand the castle.

Ignoring his own insecurities, Satoshi decided to listen to the farmers and double the size of the castle every two years.

As time went on, it became apparent that there was a problem: as the castle grew in size, more and more strong soldiers were needed to protect it if the same level of security was to be maintained.

As the subsidies given by King Satoshi continued to increase, taxation became inevitable to some extent. However, the poor farmers could afford very little tax, and at the same time, the rich farmers were unwilling to pay more taxes than the poor farmers. Without proper compensation, the soldiers would resign.

Gradually, the castle became vulnerable. One day, soldiers from Jerlen Castle came here to attack Satoshi Castle and destroyed it.

From this analogy you can see that increasing the block size limit (castle size) and increasing taxes (transaction fees) will cause the soldiers (producers) to eventually give up and reduce security.

BIP 101

Early Bitcoin users were spoiled.

After years of using a decentralized, secure, fast, cheap, and unlimited network, they are unwilling to give up any of the five features. Most of these early Bitcoin users do not know how and why Bitcoin works.

You can’t have the most secure, highly decentralized network and at the same time get massive transaction throughput, fast transaction times, and ultra-low transaction fees.

Something that needs to be confessed.

If you use Visa, you give up decentralization and ultra-low transaction fees, but you get convenience, security, and unlimited service. It's a good compromise, but it's not Bitcoin yet.

Centralized systems are much more efficient than decentralized systems, and the total cost is relatively lower. If Bitcoin has 5,000 nodes, the cost of a Bitcoin transaction will be 5,000 times that of a Visa credit card.

This is the essence of decentralization.

The reason fees are multiplying is that every node has to do the same work as every other node. The block reward currently covers these costs. When the block reward goes to zero, transaction fees will need to cover these costs.

People think BIP 101 is a solution that could work, but I think it's too dangerous.

As the castle analogy shows, BIP 101 cares more about low prices and unlimited value than security and decentralization . BIP 101 has no impact on convenience, but as the proposal to replace it with fees shows, convenience will not last long.

BIP 101 increases the block size too quickly. This will destroy the opportunity to drive down transaction fees due to supply constraints.

In order to maintain high throughput and low transaction fees at the same time, security and decentralization will eventually be compromised. This happens because producers will create large blocks that are unsustainable and uneconomical for the network.

Once other producers are no longer profitable, they will exit the field. As a result, as the block reward decreases, security and decentralization will no longer exist. What happened to Dogecoin will eventually happen to Bitcoin, and even joint development cannot save Bitcoin's fate.

This is not the Bitcoin that I am involved with.

Marginal cost of a transaction

So, if we pay a certain fee for each transaction, will the total amount of these fees be enough for producers to maintain the security of the website?

Unfortunately, the answer is no.

The Bitcoin network is a zero-sum system in equilibrium: transaction fees plus block rewards must cover the total cost of running the Bitcoin network.

When the block reward is zero, transaction fees must cover all costs. Bitcoin is designed so that although only one producer receives transaction fees, all producers pay for broadcasting, verifying, and storing the transaction.

This unbalanced relationship between payments and receipts is designed to prevent Bitcoin from maintaining security and decentralization in an equilibrium state without transaction supply constraints.

For example, if there are 5,000 producers and nodes, the marginal cost for one of them to process this transaction (i.e. verify it, add it to the block and store it) is $0.0001.

The total fee for the entire network is approximately 5,000 times $0.0001, which is $0.5. In order for the entire network to function properly, the average transaction fee needs to be $0.5.

If the fees are lower, less efficient producers will not be unable to make ends meet and will close down and exit the industry, which will lead to reduced security and increased centralization.

The only way to ensure that transaction fees are sufficient to cover security and decentralization is to make the block size limit act as a supply constraint in the transaction process.

Even absent a reasonably small block size limit, producers would incur transaction fees above their marginal costs but below the total fees the network could sustain.

For example, let me look at a transaction with a fee of $0.01.

Since the transaction only costs the producer $0.0001, he will make the transaction. But that transaction is not cost-effective for the entire network. Once the transaction is made, it will hurt the entire network.

On the contrary, if there is a block size limit, producers can complete the transaction while paying the highest fee. At the same time, this also ensures a normal balance between transaction throughput and transaction fees.

Ultimately, we need to work hard to figure out what will allow Bitcoin to grow and evolve. The block size limit dial should be turned with extreme caution, as it could undermine Bitcoin’s security and decentralization.

Bitcoin is not one-size-fits-all

I advocate that we should prioritize the security and decentralization of Bitcoin above all else.

Transactions that require the highest level of security and decentralization will, of course, need to pay more transaction fees to be used on the Bitcoin network. Although not all transactions can afford this fee, on the other hand, perhaps they do not need such a high level of security and decentralization.

This is really great.

They can use Litecoin and altcoins, sidechains, payment channels, the Lightning Network, off-blockchain networks, and other networks that have yet to be created to complete those transactions.

Heck, if the seller is willing to pay the transaction fee, they will still take Visa.

You can sell a house or a car with Bitcoin. Just wait 60 minutes and pay $1 for an extremely secure, decentralized and irreversible transaction.

If you just want to buy a cup of coffee, need a low-fee but fast transaction, and don’t care about security and decentralization, you can use Bitcoin, the Lightning Network, a sidechain, or even Starbucks’ off-blockchain transaction system.

As long as everything goes smoothly, users don’t care too much about the process. During the transaction process, the network will route the transaction to the most suitable payment network based on the needs of the transaction type.

Technologies like on-chain swaps, the Lightning Network, payment channels, and sidechains allow for seamless, cheap, and free conversion between Bitcoin and anything else.

Bitcoin wallets will take all the hassle out of it. We are not there yet, but the future is exciting. Not every transaction will be in Bitcoin, but everyone will be using Bitcoin.