BIS Against Bitcoin

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V. Cryptocurrencies: looking beyond the hype
BIS Annual Economic Report | 17 June 2018

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3 Key Errors in the BIS Report on Bitcoin

The Bank for International Settlements (BIS) released a report on cryptocurrencies over the weekend as a part of their 2018 Annual Economic Report. The intention of the report was to look “beyond the hype” and figure out if there are any real-world economic problems that can be solved by cryptocurrencies or blockchain technology.

In their analysis, the BIS made a number of obvious errors. From ignoring the fact that systems like Bitcoin can scale via multi-layered approaches rather than placing all transactions on the blockchain to claiming that miners can decide to change the Bitcoin’s protocol rules on their own via a hard fork, it’s clear that more research was needed before putting out this report.

Let’s take a closer look at three key errors in the paper.

Completely Wrong on Scalability

The most obvious issue anyone familiar with Bitcoin would have found with the BIS report on cryptocurrencies was the part about scalability. While the report rightly pointed out that cryptocurrencies tend to be less efficient options when compared to the legacy financial systems, the claims made regarding scalability were laughable. The report goes as far as to say Bitcoin “could bring the internet to a halt” if it became a widely used means of online payment.

“To process the number of digital retail transactions currently handled by selected national retail payment systems, even under optimistic assumptions, the size of the ledger would swell well beyond the storage capacity of a typical smartphone in a matter of days, beyond that of a typical personal computer in a matter of weeks and beyond that of servers in a matter of months,” says the report.

Of course, this analysis assumes a 250-byte entry into the blockchain for every transaction. Anyone who has been paying attention to Bitcoin developments over the past few years would know that a multi-layered approach to scaling has been put forth by many developers as the correct approach. With this setup, much of the transaction load can be pushed to secondary layers such as the Lightning Network.

While scaling Bitcoin to billions of users over time still has a number of challenges, the situation is not as bleak as indicated in the report.

Related to the misunderstanding of bitcoin scalability is the fact that the report confuses bitcoin as a money with the blockchain as a payment system. Bitcoin could already scale to the levels of the traditional financial system as a money by becoming much more centralized and having institutions issue IOUs to their customers, but that obviously misses the point of why Bitcoin was created in the first place.

In this way, Bitcoin is actually more scalable than traditional options in that it can enable types of censorship-resistant online payments that are not possible with the legacy system.

Miners Don’t Control Bitcoin

Another key error in the BIS report has to do with the level of influence miners have on Bitcoin’s consensus rules.

“[A hard fork] arises if some of the miners of a cryptocurrency coordinate to change the protocol to a new set of rules that is incompatible with the old one. This change could involve many aspects of the protocol, such as the maximum permitted block size, the frequency at which blocks can be added to the blockchain or a change to the proof-of-work required to update the blockchain,” says the report.

It may not have been the intention of the authors, but the way this part of the report is worded indicates that miners are the ones who coordinate incompatible changes to cryptocurrency networks such as Bitcoin. In reality, miners need support from the users for these types of changes to occur. If miners attempted to change the rules on their own, all they would end up doing is creating blocks that are invalid in the eyes of the full nodes on the network — they’d effectively be forking themselves off the network.

This point was illustrated last year when the hard fork associated with the SegWit2x proposal was abandoned after futures markets and other data points indicated a lack of support for the hard-forking change, which miners had been strongly supporting for some months (see a full explanation of this event here).

Missing the Point of Bitcoin

One last issue with the BIS’s analysis on cryptocurrencies is that the report misses the point of why Bitcoin was created in the first place. Issues such as scalability, finality, and cost are brought up as reasons Bitcoin cannot compete with the legacy system, but Bitcoin was built for and by cypherpunks for the purpose of removing third-party control from online finance.

Yes, on-blockchain payments are much less efficient than sending money to a friend via Venmo, but Bitcoin was not created for that use case. Bitcoin was created by cypherpunks to enable types of transactions that were not possible in the past.

Once this realization is made, it becomes easy to see that the importance of Bitcoin is around enabling a new type of decentralized financial system rather than trying to improve the systems of the past. Decentralization is costly, but it enables certain functions that would otherwise be impossible.