bitcoin

Bitcoin: despite the headwinds, the market solution is obvious

Meta description


Modern city future technology bitcoin cryptocurrency payment system network

alexsl/iStock via Getty Images

When I last covered Bitcoin (BTC-USD) in early July, I argued that Bitcoin bearish had turned into a one-sided trade. While Bitcoin is lower now than it was at the time of this article, the bulls got a relief rally which took the coin from $21,000 at the time of writing to $25,000 within weeks. The sentiment is bearish again, this time even though I don’t see the same contrarian opportunity. Instead, this article will focus on the technical drawbacks of Bitcoin, the Lightning Network and its activity, and the macroeconomic headwinds that all risky markets are currently facing.

Disadvantages of the network

One of the big technical flaws in Bitcoin’s base layer is the lack of scalability. While Visa (V) can process tens of thousands of transactions per second (or TPS), Bitcoin can handle less than 10. This, rightly, leads many to be highly skeptical of the theoretical mass adoption of Bitcoin. as a peer to peer payment network. This is also a big reason why there has been a proliferation of other blockchains that aim for better scalability through higher transactions per second.

  • Solana (SOL-USD) claims 50,000 TPS on testnet, although others suggest the actual capacity is much lower than this
  • Avalanche (AVAX-USD) claims to be able to process 4,500 TPS

The scalability problem for Bitcoin, and Ethereum (ETH-USD) as well, is highlighted through what has been dubbed the “blockchain trilemma”.

Blockchain Trilemma

Blockchain Trilemma (Ledger.com)

Essentially, the three desirable characteristics needed for public blockchains are security, scalability, and decentralization. What we have seen so far is that all of these public blockchains can achieve two of the three traits. None of them achieved all three. For example, Bitcoin is secure and decentralized but not scalable. Most high TPS blockchains are able to achieve scalability at the expense of decentralization or security. While Ethereum has tier two options like Polygon (MATIC-USD) and Arbitrum that help with scalability, Bitcoin’s best shot at addressing scalability is currently the Lightning Network.

Lightning Network

Joseph Poon and Thaddeus Dryja published the Lightning Network white paper in 2016 specifically to address Bitcoin’s scalability problem. Recognizing that inexpensive Bitcoin micropayments are only possible through custodial solutions, this defeats the purpose of a peer to peer network, the authors proposed a “channel” based option that does not use the base layer string for each transaction:

Instead, using a network of these micropayment channels, Bitcoin can scale to billions of transactions per day with the computing power available on a modern desktop computer today. Sending many payments within a given micropayment channel allows large amounts of funds to be sent to another party in a decentralized manner. These channels do not constitute a separate trust network above bitcoin. These are real bitcoin transactions.

Channels are a bit like a tab in a bar. When the customer gives the bartender their credit card, both parties have agreed to open a “channel” that will only be closed when the customer decides to leave the bar. If a Lightning user wants to pay for coffee with Bitcoin and the coffee has a Lightning Network node, both parties can open a channel between them that will allow the customer to pay for coffees a number of times at a cost that equates to less than penny per transaction.

Lightning Network Channel Map

Lightning Network Channel Map (afive.co)

What’s also great about the network is that users don’t necessarily have to open channels with every merchant they do business with. The map above shows the channels currently active on the Lightning Network. If adoption reaches critical mass, Lightning can route payments through channels that have multiple degrees of separation. This means that the network will allow transfers between two users who do not have an open channel as long as there is a connection somewhere in the network that connects the parties together.

For example, let’s say “Customer 1” has a lightning channel with a grocery store but not a restaurant. The restaurant has an open channel with “Customer 2” and “Customer 2” also has a channel with the same grocery store, “Customer 1” and the restaurant can transact without opening a channel because the Lightning Network will route payment through “Customer 2” and groceries.

Lightning Network Channels

Lightning Network Channels (Bitcoin visuals)

Currently, there are around 81,000 channels on the network. While the channel trend has stagnated since the crypto market topped late last year, the total number of channels on Lightning has grown by around 19% year-over-year. The real growth on the Lightning Network is in capacity, or the amount of Bitcoin available to be processed on the layer:

Lightning Network Capacity

Lightning Network Capacity (Bitcoin visuals)

There are now 4,740 Bitcoins available to transact on the network, or approximately $105 million in funds. While BTC capacity is up 91% year-over-year, the dollar purchasing power of this capacity is down 5% due to Bitcoin’s year-to-date price struggles.

So why would a trader want to do this? Transaction costs on Lightning are considerably cheaper than traditional payment processors like Visa. We are already seeing merchant fatigue with these processing fees. Just this week we see reports from Target (TGT) and Walmart (WMT) backing a bill to lower credit card fees.

The bill, which Sen. Richard Durbin (D., Ill.) and Sen. Roger Marshall (R., Kan.) introduced in July, would give merchants the right to route many credit card payments to networks other than Visa and Mastercard. . In a letter this week to all members of Congress, merchants said the proposed legislation would increase competition, leading to a reduction in the fees they pay when accepting credit cards.

Rather than trying to fight price battles through the state apparatus, it could fall to companies like Target and Walmart to start using Lightning Nodes and build integrations with their B&M channels and their e-commerce stores. Show consumers the benefit and you’ll likely get the desired result; especially with consumer price inflation still going strong.

But the general point is that there is a business appetite for cheaper transactions, and Bitcoin’s Lightning Network can be used to meet that demand. It is important to mention that these types of blockchain networks can be used to process more than just native assets. If Circle supported USDC Stablecoin (USDC-USD) on Lightning, users could transact dollars on Lightning for fractions of a penny per transaction, with BTC “sats” essentially serving as grease to keep the engine moving.

Base layer activity

When it comes to the base layer, we are still seeing spikes in hashrate and in several other areas:

Average hash rate

CoinMetrics

The average hash rate reached a new high a few days ago. This suggests that the network remains secure as an increasing number of miners compete for the block reward. Additionally, active addresses are still near highs and typically hover between 700-900,000 daily users on the chain.

BTC Active Addresses

BitInfoCharts

Despite the use of the network and the generally positive security measures, the price of BTC still depends on monetary policy.

Macro Headwinds

Like all other speculative digital trinkets that trade in crypto (or on the Nasdaq for that matter), Bitcoin’s price will likely depend on the monetary policies of the Federal Reserve. On Tuesday, risky markets largely sold off due to CPI coming in at 8.3% year-over-year, better than forecast 8.0%. Many are now calling for higher September rate hikes than expected just a few days ago:

Target Rate Probabilities

Target Rate Probabilities (CME Group)

The market is now pricing in a 30% chance of a 100 basis point rate hike next week. That’s up from 0% on Monday. Bitcoin has survived several bear cycles that have led to extreme declines. But Bitcoin has not yet been tested in a legitimate tightening cycle like the one currently being guided. While I personally wonder how far higher rates can go without causing systemic problems, all risky markets are going to struggle until there is a clear indication that the Federal Reserve eases its foot on the rate.

Summary

Bitcoin has a tough road to travel. In addition to monetary policy headwinds, the current administration would weigh against domestic bitcoin mining. Additionally, the energy consumption narrative that accompanies Proof-of-Work mining is likely to grow stronger following the merger of Ethereum with Proof-of-Stake. But Bitcoin’s Lightning Network theoretically addresses this concern as well, as the transactions are off-chain.

As I’ve explained here and in a previous article, it’s in the merchant’s interest to use something like Lightning if the UI can be simplified. It is undeniably cheaper for the seller of goods and services to use Lightning for payments than credit cards. We are already seeing major US retailers backing a bipartisan bill to reduce credit card transaction fees. The market demand for alternatives seems to be there. The question is whether this demand will find its way to Bitcoin’s Lightning Network. And if so, does that mean the price of BTC is decoupling from the rest of the market? If so, the bulls should see phenomenal gains. If not, Bitcoin will continue to trade as a risky asset. In a tightening cycle, long-term bulls should choose their place by adding lows like the one we had on Tuesday.


Comment here