Here’s How Bitcoin’s Two-Tier Economy Works

In 2008, the Global Financial Crisis and subsequent bailouts fostered an wave of mistrust and resentment towards Wall St and the wider financial system.

Many people felt the moral hazard, the idea that overleveraged institutions could be bailed out by governments for reckless lending, meant the system needed a fundamental rethink.

One of those people was Satoshi Nakamoto, who developed bitcoin on the idea that the control and ownership of money shouldn’t be centralised.

Fast forward 12 years and the DeFi revolution continues to challenge the centralised control of currency, slowing pushing it into the mainstream. As of writing, 1 bitcoin is worth almost $60,000 USD because of fiat currency devaluation, the COVID-19 pandemic and stock market FOMO¹.

This articles examine the how the two tiers of the bitcoin economy operate, the Blockchain and the Lightning Network, and explains what influences could impact bitcoin’s future.

Blockchain (Tier 1)

The Blockchain uses miners (blockchain servers) to record bitcoin transactions and group them into blocks.

When a user wants to send money to someone else, they choose (manually, or as the wallet suggests) how much to give the miner to process the transaction. This is known as the transaction fee.

After this, their wallet sends the transaction to a waiting queue to be processed by miners. Although miners do not specify exactly how they choose transactions, one likely consideration is the size of the transaction fee.

When a miner fills a block of transactions, they validate the block by playing a computationally expensive game of chance. The first miner to validate a block adds it onto the blockchain, which approves and settles the transactions in the block.

The miner then claims the transaction fees and an additional reward for validating the block (called the block reward), which is designed to happen every 10 minutes on average. They are also the mechanism to release new bitcoins into the economy, which is how inflation is determined.

When mining the first block in 2009, the reward was set at 50 BTC and is designed to halve every 4 years (it’s now 6.25 BTC). Rewards will be issued until 21 million bitcoins are released, which is expected to occur around 2140.

So far 18 million bitcoins have been mined, leaving 3 million bitcoin to be mined for the next 120 years.

Eventually miners will only earn income from transaction fees.

Lightning Tier (Tier 2)

The Lightning Network is a layer above the Blockchain which runs Lightning Nodes (advanced wallets) that connect to each other using payment channels.

The network run smart contracts called Hash Lock Time Contracts (HTLCs), which facilitate a stream of transactions between 2 parties. The Funding (start) Transaction and Settlement (end) Transaction are still required to be recorded on the blockchain and incur transaction fees.

The Funding Transaction provides the liquidity required for the smart contract while the Settlement Transaction confirms the payment and refunds unspent bitcoin.

The transactions in between, called Commitment Transactions, are validated outside the blockchain within seconds. Because they aren’t bound by block limits, the network can theoretically handle millions or billions of transactions per second².

If two nodes aren’t directly connected by a payment channel, they can route transactions through the payment channels of other nodes. Those intermediary nodes require enough money to be reserved for transaction to be facilitated.

For each node that provides this service, a Fixed Fee (the median price is 1 satoshi) is charged as well as a Fee Rate, a percentage of the money going through the network (the median price 0.000001)³.

This makes bitcoin feasible for smaller transactions, like a cup of coffee, provided the Funding and Settlement Transactions aren’t required for each purchase.

What Will Impact Bitcoin’s Future?

Here are 6 key factors that determine the bitcoin’s future success.

Factor #1: Being First

Bitcoin was the first cryptocurrency to be released and has 12 years of adoption and development behind it. It is the most identifiable crypto project that exists, likely from the 2017/2018 bull run where it reached to the awareness of the general public.

Even in 2021, where cryptocurrency has seen a notable increase in adoption, it has managed to retain about 56.5% of the $2 trillion cryptocurrency market⁵. Although it only processes a quarter of the transactions of the Ethereum blockchain, the high price suggests there is demand for it, although its current price range is unchartered territory⁶ ⁷.

Factor #2: Price Volatility

Another issue faced by bitcoin and most cryptocurrencies is wild fluctuations in price. The opportunity to “get rich with bitcoin” has traditionally attracted speculators with varied understanding of how bitcoin works. Its appeal is understandable — the last 5 year ROI for bitcoin is 13,929.2% relative to the US dollar, even after the 2018 crash¹.

In the last 12 months, bitcoin has caught the attention of institutional investors such as Tesla and Microstrategy, who are buying it to counteract the devaluation of fiat currency. A number people in the industry have also made incredibly bullish price predictions, including Thomas Fitzpatrick (head of product for Citibank’s market insights product), who predicts bitcoin will reach $318,000 by 2022 in late 2020⁹. These predictions, accurate or not, can influence people’s decision to buy bitcoin.

Since January 2020, the price has increased from $7,347 USD to $57,094 USD this month, representing a 677% increase¹. This might suggest bitcoin’s price in the latest bull run, although high, cannot multiply in the way it did previously. This is based bitcoin’s current price being high, but nobody knows if Bitcoin’s price will go higher or even remain at current prices.

Factor #3: Commitment Of Miners

Miners are a key component of bitcoin’s longevity. From their perspective, the sharp increase in bitcoin’s price increases their potential profit margins. That said, it could also attract new miners, decreasing their chances of validating a block, because bitcoin targets a block validation of 10 minutes. If blocks are validated quicker (because of increased computing power), difficulty is increased to make it closer to 10 minutes.

An increase in miners impacts mining pools differently. More miners in a pool can increase the chance of a pool earning rewards, but profits would have to be shared with more miners. Miners might respond by increasing their computing power to increase their chances, but this might compel others to upgrade.

But miners only mine if they think it’s worth the effort.

What complicates this is the intentional halving of the block reward every 4 years, meaning miners earn less bitcoin units for their efforts. In order to keep revenue from block rewards consistent, the price would need to double. Despite the current interest in bitcoin, there is no guarantee that prices will double to accommodate this.

If miners can no longer generate income from block rewards, they will seek other ways of generating income, leaving them two options. They can pick transactions with higher fees attached to them, driving up their prices, or pursue more profitable uses for their computing power.

Enough miners leaving the system also poses a serious security risk, as it would be easier for one person or group to take control of the network.

Factor #4: Lightning Network Adoption

A key reason why bitcoin cannot be used for small transactions is high transaction fees, slowing its overall adoption. This is because each block can only process about 2,600 transactions⁸, limited to 1MB of data, while each block is validated every 10 minutes. That means bitcoin is limited to about 3.7 transactions per second, which keep transaction fees too high for small purchases.

This is miniscule compared to Visa, who claim they can handle more than 65,000 transactions per second⁷.

The Lightning Network was designed to decrease the cost and processing time of individual bitcoin transactions, while also increasing its capacity. The problem is that adoption of lightning has been slow — it only holds 0.006% percent of all possible bitcoin after 5 years of existence².

It seems a chicken and egg scenario has emerged — revenue from letting others route through a Lightning Node is low, so not many are setup, meaning less payment channels for use. This combined with lack of liquidity on the network to facilitate routing makes using the network less useful.

The network is also vulnerable to a number of security weaknesses discovered and there is a fair amount of technical knowledge required to setup a Lightning Node.

Factor #5: Very High Energy Usage

Proof of Work is seen as a less favourable option of validating blocks, with some concerned about its environmental impact. Although a number of crypto projects such as Ethereum, Litecoin and Monero are using it; bitcoin receives the most attention because of its high visibility. Bitcoin is estimated to have an annual energy usage comparable to the Philippines⁴.

Unlike bitcoin, the Ethereum project is actively transitioning to the Proof Of Stake system which is estimated to be completed in 2022¹⁰. This approach validates blocks based on how much a node owns instead of how much computing power they have, reducing the amount of computing required by the network.

Factor #6: Regulation and CBDCs

It’s evident the some nations don’t want bitcoin used by their citizens. A number of countries including China, Russia and Bolivia have placed bans or restrictions on cryptocurrency usage, while other countries such as the US, Canada, Australia and EU nations have made allowances for it¹¹.

Central banks are also having discussions around the use of CBDCs — fiat money distributed by central banks to citizens. Much of the work on CBDCs is experimental and it’s too early to understand their implications.

My Take

Based on the factors I've listed above, I think it's difficult to predict bitcoin’s long term future, but I am somewhat pessimistic about it.

Bitcoin's dated blockchain approach and the slow adoption of the Lightning Network might mean its days are numbered. This is compounded by the community behind it moving slowly and having no visible roadmap. It's hard for others to work with the community without more visibility which Ethereum and other projects seem to have.

I also wonder if the block reward system will push transaction fees higher in future halvings, which tend to increase with the price of bitcoin. Unless the Lightning Network is popular enough to make Bitcoin cheaper and easier to transact, Bitcoin becomes even less usable for everyday transactions.

Sometimes I wonder if bitcoin is the Yahoo of the 2010s - popular, useful and first - but unable to focus and maintain it's relevance over time.

For that reason, it's not the only cryptocurrency that I hold.

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[2] Skalex. 2018–2020. How Does the Lightning Network Work & When Will It Go Live? Retrieved from https://www.skalex.io/lightning-network/#networked-transactions (Last accessed 3rd April 2021)

[3] 1ML. n.a. Real-Time Lightning Network Statistics. Retrieved from https://1ml.com/statistics (Last accessed 3rd April 2021)

[4] Digitconismist. n.a. Bitcoin Energy Consumption Index. Retrieved from https://digiconomist.net/bitcoin-energy-consumption (Last accessed 4th April 2021)

[5] CoinMarketCap. n.a. Retrieved from https://coinmarketcap.com/ (Last accessed 5th April 2021)

[6] YCharts. n.a. https://ycharts.com/indicators/bitcoin_transactions_per_dayhttps://ycharts.com/indicators/ethereum_transactions_per_day (Last accessed 5th April 2021)

[7] Visa. n.a. https://usa.visa.com/dam/VCOM/download/corporate/media/visanet-technology/aboutvisafactsheet.pdf (Last accessed 5th April 2021)

[8] YCharts. n.a. https://ycharts.com/indicators/bitcoin_average_transactions_per_block#:~:text=Basic%20Info,2.10%25%20from%20one%20year%20ago. (Last accessed 5th April 2021)

[9] Bitcoinprice.com. 2021. Bitcoin Price Predictions (2021 Updated). Retrieved from https://www.bitcoinprice.com/predictions/

[10] Ethereum. n.a. Retrieved from https://ethereum.org/en/eth2/ (Last accessed 5th April 2021)

[11] Bajpai, P. 2019. Countries Where Bitcoin Is Legal & Illegal (DISH, OTSK). Retrieved from https://www.investopedia.com/articles/forex/041515/countries-where-bitcoin-legal-illegal.asp (Last accessed 5th April 2021)