Background

For the past number of years we’ve been hearing a lot about bitcoin – how the technology of a blockchain, coupled with certain restrictions and incentives for various parties, could produce a viable currency, independent of either physical collateral or the authority of a state. In many respects it would seem that bitcoin has been a success. Now when economists refer to currency they differentiate it in three forms:

  1. Physical assets (gold, silver, platinum);
  2. Fiat currencies (the money we know and love) ; and now
  3. 
Cryptocurrencies

Anyone with an interest is able to convert between bitcoin and fiat currencies at will and (relatively) cheaply and many online retailers accept it as a means of payment. There are even accepted bitcoin debit cards, such as WireX, that can be used to withdraw cash or make payments in (a limited number of) stores. It should be noted that bitcoin still fails the ‘ice-cream test’. On a warm August day, bitcoin won’t be able to provide you with an ice-cream.

Bitcoin has not been without its issues. There have been widely publicised thefts or frauds, such as the now infamous Mt Gox hack which saw the theft of 650,000 bitcoin, at the time worth 363m US dollars, but it is unfair to dwell on these as theft is always going to be a risk with any asset that has value. Rather, the complaints facing bitcoin were linked to some of the technical constraints of the system.

Transactions in bitcoin are indelibly recorded on the blockchain but they are done so in set sizes, called a “block.” When the technology was designed in 2008 each block was set at 1MB and now, nearly 10 years on, this is proving a bottleneck. As the volume of transactions in bitcoin has increased in line with its wider acceptance, the time taken to confirm each transaction has started to trend upwards as well. The upper limit on processing time is approximately 7 transactions per second, compared with the thousands per second carried out be by Visa or Mastercard. This sedentary pace was directly linked to the initial constraint of a 1MB block size and it became accepted that this needed to be addressed for bitcoin to be considered a viable alternative payment system.

Open source competition

Though the problem was identified, bitcoin’s lack of a central authority means that there was no one to push through a solution. It was considered desirable to keep the blocks small so that, true to the techno-utopian origin of bitcoin, individual users could continue to check transaction validity without relying on the powerful miners who are taking on a more dominant role.

Competing ideas for how to work around the constraint were proposed and consensus formed that one approach, known as Segregated Witness, was the approach to take. Segregated Witness, or “segwit”, worked by packing blocks more densely on the chain, by effectively bundling transactions together before they were confirmed. Segwit had the benefit of being backwards compatible so that nodes could gradually upgrade without the need for a big-bang moment. Once the technology was widely accepted, the block size was due to be increased as well, to 2MB, something that is due to occur in late August.

The fork

As could be expected within a group as diverse as the developers behind bitcoin, the above approach wasn’t universally supported. Another group rejected the segwit amendment and pushed for an immediate increase in the size of a block, in this case to 8MB. This hard disagreement has led to a “fork” in the codebase where the so-called bitcoin cash (or “BCC” as it is known by its ticker) was created on Tuesday 01-August. The new cryptocurrency shares the bitcoin ledger up until the moment of the fork and anyone in possession of bitcoin prior to the fork immediately owns the same number of BCC (and no less of bitcoin) after the fork.

However, from this point in time onwards the ledgers of the two versions of bitcoin will diverge. BCC is effectively a new cryptocurrency whose success will be determined by the utility its users draw from it.
 At the time of the fork only one substantial miner was supporting BCC so it remains to be seen how widely it will be accepted. Against a backdrop of multiple new cryptocurrencies launching to success (at least in terms of their dollar prices) it was no real surprise that BCC surged on the first day of its existence by approximately 60 per cent. To an extent this is likely to be driven by speculators looking for a quick buck but there is also an element of rationality to it: if the second phase of the segwit upgrade (the increase to 2MB blocks) fails to happen, then BCC will have a definite edge over its more venerable sibling.

Conclusion

The forking of bitcoin is a very interesting and public insight into how the process of developing an open- source technology works. When there is no consensus, involved parties are at liberty to go their separate ways and develop the code as they see fit. We’ve seen this many times with various iterations of Linux distributions and the market – in the sense of the community of developers and the users of the product – determines which variety grows and which fails. Blockchain, however, is different: its claim to value addition lies in its permanence and its durability and these qualities could be undermined by public spats among developers. The thought that your transaction history could end up on a fork that ultimately falls into disuse will be a worry to some, even if only at the margin.

For now the forking of bitcoin should provide some comfort that this process can work, but question marks still remain over how the community will respond as regulatory pressure builds. The first test of this may come with the EU’s expansive General Data Protection Regulation (GDPR) which is rolling out next May, and whose data protection provisions may yet prove to clash with bitcoin’s distributed structure.

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Notes:

  • The post gives the views of its author, not the position of LSE Business Review or the London School of Economics.
  • Featured image credit: Bitcoin, by Antana, under a CC-BY-SA-2.o licence
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Simon Cullen is a founder of RiskSave, a digital asset manager. He has a first class degree in mathematics and a masters in economics from Trinity College Dublin and is qualified Financial Risk Manager (FRM). Simon worked for over fifteen years in banking and asset management, formerly being Head of Stuctured Credit Trading, Risk and Compliance for a large European Asset Manager.