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Friday, June 25, 2021

    Bitcoin Protocol

    Every payment system needs rules that regulate how new monetary units are produced (or destroyed). The Bitcoin network is calibrated in such a way that, on average, a block candidate with a valid hash value is found every 10 minutes. The winner of the mining contest receives a predefined number of newly created Bitcoin units.

    The number currently is 12.5. In the Bitcoin system, money creation is scheduled so that the number of Bitcoin units will converge to 21 million units. This limit exists because the reward for the miners is halved every 210,000 blocks (approximately every four years). Correspondingly, miners will be increasingly rewarded through transaction fees.

    But even today, the quick processing of a transaction can be guaranteed only if an adequate fee is paid to incentivize the miners to include the transaction in their block candidates.

    Most Bitcoin users believe that Bitcoin’s limited supply will result in deflation. That is, they are convinced that its value will forever increase. Indeed, up to this point we have witnessed a spectacular price increase from essentially a value of $0 for one Bitcoin unit in 2009 to a value of $7,000 at the time of this writing.

    Nonetheless, these beliefs need to be challenged. Bitcoin units have no intrinsic value. Because of this, the present price of the currency is determined solely by expectations about its future price. A buyer is willing to buy a Bitcoin unit only if he or she assumes that the unit will sell for at least the same price later on.

    The price of Bitcoin, therefore, reacts highly elastically to changes in the expectations of market participants and is reflected in extreme price volatility. From monetary theory, we know that currencies with no intrinsic value have many equilibrium prices.

    One of them is always zero. If all market participants expect that Bitcoin will have no value in the future, then no one is willing to pay anything for it today.

    However, Bitcoin is not the only currency that has no intrinsic value. State monopoly currencies, such as the U.S. dollar, the euro, and the Swiss franc, have no intrinsic value either. They are fiat currencies created by government decree.

    The history of state monopoly currencies is a history of wild price swings and failures. This is why decentralized cryptocurrencies are a welcome addition to the existing currency system.

    In the Bitcoin system, the path for the money supply is predetermined by the Bitcoin protocol written in 2008 and early 2009. Since then, many changes have been applied to the Bitcoin protocol. Most of these changes are not controversial and have improved the functioning of the Bitcoin system.

    However, in principle all aspects of the Bitcoin protocol can be amended, including the money supply. Many Bitcoin critics see this as a major shortcoming. Theoretically speaking, this is correct. Any network participant can decide to follow a new set of rules and, for example, double the amount of newly created “Bitcoin” units in his or her version of the ledger.

    Such a modification, however, is of no value because convincing all the other network participants to follow this new set of rules will be almost impossible. If the change of the protocol is not supported unanimously, there will be a so-called fork, a split in the network, which results in two co-existing blockchains and essentially creates a new cryptoasset.

    In this case, there would be Bitcoin (the original) and Bitcoin (a possible name for an alternative implementation with an upper bound of 42 million Bitcoin units). The market would price the original and the newly created Bitcoin assets according to the community’s expectations and support.

    Therefore, even though in theory it is possible to increase the Bitcoin supply, in practice, such a change is very unlikely because a large part of the Bitcoin community would strongly oppose such an attempt.

    Moreover, the same critique can be raised against any current government-operated fiat currency system. For example, since the Second World War, many central banks have become independent in order to shield them from political interference that yielded some undesirable outcomes.

    This independence has been given to them by the respective parliaments or related institutions and can be taken away if politicians decide accordingly. Political interference in the fiat currency system can be interpreted as a change in the “fiat currency protocol.”

    Undesirable changes in fiat currency protocols are very common and many times have led to the complete destruction of the value of the fiat currency at hand. It could be argued that, in some ways, the Bitcoin protocol is more robust than many of the existing fiat currency protocols. Only time will tell.


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