By Frances Coppola
The problem is that high demand for BTC is causing congestion in its payments network. BTC's market price has risen considerably, from less than $300 in January 2014 to over $10,000 now.2 Not only is the price high, but it is also volatile. As price volatility can mean significant losses if transactions don't settle quickly, and transactions with lower fees tend to take longer to settle than those with higher fees, users often choose to pay higher transaction fees rather than risk slow settlement. Consequently, transaction fees tend to track BTC's market price. In December 2017, when BTC's price peaked, the average fee for a BTC transaction rose to nearly $60, though it subsequently dropped back to about $15.3 Bitcoin is not reliably cheap as an international payments protocol.
Many now question whether Bitcoin can increase transaction processing capacity sufficiently to make it the fast, secure, low-cost alternative to existing international payment systems that its proponents would like it to be. This is known as Bitcoin's "scaling problem."4
Bitcoin's scaling problem arises from the way its blockchain technology works. For a transaction to settle, it must be verified and added to Bitcoin's distributed ledger, known as the blockchain. Each "block" can be regarded as a page in the ledger. Miners add transactions to a block, then compete for the right to verify those transactions and append the block to the blockchain. The miner who first solves a mathematical puzzle intrinsic to the block verifies the transactions it contains and is rewarded with the transaction fees and, at present, a new bitcoin.
Solving the puzzle requires computing power, so miners have an incentive to run powerful computers with cutting-edge technology, because this increases the chance of them solving puzzles before other miners. Bitcoin automatically adjusts puzzle difficulty as mining activity increases in response to rising transaction volumes, thus forcing miners to use more and more computer power to solve the puzzles. Using more computer power is costly, so transaction fees tend to rise with transaction volumes. Furthermore, when volumes are high, miners have an incentive to select the transactions with the highest fees for inclusion in a block. Transactions with low transaction fees can therefore wait a long time for verification.
Thus, the technical design of Bitcoin means that both transaction fees and settlement times tend to rise with transaction volumes.
Bitcoin developers have made several attempts to increase Bitcoin's transaction capacity. So far, all have encountered the same stumbling block, which is the fact that miners have little incentive to agree to anything that would significantly increase Bitcoin's transaction processing capacity. Miners are paid in bitcoin, so it is in their interests for BTC's price and its transaction fees to be high. And as the system depends on mining activity to work at all, miners can simply refuse to accept changes that are not in their interests.5
However, persistently poor performance and high prices can drive potential users away from Bitcoin. Most BTC miners did therefore accept one change, in August 2017. Known as "Segregated Witness" (SegWit), it reduced the amount of information carried on each transaction, thus enabling more transactions to be added to each block without increasing the block size.6
SegWit's introduction was not without dissent. Shortly before its activation, a group of miners rejected it, opting to increase Bitcoin's maximum block size instead. Bitcoin's maximum block size was 1 MB, although many blocks were smaller than that. Increasing the block size would allow more transactions to be included in each block, and thus increase the transaction throughput. The mining group argued that SegWit weakened Bitcoin's security and was not an adequate solution to the scaling problem. They said that increasing the block size would improve Bitcoin's transaction throughput sufficiently to make it viable as an international payments protocol, while still enabling all data to be recorded on the blockchain.7
Increasing the block size was resisted by other miners, and as a result Bitcoin split ("hard forked") into two competing coins – BTC, and Bitcoin Cash (BCH).8 BTC subsequently activated SegWit, while BCH increased the maximum block size to 8 MB, and is considering further size increases.9 Both coins use the Bitcoin payments protocol, although as they have separate development teams, their versions of this are progressively diverging.
Currently, BCH is significantly cheaper than BTC and has lower transaction fees, which could make it more attractive for businesses looking to use Bitcoin for international payments.10 However, BCH has fewer miners, so verification can be slow, and transactions can consequently take a long time to settle. Additionally, fewer cryptocurrency exchanges currently trade BCH, which could make it more difficult for businesses to buy and sell it for international payments.11
A planned block size increase to 2MB for BTC was abandoned in November 2017 when it became clear that the majority of miners would not support it.12 Had it gone ahead, BTC would have "hard forked" again.
Some BTC enthusiasts have proposed a "second layer" solution. Instead of trying to process all transactions through the main BTC blockchain, they are designing a protocol to sit on top of BTC, processing low-value transactions off chain and only intermittently broadcasting to the main chain. This protocol is called the Lightning Network.13
The idea is that Lightning users would open "payment channels" with each other, allowing small payments to be made within a funding limit. Opening the channel would be declared to the main blockchain as a transaction. The funds placed in the channel would then be progressively spent without further broadcasts to the main blockchain. When the channel was closed, the closing transaction would be broadcast to the main chain. Thus, a payment channel could process multiple payments, but only two transactions would appear on the main BTC blockchain. Fees for bilateral payments would be zero, and the transactions would be virtually instantaneous.14
Lightning also includes the possibility of chaining payment channels together to enable payments to be made without opening a new bilateral channel. Payments would "hop" from channel to channel on a pre-determined route. Intermediary payment channels would use their own funds to make payments, then reclaim the funds from their predecessors. For this, they would be paid a small transaction fee. None of the "hops" would be broadcast to the main blockchain.15
Lightning potentially solves the problem of high fees and/or slow settlement for low-value transactions. However, some have expressed concern about the fact that payments are not verified until broadcast to the main chain, which increases the possibility of theft.16 And others argue that Lightning will experience scaling problems of its own due to the need for channels to be pre-funded,17 while the potentially high complexity of its network relationships may make decentralization impractical.18 As Lightning is still being tested, it may be that developers will find solutions to the problems raised by skeptics – though a few analysts seem to regard the problems as insurmountable.19
Bitcoin's scaling problem potentially limits its usefulness as an international payments protocol. There have been several proposed solutions, but so far none have proved capable of delivering the transaction capacity needed for a mainstream international payments system without compromising some other feature of Bitcoin. However, a solution could still be found that will enable a version of Bitcoin to be widely adopted for international payment processing. Businesses may wish to keep a watchful eye on Bitcoin developments.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “Bitcoin.org has abandoned its claims for fast transactions at low speeds ….for now,” The Next Web; https://thenextweb.com/hardfork/2018/01/22/bitcoin-fast-transactions-low-fees/
2. “Bitcoin price history,” Coindesk; https://www.coindesk.com/price/
3. “Bitcoin average transaction fees historical chart,” Bitinfocharts.com; https://bitinfocharts.com/comparison/bitcoin-transactionfees.html
4. “The Great Bitcoin Scaling Debate – A Timeline,” Hacker Noon; https://hackernoon.com/the-great-bitcoin-scaling-debate-a-timeline-6108081dbada
5. “The Fundamental Conflict At The Heart Of Bitcoin,” Forbes; https://www.forbes.com/sites/francescoppola/2017/07/26/the-fundamental-conflict-at-the-heart-of-bitcoin/#6a547aca4fdb
6. “Segregated Witness activates on Bitcoin: This is what to expect,” Bitcoin Magazine; https://bitcoinmagazine.com/articles/segregated-witness-activates-bitcoin-what-expect/
7. “FAQ,” Bitcoin Cash; https://www.bitcoincash.org/#faq
8. “Bitcoin Cash: price of new currency rises after Bitcoin’s hard fork,” Telegraph; http://www.telegraph.co.uk/technology/2017/08/01/bitcoin-cash-everything-need-know-bitcoins-hard-fork/
9. “About Bitcoin Cash,” Bitcoin Cash; https://www.bitcoincash.org/#about
10. “Bitcoin cash price history,” Coinmarketcap; https://coinmarketcap.com/currencies/bitcoin-cash/historical-data/
11. “Where and why to buy, sell and trade Bitcoin Cash in the US,” Finder; https://www.finder.com/how-to-buy-bitcoin-cash
12. “Now the Segwit2x Hard Fork Has Really Failed To Activate,” Bitcoin Magazine; https://bitcoinmagazine.com/articles/now-segwit2x-hard-fork-has-really-failed-activate/
13. “The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments,” Lightning Network; https://lightning.network/lightning-network-paper.pdf
16. “Analysis: Risks of Lightning and SegWit,” Reddit thread; https://www.reddit.com/r/btc/comments/7ddw1z/analysis_risks_of_segwit_and_lightning_network/
17. “Why Lightning and Raiden Networks Will Not Work,” Egor Homakov; https://medium.com/failsafe/why-lightning-and-raiden-networks-will-not-work-d1880e4bc294
18. “Mathematical Proof that the Lightning Network Cannot Be a Decentralized Bitcoin Scaling Solution,” Jonald Fyookbal; https://medium.com/@jonaldfyookball/mathematical-proof-that-the-lightning-network-cannot-be-a-decentralized-bitcoin-scaling-solution-1b8147650800
19. “Lightning Network May Not Solve Bitcoin’s Scaling Trilemma,” Coindesk; https://www.coindesk.com/lightning-network-may-not-solve-bitcoins-scaling-trilemma/