Into the Hall of Mirrors: Part I — Bitcoin’s “fee-market” is an illusion by@solex1

Into the Hall of Mirrors: Part I — Bitcoin’s “fee-market” is an illusion

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Andrew Clifford HackerNoon profile picture

Andrew Clifford

What we find instead is a blockspace auction room

Searching for the “fee-market”…

A sizeable portion of the multi-year scaling debate in Bitcoin references the pros, cons, and alleged economics of a fee-market. Bitcoin transactions carry a fee so thinking of it this way makes it appear a reality.

... and learning blockspace is Bitcoin’s commodity

In Bitcoin, unconfirmed transactions are propagated peer-to-peer to be stored in each node’s mempool. The fee on a transaction purchases blockspace, i.e. a miner incentive, allowing the transaction to be confirmed forever into the blockchain. Fees are buying blockspace.

Markets are always known for the commodity, product, good or service being traded. A share-market where publicly-listed equities are bought and sold, is called a “share-market’ because it’s where shares are being bought and sold. A housing-market is where houses are being bought and sold… need I go on?

The common denominator is money; products and services are bought and sold with money and there are terms of convenience as a result. In a share-market there is an order-book made of opposing buy and sell orders. It is not called an “order-market”, because orders are the market mechanism and not the product/instrument being traded. Even in FX markets, where currency is traded, the markets are for foreign exchange, not an “order-market”.

So, there is a blockspace market in Bitcoin. This market was bootstrapped into existence in 2009, slowly becoming more robust, responding to the economics of supply (from miners) and demand (from users). It is optimal for a cryptocurrency as it enables the most users while also obtaining for miners the most income, and for non-mining investors the most capital gain from the largest network effect supportable.

However! One day something strange happened. In May 2016, node mempools could no longer be drained by miners of economically viable transactions. An “economic change event” occurred, where the blockspace market was artificially restructured into a fixed-supply auction room and it has functioned this way since.

The blockspace auction room in Bitcoin

Open markets inherently strive to be efficient because they are a mechanism by which the most buyers can get the lowest price while the most sellers get the highest price for whatever is being traded. Markets can be made less efficient by any number of environmental factors: lack of standards, lack of liquidity, cartels and side-deals, and heavy-handed governance such as licensing and red-tape, or by being structured artificially.

Further, the type of product plays a significant role in price determination because each product has a different degree of elasticity to buyers and sellers.

✦ Inelastic supply occurs when products do not have a viable alternative, and buyers will continue to buy them despite the price increase—examples: town supply water, fresh food, major event tickets.

✦ Elastic supply occurs when a product has a close substitute, so consumers choose to purchase the substitute if the product rises in price — examples: airline tickets, cars, clothing.

Implicit in Bitcoin’s blockspace auction room is a fixed supply available at regular time intervals. Buyers for blockspace have to bid against each other and the low-bidders simply miss out and have to wait for the next auction. Usually buyers have just a 1-time bid per auction, although some buyers may attempt a second higher bid (replace-by-fee) as a work-around in this highly-flawed variation of what should still be a blockspace market.

Inelastic demand occurs when buyers cannot easily go elsewhere for the same product. Opportunity cost, friction to change, adds to inelasticity of demand because buyers may have alternatives available but face challenges moving to the alternatives. The network effect makes demand inelastic because user interaction is fundamental to product usage.

Bitcoin’s payment network relies upon both parties having bitcoin wallets and accepting bitcoins. Where Bitcoin can be the only cryptocurrency then demand is inelastic within the cryptocurrency space. Where multiple cryptocurrencies exist then demand becomes increasingly elastic as the network effect builds into alternatives, and market share bleeds from the original.

A lesson from Yellow-cab Medallions

The number of New York City yellow-cab medallions has been limited to about 12,000 for the 60 years to 1996, with a further 1500 allowed since. Inelastic supply has led to demand seeking alternative taxi services. However, until new technology arrived in the form of Uber demand was inelastic for street-hailing because government regulation prevented competitive services.

Uber’s business model has been cloned and now the dominant player is constantly battling eroding market-share to many competitors:

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A lesson from Cryptocurrency

A few years ago Bitcoin transactions could be sent for free because there was a nice facility where the age of the outputs determined whether a zero fee was acceptable. So, a user could send 1 BTC for free if those coins had not moved for 1 day, or 0.25 BTC if they had not moved for 4 days. The advantage of this is that it gave a small incentive for older coins to move and thereby adds to the network effect by spreading more coins into more hands. Network-effect is critical and this early support for it was smart thinking. Yet it was also an early casualty of the advent of the blockspace auction room.

The global demand for blockspace continues to grow — whether that blockspace can be provided by Bitcoin has become irrelevant. The demand is there.

The revolutionary breakthrough invented and pioneered by Satoshi Nakamoto continues unabated as Bitcoin has been cloned into alternatives. More people in more countries are discovering the important benefits of decentralized, permissionless, borderless, be-your-own-bank, fast peer-to-peer payment networks.

The only question is which cryptocurrency software developers are smart enough, and nimble enough, to provide the software which will attract miners to accept transactions and secure the blockspace they need. This keeps users satisfied by providing the blockspace they require while remaining the most market efficient (profitable) for miners— and that isn’t in the form of a fixed-supply blockspace auction room.

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