Bitcoin Faces Urgent Scalability Problems

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Includes: ATVI, BCS, BTC-USD, COIN, F, NOC, SNE
by: Martin YK Li

Summary

Bitcoin is on a bull run as investors are becoming more comfortable with the technology and what it offers.

As a currency, Bitcoin faces major problems with its transaction speed, which if left unaddressed can limit Bitcoin's potential.

The two most likely solutions are SegWit and Bitcoin Unlimited, which each holds their own pros and cons.

Bitcoin (COIN) has more than made its entrance known to businesses and investors alike. With just over 16 million coins in circulation at a current price of about $2750 per coin, BTC currently commands a market cap of over $45 billion, on par with the likes of Ford (NYSE:F), Sony (NYSE:SNE), Barclays (NYSE:BCS), Northrop Grumman (NYSE:NOC), and Activision (NASDAQ:ATVI) to name a few. It's without a doubt that Bitcoin is on the rise and is being incorporated into the investment portfolios of the bold. Bitcoin has its strong selling points, however a large point of contention is looming quite heavily over the cryptocurrency.

Currently, Bitcoin's network can only process a maximum of 7 transactions per second. In reality, the network only handles around 2 to 3 transactions per second, as 7 transactions per second is only a theoretical maximum under optimal conditions. Compare Bitcoin's limitations to VISA or PayPal. Visa handles on average around 2,000 transactions per second, with a daily peak rate of 4,000 transactions per second. VISA has a peak capacity of 56,000 transactions per second, however they never actually use more than a third of this even during peak shopping periods. PayPal handles on average 10 million transactions per day for an average of 115 transactions per second.

Additionally, bitcoin transactions are happening at an increasingly rapid rate. The estimated Daily USD Transaction Value is a good indicator of the number of transactions that occur on a daily basis, and the Daily Transaction Value has shot up to around $2 billion per 24 hours in the 2017 year, compared to the average of under $100 million per day in 2016, an increase of 2000%.

(Image Source: Blockchain.info)

Consequently, as a result of Bitcoin's relatively low maximum transaction speed and its increasing amount of daily transactions, Bitcoin keeps a large backlog of unconfirmed transactions, at one point during the week of May 18th, 2017 reaching a backlog of over 200,000 unconfirmed transactions. This is shown in the size of the mempool, which represents the summed size of the chunks that need to be mined in order to confirm the remaining transactions. The larger the mempool, the more transactions are waiting to be confirmed.

(Image Source: Blockchain.info)

With the increase in unconfirmed transactions, the cost per transaction of bitcoin has shot up. Miners, who are the ones using their computer's processing power to confirm the transactions, need an incentive to pay for electricity and hardware costs. Currently, miners are paid through a combination of Bitcoin's block reward and transaction fees. Currently, each transaction confirmed earns the miner $23. Bitcoin currently rewards 12.5 bitcoins per block, and the average number of transactions per block hangs around 2000. meaning that $17 dollars of the miner's earning for each transaction comes from the mining reward built into the system. This leaves an average cost of around $6 per transaction that users are paying the miners out of pocket for each transaction. $6 is unbelievably high, and eliminates the option of using Bitcoin for microtransactions. Who is going to buy a cup of coffee with Bitcoin when the transaction fee is more than double the cost of the drink!

The way that bitcoin mining works, miners choose which transactions to add to each block that they mine. Transaction fees are actually optional, as in users can select to pay no fee if they so choose. However paying a fee for the transaction gives incentive to the miners to process the transaction as the miner receives the payout from the fee upon completion of the block. With such a large backlog of unconfirmed transactions, users are then incentivized to add larger transaction fees so that their transaction is chosen by miners and not left to fester in the mempool. Essentially, people are willing to pay more to get their transactions confirmed faster. This upward trend in the transaction fee will only continue if the transaction speed bottleneck isn't fixed.

(Image Source: Blockchain.info)

As usage increases, these problems will only exacerbate. If bitcoin wishes to reach widespread adoption, this issue needs to be addressed. Two of the most likely possible solutions are SegWit, which stands for Segregated Witness, and Bitcoin Unlimited.

SegWit is designed to separate signature data from Bitcoin transactions. Regarding scalability, SegWit shrinks the size of each transaction, without changing the transaction size limit of 1 megabyte. This effectively increases the block size limit to around 2 to 3 megabytes per block. However, implementing SegWit requires that 95% of current miners (as in 95% of the total hash power) signals their support for SegWit. If support for SegWit is insufficient, it may result in a contentious fork where a significant part of the network switches to the new SegWit client but some decide to keep using the old one, which results in two cryptocurrencies with different sets of rules competing with each other for users. This would have a strong negative impact on the value of both the currencies. To avoid this, the developers of SegWit have set a specific rule in the software that it will only activate if it receives over 95% support from the network. SegWit has also already been implemented in various other cryptocurrencies and has a proven track record. The problem lies in that SegWit is a temporary solution. The effective increase of each blocksize to 2 to 3 megabytes will be enough for the near future but further down the line, if bitcoin continues its growth, SegWit will not be enough to support the network and congestion in the transaction pool will arise once again.

Bitcoin Unlimited on the other hand is a full node software client for the Bitcoin network. Compared to the Bitcoin Core client (which is what is currently in use) which hard codes the block size limit to 1 megabyte, Bitcoin Unlimited removes the limit and allows users to determine the block size by consensus, allowing the block size to be configured to the preferences of the majority of the miners. Implementing Bitcoin Unlimited presents its own problems, mainly in that it requires Bitcoin to undergo a hard fork, which is irreversible. This means that if any unforeseen bugs or problems arise with Bitcoin Unlimited, the network cannot be reverted back to Bitcoin Core. Unfortunately, unforeseen bugs are a very real possibility on account of the questionable track record of Bitcoin Unlimited's small development team. Currently, around 12% of the entire Bitcoin network is running Bitcoin Unlimited, and if you have been paying attention to cryptocurrency news, Bitcoin Unlimited has been targeted with DoS attacks on more than one occasion, originating from a bug in the Bitcoin Unlimited software that left an opening for the attack.

Either way, neither solution is truly permanent. As Bitcoin continues to grow, it needs to simultaneously and continuously address its need for greater scalability. Without the necessary changes, Bitcoin will eventually fall off the main stage.

I will be covering the upcoming events of August 1st in my next article.

Disclosure: I am/we are long BTC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.