Bitcoin: Despite the headwinds, the trader’s solution is obvious

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The last time I hedged Bitcoin (BTC-USD) in early July, I argued that bearish Bitcoin had become a one-sided trade. While Bitcoin is lower now than it was at the time of that article, the bulls got a relief rally which brought the $ 21k coin at the time of writing to $ 25k in just a few weeks. The sentiment is bearish once again, this time around even though I don’t see the same contrarian opportunity. This article will instead focus on the technical drawbacks of Bitcoin, the Lightning Network and its activity, and the broad macroeconomic headwinds that all risk markets currently face.

Disadvantages of the network

One of the big technical flaws of Bitcoin’s entry level is the lack of scalability. While Visa (V) can process tens of thousands of transactions per second (or TPS), Bitcoin can handle fewer than 10. This, rightly so, leads many to be very skeptical of Bitcoin’s theoretical mass adoption as a peer-to-peer payment network. peer. It’s also a big reason why there has been a proliferation of other blockchains aiming for better scalability through higher transaction rates per second.

  • Solana (SOL-USD) claimed 50,000 TPS on testnet, although others suggest actual capacity is far less than that
  • Avalanche (AVAX-USD) claims to be able to process 4,500 TPS

The problem of scalability for Bitcoin, and also for Ethereum (ETH-USD), is highlighted through what has been dubbed the “blockchain trilemma”.

Blockchain Trilemma

Blockchain Trilemma (Ledger.com)

In essence, the three desirable traits needed by public blockchains are security, scalability, and decentralization. What we have seen so far is that all of these public blockchains can achieve two of the three traits. None of them reached all three of them. For example, Bitcoin is secure and decentralized but not scalable. Most blockchains with high TPS are able to achieve scalability at the expense of decentralization or security. While Ethereum has tier two options like Polygon (MATIC-USD) and Arbitrum that help with scalability, Bitcoin’s best shot at tackling scalability currently is Lightning Network.

Lightning network

Joseph Poon and Thaddeus Dryja published the Lightning Network white paper in 2016 specifically to address the problem of Bitcoin’s scalability. Recognizing that cheap Bitcoin micropayments are only possible through custody solutions defeats the whole purpose of a peer to peer network, the authors proposed a “channel” -based option that does not use the ground-level chain for every transaction:

Instead, using a network of these micropayment channels, Bitcoin can scale to billions of transactions per day with the computing power available today on a modern desktop computer. Sending many payments within a given micropayment channel allows you to send large amounts of funds to another party in a decentralized way. These channels are not a separate trusted network above bitcoin. They are real bitcoin transactions.

Channels are a bit like a tab in a bar. When the customer gives the bartender his credit card, the two sides have agreed to open a “channel” that will not be closed until the customer decides to leave the bar. If a Lightning user wants to pay for coffee with Bitcoin and the coffee shop has a Lightning Network node, the two parties can open a channel between them that will allow the customer to pay for the coffee any number of times at a cost that is equivalent to less than a cent per transaction.

Lightning Network Channel Map

Lightning Network Channel Map (acinq.co)

The interesting thing about the network is that users don’t necessarily have to open channels with every merchant they do business with. The map above shows the channels currently active on the Lightning Network. If adoption reaches critical mass, Lightning can route payments through channels with varying degrees of separation. This means that the network will allow transfers between two users who do not have an open channel as long as there is a connection somewhere in the network connecting the parties to each other.

For example, suppose “Customer 1” has a Lightning channel with a grocery store but not a restaurant. The restaurant has an open channel with “Customer 2” and “Customer 2” also has a channel with the same grocery store, “Customer 1” and the restaurant can transact without opening a channel because Lightning Network will route payment via “Customer 2 “and the grocery store.

Lightning network channels

Lightning network channels (Indications of Bitcoin)

Currently, there are approximately 81,000 channels on the network. While the channel trend has remained stagnant since the cryptocurrency market peaked at the end of last year, total channels on Lightning have risen about 19% year-over-year. The real growth on the Lightning Network is in the capacity, i.e. the amount of Bitcoin that is available to be traded on the level:

Lightning network capability

Lightning network capability (Indications of Bitcoin)

There are now 4,740 Bitcoins available for transactions on the network, or about $ 105 million in funds. While BTC’s capacity has grown 91% year-over-year, the dollar buying power of that capacity has decreased by 5% due to Bitcoin’s price struggles since the beginning of the year.

So why should a trader have the desire to do this? Transaction costs on Lightning are drastically lower than traditional payment processors like Visa. We’re already seeing merchant fatigue from those processing fees. Just this week we see reports from Target (TGT) and Walmart (WMT) supporting an invoice to reduce credit card fees.

The bill, which Senator Richard Durbin (D., Ill.) And Senator Roger Marshall (R., Kan.) Introduced in July, would give merchants the right to route many credit card payments to networks other than Visa and Mastercard. In a letter this week to all members of Congress, merchants said the bill would increase competition, leading to a reduction in the fees they pay when accepting credit cards.

Rather than trying to fight pricing battles through the state apparatus, it might be wise for companies like Target and Walmart to instead start running Lightning nodes and building integrations with their B&M chains and e-commerce stores. Show consumers the edge and you will likely get the result you want; especially with consumer price inflation still rising.

But the general point is that there is a corporate appetite for cheaper transactions, and Bitcoin’s Lightning Network can be used to meet that demand. It is important to remember that these types of blockchain networks can be used to transact more than just native assets. If Circle supported USDC Stablecoin (USDC-USD) on Lightning, users could trade dollars on Lightning for fractions of a cent per transaction with “sat” BTC essentially serving as grease to keep the engine moving.

Base layer activity

As for the base level, we are still seeing hashrate spikes and in many other areas:

Average hash rate

CoinMetrics

The average hash rate hit another new all-time high a few days ago. This suggests that the network remains secure as an increasing number of miners compete for the blockade’s reward. Furthermore, active addresses are still close to their highs and generally fluctuate between 700-900,000 daily users on the chain.

Active BTC addresses

BitInfoGrafici

Despite the generally positive network usage and security metrics, BTC’s price still depends on monetary policy.

Macro headwinds

Like any other speculative digital trinket that trades in cryptocurrencies (or on the Nasdaq for that matter), Bitcoin’s price will likely depend on the Federal Reserve’s monetary policies. Risk markets were widely sold on Tuesday due to a CPI of 8.3% year-on-year which was higher than expected by 8.0%. Now many are asking for higher September rate hikes than expected just a few days ago:

Probability of the target rate

Probability of the target rate (ECM Group)

The market is now pricing in a 30% chance of a 100 basis point rate hike next week. This is up from 0% on Monday. Bitcoin has survived several bearish cycles that have led to extreme bears. But Bitcoin has not yet been tested in a legitimate tightening cycle like the one currently being driven. While I personally wonder how much they can raise rates without causing systemic problems, all risk markets will struggle until there is a clear indication that the Federal Reserve is taking its foot off the gas on rates.

Summary

Bitcoin has a tough way to go. In addition to the headwinds of monetary policy, the current administration is considering action against domestic Bitcoin mining. Additionally, the power consumption narrative accompanying Proof-of-Work mining is likely to get louder after Ethereum’s merger with Proof-of-Stake. But Bitcoin’s Lightning Network theoretically addresses this concern as well because transactions are off-chain.

As I explained here and in a previous article, it’s in the merchant’s interest to use something like Lightning if the UI can be simplified. It is undeniably cheaper for the seller of goods and services to use Lightning for payments rather than credit cards. We are already seeing major US retailers supporting a bipartisan bill aimed at lowering credit card transaction fees. The market demand for alternatives seems to be there. The question is whether that question will find its way to Bitcoin’s Lightning Network. And if so, does that mean that BTC’s price decouples from the rest of the market? If it does, the bulls should see phenomenal gains. If not, Bitcoin will continue to be traded as a risk asset. In a tightening cycle, the long-term bulls should take a stance adding dips like the one we got on Tuesday.

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