Avoiding the Bitcoin Death Spiral

NOTE: The contents of this post are a professional opinion on predicted outcomes and pragmatic solutions. They are not endorsements or wishes for certain outcomes, nor are the suggestions for idealized solutions.

I feel like I shouldn’t have to keep saying this, but just watch how many comments will completely ignore this disclaimer.

There’s a catastrophe coming to Bitcoin at some point in the unspecified future.

We will see a cataclysmic event which will shake the community to its core, and cause significant, possibly permanent, damage to Bitcoin. And right now, we’re largely unprepared for it.

However, there are a few important things we still can do to protect Bitcoin from the effects of a death spiral.

Wait, What Death Spiral?!

Yes, in its current form with present technical limitations, Bitcoin is vulnerable to a cascading collapse, severely degrading network performance, spiking fees, crashing the price, and harming the security of the network.

Please read the excellent breakdown by crypto researcher Justin Bons that I’ve included below, but in summary: a momentary (and small) panic can cause users to attempt to withdraw their Bitcoin to self-custody (or move from self-custody to an exchange to sell for liquid capital), which can cause the network to grind to a halt, tanking the price, collapsing hashrate, further slowing the network, further eroding confidence and tanking the price, and so on.

What If Bitcoin Never Stops Going Up?

It will. See below:

To briefly explain this simplistic meme, the current price of Bitcoin is inflated beyond regular market demand by (at least) two entities: Tether and MicroStrategy.

Tether holds Bitcoin reserves, and is rumored to have created more USDT in order to buy Bitcoin and drive up the price, which then increases the value of Tether’s holdings, allowing them to create more USDT to buy more Bitcoin, and so on. MicroStrategy does the same, except with debt and by selling shares.

While Tether is only rumored to be doing this, MicroStrategy is openly confirmed to be trying to exploit this “infinite money glitch”. There is no such thing as infinite free money, so at some point the price will plateau, or the ability to create new debt or new USDT to feed the bubble will stall.

Then the price will start going down (as naturally happens at certain points in market cycles). Only this time, it can cause a cascading collapse effect on its pumpers (in particular MicroStrategy, which may have to sell Bitcoin to pay off its debts). This kickstarts the death spiral as Bons laid out.

Will It Be the Death Bitcoin?

Super-short answer: no. At least, I don’t think so. I’m less pessimistic than Bons on this complete and total collapse, because too many people are invested in seeing Bitcoin succeed, or at least not die catastrophically all at once.

If the above-mentioned dump, “run-on-the-banks”, and cascading network congestion and fee spikes happen, I’d expect a few things to happen to prevent a total and permanent failure of Bitcoin:

• Heavily invested actors and mining pools would start mining at a loss in order to keep transactions flowing. This is of course not sustainable long-term, but I’d expect many would be willing to take a loss in profits in order to prevent further panic-selling and network mayhem.
• After the initial panic, the fee market would normalize, and a backlog of high-paying transactions for urgent cases would continue to be processed while non-essential transactions would be resigned to wait many months to go through. Invested institutions and individuals would likely make whatever loans or other guarantees necessary to put people at ease that they would eventually get access to their money.
• Plenty of people believe in Bitcoin too much to sell, and many of them would be buying all the way down. This doesn’t mean it goes up forever, but it does put a temporary price floor at least.

What it will kill, however, is self-custody.

Bitcoin is used right now purely to preserve, or increase, value. This has nothing to do with on-chain usage, which solely serves the purpose of transferring to and from self-custody (or institutions shuffling around funds). Self-custody actually makes it more expensive and difficult to use, and in some ways less reliable than trusting institutions in times of panic.

The “run-on-the-banks” scenario would “teach people a lesson” to not self-custody, essentially. Some still would, but many (most?) Bitcoin holders would transition to a purely custodial setup, thus losing any sovereignty they originally sought to gain.

How Do We Survive?

The ability to use Bitcoin in a sovereign way, and in a way that can survive these kinds of flash crashes, is imperative if we care about the future value of Bitcoin as a tool for financial sovereignty. Thankfully, there are solutions.

First, I’d like to immediately discount any solution that requires protocol changes to Bitcoin. This includes what are considered “native L2s”, or second-layer technical solutions built on top of Bitcoin, by Bitcoin-first advocates and developers. I simply don’t view as realistic the chance that any meaningful change will happen from inside the Bitcoin community (happy to be proven wrong).

The way forward is: trust-minimized “external L2s”.

These are, basically, other cryptocurrency networks (formerly called “altcoins”) creating Bitcoin-denominated tokens in a way that doesn’t involve trusting centralized intermediaries, and gives a reasonable expectation of being able to withdraw native Bitcoin on-demand.

If people can transact in fast, inexpensive, scalable representations of real Bitcoin, and reasonably can believe that they can get Bitcoin out on the Bitcoin chain at any time, they will be much less likely to panic and put pressure on the chain. Withdrawing to L2 self-custody will take the place of full self-custody for many, and those selling will be able to sell their Bitcoin representations as easily as real Bitcoin.

Of course, there will still be users rushing to move their on-chain Bitcoin or unwrap it from their L2 tokens, and yes, this will cause network capacity to be overwhelmed and fees to spike. But it will be much less prolonged and will probably avoid some of the more serious death spiral effects, especially on price and hashrate.

Longer-term, this approach could actually mitigate some of Bitcoin’s looming security budget issues. If cryptocurrency projects make enough profit from their Bitcoin tokens, they will want to make sure their customers can enter and exit with confidence, and that demand for their product continues to exist. As such, it’s in their interest to run Bitcoin miners to make sure there’s at least a minimum security and serviceability level for the network. They may even eventually pair Bitcoin mining with their nodes at the protocol level.

Bitcoin hasn’t meaningfully innovated in years, and this could be its undoing, especially in light of the market bubble that has materialized this cycle. To save it, we must innovate around it. Building effective, elegant, and trust-minimized tokenization on other cryptocurrency networks is the one realistic path to avoiding the Bitcoin death spiral.

Posted Using InLeo Alpha