What Could Go Wrong with Bitcoin? Part 2
in Bitcoin (BTC)
In Part 1 of this series we covered topics like the centralization of Bitcoin mining in China, and whether quantum computing could eventually break the Bitcoin network.
In Part 2 we’ll consider government regulation, Bitcoin’s declining security budget and how Bitcoin’s transparent ledger could enable a two-tiered BTC system.
Aside from the centralization of mining in China, government regulation poses one of the most immediate threats to Bitcoin. Although governments can’t ban Bitcoin in the strictest sense, any government could make it very difficult to use digital currencies. So difficult that Bitcoin’s chance of becoming a reserve currency would disappear. Here are a few regulations that governments could impose.
- New restrictions that make it harder for investors to sign up for crypto exchanges. For example, in the United States there are financial products that only “accredited investors” can purchase. A registered investor is essentially anyone with $1 million or more in assets. The SEC could pass a law saying that only registered investors can buy Bitcoin on American exchanges.
- Regulations could force Bitcoin exchanges to disallow withdrawals. Anyone who purchased Bitcoin on an exchange would have to keep it on the exchange, they couldn’t withdraw it to a wallet.
- Regulators could mandate that crypto users have to report every single Bitcoin purchase and transaction. Anyone who failed to make these reports could face stiff penalties.
- The capital gains tax on Bitcoin could be raised to something horrible like 60 or 70%. This would heavily disincentivize large investors from buying Bitcoin.
If a government wants to take away Bitcoin’s potency they don’t have to ban it. All they have to do is make it very difficult to use. For Bitcoin to be a viable currency it needs mass adoption, and technologies that are very difficult to use rarely catch on.
While countries like Portugal are doing awesome things with crypto, lately the United States has been trying to push through new regulations. Rules that would force exchanges to keep track of withdrawals and regulations that would force stablecoin providers to get a bank license.
These new rules are likely just the beginning. If Bitcoin hits $100,000, the price will be like a bulb drawing the regulatory mosquitos to the light.
Lack of a Security Budget
Every four years the Bitcoin community celebrates the halving. This is the day when the Bitcoin supply issuance is cut in half. The most recent halving took place in May of 2020, when the supply rate was cut from 12.5 BTC per block to 6.25 BTC per block.
The next halving is due to take place in May of 2024, when the supply issuance will be further cut in half to 3.125 per block. You can keep track of the halving with this nice countdown timer.
Typically the Bitcoin halvening is viewed as an overwhelmingly positive thing. Bitcoin’s inflation rate goes down which means fewer Bitcoins are entering the marketplace. Assuming that demand for Bitcoin remains the same, a lower supply and steady demand means higher prices. That’s the bull case.
What doesn’t receive as much attention is the fact that all of that newly created Bitcoin is used to pay miners to secure the network. The result is that when issuance is cut in half, the security budget is cut in half.
So far this has not been a problem because Bitcoin’s price has been continually rising. If the new supply of Bitcoin is cut in half, but each BTC is worth 5x more than it was at the previous halving, there’s not much problem. Looking to the future, however, there could be a problem.
The argument for Bitcoin as a store of value is that one day the volatility will mostly be gone and BTC will hold a steady price. No more 50% drops in one day, or raging bull markets where the price goes up 3,000% in six months. Bitcoin would be like a saving’s account where you could store your money, neither expecting to get rich or lose your savings.
That’s awesome to imagine, however, a stagnant price would create a problem for miners. Their security budget will still be getting cut in half every four years, but the price won’t be going up to compensate for the reduced issuance.
At some point Bitcoin mining could become unprofitable. If that happened then miners would increasingly drop off the network. Bitcoin would become less secure which would make it more vulnerable to attack. This is a long term problem that’s worth considering since we know that,
- Bitcoin’s volatility is decreasing over time, I.e. price growth is decreasing
- The supply is cut in half every four years like clockwork
The counterargument is that even though Bitcoin’s security budget is decreasing, miners will remain profitable because of fees. I.e. Bitcoin users will pay enough in transaction fees to offset the lack of a security budget.
For this to happen the fees on the Bitcoin network will need to be quite high. $100 per transaction in 2030? $1,000 per transaction in 2040? It’s impossible to say for sure. All that’s certain is that the fees will have to be much higher than they are now.
While a $1,000 transaction sounds outrageous, it could actually work. The demand for Bitcoin may be so high that people (institutions mainly) are willing to pay any price and miners can remain profitable. However, we can’t say with 100% certainty that fees will be enough to compensate for a reduced security budget. This is why we’ve included a shrinking security budget as a potential concern for BTC.
Dirty and Clean Bitcoin
One of the most easily exploited features of Bitcoin is its 100% transparent network. Every Bitcoin transaction that’s ever taken place is recorded to the ledger, right there in plain sight for everyone to see.
A couple of problems are associated with having a transparent ledger, but no problem is larger than the potential for a two-tiered Bitcoin system. Here’s what we mean.
- Clean Bitcoin. This is Bitcoin that has originated from a KYC source like an approved exchange. If the BTC is taken off of a KYC exchange it is only sent to a wallet which has a KYC identity registered with regulators.
Any Bitcoin that is spent is only spent at an “approved” merchant. Or, Bitcoin could be sent to an “approved” financial institution, like Fidelity. So called “clean” Bitcoin only exists within an ecosystem of KYC and government compliance.
- Dirty Bitcoin. This is Bitcoin that has originated from somewhere outside of the system. Maybe it is Bitcoin from an international address or Bitcoin that someone bought in person, from a service like LocalBitcoins.
In the worst case scenario a government could make it illegal to hold dirty Bitcoin. In a slightly better case, you may not be able to use dirty Bitcoin at an “approved” merchant or deposit it with an “approved” exchange. More accurately, you could always send dirty Bitcoin to one of these institutions but they would seize it on behalf of the government.
In this scenario, dirty Bitcoin and clean Bitcoin are not interchangeable. Also, notice how all of the infrastructure to create a two-tiered Bitcoin system can be built without modifying a single line of Bitcoin’s code. Regulations are a way for governments to control Bitcoin without banning it or trying to modify its fundamentals.
It would take an awful lot of work to implement this system, and more technical know-how then the United States government has demonstrated itself as having. Nonetheless, if the price of Bitcoin goes high enough regulators may really start to try to shut down Bitcoin in a big way. This is one of the most pressing issues that the crypto community is likely to face in the next 18 months, especially if the next bull market is as big as previous ones.
Time to Panic?
Government regulations, a decreasing security budget and a two-tiered system are all potential threats to the Bitcoin network. That being said, there’s no reason that these problems can’t be solved.
As Bitcoin matures even more people will be joining the network and more intellectual capital will be driving Bitcoin’s success. So hopefully everything turns out alright in the end, and everything we’ve mentioned in this article never has to be too much of a concern!
This content is for informational purposes only and is not investment advice. You should consult a qualified licensed advisor before engaging in any transaction.