Series: Cryptocurrency will never fulfill its promise to be a Currency

Article 1 - Network capacity

Introduction

From the early days, we have used different forms of currency to trade and exchange goods and services.

In the days of the blockchain revolution, a group of tech enthusiasts developed a new currency, based on modern cryptography, to modernise traditional finance ie. Cryptocurrency. They envisioned a world with no intermediaries like banks. The motive was to make the transactions free and instant and most importantly free of government interference. However as the day passed, it was observed that as a form of currency it hit the walls of practicality, and the few places (companies and countries) which pioneered its use were forced to quickly discontinue it.

Numerous reasons make it convincing enough that cryptocurrency can’t fulfil its promises to be a practical currency suitable for a real-world economy. One of the main reasons is network capacity.

Network Capacity- Definition and Historical Context

Network capacity refers to the ability of the network to handle an increasing number of transactions and users, without compromising its performance or increasing the cost-per-transaction. Network capacity is crucial because the economy of a country consists of several thousands of people doing millions of transactions every minute. A currency must be able to process and settle all the transactions simultaneously. Moreover, the network must be able to grow according to the demands of the users, adapt to new cases, and yet the transaction cost remain competitive. By reading this, it might look like a new concept but it is not. In history, there are numerous examples that network capacity issues of the older variant directly led to the shift to other forms of currency. No currency can survive meaningfully over large periods or used by large economies without it.

Commodity Money:

Commodity money refers to the currency which is backed by rare and precious metals like gold and silver. As we already know, these were primary forms of money for centuries. Gold is a noble metal that never ages and can be passed on from one generation to another. No government or third party can devalue it, and it is nobody’s liability that can be defaulted upon. Thus, gold is truly eternal as a medium of exchange and store of value, and our ancestors passed on that knowledge for thousands of years so we value it equally highly today. But due to its incompatibility with the ‘Information Age’ and international trade & finance, it became unviable. Money for the last several decades could be transferred through binary code entries in a computer (at the speed of light through the internet), which was not possible with a physical asset like gold. Hence, it gave way to the next form - Representative money.

Representative Money:

Representative money is a paperback currency backed by gold reserves, providing a solution for faster transactions. There is a historical event, namely the Bretton Woods Agreement in which delegates from 44 countries together decided that gold would be the basis for the U.S. dollar (U.S. was anyway the owner of half of the gold by the end of WWII, kept in the vaults of New York Federal Reserve or Fort Knox), and the central authority will issue paper receipts physically as well as digitally. All other currencies across the world were pegged to the U.S. dollar’s value. It was expected that currency pegging would provide currency stabilisation in trade. But later on, another concern arose that the U.S. gold supply was no longer sufficient to cover the number of dollars in circulation, which led to the collapse of Bretton Woods. Economies (including the US) started shifting to alternatives where the value of the domestic currency was pegged to the basket of commonly consumed items (or letting market demand and supply determine its value). This is what we now know and use as Fiat money.

Fiat Money

Fiat money derives its value from being declared ‘legal tender’ by the sovereign. But since it is not backed by any commodity or asset, the central bank determines the amount of currency that is appropriate to be issued and circulated. The method they implement it through is the fractional reserve banking system. Using Statutory Liquidity Ratio and the Repurchase Rate, banks have to maintain a minimum percentage of deposits in the form of liquid cash, gold, or other securities as collateral to borrow money and lend it further to the larger economy. To maintain its value, explicit inflation targeting is implemented, in which a common consumption basket of goods and services is taken as a benchmark and its price-changes are kept within a predefined rate by legislative mandate. For instance, the Reserve Bank of India has set the targeted inflation rate at 4% plus-minus 2%, the US Fed has a 2% inflation-target and so on. Now enter the large world of cryptocurrencies, which are privately developed, used by a community and came with a lofty promise of dethroning the US Dollar someday as the global reserve.

Cryptocurrencies:

Cryptocurrency refers to a digital currency designed to work as a medium of exchange through a computer network that is not reliant on any central authority like banks or government. Cryptocurrency uses consensus mechanisms, a method to achieve agreement, trust, and security among network participants to ensure the validity of the transaction without any need for a central authority.

In the consensus mechanism, nodes (users) input data from a pending transaction and report back with an approval or disapproval status, once the request is cross-checked it will either be accepted or rejected. This process is essential in blockchain as it prevents double spending and frauds, whether done intentionally or unintentionally.

There are different types of consensus mechanisms used in different blockchain networks but Proof of Work (PoW) is most commonly used.

Proof of Work: PoW is a technique cryptocurrency uses to verify the accuracy of newly added transactions to a blockchain. Briefly, the process of PoW involves a miner who must meet the difficulty level to prove the block (file) valid. A block is considered valid only if the hash value of the entire block is below the difficulty of the target hash (a pre-decided hexadecimal number). To preserve the network's integrity, the target hash's difficulty increases (usually every two weeks) according to the number of miners in a network. A block contains crucial transaction information that cannot be changed, so miners modify the nonce (a block component that can be modified to achieve difficulty level restrictions) to achieve a hash lower than the difficulty threshold. Usually, the block hash is greater than the difficulty hash, so the miner will continuously change the nonce for hours until obtaining a block hash less than the difficulty hash. This process is purely based on chance and requires significant computational resources. The winning miner gets to validate the set of transactions and add them to the chain. Cryptocurrencies like Bitcoin, Ethereum, and Litecoin use PoW.

Network capacity is essential for all forms of currency. As economies grow rapidly, the trend of faster transactions is necessary to keep the economy running smoothly, which is challenging for cryptocurrency. For instance, Bitcoin's maximum transaction speed is 5 per second, and Ethereum processes 20 transactions per second, which is insufficient for large economies. In contrast, India's UPI processes 2348 transactions per second, and the VISA network processes 65,000 transactions per second. According to the latest data by NPCI, 12.20 billion UPI transactions were processed in January 2024, far surpassing Bitcoin's capacity.

There are three functions core to the idea of cryptocurrency:- Decentralization, Security, and Scalability. Decentralisation means multiple entities operate and maintain blockchain networks worldwide. Scalability is the ability to handle multiple transactions per second without slowing down. Security ensures the blockchain can protect its data from malicious actors.

As the technology evolves, the performance of the cryptocurrency may be improved. However, achieving these three functions together in the blockchain is impossible, as explained below.

If the majority of nodes identify that incorrect or fraudulent transactions are validated by the miner, the miner’s rewards (paid in the native cryptocurrency) are compromised. Therefore, miners have a vested interest in being accurate and honest to secure the network, and protect the value of the cryptocurrency. On the other hand, scaling up the network speed requires reduction of the target hash difficulty, lowering the incentive to preserve integrity and potentially allowing fraudulent transactions (as the miners have less to lose and more to gain from compromising the network).

Favouring scalability and security over decentralisation means that blockchain can handle a large number of TPS and maintain accurate information, but leads to the concentration of power in a few entities, ultimately failing the core concept of cryptocurrency for which it was favoured over Fiat money.

Lastly, if decentralisation and security are favoured over scalability, the network becomes congested, leading to higher transaction costs and backlogs, which can severely impact settlement.

These functions were essential from the early days of the currency evolution and were present in all forms of currency, enabling their longevity. However, they are absent in cryptocurrency.

Hence, according to our research, if blockchains like Bitcoin cannot distribute responsibilities among multiple entities while maintaining transaction accuracy, they are of no use, even if network capacity or TPS increases. This fundamental problem completely fails the concept of cryptocurrency.