What’s the deal with off-chain transactions?

Based on comments from both reddit and Coindesk, the number one question today seems to be related to off-chain transactions.  Why aren’t these being factored in to the equation? [Note: it bears mentioning that I did discuss this on p. 84, Chapter 4]

There are multiple problems with this perspective, however before delving into that I should point out that in the previous article, I did in fact link to Coinbase’s self-reported off-chain transaction numbers.  They are relatively marginal, on most days comprising less than 5% of the total transactional numbers.  But it is not clear from these numbers alone are or what they refer to: Coinbase user to user, user to merchant, and possible user wallet to user vault?

Below is their chart:

coinbase offchain transactions

What impact does this have on the network?

It actually makes the network insecure in two ways:

1) Users become increasingly dependent on trusted third parties (TTP) on the edges, which defeats the purpose of having a blockchain in the first place (recall that “trusted” appears 11 times in the white paper).  This also opens both consumers and entrepreneurs up to a host of vulnerabilities and abuses that the industry is continually plagued by.

2) As more users leave the actual blockchain and move off onto TTP, less funds (or “fees”) are going to pay miners for actual security, making the entire network more reliant on seigniorage (block rewards) which in the long-run has empirically been a losing battle.

Below is a chart from Blockchain.info that illustrates fees to miners:

total transaction fees two year

Another chart illustrating this data was compiled from data by Jonathan Levin (formerly of Coinometrics) over the same time period:

Notice how fees have actually decreased and are now at a two year low.  This is actually the opposite trend we would want to see and potentially troubling.  In fact, contrary to prudence, instead of floating fees the core developers have “slashed” fees (more accurately called “donations“) by tenfold this past year.  From an economic sustainability point-of-view, this is the diametrically opposite action that should be taking place.  It will make the adjustment period at the next block halving much more painful to consumers as fees have to go up to incentivize miners to stay.

Earlier this summer, L.M. Goodman (creator of the Tezos protocol) noted a similar conundrum:

The race to build more hashing power (by developing ASICs for instance) means that the cost to pull off a 51% attack on the network increases. In this respect, the network is more secure. Note however that the amount of money spent on mining and mining equipment must be approximately equal, in the long run, to the amount of bitcoin paid in transaction fees or created through mining. Given off chain transactions, this could dwindle to very low levels in the future.

As Dave Hudson and others have pointed out (see Chapter 3), this fee has to increase because transactional volume simply is not increasing to the level it needs to in order to replace the block reward.

Meher Roy succinctly summed up this conundrum in a comment earlier today:

The question is how will the low-fee high volume work when off-chain is / will prove to be more convenient?  Any on-chain fee will be out-competed by speed, lower fees and convenience of off-chain transactions. Why exactly are we sure on – chain transactions will rise 10000 fold that it needs to? How exactly does Bitcoin solve this collective action problem?

These are important questions that thus far, everyone seems to punt on.

What about off-chain data from exchanges?  Surely they should be factored into this?

Unless exchanges are willing to publicly share that data, it is difficult to surmise what is taking place in their black boxes (we can have some idea based on public addresses).

But again, this is not a particularly good metric for those who believe lots of commercial trade is taking place.  Off-chain transactions on an exchange are equivalent to forex.  Value transfer, possibly.  Retail commerce, no.

We do in fact know how much Bitpay and other payment processors do in business each day, we know this through the bitcoins they sell each day to liquidity providers.  And altogether this amounts to around 5,000 – 6,000 bitcoins per day.  Although there are some merchants that keep part or all of their bitcoins, the liquidity sales is the most accurate version of retail commerce we can estimate with today.  And that has not changed much over the past six months.

[Special thanks to Dave Babbitt and Jonathan Levin for their constructive feedback]

One thought on “What’s the deal with off-chain transactions?

  1. Pingback: OP-ED: The Rise and Rise of Lipservice: Viral Western Union Ad Debunked « North American Bitcoin Conference

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