Bitcoin and the fundamental problems of blockchain technology
As software developers and users we are often faced with trade-offs, which describe a situation, in which a certain advantage comes with a cost. In blockchain development one of the main problems is the fundamental trade-off between resilience and efficiency: either the blockchain is decentralized and secure, which comes at the expense of efficiency or it is centralized and efficient and allows scalability, but comes at the expense of its resilience.
Theoretically, a single server could process billions of monetary transactions on a daily basis. Such a system would be highly efficient, but a single computer could be confiscated by the state, it could be attacked by a hacker or it could be compromised by hardware failure and blackouts.
It seems that the history of pre-Bitcoin digital currencies and their failures had a significant influence on Satoshi's way of how he conceptionalized Bitcoin. While pre-Bitcoin digital forms of money were shut down by the US government, legally backed by the Patriot Act, the original idea behind Bitcoin was to create a resilient monetary network based on a decentralized structure, which is more secure the larger the network is. But the decentralized structure comes with a cost: the network is less efficient, which is why scalability is difficult and transaction costs tend to be high for every day usage.
Bitcoin is a system, in which the database and the verification of transactions are distributed among tens of thousands of computers - so-called nodes, which collectively arrive at a consensus in the absence of a central authority. In the Bitcoin network the nodes are running the protocol, enforce the rules of the network, communicate with other nodes, users and miners, scan the entire blockchain, validate the transactions and so on - a decentralized process that is less efficient than a centralized database.
The "Block Size War"
The trade-off between resilience and efficiency was one of the main issues in the so-called “block size war” between largely two camps: the big blockers and small blockers. The heated debate about the direction of Bitcoin had its roots in the growing number of transactions and the increasing costs to settle Bitcoin transactions on the base layer around 2015, when Bitcoin caught the attention of the media and usage started to grow significantly.
The higher transaction costs were caused by two bottlenecks. The first bottleneck arises from the fact that the Bitcoin protocol allows a maximum block size of 1 MB, meaning that a block can only store a limited number of transactions. The second bottleneck is the result of the so-called difficulty adjustment - an important protocol rule which determines that only every ten minutes a new block can be mined and added to the blockchain regardless of the computing power that goes into the mining process.
The position of big blockers was that the block size should be increased and become more flexible in order to create more space for transactions per block and to scale the network at the base layer. But small blockers maintained that an increased block size and a higher efficiency of the network implies a trade-off at the expense of its decentralized structure, which was really the key point.
What is called blockchain bloating describes the problem that a higher block size and scaling the base layer would increase the size of the blockchain to a considerable extent and would cause hardware limitations on customary laptops, forcing node operators to give up their node and making the network less secure and resilient against attacks.
Recently, I ran a couple of computer simulations assuming different block sizes with a growing number of transactions per day, which clearly showed how increased block size would lead to a massive explosion of the blockchain size, especially at a global scale.
The massive explosion would entail significant hardware limitations for the foreseeable future, even if we assume a continuing exponential growth of the number of transistors and storage capacities. With growing hardware requirements less and less Bitcoin users such as merchants or private users would have been able to operate a node on their customary laptops, centralizing the network and making the network less and less secure.
There is not really a strong argument coming from big blockers how centralization can be avoided in the case of big blocks. One of the arguments is that transactions can be verified by light nodes, which don't store the entire blockchain - an argument that is not really convincing since the light nodes would still rely on full nodes to verfiy transactions by going back to the first UTXO / coin base. The fact that the vast majority of Bitcoins were mined in the early years also needs to be considered here.
Big blockers lost the war, many of them split from the Bitcoin scene and became largely irrelevant. Instead of scaling the network at the base layer, Bitcoin nodes enforced changes in the Bitcoin protocol that paved the way for a multi-layer solution to scale the network.
Bitcoin will be a multi-layer network, but let's not forget to address its trade-offs
The end of the block size war set Bitcoin into a new direction. The nodes agreed that Bitcoin as a multilayer network is probably the most reasonable direction to bridge the gap between resilience and efficiency. In a multilayer network not all financial transactions are settled at the base layer and stored in a block. Instead, multiple smaller transactions are aggregated into one larger transaction, which allows the network to scale.
But most Bitcoiners would also agree that a multi-layer solution at the global scale implies trade-offs and risks, which involve extremely complicated questions. What about the trust issue and counter party risk at the second and third layer? What should be done with the beliefs and preferences of people, who fear to lose their key and prefer a custodial solution? How can fractional reserve be avoided? How to deal with KYC and regulatory capture at the second and third layer?
The base layer would be decentralized with no government entity or central bank being able to control it or change the rules of the network, while the secondary and third layer would provide the scalability and flexibility of today’s complex global economy. But it is also important to understand the trade-offs and risks, such as fractional reserve, third party risks, KYC or regulatory capture.