Scaling the Decentralized Economy

Dec 2, 2020

Scalability has been a long-standing topic of discussion in the crypto space. Already very early on, the necessity and future of Bitcoin’s block size limit was debated, which much later led to the forks BCH and BSV. In the year 2017, a related metric – number of transactions per second – was brought into focus and was often used as a selling point for novel base layer protocols (which mostly sacrificed decentralization to achieve higher throughput), as both Bitcoin and Ethereum struggled with high transaction fees.

However, this type of “technical” scalability is not the only way the crypto ecosystem needs to scale. The overall crypto space, as measured by its total market capitalization of ca. $570 billion at the time of writing, is still small on a global scale. Plus, while the number of users and developers involved in crypto has grown at an astonishing pace, real world applications are still scarce. What is needed to scale technically, economically, and socially?

Technical Scalability The approaches to scale from a technical side have been outlined in detail in a previous episode. In the meantime, several developments have occurred.

Ethereum 2, which ultimately aims to increase Ethereum’s base layer capacities, has met the criterion of 524’288 ETH in the deposit contract needed for the beacon chain genesis on Dec. 1 – with around 600k ETH deposited currently.

Illustration 1: The pace at which ETH is being sent to the deposit contract has picked up. The 525k ETH threshold needed to ensure genesis of the beacon chain on December 1 has been reached.
Source:, Bitcoin Suisse Research.

On top of that, the implementation of second layer solutions is progressing, for example through the collaboration of Optimism and Synthetix (using optimistic rollups to scale). The major challenge for DeFi protocols will be to switch to a second layer either all at once, or not at all – a gradual transition may run into problems, since composability is such a strong value proposition for the DeFi ecosystem and would temporarily be interrupted in this case.

On a protocol level, Polkadot’s parachains also hold a lot of promise. As a heterogeneous sharded system, the design of parachains allows for optimization for certain use cases, such as high transaction throughput or strong privacy guarantees. This means that base layer scalability can be achieved as required through a specific parachain.

For Bitcoin, the Lightning Network remains the scaling solution of choice. Recently, Lightning Pools were introduced, which enable buying and selling of Lightning channels, and thus effectively created a market for liquidity in the Lightning Network. Overall adoption remains limited, though, and the total value locked currently stands at around $20M (or slightly more than 1’000 BTC).

Economic Scalability The total crypto market capitalization currently is around $550 billion. The price of its native currency is an important metric for any public blockchain, since it is directly related to the security budget of a chain. Capital and operational expenses for miners and validators (who secure the network) still need to be paid in fiat currency. Thus, attacking a network becomes more costly the higher the price of the native token both in Proof-of-Work and Proof-of-Stake based system, and the network can hence secure more value.

The total value in the crypto space also represents the maximum amount of available collateral to build out the system. Not all collateral is equal; the native currency is the most trust-minimized and universally accepted collateral within one blockchain, but migration of one coin to another blockchain – in whatever form this takes place – to use as collateral is to be expected when the economic incentives are there. This has indeed happened with the surge of DeFi and tokenized Bitcoin on Ethereum (currently more than $1 billion). While this is the first time a fully on-chain debt-based economy has grown to significant size and found its product-market fit, Bitcoin has been the main driver for the powerful, widespread off-chain (and mostly centralized) ecosystem consisting of spot and derivatives markets, lending and borrowing (e.g. miners collateralizing their BTC to fund operations instead of selling), and its continuously higher acceptance as means of payment.

Scaling up the size of the decentralized economy can happen in two ways – either simply through higher prices for cryptocurrencies, or through onboarding more collateral into the system. This might happen in the future, for example, through the tokenization of traditional assets such as stocks, derivatives or real estate. The quality of this collateral would be worse than the native currency, since its value will likely rely on centralized counterparties (such as a company), but could still help to scale up the ecosystem.

Social Scalability In the end, it is reasonable to assume that what provides most value to users of all kinds will get adopted most quickly. As such, the overall user experience as well as user interfaces matter a lot – a simple, one-click savings account in DAI would likely attract more users than the same savings account which needs to be set up by going through all the steps (of various approvals and transactions) individually. Simple onboarding mechanisms and accessibility are crucial to attaining social scale.

Similarly, a decentralized economy needs developers that create new decentralized applications and add to the value of a blockchain. This requires open-source libraries and code to build, easy to use software development kits and interfaces, and previous knowledge should be easily transferable.

A growing userbase will also bring up more discussions about the values and “unbreakable principles” of any blockchain. There is usually some loose social consensus about what those principles are – for Bitcoin, for example, one could name the limited supply of 21 million coins, its censorship resistance, or that the trustless verification of the entire chain should be easily possible (hence putting some constraints on acceptable node requirements). Despite being a global, decentralized system, this unwritten social contract between all community members is what unites and defines Bitcoin (and other cryptocurrencies). Over time and as the number of holders grows, this social contract becomes widely accepted, its clearer definition lowers the barrier to entry and the underlying protocol might ossify and adopt changes to it more slowly.

Conclusion This framework of thinking about scalability could help to more easily identify strengths of certain protocols – while Ethereum’s smart contract capabilities might allow it to more easily onboard new collateral and scale economically, the social contract of Bitcoin is unrivaled in its simplicity and trust that it has built up over the past decade. Ultimately, improving all three aspects of scalability (technical, economic, and social) in some way will be needed for wide-spread adoption.

Bitcoin Suisse