Bitcoin’s Achilles’ heel

Luna token’s hyperinflation was a thing to behold. On 05/May/2022, each Luna token was valued at ~$85 in markets where it was listed. On 11/May/2022, there were 377,000,000 Luna tokens in circulation. On 14/May/2022, there were 6,530,575,000,000 million tokens in circulation. That’s a 1,700,000% inflation over a 72 hour period. How did that happen?

Read Swan Bitcoin’s fascinating account of the episode, even drawing parallels with Soros’s attack on the Bank of England peg.

The question to ask is – can this happen to Bitcoin? Can Bitcoin’s current supply of 19,046,954 tokens just go up a few billion, and be credited to a specific account? Here’s a hypothetical scenario.

  1. Bitcoin’s software running on a specific computer is altered to do the following:
    1. Bring about trillions of new bitcoins into existence. It’s not that hard to type the number 1,000,000,000,000 on a keyboard. It takes a few keystrokes at the most.
    2. These new bitcoins are allotted to a specific cryptographic public key, whose private key owner can send these bitcoins anywhere.
  2. The owner of private key from step (1.1) transfers the new bitcoins to a few specific exchanges’ public keys. Together we call these exchanges as CEX’s.
  3. The CEX’s agree that these new bitcoin are valid and as good as the old ones (that is, the tokens are fungible). The Bitcoin software running on the CEX’s was thus modified to accepted these new bitcoin.
  4. CEX’s already have user accounts with money in them. Some of these users buy the new bitcoins at some price they think is reasonable. They use the other assets in their accounts to do the purchase. Their expectation is that this price would go up in the future.
  5. Given that steps 1,2,3 can be done many times – the supply of “valid Bitcoin” keeps going up, and consequently its price keeps going down.
  6. The user accounts on CEX’s now show the USD value of the bitcoin they have bought is near zero. As CEX’s agree that these new bitcoins are as good as the old ones, if a user wants to convert their bitcoins to USD, they get the same low price.

It’s highly unlikely. How unlikely exactly? Hard to say.

The critical step in the hyperinflation process is step (3) from the above list. The CEX’s who are a part of the Bitcoin ecosystem have to modify their software to accept the trillions of newly minted bitcoins as valid, and fungible with the millions of existing bitcoins. Why would the CEX’s do that? And more importantly, could the CEX-users prevent them from doing that?

It’s about transaction costs. Transaction costs “force” users to rely on a few facilitators to handle their money for them. It’s just easier to deal with one CEX account’s username/password and slick UI than to deal with software validating many rules of many tokens. Once the CEX’s agree that the new money is good money – their users typically have no choice but to go along.

A few token holders could claim that that these new tokens are not valid, and stick to their existing tokens. But this small group of users is not large enough to form an economy where their tokens can retain the value of $30,000 per token. If this group of users is large enough, the old token could retain its value. This has happened in the physical world as well – with the Iraqi Swiss Dinar. After the 1990 Gulf War, the Iraqi government issued Saddam Dinars, and made the older Iraqi Dinar (printed in Switzerland) illegal. But a substantial number of Iraqi people decided by themselves that they would only deal with the Swiss Dinar, and kept the economy going. The local merchants, banks, and other middlemen who facilitate transactions all went along with this scheme, and the Swiss-Dinar economy survived. Governments can, and often do, change the rules of the money-game, and force people to go along with it – with the threat of violence. But in the realm of non-state money, such violence doesn’t exist, and it’s down to transaction costs, and relative sizes of these voluntary economies.

In Bitcoin, step (3) would be considered a hard-fork. A hard-fork is when nodes running Bitcoin software have to change the software to accept something that was invalid earlier (new tokens) as valid now (merged with old tokens). Bitcoin doesn’t do hard-forks. What that means is that the culture of Bitcoin is such that merchants, users, and facilitators of all sorts do not change their software to accept what was invalid before as valid now. How many such merchants, users, and facilitators exist? Are they enough to sustain a local economy that matters – this is the hard question to answer. This is where Bitcoin’s fixed supply relies on something vague – the sustainability of an economy of people who believe in the fixed-supply meme. Bitcoin maximalism – is one of the cornerstones of this meme. The constant drum-beat of memes like:

  • Not your keys, not your coins
  • No hard forks, ever
  • Bitcoin should ossify, now
  • Everyone should run their own full node and validate their own coins
  • Running a full-node should be trivial
  • Centralized exchanges are evil

and others reinforce these ideas in the ecosystem that Bitcoin will stay as it is for the next 1000 years. But obviously, memes are not set in stone. Social, cultural, and political movements can upend these memes and Bitcoin might lose its status as can’t-fuck-with money. On the other hand, it’s also likely that human society craves for a neutral, fixed-supply money to run its economy, and will gravitate towards Bitcoin as that.

Either way – Bitcoin’s fixed-supply is decided by people, not physics. That’s its Achilles’ heel.