The structural impact of the cost of transaction

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This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

The longer-term impact of the cost of transaction (CoT) is misunderstood and underestimated. It’s not just about something being cheaper or more expensive from an individual user’s viewpoint.

The CoT is more fundamental in that it is structural. It determines what kind of transactions may happen and what kind may not. It also determines what kind of structures may be formed and be sustainable once formed. In this article, the term “structures” is used in a broad economic sense to include not only business structures such as business relations and organizations but also technology structures such as IT structures. This is true not only in a positive sense, in that low CoT creates space for more innovative and more efficient transactions, and structures, but also in a negative sense, in that high CoT forces participants to restrict innovative transactions and to build structures that compromise on other matters such as security.

The positive impact of low CoT

Nobel-winning economist Ronald Coase’s seminal work “the Nature of the Firm” published in 1937 provides insights into this basic question about the positive impact of low CoT. Economic activities and industrial experiences have since accumulated strong confirmation of Coase’s profound theory.

One must realize that the CoT is an elemental force that operates in economics, driving and forming structures, rather than an emergent property or superficial phenomenon. This force is so elemental that it operates way beyond individuals’ consciousness. It is said that the most important function of the market is to discover truth in pricing. But what actually drives the pricing is also the CoT.

But CoT does far more than determining prices. It determines what kind of transactions and structures may happen and what kind may not. Structures such as business models, even human collaboration models such as employment, are a function of CoT.

The CoT and the changes of CoT determine almost everything in economics in long-term.

The CoT is not just a matter of the computational cost of executing a pre-formulated transaction. In the economics of the real world, the largest contributors to CoT are (1) the formation of transactions (ideation and negotiation for an agreement for example); and (2) administration of transactions (communication, execution and safeguarding for example).

Both the above two contributors to CoT are also related to standardization and long-term stability of the system’s base protocol. These matters are often neglected, or don’t even come to people’s awareness. Business people may intuitively understand some economic aspect of this but without insights to technological underpinnings, while tech people tend to only look at the computational cost of transactions, but missing the broader and deeper economic aspects of the CoT.

The CoT not only has to do with direct costs, but also to do with indirect costs due to lack of security or lack of trust.

All this has a great deal to do with blockchain and the next generation Internet. The whole future relies on it. It is not only about reducing the cost of the existing kinds of transactions, but also reducing the fundamental CoT so much that new kinds of transactions start to emerge in the context of new structures.

Micro transactions (including micro payments), value streaming (including payment streaming), and micro businesses are examples of such transactions. These transactions were previously impossible, and may even be inconceivable, due to the systemic limitations.

The even bigger impact, however, will be at the next generation internet where IPv6 and blockchain are integrated at a base layer rather than application layers only. The integration will be much more deeply structural and fundamental. It will be a shut off and shut out event for not only blockchains that have high CoT but also those that have quite low but not low enough CoT. This is because to integrate with IPv6 at the base layer of the new internet, the blockchain’s CoT needs to be below $0.00001 (1/1000 of a cent). Mere subcent is not going to be enough. See for example, Extreme stress tests of Bitcoin scalability.

Further, because it is at a base layer, the standardization requirement and the integrity of the internet means that only one blockchain will be adopted. This will result in the most important structural differentiation made according to CoT. It is not merely a matter of lower cost as a better choice for individual users, but an absolute division and elimination at the get-go.

See for example, One blockchain as the base layer of IoV. And stay tuned for further reports on this important topic of the integration of IPv6 and blockchain.

The negative impact of high CoT

As discussed above, many transactions will not occur if the CoT is high. In fact, many kinds of transactions will not occur at all if the CoT is high.

But the negative impact of high CoT is far beyond transactions themselves. The impact can be far more structural, because it forces or allures people to building compromising structures in order to mitigate or cover up of the much bigger problem that is high CoT.

To explain this, let’s look at layer 2 solutions and digital currency exchanges separately, both being such problems caused by high CoT of the blockchains.

1. Layer 2 solutions

In the field of blockchain and digital currency, all the layer 2 (L2) solutions that compromise on other important matters such as security are a direct result of high CoT of the underlying layer 1 (L1) blockchains. L2 solutions such as rollups, state channels, and sidechains may also be driven by overall scaling considerations, but they are necessitated by a need to reduce the CoT of the system.

L2 solutions are not categorically invalid. It all depends on what is actually being done for what purpose and with what kind of a blockchain. See for example, useful L2 solutions.

Sometimes, even a method or technique that is called by a common name may mean substantially different things with a blockchain system that has low CoT and a system that has high CoT.

Take rollups for example.

Rollups perform transaction execution at L2, and post data to L1 where consensus is reached. As transaction data is included in L1 blocks, people have been told to believe that rollups are secured by native L1 blockchain security, notably that of Ethereum.

However, whether that is true depends on what kind of rollup is being performed.

A rollup can be performed on a blockchain that already has very low CoT, to just increase the price competitiveness without compromising security in any real sense. For example, with Bitcoin Satoshi Vision (BSV) that has extremely low CoT, businesses may still be interested in doing rollups to save cost. This is because low CoT means large transaction volumes, and from a base CoT that is already low for everyone, even a 5% additional savings may mean a competitive edge.

Specifically, on BSV, a user may consolidate many transactions, perform its own pre-chain processing and validation, and submit the collections in batches to miners. This way, the user might be able to negotiate a lower mining fee with the miners, both due to the volume and the user’s performing pre-chain processing. Doing this compromises nothing in security, as everything is done according to the Bitcoin consensus, and every individual transaction within the rollup is ultimately verified by the miners.

However, this kind of a pure rollup is not helpful for a blockchain that has high CoT. The cost reduction using the above method is limited, because it is hard to imagine miners being willing to offer a discount deeper than 50% when they are required to do almost the same amount of work anyway. But as said, with BSV which already has extremely low CoT across-the-board, there is no need to resort to the kind of rollups that need to reduce the price by many folds in order to save a systemic problem of high CoT (see below). The user of a rollup only needs to benefit from some discount to gain business competitiveness on a relative and individual basis, rather than solving a problem for the overall system itself on an absolute basis. In this sense, even a 5% discount from the already low CoT may give a business a competitive edge, and it is not hard to imagine a discount of 20% or even higher, but probably not beyond 50%.

But with a blockchain like BTC or Ethereum that has such high CoT, a 5% discount means nothing. Even a 50% discount means nothing to the system as a whole. This is because what these blockchains have is a systemic problem for the entire ecosystem, specifically CoT that is tens of thousands of times too high. It is an absolute problem for everyone in the system, not a relative one for certain users who wish to pursue a competitive edge.

Therefore, when CoT runs as high as $50 per transaction, the L2 solutions on Ethereum aim to reduce the CoT by thousands of times in order to save the system. (Note: even after being reduced by 1000 times, the CoT on Ethereum would still be above one cent, many times higher than that of BSV, which is currently at about 1/100 of a cent, expected to drop further in the future as the transaction volume picks up.)

But how can you reduce the CoT by that many times using a rollup? Certainly not merely by a volume-based negotiation with miners. The miners of Ethereum charge high fees not because they are simply greedy, but because they have their own economics to cope with.

As a result, rollups on Ethereum collect and process batch transactions off-chain and only submit the final settlement to the L1.

There are several critical problems with this arrangement:

(1) These off-chain batch transactions are not blockchain transactions at all in the first place, for otherwise it would defeat the purpose of saving costs by many folds (if the transactions could be processed using a real blockchain in a rollup, it would have been done on L1 in the first place; alternatively if all individual transactions were ultimately processed and verified on the L1 blockchain, it would straightly defeat the purpose of solving the high CoT problem).

(2) Only the final settlement is submitted to the L1 blockchain. That is, what the L1 blockchain can validate is just one final transaction which the rollup treats as the settlement of the multiple transactions that have happened in the rollup. Even if the history of the entire rollup transactions is submitted to the L1 blockchain (which may not even be the case), the L1 blockchain only sees a transaction history, and cannot perform any meaningful verification. Everything depends on what has been done in the rollup. It is garbage in and garbage out, only with a façade of decentralized blockchain security.

(3) Because rollups on a blockchain with higher CoT needs to solve the systemic problem rather than mere competition of individual users and businesses, they must be highly concentrated large operations. This is in stark contrast with that in BSV in which a rollup can be carried out by a separate user for its own or its customers use, and there can be an unlimited number of small rollups.

The concentrated large operations of rollups on the high-CoT blockchain such as Ethereum is a different form of centralization. They are not done using any reliable blockchain protocol nor using any blockchain-based secure system. They gain efficiency by centralization or recentralization, and become easy targets of attacks such as hacking.

Overall, with hundreds of millions of dollars being stolen in each incident and multiple incidents occur every year, it is a marvel that the speculators still have confidence in these systems whose security is so shockingly and embarrassingly terrible, which is contributed in no small part by the L2 solutions, which in turn are a result of high CoT.

In the Ethereum ecosystem, it is all because Ethereum itself has ridiculously high CoT, making all these ridiculously fake and insecure solutions a necessity. And real negative impact of a high CoT tends to manifest itself in the longer term, meaning that the situation can only get progressively worse in the future, not better.

2. Speculative asset trading on insecure exchanges

The entire digital currency world has become an irrational Ponzi-laden frenzy. Although there are many factors that contributed to it, one important contributing factor is often overlooked: High CoT.

How did high CoT cause speculative asset trading on insecure exchanges?

It all started with BTC when it decided to limit the block size to 1M bytes in order to promote its “digital gold” and “every PC is a full node” narratives. The decision directly resulted in high CoT. Satoshi’s original vision of a Peer-to-Peer electronic cash system was utterly destroyed, moving the digital currency world toward speculative trading of useless assets. When CoT is high, the real utility (if there is any in these new systems in the first place) is ignored or destroyed, and speculative trading becomes the only thing that attracts people into the digital currency world.

Then came the digital currency exchanges. Because it is purely speculative trading, they needed digital currency exchanges, in large scales. Leaving the legality of such exchanges aside, the digital currency exchanges that perform off-chain transactions are all completely centralized, not only the regular ones such as Binance and Coinbase, but also the so-called decentralized exchanges (DEX, these being actually centralized is a different topic to cover).

The high CoT of the participating blockchains is the direct cause of such centralization.

With a blockchain that has extremely low CoT and high scalability, there is no need for developing thousands of other blockchains, nor tens of thousands of coins or tokens without actual utility in the first place.

But more importantly, all transactions of every token created on such a blockchain can be processed and verified on-chain, enabling a truly decentralized exchange if needed, and making centralized exchanges unnecessary.

Tokens representing assets of real utility can be, and will be, created on such a blockchain, but they can all be carried on the same blockchain, and traded within the same ecosystem. For example, with STAS tokens on BSV, all kinds of custom tokens can be created, but they can be transferred and traded just like bitcoin (BSV) itself, like Peer-to-Peer electronic cash. Even with L2 tokens such as Tokenized, every single transaction can be recorded and verified on-chain, and only the business logic of the tokens needs to be administrated off-chain.

But a world with the tens of thousands speculative coins and tokens needed centralized exchanges. Because most these speculative coins and bargains are based on blockchains that have high CoT, the exchanges have no choice but to use high-level centralization to make the transactions less costly. This is akin to L2 solutions that have to use centralization to lower the CoT of the underlying blockchain (see above, “L2 solutions“). When you start from a wrong premise, you end up with a wrong conclusion, even if the rest of your logic is flawless. It is dictated by hard reality, be it economics or physics.

More specifically, with these underlying blockchains having such high CoT, these exchanges cannot possibly run all transactions on-chain, because if they did the high cost would have driven the customers away.

Ever wondered why trading BTC or ETH on a digital currency exchange would cost as little as a few cents, when the CoT of these blockchains are above $1 and can be as high as $50?

For example, if the total transaction value is $10, your cost would be about 2 cents based on a transaction fee of 0.2% on Binance, or 10 cents based on a transaction fee of 1% on Coinbase. But all this is masked by the fact that most people probably make transactions of at least $100, perhaps even $1000 or above. At $1000, the transaction fee would be $2 on Binance or $10 on Coinbase, and people probably think that is a result of the CoT of the blockchains.

But those are not the CoT of the blockchains. They are just fees charged by the exchange itself.

So how did exchanges magically make the CoT of blockchains disappear?

They have a clever solution, but they’re not going to truthfully explain to the public what they do.

They create virtual accounts for their customers but hold the bitcoin of customers in a collective (pooled) system account. Other than entering and exiting, customers who do trading on an exchange do not transact on-chain at all. Instead, they just allow the exchange to reallocate numbers from one virtual customer account to another while continue to keep the bitcoins in the collective system account. Only when the customer transfers bitcoin out of the exchange to an external address will the transaction be settled on-chain.

The result is a completely centralized system that creates and manages virtual accounts (which are completely off-chain) for users. These virtual accounts do not provide even a common legal/contractual ownership of the assets contained therein for the users (see below), let alone secure ownership safeguarded by a blockchain.

Due to the way these user virtual accounts are setup, users are creditors who have lent the assets to the exchange, rather than absolute owners of the assets.

That was the reason why in a recent disclosure made by Coinbase it stated that if Coinbase is in bankruptcy, digital currency holders may not retain their digital assets, because they will be treated as creditors rather than absolute owners of the assets in a liquidation and will have to fight for their priority order without any certainty attached.

Coinbase was not wanting to be mean. They were just telling the unfortunate truth. Given their priority when they designed their exchange, the choice they made was inevitable, and also intentional. This was at least partially because the coins and tokens they wanted people to trade were products of high-CoT blockchains. And they intentionally and persistently reject the blockchain that has extremely low CoT, namely BSV.

However, it should be noted that, even if an exchange has included BSV, it won’t change the overall picture. This is because, even though BSV itself can allow every transaction to be settled on-chain with negligible cost and no impact on its capacity, the exchange is not going to make such an exception for BSV. Making such an exception would cause an inconsistency of the exchange’s system and may also expose the secret of what the exchange does. Besides, doing the right thing for the customers in this case is simply not a digital currency exchange’s priority.

The priority of a digital currency exchange is to profit from speculative trading, rather than fairly representing useful assets. This in itself may not seem to be so egregiously wrong, but one should remember that if a stock exchange did what Coinbase did it would be in big trouble because stock exchanges are highly regulated. Digital currency exchanges are essentially doing a business that should be highly regulated but has not been. So they get away, at least for now. The fact that Coinbase itself is listed on NASDAQ does not mean that its digital currency trading business itself is under the oversight by the SEC the way a stock exchange is. As a result, people don’t realize that regulators lack the oversight of these digital currency trading platforms, and investor protections for Bitcoin investors are not the same as that are built into traditional financial services.

The situation with other exchanges is either the same or even worse. A key difference is that Coinbase was forced to make such disclosure because it is a publicly traded company listed on a stock exchange in the US. Even though its digital currency trading business itself does not meet any special regulation, the company itself is subject to regulations just like any other publicly listed companies. Other digital currency exchanges, however, all enjoy their outlaw status thanks to even weaker regulatory supervision.

You thought these exchanges have magically and graciously solved your high CoT problem, but you probably didn’t know that they did it all out your expense. You sold your property rights because of your ignorance or perhaps even greed. But on the other hand, what you have may not be genuine “property” in the first place because most of them are speculative junk created by Ponzi schemes. Therefore, your justifiable level of rage against these exchanges may not be that high after all.

But there are additional defects with these exchanges. They may not be legal. For one thing, although they are not mining nodes of an external blockchain, and are not supposed to influence or collude with the miners for their own interests, but the history of the digital currency exchanges shows that they did just that. What they did was a major contributor for the digital currency world’s near unanimous exclusion of the real Bitcoin that has true utility and extremely low CoT, and the public’s erroneous belief that BTC was the real Bitcoin, both of these two factors concomitantly making room, in fact creating an ideal environment, for the disastrous speculative Ponzimistic digital currency world.

As Dr. Craig S. Wright (a.k.a. Satoshi, the inventor of Bitcoin) points out in the article Peer-to-peer electronic cash, there are essential differences between the miners and digital currency exchanges such as Binance and Coinbase (NASDAQ: COIN).

The exchanges are not miners. Not only are exchanges not part of the miner network, but they also don’t even settle transactions on-chain under normal conditions. An exchange creates virtual accounts for their customers but hold the bitcoin of customers in a collective system account.

An exchange is therefore both a money transmitter and a money broker, doubly qualifying as an “MSB” under the Bank Secrecy Act (BSA). Therefore, leaving alone the question of securities law violations, a digital currency exchange’s business operation should comply with BSA. Yet the exchanges have enjoyed the freedom from both securities law and BSA so far.

Conclusion

The messy and treacherous conditions of the digital currency world are all majorly (although not singly) contributable to high cost of transaction (CoT) of the underlying blockchains. It is time to focus on the true Bitcoin (BSV), a straight peer-to-peer electronic cash system that has remained truthful to Satoshi’s design and has extremely low CoT and unbounded scalability without sacrificing security.

With a blockchain that has extremely low CoT, all kinds of innovations, even surprising ones, may happen, while the scalability, decentralization and security continue to be ensured. In contrast, with a blockchain that has ridiculously high CoT, more and more L2 patchwork will need to be done with marginal improvement on CoT and scalability but uncontrollably worsening centralization, recentralization, and security hazard.

The hope is in the true Bitcoin. It will not only solve the existing problems but will also open up entirely new territories which are not even in the mental sight of those who are currently stuck with a low-information model.

This article was lightly edited for clarity purposes.

Watch: The BSV Global Blockchain Convention panel, Small Payments, Big Fun: Micropayments for Casual Games

https://www.youtube.com/watch?v=ggbZ8YedpBE&t=4003s