This thread has been a long time coming. For those who are not aware, for the past 5 months I have been writing an education section for the new Peercoin website. This originally began as two pages that covered the security and economics of Peercoin, however as I got deeper into it I realized that we needed something more in-depth.
Peercoin has always lacked a proper guide to introduce beginners to the technology and what makes it so special. The original whitepaper from Sunny King for example is not very newbie friendly. It's very technical and leaves out most of the important arguments and insights about the technology.
This document I've written here is designed to be more friendly to beginners and fills in many of the gaps that are not covered by the original whitepaper. My hope is that it can act as the ultimate beginner guide for understanding Peercoin.
Much time was spent in trying to figure out how to order the information. I wanted to create something that was self-contained in which the reader did not need much prior knowledge in order to understand. For example I could not just begin by explaining proof-of-stake. I wanted the reader to understand everything, so I started at the very beginning.
First I explained why we are moving away from centralized entities. Then I explained distributed public ledgers, what the blockchain is and how it benefits society. Then I moved on to consensus protocols and first explained how Bitcoin's security model works. Then I explained the many faults of proof-of-work. Finally I wrote about Peercoin and the benefits of proof-of-stake as well as its economic model and philosophy on scalability.
So it's a pretty complete piece I believe. One thing I did not write about though is nothing at stake. If we want to include something about that then I will need more help. Many months were spent researching to write this and I felt I had already spent too much time on it. Delaying it yet again to further expand it did not feel like the right thing to do when we still need our website redesign to be finished. Now that this text is finished I will spend more time on the redesign so we can make more progress on it.
What I need from the community is for all of you to review this text. It's very long and it's possible I may have misunderstood something or made a mistake somewhere. I need help verifying whether all the information sounds correct. During this review process, please point out any errors you can find in this thread. If there is something missing that you think should have been included, please let us know below. Also if you think something I wrote could have been phrased better and you think you can help improve the text, don't hesitate to let us know.
What we need right now are lots of eyes on it and people that can provide constructive feedback. My current plan is to place this text on the new website in its own section and it will be there for people who want to learn more. It is not the only learning material though as I understand I can't expect people to read 47 pages in order to understand Peercoin. We will have much lighter reading for example on the home page along with graphic visualizations, however this text will also be available for those who wish to delve deeper.
I'd like to thank @peerchemist for putting up with and answering many of my constant questions during my research period. I know he anticipates the new website as well and was eager for me to finish this project up. Now I can move on to the next step in the process. I also want to thank everyone who reads this in the near future and provides feedback.
Table of Contents
2. What is a Blockchain?
- Centralized Private Ledgers
- Distributed Public Ledgers
- The Blockchain
- Distributed Consensus Protocol
3. Benefits & Use Cases
- Blockchain as Money: Cryptocurrency
4. When Decentralization Fails
- Controlled by the Few
- Consensus on a Single Shared Truth
- Incentivizing Security by Validators
5. Bitcoin & Proof-of-Work Consensus
- Mining Blocks by Solving Problems
- Hashing Algorithms
- Searching for a Valid Hash
- Block Rewards
- The Cost of Lying
- Blockchain History Protection
6. Centralization of Bitcoin
- Mining is a Profit Driven Competition
- Mining Pools
- Difficulty Adjustments
- Domination by Large Mining Pools
- Majority Attacks
- Unsustainable Energy Consumption
- Geographical Centralization of Miners
- Diverging Interests of Miners & Users
7. Bitcoin's Lack of Sustainability
- Voluntary User Transaction Fees
- Block Reward Halving
- The Tragedy of the Commons
- Short-Term Behavior Sabotages Long-Term Security
- Security is Dependent on Price
8. Bitcoin's Lack of Scalability
- The Block Size Limit
- Block Size Limit Increases & Centralization of Full Nodes
- 2017 Bitcoin Chain Split
- Transaction Fee Market
- Block Size Limit Solves Block Reward Halvings
- Block Size Limit Impacts Network Usability
- Bitcoin as a Settlement Network
- Secondary Layers & Off-Chain Transactions
- The Lightning Network & Payment Channels
- Blockchain as a Base Layer
- Putting it all Together
- Fee Competition Between Miners & Secondary Layers
- Conclusion on Bitcoin & Proof-of-Work
9. Peercoin & Proof-of-Stake Consensus
- Time as an Alternative Scarce Resource
- Time Based Rules & Restrictions
- Majority Attacks are Cost Prohibitive
- Attackers are Financially Tied to the Network
10. First Efficient & Sustainable Blockchain
- Qualities of Proof-of-Stake Consensus
- Higher Resistance to Censorship
- Reduced Incentive for Minters to Centralize
- Minting Pools
- Cold Minting
11. Economics of Peercoin
- An Unlimited, but Ultimately Scarce Supply
- The 1% Standard
- Pure Proof-of-Stake Distribution Problems
- Hybrid Blockchain: PoS Security & PoW Distribution
- Dynamic Proof-of-Work Block Reward
- Inheriting the Mining Industry
- Deflation Through Transaction Fee Burning
- Benefits of a Fixed Transaction Fee
- A True Digital Replacement for Gold
12. Scalability of Peercoin
- The Backbone of Crypto
- The Original Base Layer Settlement Network
- Compatibility of Minters & Second Layers
- Dynamic Block Sizes
13. A Stronger Foundation to Build Upon
Peercoin was launched in 2012, making it one of the first blockchains to be released. It introduced a number of new innovations which substantially improved on the design of other blockchain protocols that existed at the time, principally Bitcoin's proof-of-work. Peercoin's alternative to proof-of-work, proof-of-stake, remains unrivaled to this day as a blockchain consensus protocol and one which is achieving more mainstream adoption with each passing year.
For the newcomer, understanding why Peercoin's blockchain technology is superior first requires some understanding about blockchains in general, as well as understanding Peercoin's primary competitor, Bitcoin; therefore we will start by learning what blockchains are, and what they offer. Once we understand this, we'll cover the main problems behind the world's first blockchain, Bitcoin, and how Peercoin has fixed these flaws.
You will discover that Sunny King, Peercoin's original creator, had incredible foresight into the future of proof-of-work networks, and how Peercoin has been designed as a drop-in replacement in preparation for their inevitable decline.
2. What is a Blockchain?
Ever since the initial launch of Bitcoin in 2009, blockchain technology has proliferated throughout the world in many different forms. This new and exciting technology has the potential to impact society in innumerable ways. In this section we will explain what a blockchain really is, how it functions and its core purpose.
Centralized Private Ledgers
At its core, the Peercoin blockchain is a distributed public ledger. A ledger is a document such as a spreadsheet in which accounts are kept of economic transactions, including credits, debits, and balances. They are generally used to keep track of an individual or organization's financial standing or other recordable data such as assets, liabilities, income, expenses and capital.
Before the invention of the blockchain, in order for individuals to manage their financial accounts it was necessary for them to place their full trust in a centrally managed third party organization or business which maintained its own private ledger. Examples of services like this include banks, credit card issuers, money transfer services or other financial institutions based on customer or user trust.
A high degree of trust is placed by customers in these centralized services and the people running them, all of whom are human and fallible. The ledger of customer data for each individual organization is kept private and not shared with the public for independent verification. In this outdated model, the customer is forced into a situation where they need to fully trust that the organizations handling their financial accounts are being truthful.
This lack of transparency is a central point of failure because it forces the customer to trust that the organization is acting in their interest and not against them. This requirement to trust without the ability to verify can invite errors, unaccountability and even outright fraud and corruption within an organization, which can eventually impact the customer in a negative way.
Distributed Public Ledgers
Blockchain technology however completely removes the requirement of the user to place full trust in a centralized organization to accurately manage its own private ledger. The blockchain instead introduces the concept of a shared or distributed public ledger where a copy of the ledger is held by a large group of people all around the world who work together to validate transactions that are initiated by users of the blockchain network. The individuals who carry out this important work are called validators.
Each validator hosts a full copy of the public ledger and operates a node, which is a program that validates incoming transactions and relays them to other nodes. Together, these validators form a global network of nodes that secure the blockchain by preventing fraud from double spending attempts, which is a problem unique to digital currencies that allow a potential attacker to spend the same coins multiple times. Transactions initiated by users of the blockchain are broadcast out to this network of nodes and these transactions are either validated and accepted or detected as a double spending attempt by a malicious user and rejected as invalid.
Rather than trust being concentrated in a central entity to manage its own private ledger without transparency or oversight, the blockchain instead distributes trust both publicly and globally to a wide number of these validators who work to prevent errors, alterations and acts of fraud against the ledger. This open and transparent sharing of the public ledger allows each of these security providers holding a copy of the ledger to independently verify its legitimacy. In this way the public ledger acts as a digitally shared truth about the state of the network.
A blockchain can be accurately described as a continuously growing list of individual transaction records called blocks. When combined together these individual blocks of data form the entirety of the public ledger, which consists of all the transactions that have ever taken place on the network.
As transactions are initiated by users of the network they are broadcast out to the network of validation nodes. One by one these transactions are validated, grouped together and recorded into a block which is then attached to the end of the blockchain as the next link in the chain. Therefore every block is linked, forming one long cryptographically secured chain of blocks.
In Bitcoin and Peercoin, about every ten minutes a new block is added onto the chain which contains all the transactions initiated by users of the network over the past ten minutes. Account balances on the public ledger are consistently and automatically updated with each new added block to reflect changes from these transactions.
Distributed Consensus Protocol
Unlike a centrally managed entity that depends on user trust of authority figures who are capable of errors or intentional acts of fraud, the blockchain is designed with no such central point of failure. Instead user trust is placed in a blockchain's distributed consensus protocol, which is an automated process responsible for achieving majority agreement among the network's many validators on whether the public ledger can be considered valid or not. If the majority of validators working to secure the network can verify and agree that the public ledger is accurate and has not been tampered with, then it can be trusted as legitimate and held as absolute truth by all participants of the network.
A private ledger usually comes in the form of an account book or computer file, however a blockchain which hosts the public ledger runs on a coded set of rules called a distributed consensus protocol. This protocol and its underlying rules are entirely responsible for how a blockchain functions as well as its process for validating transactions and blocks. The protocol is also what gives the blockchain its many beneficial qualities, many of which are described below.
Automated: Since a blockchain protocol runs on code, security providers do not have to partake in a time consuming process of manually validating transactions and blocks. This means the consensus and verification process of the public ledger is able to be completely automated so that no manual labor is necessary on the part of security validators. From the standpoint of the end user, a submitted transaction is automatically processed by the network. From the standpoint of the security validator, transactions submitted by users of the network are automatically verified and accepted or rejected by the node software they are running.
Trustless: This is a significant development as for the first time in history this results in an automated network that is transparent, verifiable and can be trusted by all parties as it is impartial by its very nature. This unbiased or neutral quality of the blockchain is made possible only by the public nature of the ledger and the ability of a large and globally decentralized group of security validators to verify its accuracy.
This prevents the falsification of transactions and leads to a state of trustlessness in which all participants of the network can be assured that their data is guaranteed to be accurate. This state of trustlessness is the core value proposition of the blockchain. In this state the users of the network no longer need to trust anyone because security is automatically handled for them by the blockchain's consensus protocol. Users only have need to trust that this protocol continues functioning as it was designed to.
Censorship Resistant: Censorship resistance is another vital quality of the blockchain. Banks and payment processors for example are centralized entities that have power over their users and are free to censor transactions or freeze funds at will. They can take actions against their users for any reason, but especially if being coerced by governments. The blockchain introduces a level playing field where no one has power over anyone else and censorship of transactions and freezing of funds is not possible.
Immutable & Tamper Proof: The blockchain is also immutable, meaning that recorded data is permanent and cannot be altered. This data is therefore locked into the blockchain forever. This immutability makes the blockchain tamper proof, which means attackers, governments or other external threats cannot alter the blockchain or falsify transaction data.
3. Benefits & Use Cases
Ultimately, all of these qualities combine as one to create a self auditing and trustless public record which can be used as a tool by people and organizations all over the world to conduct their day to day business. Use cases for the blockchain are plentiful and new ones are popping up every single day. At a basic level it features trustless mechanisms for money and data transfer, traceability and the chronological ordering of data. Digital identities can be created to represent data on the chain and provide proof of exactly when a piece of data was created, its history as well as the ability to prove ownership of data through the use of the blockchain's native public and private key technology.
Data Verification: Immutability of the blockchain allows for the creation of a robust audit trail of data hosted on the chain, which can be helpful for situations involving data verification. Searchability is improved as the blockchain can act as a common database for relevant records or even carry pointers to externally hosted data.
Many industries still rely on physical documents to verify data, which is a manual process that is very time consuming and prone to loss of information and errors. Leveraging blockchain technology to speed the digital evolution of various industries that are still heavily reliant on outdated manual verification practices can improve the efficiency and integrity of virtually any process involving data validation.
Smart Contracts: Other use cases include smart contracts, which are self-executing applications with the terms and conditions of an agreement written directly into code. The rules and penalties coded into a smart contract do not require the services of a middleman as all obligations are automatically self-enforcing. Smart contracts are great for setting up automated agreements for exchanging different forms of value without conflict or interference from third parties.
Tokens: Further still are token protocols, which make it possible to create assets or tokens that are hosted on top of the blockchain. Tokens can be made to represent anything, anywhere from equity in a company to property or even coupons at a grocery store. Tokens are great for seeking investors for business ventures through crowdfunding or initial coin offerings.
Distributed Autonomous Corporations: Token protocols also make it possible for distributed autonomous corporations to be created, which are organizations or profit driven companies that exist solely on the blockchain. A distributed autonomous corporation can organize itself in a number of different ways, including allowing token holders governance and decision making power over the business through voting rights and the ability to receive a portion of the company's profits through dividend distributions.
Blockchain as Money: Cryptocurrency
It also goes without saying that blockchains have the potential to become large competitors to traditional state sponsored paper fiat money in the form of cryptocurrencies. The first blockchain, Bitcoin, for example was originally invented by Satoshi Nakamoto as a replacement for fiat money, a peer-to-peer electronic cash system. It is believed by many that with enough time, development and adoption cryptocurrency can eventually rise up to challenge existing financial institutions like central banks, which are responsible for managing monetary policy in various countries.
Where a central bank manages the supply of money in a centralized fashion with decisions being made by a core group of bankers, blockchains instead have strict coded rules about how new supply is introduced into the economy, how much and over how long a period of time. This makes distribution of new supply in cryptocurrencies more controlled and predictable and not subject to the changing opinions of central bankers.
Each blockchain can have its own separate rules regarding inflation of the supply and those rules can only be changed if a majority of network validators around the world agree to the upgrade, which prevents sudden changes from happening and helps maintain trust and stability in the system. In addition to controlled and predictable inflation, the blockchain also has a number of other benefits when being used as money:
Irreversible: Transactions are irreversible, which prevents chargeback fraud like seen with credit cards. Transactions also cannot be denied by the network itself.
Transparency: All transactions are transparent and easily viewable on the blockchain using tools like block explorers. This allows easy verification of data.
Pseudonymity: As long as a user's personal identity is not linked to the address they use to transact with, their transactions will remain entirely pseudonymous.
International Payments: Cross-border trade is easier because payments are quick and not delayed like traditional methods.
Identity Protection: Merchants with lax security measures are at risk of losing your stored credit card information to hackers, but with the public and private key technology of blockchains you are protected as vital payment information is no longer stored by merchants.
Convenience: There is no need to carry around a bulky wallet. With cryptocurrency your money can easily be transacted with by downloading various wallet apps on your phone.
Ease of Access: For those in developing countries who may not have access to traditional banking and exchange systems, cryptocurrencies provide greater access to the rest of the world economy because all that is needed to get started is a phone and an internet connection.
No Counterparty Risk: There are no third parties that you need to trust or rely on in order to transact with your money. Due to the peer-to-peer nature of blockchains, you can cut through any middlemen and send your payments directly where they need to go.
Independent Control: The automatic nature of transactions from one user to another offers independence from banks and an increased level of control over funds, however this also comes at a cost as greater thought must be put into securing access to those funds.
4. When Decentralization Fails
It is clear when considering just some of the benefits and use cases mentioned above that blockchain technology has the potential to transform finance as we know it, however it's very important to realize that not all blockchains are created equal. When choosing a blockchain you or your organization should operate on, the most important overriding factor above all else to consider is whether the chain is truly secure or not.
It doesn't matter how many useful features are available for you to take advantage of. If the underlying blockchain is not secure then it's just like building on top of quicksand. At some point its security may be compromised, which could result in the total loss of all funds. It's also not just a question about if a blockchain is secure right now, but whether it will continue to be secure in the long-term future.
Controlled by the Few
A blockchain can only be considered trustless if the security validators each holding a copy of the public ledger are numerous and widely distributed around the world. Blockchain security stems from the fact that there are many validators and power is decentralized among them. This prevents collusion among validators as a great majority are likely to continue working in the interest of the network and its users. The few who attempt to collude and defraud will have no impact because they will be highly outnumbered by the many who play by the rules.
As an example, if a blockchain's security protocol contained a design flaw that caused the number of validators to shrink over time to the point where there were only a handful of them left then that would end up being a highly centralized blockchain, which would completely defeat the purpose behind the technology as it could no longer be considered trustless. The fewer validators there are securing a blockchain, the more centralized it becomes and the more trust creeps back into the system making it just like the centralized organizations that we left behind.
As validators dwindle in number, the few that remain end up having a larger degree of influence and control over the network, which means there is a much higher chance they could collude and perform a double spending attack against the network. If a single entity somehow managed to gain majority control over the blockchain, then users of that blockchain would be at the mercy of that entity and would need to trust and hope that it would continue working in their interest instead of sabotaging the network for personal gain. The ideal situation is if it never comes to this point and validators continue to remain thoroughly decentralized so users of the network never have to trust any individual or centralized entity.
Consensus on a Single Shared Truth
The degree to which network validators preserve their level of decentralization over time in a blockchain is highly dependent on how its distributed consensus protocol is designed. There are many types of distributed consensus protocols, but the two most well known are called proof-of-work and proof-of-stake.
These two consensus protocols operate in very different ways, but their overall goal is the same which is to bring validators to consensus so they can agree on a single shared version of the truth regarding the state of the blockchain and its ledger while at the same time preventing malicious or hostile actors from exploiting and derailing the system.
It is possible for certain validation nodes across the network to hold slightly different versions of the public ledger for example. This can happen if nodes are unreliable or slow because of issues with network latency or also because they are acting maliciously and run by people intentionally trying to fool the system by attempting to pass off their tampered version of the ledger as the real one.
Regardless of the reason for the disparity, it is the purpose of the consensus protocol to strive to keep all validation nodes synchronized so that a single version of the blockchain can be decided on, used and followed by all the participants of the network.
Incentivizing Validator Security
A consensus protocol achieves all this by incentivizing validators with monetary rewards in order to motivate them to perform validation and transaction processing work for the blockchain and its users. There are different types of validators however and not all of them receive this compensation for their work.
A full node is a validation node that has a full copy of the blockchain downloaded. There are three types of full nodes. The first type is run by individual volunteers who perform verification of transactions and blocks for free without compensation. This type of full node is run more by hobbyists who just want to help support the network.
The second type are full nodes that are run by large entities such as merchants, exchanges and payment processors. These nodes are also voluntarily operated, however the ability to see new transactions as they come in can give these entities certain benefits that can be passed on to their customers.
The third type of validator is only responsible for the task of building and adding new blocks of transactions onto the chain. These nodes are different however and receive automated payments for their service from the network itself. In this way the blockchain literally pays for its own security maintenance and upkeep.
Whether a block producer is required to hold a full copy of the ledger differs from blockchain to blockchain. Block producers in Bitcoin for example are not required to hold a full copy of the ledger while it is a requirement in Peercoin because of the way it was developed.
Validator roles can be thought of in this way. Simple validators who voluntarily run full nodes work to perform validation of transactions and blocks. Block producers however make it possible for the network to settle on a common truth every 10 minutes. Without a consensus protocol to help decide who can create the next block, anyone would be able to produce and submit a new block to the rest of the network.
Validators could try verifying the transactions and blocks that are submitted to them, however each validator may end up checking a different block which would make it impossible to determine which block gets added to the chain. The consensus protocol ensures it is possible for these validation nodes to settle on a common state. Once this state is decided, it is broadcast to the rest of the network so that all validators work to verify the same block of transactions. It is a way of putting all validators in the network on the same page.
The way in which a blockchain's consensus protocol is designed to incentivize validators to produce blocks however is precisely what causes them to either retain or lose their level of decentralization over time. This is exactly what we need to learn in order to develop an understanding of which blockchain protocols are designed for long-term security and which are not.
5. Bitcoin & Proof-of-Work Consensus
In order to create the world's first decentralized blockchain, Bitcoin's original inventor Satoshi Nakamoto had to figure out how to solve a number of different problems. How to get a large distributed group of validators to agree on the true version of the ledger. How to incentivize and motivate those validators to process new transactions and provide overall security for the blockchain network. How to prevent malicious and hostile entities from being able to easily alter transaction records by tampering with the ledger's history of events. How to space out the production of new blocks so the time between each one is consistent and predictable.
The brilliance of Satoshi is in combining multiple fields of study in order to solve all these problems. Some of these fields include incentive engineering, cryptography, game theory and computer science. This specific combination led to a solution for Bitcoin known as proof-of-work consensus, also referred to as Nakamoto consensus.
Mining Blocks by Solving Problems
The specific set of validators that are responsible for producing new blocks in Bitcoin are called miners. The block production process itself is called mining. In order for a miner to be able to add their newly created block as the next link in the chain, they are first required to do the work necessary to solve a difficult math problem. The problem itself involves making lots of random guesses in order to find a solution that matches.
There is more than one possible guess that will work as an answer for each problem. Every time a miner makes a new guess, that guess is first combined with some other relevant data and then it is run through a hashing algorithm, which is a special program that checks and verifies whether the guess is correct or not as an answer to the problem. The first miner that is able to solve the problem is the one who gets the honor of adding their new block onto the chain.
The hashing algorithm is very important to the overall mining process for more than just simple verification of whether the problem has been solved or not. When a hashing algorithm is fed some data as input, the algorithm takes all that data and converts it, producing output data in the form of a small string of numbers and letters. This output data is called a hash. A hashing algorithm only works in one direction, which means the hash that is produced from the input data will always result in the same string of numbers and letters as the output.
For example, you could take an entire book as input data and run it all through this algorithm and it will always produce the same resulting hash no matter how many times you do it. If however you were to change just a single character in the book and run it through the algorithm again, then the resulting string of numbers and letters would be completely different. This makes it possible to verify whether something in the book or the input data has been tampered with, even if it is something as simple as changing a single character.
If the resulting hash features the same string of numbers and letters every time it is run through the algorithm, then you can always be sure that the input data was not tampered with. Every single block in the blockchain contains its own hash, which acts as a guarantee that the contents of each block is true and has not been tampered with.
Searching for a Valid Hash
In order to find an answer to the problem, miners need to combine three pieces of data together, the hash from the previous block, the transactions from the block they are currently working on building and a random guess. They run this combined input data through the algorithm in order to produce a hash. The resulting hash of this data is then checked to see if it works as an answer to the original problem.
If it matches then the hash is considered valid. If not, then it is considered an invalid hash and miners will repeat this process over and over again by changing their guess and hashing all three pieces of data until they are able to find a hash that is valid. When a miner finally finds a valid hash, then they can be sure that the problem has been solved.
Once a miner succeeds in finding a valid hash, they broadcast their new block along with their correct guess to the rest of the validators on the network, who then take this guess and verify whether it is correct by also running it through the algorithm to see if they can produce the same valid hash. This makes it possible for validators across the network to quickly verify and prove that the miner did the necessary work to solve the problem.
If the hash produced from the three pieces of data can be verified by others as valid, then the block will be accepted by participants of the network and added as the next block in the chain. If however validators are unable to produce a valid hash when doing their verification check on the miner's guess, then the new block will be rejected and not added onto the chain because validators were not able to prove that the miner did the work to solve the problem. In the case of rejection, validators will just wait until another miner submits a new block that can be accurately verified.
This whole process may sound complicated, but it is vital in order for proof-of-work based blockchains to function properly. To simplify it into several sentences, a miner basically makes a number of guesses until they find the correct answer to a problem. Once the correct answer is found the miner lets other validators on the network know so they can all verify whether the answer they got is correct. Once verified, the new block is then added onto the chain.
This process is not done manually by miners, but automatically using computer processing power. Modern computers for example are able to try out thousands of combinations of hashes per second, so miners are capable of making many guesses very quickly.
The process of mining blocks is very expensive because of the use of limited resources like electricity to power the computers that do the hashing. To make up for this cost, every time a miner solves a problem and their block is accepted by the network, that miner receives a block reward in the form of new coins. These new coins are created out of thin air by the network with every new block that is produced. This is how new currency is introduced into the supply and distributed over time.
Validators in Bitcoin are called miners because they are always digging for new coins by fulfilling the requirements of producing new blocks. Miners then sell the new coins they earn on the market to cover their costs while keeping the profit for themselves or reinvesting it in better mining equipment, which allows them to increase the hashes per second they perform along with their chances of earning more block rewards.
The Cost of Lying
The purpose of requiring miners to solve a problem before being allowed to add their new block of transactions onto the chain is to make it difficult, expensive and costly to lie. Mining is a money generating business and it can be very costly to mine blocks that contain fraudulent transaction data.
If a miner for example tries to include invalid transactions in the block they submit or they attempt a double spend and it is detected by the network’s validators, that miner risks having their block rejected by the network. A rejected block means the miner will forfeit their block reward and they will end up losing any money they spent on electricity to mine that block. Bad behavior is punished and is therefore money losing behavior. This results in miners having a financial incentive to tell the truth and play by the rules.
This process also explains how blockchains are designed to be immutable and unchangeable. For example, if a miner tried submitting an alternate version of the blockchain history where they altered previous transactions from a specific block in the distant past, validators would be able to detect the change because the hash of the altered block would no longer be considered valid.
It is similar to the previously mentioned book hashing example. A miner that makes a change to a transaction from some block in the past is simultaneously changing the input data that was originally used to produce the hash for that specific block. Changing any transactions in that block will also change the original input data, which will cause the hash that is produced from that data to no longer work as a valid solution to the problem associated with that block. Network validators will detect this invalid hash and reject the altered version of the blockchain. The miner will then lose any money they invested in attempting to alter the blockchain.
Blockchain History Protection
In order to get around this detection mechanism a miner would need to spend the electricity required to prove they did the necessary work to find a valid hash for the altered block. Basically this means they would need to spend the resources necessary to mine the altered block over again, however even if the miner did this there is still a problem.
Recall that every block's hash is produced by including the previous block's hash as one of the three pieces of input data. This causes the hash contained in every block to be connected to the hash of the block that comes directly before it, which means every single block in the chain is cryptographically linked.
Because of this, if you try to alter data in one block the hash for every subsequent block will become invalid. This means that the only way to truly alter a block in the past is to mine that block over again and every single block that comes after it until the end of the chain. You would literally need to spend the resources to prove that you did the work to find a valid hash for every single block after the one you altered. Currently it would cost billions of dollars to mine Bitcoin's blockchain from scratch in order to change something, which is financially infeasible even for the very wealthy.
Proof-of-work consensus therefore acts as a financial deterrent against altering the history of the blockchain by forcing a massive cost on those who try to attempt it. By rewarding miners, it incentivizes them to tell the truth and submit blocks with accurate transaction data while also punishing those who attempt to cheat the system with the risk of losing invested funds.
In addition, the requirement of solving a problem first before being permitted to add a new block onto the chain has the side effect of creating a time delay so that new blocks end up being spaced out by a time span of about ten minutes, which keeps block times consistent and predictable. In this way, proof-of-work consensus solves all the main problems that Satoshi faced when trying to invent a decentralized Bitcoin.
6. Centralization of Bitcoin
Proof-of-work is not perfect however and years of operating in the wild have exposed many of its weaknesses as a distributed consensus protocol. Recall that a blockchain can only be considered trustless if there are many different network validators and power is distributed among them, which works to prevent collusion or outright majority control by a central authority.
Unfortunately, proof-of-work does not fit this model as its design has caused a large and distributed group of miners to naturally centralize over time. This centralizing effect is inherent in the economics governing the protocol and cannot be eliminated by any technical improvement or upgrade of the code.
Mining is a Profit Driven Competition
By its very nature, proof-of-work is a consensus protocol that incentivizes heavy competition among its validators. As a money generating business, miners compete with each other to be the first one to mine a block so they can add it to the chain and receive their block reward of new coins.
In order to stay ahead of the competition, miners will reinvest their profit in order to purchase better mining equipment that is capable of increased hashes per second. This increased hashing power allows a miner to be able to make more guesses per second, which gives them a higher chance of solving a block's problem before other miners. Miners who can afford to purchase this specialized mining equipment will naturally have an edge over others when it comes to earning block rewards.
In the very beginning, Bitcoin miners were plentiful, distributed and they used basic CPUs to mine blocks. As time went on, the CPU became obsolete as miners began using their GPUs to increase their hashing power along with their chances of receiving block rewards. Eventually miners graduated to ASICs, which are customized chips that are designed specifically for mining Bitcoin rather than for general purpose use.
At each phase, miners were either forced to upgrade their equipment in order to keep up with the competition or face becoming obsolete as their block rewards dried up. The mining industry became similar to an arms race. Faster and more efficient mining equipment was being released that needed to be purchased by miners in order for them to remain profitable.
The constant upgrading and lack of profitability led to a situation where smaller miners with obsolete equipment could no longer compete with the hashing power of larger miners who used better equipment. In order to increase the lifespan of their outdated mining equipment, these small miners began pooling their processing power together into mining pools. Instead of block rewards being distributed to individual miners, mining pools split rewards which were partially shared among all participants of the pool in proportion with the overall hashing power they each contributed to mining a block.
Mining pools became necessary once the probability of mining a block took years for small miners working alone by themselves. Pools allowed smaller miners the chance to pool their computing resources together and receive smaller but more consistent rewards so they could continue competing a little while longer. Even with pools though, eventually mining equipment became obsolete and miners were either forced to upgrade to something better or drop out completely.
Difficulty adjustments also had a large impact on the profitability of outdated mining equipment. Over time mining technology advances and faster and more efficient mining equipment is released onto the market. Due to economies of scale, miners with larger operations can afford to be the first ones to upgrade to the newer equipment when it is first released, giving them an edge over their smaller competitors.
As a result of the faster speeds and increased hashing power of the newer technology, blocks start getting solved faster than the usual ten minutes. In order to maintain the ten minute timespan between blocks, the protocol detects miners are solving blocks faster than usual and in response it automatically adjusts the difficulty of the problem that needs to be solved for each block.
A higher difficulty increases the amount of hashing power required to solve a block, which has the side effect of increasing the time it takes to solve a block so that blocks are always able to maintain a consistent time span of around ten minutes. However a difficulty adjustment upward also has the effect of forcing miners who cannot afford to upgrade their hardware to either drop out altogether or join a mining pool so they can maintain their profitability.
Domination by Large Mining Pools
Due to lack of profitability and the inability to compete, the number of miners in Bitcoin have dwindled over time. What began as a distributed network with a large group of individual miners has slowly devolved into an increasingly centralized operation with a small number of larger mining pools. The operators of the mining pools have been able to increase their power and influence over the network because they are now the ones responsible for submitting new blocks.
The individual participants of a pool can contribute their hashing power to the pool and collect their partial block reward, but only the owners of the pools themselves can build new blocks and submit them to be added onto the chain. If an individual pool comes close to owning the majority of the hashing power on the network, participants of that pool are forced to redirect their hashing power to smaller pools in order to prevent the larger pool from gaining too much power over the network.
This is precisely the situation that blockchains were designed to move away from, centralized control by trusted entities. If one of these large mining pools were able to obtain majority control over the hashing power or a few of the larger pools got together and colluded, they could perform a number of actions against the network and its users.
They would be able to control who gets their transactions included in new blocks, effectively having the ability to temporarily prevent the processing of transactions from certain individuals. Someone having their transactions censored by a misbehaving mining pool would need to wait until a different pool produced a block that included their transactions.
Worse though is a double spending attack against the network in which the mining pool attempts to spend the same coins twice. A double spend attack could potentially destabilize the network and compromise the trust users have in the system itself. In reality users are only supposed to be able to spend the coins they currently own.
Breaking the rules by being able to spend the same coins over and over again would constitute a severe violation of the trustless nature of the blockchain. Double spends have already been successfully performed against other proof-of-work based blockchains besides Bitcoin, so it is not out of the realm of possibility that this could occur in the future if the centralization of miners is allowed to worsen.
With that said, miners are financially dependent on the Bitcoin network through the dedicated mining hardware they own. The sole purpose of this hardware is to mine proof-of-work based networks like Bitcoin. It is useless for any other computing task. Therefore directly attacking the network in this way may render all this hardware useless as trust in the network is lost.
There are other proof-of-work blockchains that miners could switch to in the event Bitcoin falls victim to an attack, however a successful attack against Bitcoin may completely destroy confidence in proof-of-work as a security protocol. In this case there would be no safe haven for miners because all proof-of-work based networks would suffer incredible price drops from the loss in trust.
This possibility acts as a financial deterrent against attempting double spends against the network. Rational miners would not want to destroy their golden goose. This deterrent however would do nothing to stop a government sponsored attack with the sole purpose of bringing down the network. If a pool is the one committing the attack, then the only thing that could be done to stop it is for miners to withdraw their support from that pool.
Unsustainable Energy Consumption
Centralization of mining power is not the only major concern though. The level of energy consumption by miners in order to keep the network securely operating is completely unsustainable and only growing worse by the day. While it is difficult to accurately determine, current estimates put Bitcoin energy expenditure in the same league as what some medium sized countries consume in an entire year and this is only expected to increase as time goes on. This increasing energy consumption just to secure a distributed network and prevent cheating is incredibly wasteful, especially when other consensus protocols exist which have been proven to drastically reduce the level of energy usage.
Geographical Centralization of Miners
Another problem concerning energy usage is the fact that most large miners operate in areas where there are low energy costs. Lower energy costs make it possible for miners to keep more of the profit they earn from block rewards distributed to them by the network. The problem with this is that it has had the effect of centralizing the majority of mining in one country where the electricity is inexpensive.
Geographically centralizing the majority of mining power in a single country opens up those miners and the network itself to the possibility of being targeted by the local government. This could include heavy regulations, the potential for shutting down mining operations altogether or even forced censorship of transactions. A truly distributed network needs to have global security providers who are based around the world. A worldwide security setup like this makes it incredibly difficult to influence or shut down the network.
Diverging Interests of Miners & Users
It should also be noted that miners may not necessarily have the interests of the blockchain in mind when it comes to the long-term development and evolution of the network. Miners are first and foremost profit generating businesses. Their main priority above all else is making money, therefore they will inherently favor developments to the network that may place them at odds with users of the network. When considering technical improvements and upgrades to the network for example, miners may want one thing while users want something completely different. The desires of both groups end up out of alignment, making governance and protocol rule changes difficult.
This may even lead to situations where miners act against the network, favoring short-term rewards over long-term growth. There have been examples of this in the past, anywhere from miners mining empty blocks to spreading misinformation and fearmongering on blogs and forums in order to turn public perception in their favor.
In a severe case where miners refused to upgrade the network, other validation nodes were forced to start rejecting new blocks from miners who would not upgrade to the newest version of Bitcoin. This caused miners that refused to upgrade to lose block rewards, since their blocks were no longer being accepted by validation nodes until they upgraded. Validators across the network basically held miners hostage financially, forcing them into a situation where they had to upgrade in order to continue earning money to pay for their mining operations.
This ability creates a sort of separation of powers where block validators on the network can force miners to upgrade the blockchain to a new version by rejecting their blocks and not providing them compensation. A better model however would be if the interests of both users and miners were aligned so that many of the toxic community disagreements between different factions were reduced, however a model like this is impossible with proof-of-work.
7. Bitcoin's Lack of Sustainability
There are a set of rules coded into the protocol that govern Bitcoin's supply. One of the rules states that only a maximum of 21 million bitcoin can ever be mined. Once the final block reward is mined, no more coins will be produced. Since block rewards act to subsidize costs so that miners always have an incentive to continue producing new blocks, this rule has massive implications for the future security of the network. How will miners be compensated for producing blocks and security for the network once the last coin is mined and block rewards come to an end?
Voluntary User Transaction Fees
The answer is that block rewards are not the only form of compensation that miners receive. Users of the network also pay transaction fees to miners in order to get their transactions included in the blocks they produce. So miners are always receiving two forms of compensation, block rewards generated by the network itself and fees paid by users of the network who transact with their coins.
Users can pay any size fee they want. A user paying a larger fee provides financial incentive for miners to prioritize and process their transaction more quickly, but naturally most users will elect to pay the lowest possible fee that they can get away with.
Block Reward Halving
Rather than coming to an abrupt halt, block rewards are designed to be gradually phased out over a long period of time. Instructions are coded into the protocol that detail a schedule where block rewards automatically halve every 210,000 blocks, which occurs about every four years.
The original block reward for example was 50 bitcoins, which was reduced to 25 after four years, then 12.5 and will continue to reduce in half every four years until it reaches zero. The last block reward will be mined around the year 2140, which provides a long transitionary period of many years for miners to switch from block rewards solely to user transaction fees.
The Tragedy of the Commons
Phasing out automatic, network generated payments in favor of user provided transaction fees may sound great in theory, but the reality has turned out quite different. The major problem with this model is the tragedy of the commons, which is a term used to describe a situation in a shared-resource system where individual users acting independently according to their own self-interest behave contrary to the common good of all users by depleting or spoiling that resource through their collective action. A commonly cited example of this is the collective destruction of the environment by self-interested individuals attempting to use it as a resource in order to achieve personal economic success for themselves.
In Bitcoin the common shared resource is the blockchain and the security of the network itself. Users have a personal financial incentive to spend as little on transaction fees as possible, however this self-interest has the effect of damaging the very system they are so reliant on.
As block rewards continue to reduce in size over time, miner compensation increasingly needs to be made up with user transaction fees. Without an appropriate level of fee compensation by users of the network, miners will not be able to afford the massive costs associated with mining, leading to the eventual shut down of their operations as funding runs low.
Short-Term Behavior Sabotages Long-Term Security
While users do care about the long-term health of the network they operate on, their immediate concern is saving as much money in fees as possible. Unfortunately this normal and predictable human behavior works against the financial interests of the miners who secure the network for them. In the future, if voluntary user transaction fees are not enough to sustain network security in the absence of block rewards, then unprofitable miners will continue to drop out until a majority of the hashing power is controlled by a few people or even one large mining pool, which will put the network at serious risk for a double spend attack.
Therefore it is a completely acceptable and legitimate question to ask if proof-of-work consensus will continue to be viable as a blockchain security protocol. It may still be secure right now, but due to the inherent flaws designed into the system that security may not be sustainable in the long-term.
Security is Dependent on Price
Another factor to consider is the price blockchain tokens are valued at on the market. Since miners are compensated by Bitcoin’s native token, their profitability is highly dependent on the price it fetches on the market. In times of price appreciation, miners don’t have as much to worry about because the coins they earn are sold on the market for high valuations and maximum profit.
In times of price depreciation though, the market may not value the coins highly enough in order for a miner to be able to pay for their overall cost of operation. Proof-of-work network security is therefore also dependent on the market price of a blockchain’s native token. A token that is performing poorly on the market makes it difficult for miners to earn a profit, which can put the network at risk if too many miners drop out because of unprofitability.
8. Bitcoin's Lack of Scalability
Bitcoin was originally designed by Satoshi Nakamoto as a digital replacement for cash. In fact the original whitepaper was titled Bitcoin: A Peer-to-Peer Electronic Cash System. This implies that Bitcoin has the ability to scale to a global level where everyone in the world has the opportunity to transact with the digital currency.
However time has shown that blockchain technology is not capable of scaling to worldwide use, at least by itself. An intense debate has been raging in the crypto community for years now about the best way to scale the blockchain to higher usage levels. The core argument is about whether to increase the size of blocks.
The Block Size Limit
One of the rules coded into the protocol states that the size of each block can only be one megabyte or less. Since blocks contain transaction data, it follows that as users increase the number of transactions they perform on the network blocks will get closer to being full. Once a block contains enough transactions in it that the space it takes up equals 1MB, that block is considered full and no more transactions can be added to it. Any transactions over the block size limit would have to wait for the next block in order to be added.
At a 1MB block size, the Bitcoin network is restricted to the point where it can only support about seven transactions per second. This block size limitation prevents the blockchain from being able to scale to support worldwide usage levels. In order to solve this problem, one faction in the Bitcoin community wanted to increase this limit so that the blockchain could support a higher capacity of transactions per block. However the other side rejected this proposal because they feared it would further centralize the network.
Block Size Limit Increases & Centralization of Full Nodes
Remember that full nodes carry a complete copy of the public ledger. The blockchain itself is massive in size due to the requirement to store every single transaction that has ever been processed by miners. This massive ledger needs to be stored on the computer that the validation node is operating on.
If the size of the blockchain becomes larger than what a validator can store on their computer then they will be forced to upgrade their storage capacity in order to continue holding a full copy of the chain. If they do not upgrade then they won't be able to store the entire ledger, which will prevent them from being able to perform validation of transactions and blocks.
If the block size was increased for example and the number of transactions increased along with it, one fear is that there would come a point in the future where there were so many transactions being performed on the network that advances in storage technology would not be able to keep up with and support the rate of growth in the size of the blockchain.
If this occurred and prices for higher capacity storage did not fall fast enough, it might become unaffordable for certain validators to be able to store the entire blockchain history on their computers. As the number of transactions increased per block, validators would need to continue upgrading their storage capacity in order to hold the entire chain.
This may lead to a situation where volunteers and hobbyists operating full validation nodes would have to quit because they could no longer afford the costs of upgrading their storage capacity. The number of full nodes would decrease over time due to the unsustainable growth of the blockchain and only those with enough resources would be left operating full nodes, namely large merchants, exchanges or payment processors. Once again we have another path that leads to centralization, this time affecting the number of full nodes that do accounting and verification work for the network.
However this possibility depends on how quickly storage technology advances and how affordable it becomes for the average person. It is possible that storage technology may keep up with the rate of growth in the chain size, but only time will tell. In the meantime, other more pressing issues exist with bigger blocks.
Validation nodes have the responsibility of relaying new blocks to other nodes in the network. However this process of propagating new blocks throughout the network will take much longer if block sizes start increasing, especially considering how unreliable internet infrastructure is around the world.
Bandwidth limits may also cause problems with propagating large amounts of data. Consider for example that many home internet packages have much lower upload bandwidth compared to the higher limits offered for downloads. Also remember that each new block takes about 10 minutes to produce. Once blocks become large enough they may reach a point where there is not enough time for each new block to propagate to the rest of the network before the next block becomes due.
Yet another problem is how validation nodes will process all this data. Research suggests for example that it will cost a considerable amount of RAM in order to process large blocks. Most people do not have access to the amount of processing power that will be required, which places the network in a position where volunteer nodes will no longer be able to participate. So both broadcasting and processing this level of data becomes a problem for the average user, placing the task of transaction and block validation mainly in the hands of larger entities that have the resources to continue operating full nodes.
2017 Bitcoin Chain Split
In 2017 the block size debate came to a head when two arguing factions inside the Bitcoin community decided to split the network into two separate blockchains that each followed different rules. Both blockchains contained the same exact history of transactions, but diverged at the block where the split occurred.
The first blockchain remained the same at a 1MB block size and continued to be called Bitcoin. The second blockchain however increased the block size from 1MB to 8MB and became known as Bitcoin Cash. Supporters of each network went their separate ways with Bitcoin Cash supporters following the philosophy of scaling with block size increases and supporters of the main Bitcoin network following an alternative scaling philosophy.
Developers on the main Bitcoin chain realized they had a problem on their hands. The block reward reduction schedule was already set in motion. It would only be a matter of time before reductions in the block reward started to negatively impact miners, so developers needed to solve all these problems quickly or risk network security being affected. Ultimately developers intentionally chose to keep the 1MB block size limit for reasons that will become clear shortly.
Transaction Fee Market
When the Bitcoin network is too congested with transactions and blocks are full, there needs to be a way for a miner to decide which transactions to include in a block. There is limited space available, so it becomes necessary to pick and choose which transactions get priority over others. The Bitcoin network has a transaction fee market which takes over when blocks reach 1MB. When blocks are full, users realize that it will be difficult for them to get their transactions included and added to the chain, so they voluntarily begin to increase the transaction fees they pay to miners.
A higher transaction fee is more profitable for miners, so they will be more likely to include transactions from users with higher fees first over transactions with smaller fees. In this way users of the network enter a bidding war in order to get the attention of miners. The highest bidders paying the largest fees will be the first ones to get their transactions included in new blocks. The lowest bidders however will need to wait until a miner decides to include their transactions.
Block Size Limit Solves Block Reward Halvings
Bitcoin developers eventually had the realization that this transaction fee market was the solution to their decreasing block rewards. Once again, miners need to be able to stay profitable in the future once block rewards have been reduced to nothing and users are not a reliable fallback option as they are unwilling to voluntarily increase the fees they pay. Therefore the only way to ensure miners get properly compensated is to create a situation where users are forced to pay more in fees. Bitcoin developers have brought about this very situation by deciding to artificially limit the block size to 1MB.
With this artificial limit in place, as blocks fill up and transactions reach maximum capacity, users are forced to pay higher fees in order for their transactions to be validated by miners. If a user refuses to set a higher fee, then miners will likely pass over them in favor of others who pay higher fees. They may eventually get their transaction included hours or days later by a generous miner, but not everyone can afford to wait this long so in order to avoid the long wait times they will voluntarily raise their fee so they have a better chance at getting their transaction processed sooner.
This artificial block size limit therefore motivates users to voluntarily raise the transaction fees they pay to a profitable enough level for miners to be able to continue their expensive mining operations in the face of vanishing block rewards. In this way network security is able to be sustained for a while longer.
Block Size Limit Impacts Network Usability
This model solves the issue of decreasing block rewards so that miner provided security is retained, however at the same time it also creates new problems. As mentioned before, Bitcoin was originally designed as a peer to peer digital replacement for cash. By limiting the block size, this original vision Satoshi had for the network is no longer possible through use of the blockchain alone.
The Bitcoin community for example once advertised the blockchain as having lower fees than credit card networks. With the implementation of a fixed block size limit however, this core benefit of lower fees is completely eliminated when blocks are full. When this occurrs, users of the network are forced to pay outrageous fees in order to transact with their coins.
While the block size limit has solved the problem of decreasing block rewards, this solution effectively destroys the utility of the blockchain as a medium of exchange during periods where network traffic is considerably high. The network can operate well under normal conditions, however an extreme rise in price causes trading on exchanges to spike. At the peak of a price bubble like this, network congestion is usually at its highest.
Transaction fees will ultimately spike during conditions like this due to a fight over limited block space. This extreme rise in fees negatively impacts the user experience by preventing users from being able to make smaller transactions without significant cost to them. Not only does the block size limit raise fees to unaffordable levels during periods where trading is at its peak, but it also does not solve the scalability problem. A 1MB block size does nothing to support higher usage levels.
Bitcoin as a Settlement Network
Bitcoin developers however recognized beforehand the negative impact this block size limit would have on the usability of the network, therefore they put plans in motion to solve these remaining issues by using an alternative solution. At some point the realization finally dawned on developers that it was just not possible for blockchain technology to directly facilitate worldwide transaction volumes.
Rather than attempting to engineer changes into the blockchain that would eventually centralize it like block size increases, it became obvious to developers that the purpose of the blockchain itself needed to be refocused to that of a settlement network. In this model, the blockchain itself acts more as a settlement layer for high value transactions.
Secondary Layers & Off-Chain Transactions
At the same time, secondary layer technologies are built to function on top of the blockchain. These secondary networks are designed to work in conjunction with the underlying blockchain in order to take full advantage of its decentralized and trustless security. They benefit the overall network by providing additional functionality that the blockchain is unable to perform alone by itself.
Secondary layers for example allow users to make lots of transactions instantaneously at low cost without the requirement of needing to wait for miners or new blocks. This is possible because transactions that are performed on layer 2 networks exist completely outside of the blockchain.
Transactions performed directly through the blockchain for example are expensive and slow. They are processed on the blockchain and are therefore considered on-chain transactions. Transactions performed on layer 2 networks however are quick and inexpensive. They are processed off the blockchain and are therefore considered off-chain transactions. On-chain transactions are stored in the blockchain history by a miner. Off-chain transactions however are not stored in the blockchain history at all.
The Lightning Network & Payment Channels
The primary example of this technology is a layer 2 solution being developed for Bitcoin called the Lightning Network. A user will make an on-chain transaction by first depositing some coins into a special address that is associated with the Lightning Network. The user then opens what is called a payment channel, which allows them to securely transact with other users of the Lightning Network. All transactions are performed off-chain and balances are kept track of by the Lightning Network.
A user can perform as many off-chain transactions as they want as long as they pay intermediaries on the network a small fee in order to route their transactions where they need to go. Finally, once a user is done making payments on the Lightning Network they finish by closing their payment channel. Closing a channel has the effect of settling by recording the final changes in balance on the blockchain.
In this way, it allows users the ability to bypass expensive miner fees by performing the majority of their transactions instantly off the blockchain on secondary layer networks. In this situation the blockchain itself is used mainly to synchronize balances from time to time whenever a payment channel is closed and changes need to be recorded.
This is what is meant by the blockchain becoming a settlement layer. Transactions are conducted off the blockchain, thereby preventing the chain from bloating and growing in size too much. Those off-chain transactions are then totaled at some point in the future and settled by permanently recording the changes into the ledger.
Blockchain as a Base Layer
Lightning is also only one example of a layer 2 network. Another that exists is called Failsafe Network. There will be other examples as time goes on and improvements are made. Eventually features and improvements will build on each other to the point where we will have layer 3 networks and beyond. All future layers however are completely dependent on the security of the base layer blockchain. Without a secure base layer acting as a solid foundation, everything built on top of the blockchain will eventually collapse.
Satoshi's original vision of a peer to peer cash system where all transactions are conducted on-chain is no more, at least when it concerns the main Bitcoin chain. Developers have instead elected to focus on an alternate scaling solution that limits the amount of on-chain transaction volume. Let's sum all this up in order to understand the reasoning behind the decisions of the developers.
Putting it all Together
A block reward is distributed with every new block, which compensates miners for the costly work they perform and incentivizes them to continue producing new blocks and securing the network. The block reward is on a set schedule where it will continue decreasing until it becomes zero. Voluntary user transaction fees are not a reliable replacement for block rewards because users are motivated to save as much on fees as possible. Developers therefore instituted a 1MB block size limit.
Because of this limit, as a block fills up with transactions users are forced to pay higher fees in order to have a better chance of getting their transactions accepted by miners. These raised fees are profitable enough for miners to sustain themselves in the absence of block rewards. However these raised fees make it too expensive for normal users to transact on the blockchain.
In response, developers are building secondary layer networks that make it possible to perform lots of quick and inexpensive off-chain transactions. High fees for on-chain transactions will push users conducting micro-transactions and low value consumer payments off the blockchain onto these secondary layer networks where transactions are more affordable.
These developments accomplish a number of things. Miners receive their proper compensation to continue operating. Low value transactions are off-loaded onto secondary layer networks, which makes fees cheaper and speeds faster for users and prevents the blockchain from bloating and growing too fast from too many on-chain transactions.
Any on-chain transactions will be high value transactions where the fees spent are marginal compared to the value that was exchanged. Secondary layer networks also finally make it possible for Bitcoin to scale to support global transaction volumes and usage levels. With layer 2 networks the number of possible transactions is no longer limited by the block size.
Fee Competition Between Miners & Secondary Layers
It may seem like this finally solves the main problem, however there is still a major flaw that is being overlooked. The flaw is that proof-of-work based blockchains are inherently incompatible with layer 2 networks. The flaw is also in developer's thinking that miners will continue to be properly compensated in the future.
Any transaction being conducted on a layer 2 network results in some amount of fees not going to miners. Instead small fees are paid to intermediaries operating on the layer 2 network who routes transactions where they need to go. In reality, miners and layer 2 networks are in direct competition with each other for earning transaction fees.
This is not even the main problem though. Regardless of whether intermediaries on layer 2 networks earn fees from users or not, it is a fact that any off-chain transaction results in a miner who doesn't get paid. Miners can only be paid from users conducting on-chain transactions, therefore it is a fact that layer 2 networks leech off of miner profits.
As layer 2 networks develop further in the future and become easier to use, more people are going to be drawn to using them for their cheap fees and instant transaction times. There will come a point in the future where not enough users are making on-chain transactions and miners will suffer because of it. This will result in the further centralization of miners as they become unprofitable and quit, which will place the network at risk for a double spend attack. Bitcoin developers see layer 2 networks as their savior, however they could just as easily be their death sentence.
Conclusion on Bitcoin & Proof-of-Work
In the end, proof-of-work based blockchains suffer from a number of design flaws that should cause concern for the sustainability of the system. The mining process is inherently designed to centralize over time. Faster and more efficient mining equipment is released, forcing everyone to upgrade or go broke. Mining itself is an unsustainable waste of energy. It also causes mining to centralize in locations where energy is inexpensive, opening the network up to attack from local governments and regulation. Miners and users are often out of alignment in their desires for the long-term development and evolution of the network. Miners are dependent on a high bitcoin price.
Miners are also incompatible with layer 2 networks. Eventually layer 2 networks will steal enough profits away from miners that they could centralize and open up the network to a possible double spend attack. With such a large number of systemic flaws, the Bitcoin blockchain does not seem like a great foundation to build on top of.