Bitcoin Core/Unlimited Risk Management & Probabilities

Bitcoin holders are keeping an eye on a potential fork that will create “Bitcoin Unlimited“, a proposed new chain that will solve some perceived shortcomings with the current bitcoin “core” network. Bitcoins have the largest market cap of any crypto currency, and so there is an important network affect associated with bitcoin values/prices. Any forks or modifications to the bitcoin blockchain is bound to have implications for holders. This post describes my current thinking on how bitcoin/crypto investors should approach the anticipated Bitcoin Core (BTC) / Bitcoin Unlimited (BCU) fork.

The first thing we should understand is why there is a split in the bitcoin community. Bitcoin exists as long as its blockchain is being updated, and the value of bitcoin is related to the number/amount of miners/users willing to do things with or make transactions using bitcoins. Whether bitcoins are more or less valuable depends on a number of factors, including the scale of the bitcoin economy. If the scale of bitcoin use/adoption falls, its also likely the value/price of bitcoin will fall as well. One of the features of bitcoins is there is a fixed block size limit of 1MB. This “hard coded” limit restricts the amount of traffic that can be processed by the bitcoin blockchain, and therefore causes processing delays when the number of transactions on the bitcoin blockchain reaches certain levels. Lately, with the popularity of bitcoin rising, the bitcoin blockchain has pressed up against this constraint, causing transactions to either be delayed or expensive.  Part of the reward for bitcoin miners is receiving newly mined bitcoins but they also prioritize processing transactions with associated fees, and the portion of mining earnings coming from fees relative to newly minted coins has been rising along with blockchain “congestion”.

As a way to overcome this perceived handicap of the bitcoin blockchain, various forks have been proposed and implemented that remove or modify the hard coded cap on the block size.  Let’s keep in mind that anyone can copy, modify, and create a new crypto currency based on bitcoin or any other open sourced crypto currency. As a way to encourage adoption, new cryptos will provide credit to holders of other currencies. For example, a new “better coin” could be forked from bitcoin and all bitcoin holders could automatically have their address and keys available on the “better coin” blockchain. Users of the new chain receive tokens for “free” and the value of those tokens will be determined by other means (such as a market).

Since the value of a new crypto is related to its popularity, for any crypto to exist, there needs to be at least some miners/users willing to keep the blockchain up to date. Cryptos with low popularity, will likely be worth less. With all this in mind, we cannot create something out of nothing, a market will bake in all the perceived risks/rewards and prices will tell us the weighted aggregate opinion.

I want to make it clear, bitcoin unlimited does not impact the current bitcoin blockchain. Miners/users might stop using BTC in favour of BCU, but the bitcoin blockchain cannot be destroyed as long as at least someone is willing to defend it. If you currently own bitcoins on an address you control with a private key, you will still own those coins following a bitcoin unlimited hard fork. After the fork, you might also have access to new coins on the bitcoin unlimited network. Since you can’t create something out of nothing, its likely that the value of the combined bitcoin core and bitcoin unlimited coins will be worth some related amount. We don’t know whether this will be less than current, more than current, or the same amount. Time will tell, but anything is possible.

How do we determine the value of BTC and BCU?  The first place I’d suggest starting is the split chain tokens traded on Bitfinex. Bitfinex has listed a few different tokens that represent part BTC and part BCU. A holder of a split token can request delivery of each constituent part, so with these split tokens, we can use market prices to determine the relative values of each constituent part and therefore the probability of the impact on the future value of BTC and BCU.

At the time of writing, here are the current prices

BTC/USD @ 2285

BCC/USD @ 2000

BCU/USD @ 220

BCC/BTC @ 0.90

BCU/BTC @ 0.095

We can glean a lot of useful information from the prices listed above. First thing to notice is the market is expecting the combined future value of BTC + BCU to be worth less than the current value of BTC. In other words, the sum of the parts are expected to be worth less than the current whole. In other words, the sum of BCC/USD & BCU/USD is less than the current price of BTC/USD. This may be caused by an implied carry (a risk premium) that is theoretically baked into the current price of the future. This spread might also reflect the market’s expectation that when you split the current bitcoin economy into more constituent parts, some of the network affects are eroded, so the sum of the parts ends up being worth less than the whole. We could also study this phenomenon with other forks, most prominently with ETH/ETC.

The next thing I notice is the current price of the future value of bitcoin unlimited is worth a lot less than the current price of the future value of bitcoin “core”. Its about a 90/10 split with BCC being worth 90%. This information helps us make some judgments on the likely adoption of bitcoin unlimited. The market does not expect bitcoin “core” users to jump ship en-mass and begin to use the bitcoin unlimited blockchain.

What can bitcoin holders do to manage the “fork risk”?  The first thing I think holders should do is re-examine the way they hold their coins. Do you hold your own key or do you use a hosted service?  Are your coins invested somewhere, and does that debtor have access to the future bitcoin unlimited coins and are they obligated and/or willing to share those with you?  If you are using exchanges such as Poloniex and Bitfinex to make margin loans, how will these exchanges treat your position?

When deciding what to do, its important that you review your investment objectives and allow those objectives to determine your investment strategies. There is a lot to consider when investing in crypto currencies, and users should also consider using hosted services or obtaining advice if they are feeling overwhelmed.