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The Bitcoin Hard Fork-A Tiger by the Tail

Courtesy of ZeroHedge. View original post here.

It did not happen. The bitcoin hard fork scheduled for block number 494,784 that was agreed to at the Consensus meeting in May that was to be enacted in mid-November has been cancelled.  Mike Belshe, CEO of BitGo, stated, “we have not built sufficient consensus for a clean block size upgrade at this time.” SegWit2X, as the upgrade was to be known, would have doubled the bitcoin block size from one megabyte to two and removed the signature data now processed with each transaction. With the greater capacity and decreased amount of necessary data, SegWit2X intended to multiply the speed at which transactions can be processed. Visa’s global network (known as VisaNet) processes about 1700 transactions per second. In its current form, Bitcoin technology can process seven. Faster transactional speed would make bitcoin into a more attractive alternative to fiat currency.

Demand has always existed for a way to exchange money and property securely and anonymously. In the United States, cash is handy for purchases of less than ten thousand dollars, but red flags appear on bank statements, deposits or withdrawals, for more than that amount. With gold, to which Satoshi Nakamoto compared bitcoin, an anonymous transaction can take place, but for larger transactions, transport and storage becomes a problem.

Bearer bonds—municipal and corporate bonds without a registered owner—were once exchanged like $5000 bills until issuance was suspended in 1982 and the outstanding bonds were called or matured. Bitcoin has no upper limit as to size of transaction, can be stored on a memory stick, transferred with the click of a mouse, and is constantly increasing in supply although at a decelerating rate. All one needs to believe is that this is the future of currency on the planet.


Uncertainty is the enemy of any market. Bitcoin is dominant in crypto-currency because it has come to be accepted as the standard for security from digital theft, and anonymity of transactions. It has been eight years since Satoshi Nakamoto mined the first bitcoin, and in that time hundreds of thousands of “blocks” of transactions have been mined and digitally archived on the network of bitcoin miners, owners, and developers. Each of those recorded transactions lengthens the “block-chain” and makes it harder to hack. As Nakamoto said in his October 2008 whitepaper, “If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new coins.”

Each bitcoin is identified by its unique code, but not by owner, thereby allowing transactions between anonymous buyers and sellers. As a decentralized currency, bitcoin may be exchanged instantly for real-world goods or fiat currency, without possibility of reversal, and with only the updated block-chain as permanent record of the transaction.


Uncertainty as to outcome of the SegWit2X hard fork was implicit in Mr. Belshe’s statement of cancellation. This type of restart had been accomplished before, that by Ethereum when the Decentralized Autonomous Organization (DAO) was hacked and $50 million dollars of Ethereum went missing. Their workaround involved starting a new block chain at a point in time and calculation previous to the insecure event. Very much like using the “restore” function to rebuild a Windows hard-drive, Ethereum began again without the egregious corrupted code. However, the original Ethereum digital currency continued to trade as Ethereum Classic ($18) and the new forked version now trades as Ethereum ($314).


Pete Rizzo writing for Coindesk suggested that because success or failure of the proposed SegWit2X hard fork depended upon adoption by potential users, three outcomes were possible. Miners might upgrade their software and bitcoin would continue but with blocks doubled in size. Miners might not download and run the new software and bitcoin would continue as before. But the worst answer is never yes or no, it is “maybe”, and maybe in this case would have created another coin, just as did Ethereum. There could have been a Bitcoin2X and a Bitcoin Classic competing for the title of ultimate standard of digital currency. Uncertainty would not have been good for either coin, as owners of one or both coins may have come to doubt the certainty of its value.


As it turned out, Bitcoin hit an all time high of $7879 on the Wednesday of the cancellation announcement and has fallen since to an intraday low of near $6200 on Saturday. That is more than a 20% loss. On two of the three trading days since the cancellation, bitcoin futures would have triggered the “limit-up” and “limit-down” restrictions the Chicago Mercantile Exchange (CME) plans for its proposed bitcoin futures. With drops of 7% and 13%, the CME would pause trading. A 20% drop would be a “hard” cap and would end trading for the day. Bitcoin rose 8% on Wednesday and fell 9% on Friday.


So far this year, bitcoin has swung more than 20% in price on two separate days. Eleven times bitcoin has moved at least 13% up or down, and 69 times has moved at least 7%. Once a volatile futures contract goes limit up or limit down and closes trading, that same contract will often open at the limit in the same direction as the preceding day. The CME may have a tiger by the tail with bitcoin futures, especially if it uses the same limits for price movement of bitcoin contracts as it does for the Standard and Poor’s 500 contracts.


Benoit Mandelbrot, sometimes referred to as “the father of long-tails”, warned that a market must be taken as it comes, without presupposition as to its expected behavior. Only after observing prices over time can one model a curve that limits the probabilities of market action. According to Mandelbrot, modern portfolio theory continues to make the same two errors. It assumes each time period, whether hour or year, is independent of the previous period. Modern portfolio theory also imposes the same “bell-curve” of standard normal distribution upon all markets from tulips and soybeans to computer chips and crypto-currencies.


Mandelbrot, among mathematicians, is also considered the “father of fractal geometry.” He invented a geometric function that approaches a description of shapes found in nature like the edge of a leaf or the coastline of England. His claim is that an individual market, when compared to itself over different timeframes, presents an identical picture. A market, measured by price over a day, presents the same curve as when it is measured over a year or a decade. If an accurate curve can be discovered, the probabilities of market action can be limited.

But establishment of bitcoin futures trading is necessary for the eventual securitization of the coin and for access by more conservative investors. The CME plans to launch a bitcoin futures contract by the end of 2017, while the Chicago Board Options Exchange (CBOE) plans a launch by early 2018. Futures would not only allow traders to bet on the direction of the bitcoin market; futures would also allow an individual or institution “insure” his portfolio against outsized losses. If one wishes to take part in the bitcoin parade, one might buy the actual coins and sell the futures.


Once bitcoin futures trade, exchange traded funds (ETFs) may also be granted approval. The United States Oil Fund is an ETF that invests in crude oil futures, not barrels of oil. Securitization of bitcoin would allow for a greater flow of funds into what Jamie Diamond of J. P. Morgan has called a “fraud”, and which Warren Buffet would warn against investing in what one does not understand. But money flows where it will, and for the last year especially, it has been flowing into bitcoin. If an ETF can own bitcoin, maybe banks and mutual funds will collect some coins as well. The Vanguard Group of funds alone has $4.5 trillion in assets. The total market cap of bitcoin is around $100 billion.


The potential for a new influx of funds into bitcoin over the coming years brings up the question of valuation. What is bitcoin really worth? What should it be worth? Shall it be compared to a hard asset like gold, as did Satoshi Nakamoto in his original whitepaper? Shall it be compared to currency like the US dollar as a means of completing transactions? Or does the fact that it really does not exist in any traditional sense make it more comparable to web-based firms that disappeared after the “dot com” crash of 2000?


If there are 6 billion ounces of gold in circulation worth about $7 trillion, does that mean that bitcoin’s approximate 16 million coins could be worth $437,500 each? If the M2 money supply is $14 trillion, should a bitcoin be valued at $875,000? If by vote, a small group of core developers can alter the algorithm that originally created bitcoin and spin off an unlimited number of variations, does the price of bitcoin have a bottom?


“Still, the idea of chance in markets is difficult to grasp, perhaps because, unlike the anonymous particles in a magnet or molecules in a gas, the millions of people who buy and sell securities are real individuals, complex and familiar. But to say the record of their transactions, the price chart, can be described by random processes is not to say the chart is irrational or haphazard; rather, it is to say it is unpredictable. ? Benoît B. Mandelbrot, The (Mis)Behavior of Markets


When observed through the Mandelbrot lens, the idea of the CME using the same limits for price movement of bitcoin futures as those it uses for those of the S&P 500 seems ridiculous. In popular culture, the definition of insanity "is doing the same thing over and over and expecting different results." Try to put a tiger into the same cage one uses for a housecat and see what happens.

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