Bitcoin as a Technology and Operations Management Case
Today’s article was submitted by Sumit Malik, Economics Editor.
Bitcoin, a first-of-its-kind digital currency devised in 2008, crossed $50 billion in total value for the first time this summer. It’s weathered severe volatility, technological obstacles, and government regulation to remain the dominant alternative currency. At Consensus 2017, the largest conference for bitcoin and its underlying infrastructure in the US, I was struck by the massive appetite for the technology and the breadth of participants relative to the year prior, beyond the core community of developers and entrepreneurs. In her keynote address on the New York Marriott Marquis main stage, Fidelity Investments CEO Abigail Johnson (HBS ’88) reflected the crowd’s enthusiasm: “I love this stuff—bitcoin, ethereum, blockchain technology—and what the future holds.”
The vision for bitcoin is a controversial topic. For every vocal proponent of bitcoin’s potential to uplift the unbanked and reinvent the monetary system, there is an equally outspoken skeptic. In stark contrast to Johnson’s optimism, other financial industry luminaries express distrust, and even disdain, for bitcoin. JP Morgan CEO Jamie Dimon (HBS ’82) reportedly described the digital currency as “a fraud” that “will blow up” and characterized its millionfold appreciation in seven years as “worse than tulip bulbs,” alluding to a 17th-century speculative bubble that abruptly collapsed. Ray Dalio (HBS ’73), founder of the world’s largest hedge fund Bridgewater Associates, took a similar stance concerning the speculative nature investments in bitcoin, citing limitations in systemwide transaction volume and difficulty of use as key risks.
At the heart of the debate surrounding bitcoin’s utility is a fundamental operations management and system design challenge. Detractors argue that bitcoin is facing an existential crisis as three core functions of an effective currency—medium of exchange, store of value, and unit of account—are increasingly unviable in light of the technology’s struggles to keep pace with rapid adoption. Delays in transaction processing and rising transaction costs threaten bitcoin’s convenience as a routine medium of exchange, and the need for structural changes creates apprehension among investors, resulting in volatility that precludes reliability as a store of value or unit of account.
The bitcoin network is capable of processing roughly 3 transactions per second, increasing to up to 6-7 transactions per second through a recent software update. Visa, by comparison, can handle upwards of 24,000 transactions per second. Capacity constraints have recently forced themselves to the forefront of bitcoin aficionados’ concerns, as growth in average daily bitcoin transactions grinded to a halt in the second quarter of 2017. Bitcoin transaction volume increased just over 1% quarter-over-quarter, only a fraction of the 14% quarterly growth rate experienced in the last 3 years. Simultaneously, transaction fees skyrocketed tenfold between year-end 2016 and the second quarter of 2017, from $0.24 per transaction to $2.41 per transaction, reflecting the network’s inability to process additional volume and impairing the technology’s value proposition of low-cost value transfer.
Bitcoin transaction fees rose sharply as transaction volume hit capacity constraints
From an operations management perspective, system capacity in bitcoin transfers is limited by a bottleneck in the process of validating transactions. To understand the process flow more precisely, consider a hypothetical where Alice wants to send a bitcoin to Bob. Unlike a bank transfer, in which the participants must trust banks as intermediaries to debit Alice’s account and credit Bob’s account a corresponding amount, a bitcoin transfer distributes trust across computers plugged into the bitcoin network. Rather than use a bank ledger, a bitcoin transaction is tracked on a “blockchain,” which is a shared ledger jointly maintained by network participants.
To complete the transaction, several processes occur in series: (1) Alice decides to send money to Bob; (2) the transaction is grouped with others in a “block;” (3) the block containing Alice’s transaction is broadcast to computers plugged into the bitcoin network; (4) participants in the network sign off on the validity of the transaction; (5) the block containing Alice’s transaction is appended to the shared ledger; (6) the updated shared ledger includes Alice’s completed transaction.
The fourth process in this system is the bottleneck, which limits the capacity of the system. The time required for transaction validation is an average of 10 minutes, enabling about 144 blocks to be added to the shared ledger each day. Each block contains up to approximately 2,000 transactions (1 MB per block with 500 bytes per transaction), setting a theoretical limit of approximately 288,000 transactions per day (3 transactions per second). Any excess transactions that have not been added to the blockchain idle in “inventory” until it is their turn to be validated. A transaction can be prioritized and skip the queue if the sender pays a discretionary fee, an expense that has become all but necessary as the backlog of transactions has grown, at times numbering in the hundreds of thousands.
Addressing limitations in bitcoin’s infrastructure has become an existential question for users; it isn’t worth buying morning coffee with bitcoin if the transaction takes hours to complete and several dollars of fees. To reduce throughput time, or how long it takes to complete a transaction, developers have devised methods to fit more transactions per block. Recent software updates enable transactions to be posted using less data, allowing roughly double as many transactions to be included in each 1 MB block. An alternative proposal to increase block size from 1 MB to 8 MB was so controversial due to resource and efficiency concerns that “bitcoin cash,” an entirely new digital currency, was created with this change. Other innovations under development include enabling transactions to occur through faster channels that are segregated from the bitcoin blockchain.
As the bitcoin scalability debate evolves, there’s one area where bitcoin enthusiasts and skeptics can agree: bitcoin is no longer confined to the developers’ backyard. Technologists, operations managers, and business folk alike will play important roles in shaping the future of bitcoin.
Sumit Malik (HBS ’19) is an investor, writer, and entrepreneur. Professionally, his background is in venture capital and private equity at Warburg Pincus, strategy as a board member of Santander Asset Management Chile, and investment banking at Goldman Sachs. Personally, he writes for academic and popular publications and performs music and poi (light- or fire-spinning). He previously received an A.B., summa cum laude, from Harvard College and an S.M. from the Harvard Graduate School of Arts and Sciences.
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