Introduction to Cardano (ADA) Part 3

Three generations of cryptocurrencies. Limitations of first-generation cryptocurrencies.

First generation cryptocurrencies such as Bitcoin offer a lot of advantages, including transparency and decentralization. However, they also come with a lot of limitations.

 

Scalability

One of the biggest problems with Bitcoin is that the Bitcoin network can only process between three and seven transactions per second.

Here is why the capacity of the Bitcoin network is what it is: a block of the Bitcoin blockchain is 1 megabyte. An average transaction is 250 bytes in size (it can be bigger or smaller depending on the number of inputs and outputs). The blockchain creates a block every 10 minutes. These numbers result in the transactional capacity of the network being equal to 3 to 7 transactions per second, which is much less than 20,000+ transactions per second that the Visa Financial Network can handle.

The Bitcoin network operates based on the laws on supply and demand. The users do not have to pay fees for sending a transaction, but miners who are responsible for including the transaction into the Bitcoin blockchain also do not have to include the transaction if they choose not to do so.

As the popularity of the Bitcoin network exploded in 2017, so did the average transaction fee. Suddenly, the network had more transactions that it could handle and the miners were free to choose any transactions they wanted when creating the blocks of the Bitcoin blockchain. On the Bitcoin network, all transaction fees go to miners, which is why miners started choosing the transactions with the highest transaction fees. This led to the fees increasing exponentially. For example, on December 21, 2015, an average transaction fee on the Bitcoin network was USD$0.0784. Two years later to date, on December 21, 2017, an average fee was USD$54.901 (this is not a typo: the fee went from seven cents to over fifty dollars).

Because the network has fee and capacity issues, it simply can’t become a mainstream worldwide currency. Nobody will be paying an equivalent of USD$3 for a cup of coffee when they together with the $3 payment they have to include $50 as a transaction fee.

 

Functional limitations

The blockchain technology offers a lot of benefits and possibilities. In essence, it allows the creation of transparent tamper-proof ledgers that could solve a lot of problems and inefficiencies in a lot of industries. For example, if a description of actions of doctors were to be included in a public ledger, then it would be easier for patients to choose a doctor. There could also be a ledger with a repair history of cars. While blockchain only allows to send money without any conditions, ledgers could also implement conditions such as “send $X only if Y happens,” where $X is a sum of money an Y is some event. Blockchain could be beneficial in data storage. There could be a blockchain network that stores several copies of files on different servers and connects storage users to storage providers based purely on supply and demand, without any third party. There could also be all kinds of blockchain-based marketplaces for everything and anything from unused cellphone minutes to apartment rentals. None of this functionality is available on the Bitcoin network.

Finally, it is impossible to change the way the Bitcoin network operates, be it block size, the speed of block creation or introduction of conditional transactions, without getting the majority of the users to update their software. At the same time, the network doesn’t provide incentives to users to reach a consensus on anything, be it software updates, new features or the future of the Bitcoin blockchain in general. The Bitcoin network uses an algorithm called “proof-of-work” to verify the blocks that miners add to the Bitcoin blockchain. Consensus and voting are not a part of the algorithm, which is one of the reasons why so many new cryptocurrencies have appeared simply because someone wanted to make a change to bitcoin. Such cryptocurrencies include Litecoin and Bitcoin Cash, both of which are first-generation cryptocurrencies.

Litecoin is different from Bitcoin in that it uses a different cryptography algorithm called Scrypt versus Bitcoin’s SHA-256. Litecoin also creates blocks of its blockchain faster, every 2.5 minutes instead of Bitcoin’s every 10 minutes. Other than the technical differences, the functionality of the network is very similar to Bitcoin. Bitcoin Cash is a cryptocurrency that split from Bitcoin on August 1, 2017. Bitcoin Cash and Bitcoin have the same blockchain for the blocks one through 478558. Block 478559 was the first block that was different on the Bitcoin Cash and Bitcoin blockchains.

Bitcoin Cash came into existence as an attempt of a group of developers to solve the Bitcoin scalability issue by increasing the size of a block on the Bitcoin Cash blockchain from 1 megabyte to 8 megabytes.

Because of a much larger size, blocks on the Bitcoin Cash blockchain can include eight times more transactions compared to Bitcoin. This means that the supply of space for transactions is much higher. Higher supply usually means lower prices and that’s exactly what happened on the Bitcoin Cash network. For example, on January 6, 2018 average transaction fee on the Bitcoin Cash network was USD$0.192. On the same day, average transaction fee on the Bitcoin network was USD$32.498.

However, the events that have occurred since August of 2017, when Bitcoin Cash became a separate currency, have shown that such an increase can only work as a temporary solution. The switch of SatoshiDice to Bitcoin Cash is a perfect example of that.

Satoshi Dice is a betting game that operates on a blockchain network. The difference between Satoshi Dice and regular betting websites is that to play the game, a player doesn’t need to visit any websites or install any software. To play, a user sends money to one of the static addresses. Different addresses are associated with different betting outcomes. Once the service determines the winners, it distributes the money it has received. Satoshi Dice migrated to Bitcoin Cash after the Bitcoin Cash network came into existence because of the lower fees on the network. Satoshi Dice transactions quickly started accounting for more than 5% of all block space on the Bitcoin Cash blockchain. If the popularity of cryptocurrencies continues to grow, another twenty or so games will take all the space on the network and the size of the blocks will become an issue again, which means that the real issue is not the size of the blocks but a way to achieve consensus on the blockchain network such as Bitcoin.