What is the Bitcoin Trilemma? Brace yourself for some econ theory

Hey everyone, I’ve been on vacation for the past several weeks which is why I’ve been so radio silent. I’m back in action starting this week though and look forward to a great 2018 in the crypto industry!

To kick off the new year, the Bitcoin trilemma is in the news again amidst further talks of the progress of the lightning network. The lightning network is designed to mitigate some of the problems that Bitcoin has with scalability, namely that conducting transactions on the network has already and will continue to become prohibitively slow and expensive. In solving this problem surrounding transaction scalability, the lightning network also hopes to solve some element of the Bitcoin trilemma.

So what is the Bitcoin trilemma, and why is it so difficult to overcome? Let’s start with the theory.

According to the economic theory, it’s impossible to have a financial system with sufficient liquidity to act as a medium of exchange in which there is a fixed money supply, and a decentralized regulatory structure.

Let’s break that down.

If you have a fixed money supply and fully decentralized money markets, you can’t have sufficient liquidity in the currency because the two aforementioned conditions will, at best, create enormous price instability, and, at worst, cause massive deflationary conditions. Why does that matter for liquidity? If a currency is rapidly deflating or unable to hold a predictable value, no one will want to spend it. People will hoard the currency as an investment like many people are now doing with Bitcoin. If you expected the value of the US dollar to double over the course of the next week, you wouldn’t want to get rid of any of your money, and neither would anyone else, i.e. poor liquidity.

If you have fully decentralized markets and sufficient liquidity for a currency to act as a medium of exchange, it’s impossible to maintain a fixed money supply. They amount of money in circulation must fluctuate according to demand for the currency in order to control the price fluctuations and deflationary tendencies that might otherwise exist.

If you have sufficient liquidity and a fixed money supply, the value of the currency must be guaranteed by a centralized authority such as the Central Bank of England during the 19th century when the British Pound, used widely across the empire, was tied to the gold standard.

Going back to Bitcoin, the inherent structure of Bitcoin has created a fixed money supply (21 million coins) and fully decentralized markets (that’s kind of the whole point of the project in the first place…). Given those two preconditions, economic theory tells us that Bitcoin shouldn’t have sufficient liquidity to act as a medium exchange as a result of the generally deflationary environment it operates in — indeed, this is exactly what is happening as more and more people are clinging to their Bitcoins as investments.

But the Bitcoin community is not one to give in easily. There has to be a way to break historical theory and create the perfect cryptocurrency (with an emphasis on the word currency).

In order to do this, we must figure out how to overcome the limitations of having a fixed money supply and decentralized structure in order to maintain sufficient liquidity in global markets for the currency to serve as a medium of exchange. This is exactly one of the many problems the lightning network is trying to solve.

To learn more about the technology behind this, have a look at an article I wrote several months ago.

And as always, if you have any questions or comments, please leave them below! :slight_smile: