I’ve decided to start my Bitcoin 2.0 series with side chains. The story definitely doesn’t start here, but proponents are making it sound like it ends here. There are a lot of competing technologies fighting for mind share trying to build next generation blockchains. As incredible as Bitcoin is, there are still limitations, and the argument is that a side-chain that allows for transfer of value between Bitcoin and other blockchain implementations is a valuable and needed innovation. Austin Hill and Adam Back are working on a blockchain company that is trying to shake things up with a new paradigm. They should be commended on a very interesting idea, a cryptographic 2-way peg that allows back and forth transfer. The question in my mind is, do we really need this? What does this offer beyond alt-coin implementations, and are those features fundamentally important?

The idea of an interoperable side-chain is that value can be transferred back and forth with another blockchain in a trust-less fashion. You don’t need an intermediate exchange to do multi-crypto transfer. You don’t need to rely on unfair mining, or pump-and-dump style trading. This is the “can’t do evil” idea, that cryptographic trust is all you should need. This is predicated on the concept that the digital scarcity of Bitcoin is a good thing, and that it should be preserved across blockchains. Separating utility value from the unit of account is a neat idea, but it doesn’t change the fact that the utility value of Bitcoin or a side-chain can be immediately duplicated in an alt. So instead of experimenting with new ideas in siloed environments and allowing the market to determine the value of the blockchain in question, the liquidity and ultimate value of the chain is entirely determined by BTC transfer.

Shouldn’t the value of a particular coin float against the values of the others? Shouldn’t I be able to experiment with new ideas in the space without hitching them to the Bitcoin bandwagon? It seems that most of the major benefits of side-chains are actually provided by merged mining, the same system that has driven Namecoin. The thing is that exchangification is extremely powerful, very efficient, allows high speed off-chain trading, and has other efficiencies with respect to capital that make it very appealing. The fact that some entities in the space have violated the community trust doesn’t mean that exchanges are a terrible idea that need to be thrown out. In fact there are many trading paradigms that would probably be very difficult to replicate outside of an exchange ecosystem.

What about digital scarcity? Limited supply drives value. So we are taking the limited supply of Bitcoin and allocating it across blockchains, and thus increasing the value of Bitcoin. The thing is there are alot of alt-chain concepts that revolve around inflationary policy, and there is quite a bit of evidence that Bitcoin’s efficacy as a currency decreases as the value increases. The hoarding mentality coupled with deflationary tendencies is pushing the value up, but the utility remains unchanged. Side chains seem to be poised to increase that overall utility, while also increasing the value. Do we want to pay more for utility that can be provided for less? Look at XRP in the ripple ecosystem, massive amounts of available units, because those units are being used in the transactional system. They are meant to protect the network, not drive the cost of doing business up as the supply dwindles. If a company wants to issue a stock, why should the value of that issuance be tied to BTC? If I issue stock on a side chain with transferred BTC and then transfer that BTC back what happens to the stock?

Let’s do a thought experiment. I’m going to create a side chain called CheaperBTC. You can transfer BTC into it from the main chain, and I’ll guarantee that the transfer fees are a fraction of the BTC blockchain on that network. Since this is a merged-mined alt-chain there is no incentive not to run the network as fees are accumulated across networks. What is to stop massive capital flight from the main blockchain in the search for market efficiency? Would this have a destabilizing affect? Interoperability can have pitfalls and unintended consequences, with a network of the value and size of Bitcoin is there strong incentive to adopt this idea? If BTC irrevocable travels between experimental side chains, what percentage of BTC will be lost in that transfer if the side chain infrastructure collapses or has fundamental bugs that Bitcoin doesn’t have? It seems likely that the deflationary spiral of BTC will become steeper in that scenario. Every change incurs risk, and there would need to be some kind of protections against abusive side chains.

Enough of devil’s advocate. This is a new idea, and it is bound to have some teething issues. The fundamental concept is interesting, and there are certainly use cases that would benefit from cross-chain asset transfer. It remains to be seen whether the benefits outweigh the risks. I believe that most of the value in side-chains already exist in a combination of alt-chains, the free market, and merged mining. Anything that expands the ecosystem is probably a good thing, but side-chains are built on many assumptions about the value of digital scarcity and the fixed monetary policies that exist in Bitcoin. Let’s work towards integrating it but judge the technology on its merits when it delivers tangible value.