Sidechains have been getting a lot of press recently within the Bitcoin community, backed by a fresh round of 21 million in investment, and with a team including some of the Bitcoin core developers they are in a position to push through changes and adapt Bitcoin to different purposes. For those unfamiliar the premise is very simple. Sidechains is a cryptographic mechanism by which Bitcoin can be locked in the main chain, and redeemed for a deterministic amount of an alt coin. This alt coin has its own blockchain, its own rules, and its own code. It runs completely independently from Bitcoin, but at any time it should be possible to redeem this coin and transfer the value back into the main Bitcoin blockchain.
Blockstream has been touting this as a major innovation, something worthy of investment, and a game changer for Blockchain technology. I’m not convinced yet. Like many good ideas its worth trying to separate fact from fiction, and take a hard look at what Sidechains really do from a technical and monetary perspective.
The first thing to keep in mind is that a side-chain is an alt coin. It is an alt coin that is subject to the same rules as any other alt coin. It is not secured by the Bitcoin proof-of-work by default. It is not immune to bugs. It may not even be extensively tested. It is in almost every way equivalent to any fork of Bitcoin we have ever seen. However, its value is derived from Bitcoin because Bitcoin can be transferred into it at a deterministic rate in order to prop up the chain. The main argument for this, is that it shields people from transactional risk. I would argue that it does the opposite, and hides risk by preventing the free market from discovering its true value.
From an operational standpoint the benefits are clear. If you were running multiple block-chains, and they were all secured via merged mining so that they had identical proof-of-work security, then you could increase the scale by the number of simultaneously running block-chains. The thing is this is true for any alt coin. If you start an alt coin, and it is secured via merge mining, then you can specialize it and increase the transactional throughput of digital currency networks by having multiple simultaneous running chains for different purposes (this is how the system works now).
I think from a scale perspective the thing that is interesting is not running multiple alt-coins, but just scaling Bitcoin itself out horizontally with multiple block-chains that can share data. This lets you increase the scale and size of the Bitcoin network, alt coins be damned. It could also be a way of simply migrating the entire Bitcoin network to a new one, or a different code base. For people who are worried about centralization concerns and regulatory control there is something to think about here. In our effort to scale Bitcoin we may be creating mechanisms to assert regulatory control. What if Bank transactions can only happen on a Bank run side chain? What if transactions for government services can only occur on a government run Sidechains with identity controls? It seems to me to be a slippery slope, once a mechanism exists to migrate coins away from Bitcoin to alternative chains, won’t we see a fragmentation of the ecosystem as companies silo specific functionality?
So the argument seems to be primarily an economics one. We aren’t gaining very much technically from this shift, that we don’t already have with existing alt coins, but are getting “risk-free” value transfer. Of course, that isn’t really true, the risk is being hidden because of lack of information sharing. Despite the negative publicity that traders get the market serves many purposes, including being able to price the value of a commodity or service based on the underlying fundamentals. When you deterministically 2-way-peg an asset you are making a statement. These two things are equivalent. 1 side coin is worth 1 Bitcoin, and 1 Bitcoin is worth 1 side coin. Of course, if a side chain is an alt coin that may not be true. If it isn’t secured by the same proof of work, and the network isn’t as large, and the code hasn’t been vetted I would say that the peg rate doesn’t make much sense. It may be that 1 Bitcoin should be worth a 1000 side coins because that network isn’t as good. Similarly if a major bug shows up in the side chain, shouldn’t its value decrease? If you have new information that the coin isn’t good, then when you buy into it you are paying more than its worth. When you sell it you are getting more than you should.
I think very little effort has been spent on the economics side of this equation. Side chains don’t make good economic sense, if they limit price discovery. The thing is when you deterministically peg something you are making a statement about value that may not be true. A side coin is not Bitcoin by definition, how can you make a value statement in code? There are people who say that Side-coins will trade on alternative markets also, but this is not the case. If I can always buy at a fixed rate, and sell at a fixed rate, I’ll only ever go to the market if I can get a better rate. Market dynamics tell me that I should never be able to get a better rate though because there is the certainty that I can buy and sell at a fixed price indefinitely. Put it another way, if I can buy a side-coin for 1 bitcoin, why would I ever buy it for 2? If I can sell a side coin for 1 bitcoin, why would I ever sell it for less?
It also plays around with incentive structures. Bitcoin itself has taken root because people believe it offers something different then what is out there, and that its network, and technical underpinnings have real value. They have put their money into Bitcoin, some simply to store it, but many with the hope that it will increase in value. A side chain never decreases in value, nor does it appreciate. You are taking a risk in that the coin may fail or have other issues, but there is no upside. Why put your money in an alternative coin and absorb that risk if there is no long term incentive? Similarly as a technologist, why should I spend the considerable effort necessary to create a side chain when there is no long term monetary incentive in the form of ownership to continue developing it? It forces us to find monetization channels outside of the currency proper, which I would argue is not an efficient means of work appropriation.
People also point out that Alt coins are frequently scams (which is true), but I would hazard that their value fairly accurately determines their risk profile. Their is a reason when a coin is trading at fractions of a penny. If the side coin chain stops working (51% attack) or some other transactional bug, Bitcoin may not be redeemable. This is not a risk-free way of trying anything, but many frame it that way.
Like any new technology the rule book is still being written. Its possible that a combination of technologies and methodologies might provide an accurate market-driven structure that preserves incentive structures within digital currency. Side chains is not a panacea to all problems Bitcoin, and there is considerable cause for concern that it may provide a mechanism to subvert Bitcoin proper. Remember Microsoft’s old adage, embrace, extend, and extinguish. Sometimes people with the best intentions make critical mistakes, for even the very wise cannot see all ends. Sidechains may provide a migration path that ultimately inadvertently undermines Bitcoin.