Invest or not to invest on Bitcoin?

With a bitcoin hard fork being an inevitability, I spent some time examining the possible outcomes and how to best position a portfolio given those outcomes. In this post, I'll review some scenarios that could occur as a result of the fork, and how I would react to these situations.

The hard fork isn't a simple event where there is either a fork or not. The circumstances surrounding the initial split will have a huge impact on the best investment strategies and the eventual outcome. Miners could reach the 75% Bitcoin Unlimited activation threshold and the fork could activate as coded. Alternatively, a group of users from one side of the other could announce that they will fork regardless of hashrate on a certain date and list the forks on an exchange. Finally, absolutely nothing at all could happen, leading to a slow demise.

I was able to come up with a large number of different combinations of scenarios that could happen, but most are unlikely and reviewing them all would dilute the quality of this post. Therefore, I'll divide my focus into the three most likely categories of outcomes, and then will examine how to invest depending on which actually happens.

Scenario 1: Bitcoin Unlimited reaches 75% of threshold and activates

Of all the scenarios, I think that Bitcoin Unlimited reaching its activation threshold is the most likely one. To understand why, it's important to understand that the blocksize controversy is largely a war between developers. Miners have not been shown to care all that much about the situation, and pool operators are most concerned with their profits rather than development controversies.

Since the coinbase value is fixed, profits can be increased by two factors: more transaction fees, and reduced overhead. More transaction fees can be obtained by including more transactions in blocks, encouraging miners to switch. The "overhead" argument is not discussed often enough. It is very difficult to implement Segregated Witness in code, while Bitcoin Unlimited is very simple by comparison. It takes a lot of research and development time to work with SegWit, because the bytes in the blocks change. It is difficult to debug these issues because when one byte is missing from a serialized block, then every other field after it is wrong.

Implementing merge mining cost us two months of development time simply trying to understand how the concept works and how to modify our code to support it - and you never really know whether it truly works until you find (or reject) a real block. There are all sorts of SegWit edge cases that need extensive testing.

Many pool operators have taken simply open source software and decided to set it up to run a pool. The spinup time of those operators trying to learn SegWit is likely months. If forced to choose, these operators will go with Unlimited because they believe they cannot teach themselves how to modify all the code necessary to implement SegWit. This is why I've repeatedly stated that SegWit's implementation is the wrong solution - not only does the soft fork break all sorts of software, it increases complexity so much that new developers have too difficult a time figuring out how to use it.

Once AntPool completes its conversion of nodes, around 40% of hashrate will support Bitcoin Unlimited. This number will likely continue to inch upward over time. Once more than 50% supports Unlimited, it's difficult to see support stalling out below the activation threshold because it will become obvious that the threshold is going to be reached.

At that point, it's most likely that most pools that do not already do it will implement coin switching, so that when the fork occurs, they will simply mine the most profitable fork.

Scenario 2: Bitcoin Unlimited stalls after Antpool completes its upgrades

While less likely, there is also a possibility of Bitcoin Unlimited stalling at the 40% threshold. In this case, I think that the fork will be much more contentious. This is the scenario where we may see the /r/btcfork people initiate the split by releasing a client with a set date for activation. I don't follow the logic that Unlimited's developers will somehow split the network with a minority of miners on their side, but demand for blocks is great enough, and the potential profits for exchanges offering the new coin immense enough, that someone else will eventually do it.

How we get to the fork is less important than the legitimacy of both forks afterward. In this scenario, Core developers will be able to claim that the larger blocks fork has less legitimacy, because it was supported by lesser known or less popular people, who they can portray as inexperienced or malicious. The "battle" will be drawn out and nasty. Criminals like the reddit user who stated he would use zero-day exploits on systems running software opposed to the Core will not only harm bitcoin, but will deal collateral damage to unrelated servers and systems. Due to technical issues, a political belief, or malicious intent, there could even end up being more than two forks.

But the critical difference in the long term between scenarios 1 and 2 is that in scenario 1, SegWit could activate on Bitcoin Core. In scenario 2, SegWit is very unlikely to activate because of its high 95% activation threshold.

In the first scenario, all but the most diehard Core supporters would transition to the Unlimited chain, perhaps leaving the remaining miners who most aligned with the long-term mission of the Core developers to activate the Lightning Network. Why some Core developers are threatening attacks baffles me, because eliminating people who disapprove of the Lightning Network through a hard fork allows Bitcoin Core to activate the Lightning Network and regain value if it the network does indeed provide a valuable service.

But if some Core supporters continue to attack people who want more on-chain space, then they will unwittingly delay the Lightning Network, not only by delaying the fork, but also by ensuring that people who do not support Segregated Witness remain with the Core chain. That's why I believe, perhaps counterintuitively, that the scenario where larger block supporters activate a fork without miners results in the most positive eventual outcome for the larger chain.

Bitcoin Core would continue to be fraught with the current debate, perhaps even with the Unlimited developers still fighting over "bitcoin," because they would all see Bitcoin Large Blocks (or whatever it is called) as illegitimate. While they continued to attack each other, users and businesses would have an API-compatible, cheap chain ready to go, and it would skyrocket in value as it was accepted at more exchanges. The process would take much longer, but in the end the Core would be left with too much opposition to accomplish anything on its chain.

Scenario 3: No large blocksize fork occurs

The most negative scenario for Bitcoin is that Bitcoin Unlimited does not activate and that nobody takes the initiative to fork the network without miner support.

Segregated Witness simply cannot activate in the current situation. The activation threshold is an impossibly high 95%. The people flooding forums claiming that Segregated Witness is the solution to Bitcoin's problems need to reevaluate their position. Even if Segregated Witness could fix the blocksize problem, it isn't going to activate.

Bitcoin Classic and BIP101 have lost support and are also dead. The only feasible path to resolving the blocksize issue in Bitcoin is to fork with Bitcoin Unlimited's. There is not enough time remaining for a new solution.

If miners don't activate Bitcoin Unlimited, then it will be up to someone to take the initiative to activate a fork themselves. I'm pessimistic about anyone doing that because the person who activated the fork would be seen by some as the "leader of bitcoin" and be expected to campaign for activation and maintain the repository. The position of "open source leader," unfortunately, is unpaid. This is one of the reasons that, despite my recommendations that someone publish a fork without miner consent, I have not done so myself, because I need to spend my time earning a wage. People who are qualified to maintain a fork are all doing things that would actually earn them money.

This scenario results in the "altcoin takeover" situation. Core developers will recognize that Litecoin has a reasonable SegWit activation threshold of 75% and focus their attention there, while Ethereum provides others who support Unlimited or just need cheap transactions now with the potential for larger blocks and smart contracts. This outcome is why I've repeatedly written about how Ethereum is undervalued.

Charlie Lee has become extremely aggressive in pushing for the activation of Segregated Witness on Litecoin. A supporter of the Bitcoin Core, he has a clear conflict of interest with his position at Coinbase. Nevertheless, I suspect that he agrees with me on this one issue: if Segregated Witness activates on Litecoin and nothing occurs with Bitcoin for a long time, then the Core developers will switch to a project more aligned with their visions. As a result, while Ethereum was a steal at $18 and still has room to grow even at $30, Litecoin is severely undervalued right now.

Which will be the dominant currency?

In the end, here are the odds I see as to which coin will be dominant two years from now:

Bitcoin Unlimited: 60% - if the miners activate it soon, then what remains of the "network effect" will cause users to prefer this chain, simply because it is cheaper. Segregated Witness and the Lightning Network will not be ready in time for Bitcoin Core to compete.
Bitcoin Core: 5% - the only scenario where I see this happening is one where a clean split happens immediately, and the Core developers stop attacking Unlimited supporters and instead encourage them to leave. In that case, SegWit might activate quickly, and if the Lightning Network works as well as they promise, people could prefer it. The odds are low because I don't think that Gregory Maxwell and theymos will recognize that it is in their best interests to facilitate an orderly transition. Additionally, if SegWit fails to activate, which is likely given the ludicrous threshold, Bitcoin Core has no other advantages.
Ethereum: 25% - Ethereum is being taken very seriously by major corporations. People writing it off as a "contract coin" are sorely mistaken. It is largely ready right now. If we are still talking about this debate a year from now, I think Ethereum's odds will increase to be more likely than not.
Litecoin: 10% - People have ignored Litecoin for years, but it has remained a consistent store of value that is supported by many exchanges. The reason Litecoin is more important than other coins like Monero is that if it activates Segregated Witness, frustrated Core developers are likely to switch to it to activate the Lightning Network there.

I do not believe that DASH has the potential to become dominant. It is a useful coin that is valuable and will serve a specific market, but banks are unlikely to deal with a coin that was specifically designed for anonymity and allow it to become the world currency. It also doesn't have Segregated Witness and the support of proponents like Lee to attract the Core developers to it in the event of continued stalemate. DASH is also not a good hedge during the fork period, because at $100, it is significantly overvalued at present.

Pricing in scenario 1

For the x-axis of these pricing scenarios, instead of dates, integers are used. The point of the integers is to avoid a focus on specific dates, since the date of the fork is less important than the circumstances surrounding it. From here on, "BTC" refers to Bitcoin Core, and "BTU" refers to Bitcoin Unlimited. In addition, the values for LTC are largely dependent on the prospects of Segregated Witness activation, and LTC will not appreciate as much as indicated if it does not activate or at least appear to activate.

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In scenario 1, I see both Bitcoin Core and Bitcoin Unlimited surviving. Bitcoin Core could activate Segregated Witness to allow it to remain relevant, while Unlimited takes up the majority of hashrate and merchant support. After an initial dip lasting months, the Lightning Network allows Bitcoin Core to regain value.

Remember that hashrate follows price, and profit switching pools will quickly become dominant. It is unlikely that under any scenario, one chain will be destroyed by a lack of hashrate. Profit switching pools also reduce the likliehood that Segregated Witness will ever activate on Bitcoin Core, which is why I place the Core's odds of activating it on Bitcoin Core and succeeding at just 5%.

The winners here are BTU and ETH, the latter of which serves as a hedge during the transition. LTC is so low now that it's difficult to see why it would decline further, but its future gains will depend on whether profit switching pools destroy Segregated Witness or not.

Pricing in scenario 2

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In scenario 2, both forks of Bitcoin take huge initial losses. Bitcoin Core starts out with the lead, but BTU slowly rises as the network congestion leads people to seek alternatives. Since there will be continued dispute from Core opponents who are adamant that Bitcoin Core is the legitimate Bitcoin and that it should also be unlimited, causing Segregated Witness not to activate. BTU will eventually surpass BTC, and BTC will slowly dwindle to having almost no value.

In this scenario, everything except BTC wins. After having little initial value as an "altcoin," BTU will make the people who bought it at rock bottom rich. Many Core developers will grow frustrated and switch to Litecoin to work on the Lightning Network there. ETH will continue to have its uses and remain the dominant smart contract platform.

Pricing in scenario 3

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Scenario 3 is the worst outcome for owning Bitcoin. In particular, indefinite bickering combined with Segregated Witness activation on Litecoin would be disastrous. This is where I see Ethereum becoming the dominant currency, because it already solves most of Bitcoin's problems.

Note that the charts appear to show that Bitcoin with a higher single coin value, but there are many more ETH and LTC in existence, so their price will be lower. There will still be investors who hold BTC and use it as fees decline, but it will lose value over time.

In this scenario, Litecoin could become dominant in addition to Ethereum if circumstances line up. Litecoin still has advantages over Ethereum. First, it is API-compatible, so existing merchants can switch with little risk. Unlike Ethereum, it has ASICs, so nobody can buy cloud farms with GPUs to attack the network. Perhaps most importantly, most exchanges offer Litecoin trading as a base pair, meaning that other coins are already denominated and traded in litecoins.

If Segregated Witness fails to gain traction on Litecoin, then I think money slowly drains from BTC into ETH (and also into other altcoins at lesser rates.) If Segregated Witness does activate and the Core developers switch over quickly enough, then the new battle will be between the "unlimited" Ethereum and the Litecoin Lightning Network.

Conclusions

After considering all the outcomes, a few key facts stand out. First, holding onto Bitcoin Core provides a poor risk-benefit ratio, because it has many more possible failure modes than successful or neutral outcomes. Second, if a fork does occur, Bitcoin Unlimited is likely to grow simply because Bitcoin Core can't handle as many transactions as BTU can. Third, Ethereum has many independent applications that give it value independent of the outcome of this blocksize controversy. Fourth, Litecoin is so ridiculously undervalued that a few thousand bucks will make people millionaires in a right circumstances. Even if it does not become a major player, it can't fall much lower given that it still is the best API-compatible network for transferring value right now, and what's the worst that can happen? It will be worth $3.50 instead of $4?

Therefore, the conclusion I came to is that no matter what happens, the safest course of action from an investment perspective is to immediately sell all BTC as soon as the fork markets are added to the exchanges, to retain the BTU, and to invest the profits from the BTC sales into ETH. The highest expected value can be obtained from selling BTC, retaining BTU, and investing the BTC profits into LTC. For a compromise between safety and expected value, the BTC profits can be split between ETH and LTC depending on how likely Segregated Witness activation appears to be on LTC. In the event that no fork is on the horizon after six months, then my strategy will be to slowly increase my allocation in these altcoins over time.