Blockchain-based cryptocurrency platforms like Bitcoin and Ethereum have a major problem to solve if they are going to conquer the world of finance: scaling.
In this context, scaling refers to the ability to process more transactions in a timely fashion. Scaling is important because it’s the only way to ensure that Bitcoin and Ethereum meet increasing demand as they become ever-more popular and their numbers of users grow.
Bitcoin, which is currently the most popular cryptocurrency, has already faced significant scaling problems. Because of the way Bitcoin was originally designed, the number of transactions that the blockchain can accommodate in a given time interval is dependent on the size of blocks in the blockchain. Bitcoin blocks are currently limited to one megabyte in size. The Bitcoin community has grown sufficiently large so that users send more transactions per second than one-megabyte blocks can support. As a result, transactions can now take several hours to complete, especially if they involve small amounts of bitcoin.
This limitation has left users in the unhappy position of having to wait for their money when they receive bitcoin. Plus, bitcoin senders can’t confirm their transactions until several hours after they have been executed. Real-time bitcoin management has become quite difficult because of slow transactions.
Ethereum, the second-most popular cryptocurrency platform, does not yet face serious scaling issues. But it is by no means immune to them. If the Ethereum user base grows as large as current trends suggest it will and the community does not change the way that Ethereum handles transactions, Ethereum will run into scaling issues, too.
Why Scaling Matters for Finance
The scaling limitations of Bitcoin and Ethereum impact all types of technologies built using these platforms, from media and advertising to identity management.
Perhaps nowhere, however, is scaling more important than in financial services. Solving the scaling problem is essential if blockchain developers hope to disrupt the traditional financial services industry.
After all, scaling is one thing that legacy financial services companies do quite well. Banks can process millions of credit card transactions or account withdrawals per minute. They can accommodate virtually limitless pools of capital. Big banks suffer from lots of problems and operational inefficiencies, but scaling is not one of them.
Yet scaling is a big problem for blockchain upstarts seeking to establish a foothold in financial services. If the cryptocurrencies that undergird these companies’ operations cannot support quick transactions without incurring extra costs, the companies’ ability to grow is severely limited.
In addition, the failure to process fast transactions undercuts one of blockchain’s main selling points in the financial services world. As anyone who has ever deposited a check in an American bank account knows, traditional banks take some time — usually a day or more — to make funds available when they are transferred. This is the more the result of bureaucratic problems than it is of technological ones.
In theory, blockchain-based transactions can be instantaneous because they are not subject to the same red tape as conventional financial transactions. Yet because of scaling problems, blockchain-based financial service companies are currently not able to leverage this advantage fully as they work to compete against traditional financial services businesses.
Initially, blockchain companies worked around the scaling problem by paying more to prioritize certain transactions. Token processors like Coinbase and BitPay shelled out extra cash to make sure that their customers’ blockchain transactions were processed quickly.
This approach is neither cost-efficient nor feasible in the long term. It handicaps blockchain financial services companies by decreasing their profitability. And the expense of paying extra to ensure fast transactions will only increase as long as the underlying scaling issues remain unsolved and cryptocurrency communities grow in size.
A better solution is to solve the underlying scaling issues. For Bitcoin, the solution of choice has become SegWit. Put simply, SegWit changes the nature of Bitcoin transactions in such a way that transaction speed is not dependent on block size. Although SegWit has its critics, it has now been adopted by a majority of Bitcoin miners.
Blockchain-based financial services companies that don’t want to use the SegWit-enabled Bitcoin blockchain have the option of choosing Ethereum instead. As noted above, Ethereum does not currently face serious scaling issues. And because of the Bitcoin experience, Ethereum stands a better chance of having its scaling issues worked out before they become a serious problem.
There are several potential ways to solve Ethereum’s scaling limitations. It’s hard to say exactly which solution, if any, will prevail; however, a leading contender is sharding. Sharding is a system that, rather than have the entire blockchain confirm a transaction, would require only a subset of nodes on the blockchain to confirm it. This decreases the security and reliability of the transaction. Yet if a sufficiently large number of nodes confirms a transaction, the network can trust it with a high degree of confidence, even though not all nodes have confirmed it.
All in all, things are looking up for financial services companies hoping to leverage blockchains to disrupt the existing finance industry. Scaling woes remain, but progress is being made.
Although Bitcoin’s adoption of SegWit has left some Bitcoin users unhappy, it does not appear that the decision will create enough waves to sink the Bitcoin ship — and more importantly, Bitcoin now has a widely accepted solution to its scaling limitations in place.
As for Ethereum, users can make a safe bet on the community achieving a fix for the scaling issues before the Ethereum user base grows so large that scaling becomes a real problem.
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