A framework to understand its value propositions, risks and upside potential.
|Alexander Lange||May 24, 2020|| 1|
Bitcoin is the biggest socio economic experiment on the planet. Most people are still perceiving it as highly technical and confusing. This post shall provide a simple framework to grasp its value propositions, risks and upside potential.
What Bitcoin is
Bitcoin can mean different things to different people as it is a living project everyone can contribute to. Today, for most people it is a digital payments network that is run and secured by specialised computers around the world that are getting a reward for doing so (miners). The reward is paid out of Bitcoin's inflation which is at ca. 1.8% p.a. currently and decreases over time until all 21 million coins are minted to the miners in ca. 120 years from now. No central authority holds the power to coordinate the miners, delete or tamper with any historic transactions or change its pre defined and transparent issuing plan. Neither can it be redeemed for any other underlying asset, nor can it be minted by any government or institution.
The 21 million units of value flowing across the Bitcoin payment network are called Bitcoins as well. Bitcoins are a monetary asset. A monetary asset serves three main functions: it stores value, is used as a medium of exchange and a unit of account. Humanity has been using monetary assets of different kinds for around 3000 years in the form of rocks, salt , animal skins, weapons or miniature replicas of objects like spades or daggers (700 b.c. in China) until the first coins have been minted in Lydia (600 b.c., western Turkey) made of gold and silver. To settle transactions faster without carrying coins or gold around, paper money in the form of IOUs has been invented. It allowed its holder to go to the issuer - a bank or private institution, not a government - to exchange it for the underlying asset at face value. Today's fiat money is a form of paper money that is issued by governments and cannot be redeemed for any underlying asset. It is based on debt. Contrary to that Bitcoin is an ownership based money - it's owner has complete control over it and doesn't owe it anyone.
Beyond its nature as a monetary asset and payment network the Bitcoin protocol resembles a constitution - an alternative social contract that is composed of a set of rules that are self executing and binding for everyone interacting with it like developers, users, miners, investors or exchanges. The rules can only be changed if all these different groups of people agree on changing the protocol's rules together.
What makes Bitcoin exciting is not that it is digital. We have digital money since the late 1990s and use it through services such as paypal, stripe, square, online banking services etc. Bitcoin is interesting because of its unique traits that no other money in existence have.
Before diving into Bitcoin's unique traits - which are listed in the bottom part of the box above it's worth highlighting how Bitcoin outperforms gold and fiat money in some of the 'regular' traits of money:
Verifiability: Bitcoin can't be counterfeited or double spent. Whoever possesses the private keys has the power to create new transactions that are cryptographically linked and written into the ledger. The ledger is transparent allowing everyone to verify the validity of previous transactions.
Fungibility: all units of Bitcoin are created equally, they are interchangable.
Portability: Private keys can be memorised what empowers humans to store their wealth in their heads. Bitcoins can be sent across the globe in a matter of seconds turning it into the most portable asset in the world.
Durability: Bitcoin is dependent on physical mining infrastructure and the internet, even though alternatives are explored and implemented (satellite).
Divisibility: Each unit of Bitcoin can be devided into 1 million pieces (8 decimals) what sets it up for new forms of transacting like micro payments or payment streaming.
Scarcity: With a fixed supply of 21 million units Bitcoin is the most scarce monetary asset in the world. It is the 'hardest money'. Gold has been and will be mined continuously with varying inflation around 2% while fiat money can be created out of thin air like we've seen in the aftermath of the 2008 and cov19 crisis.
History: Gold is a monetary asset backed by thousands of years of history. Fiat money in its current form has just been born in 1971. With quantitative easing unlimited it still seems like an anomaly in the history of monetary assets what is even more the case for Bitcoin with its 11 years of history.
Broad acceptance: Bitcoin is still far from being used as a means of change for various reasons - merchants can't pay their taxes in BTC, high volatility, technical complexities, regulatory uncertainty and lacking economic incentives of consumers to spend their holdings. The rise and broad scale adoption of an internet native monetary asset seems far out but can be significantly accelerated once adopted and distributed by big tech companies (facebook, google, apple, amazon, tencent, alibaba etc.).
Bitcoin's unique traits against other monetary assets and payment networks are discussed below. They are what makes it exciting and powerful. Some of them are related and intertwined.
Censorship resistance: money can be seen as a form of speech as it empowers humans to interact and transact with one another without asking anyone for permission. Bitcoin is designed in such way that transactions are executed on a peer to peer basis, without any intermediary. If there is no intermediary, no one can censor the flow of money - no bank, no SWIFT network, no government. This is a double edged sword as it allows investigative journalists, whistle blowers, political organisations like Wiki Leaks or the EFF to have access to financing under any circumstances while also keeping payment pipes open for criminals. Bitcoin's private keys can be memorised what allows people to store their wealth in their heads without anyone being able to seize the asset forcefully from them. That alone fundamentally changes the power dynamics of wars and political unrest.
Programmability: How is Bitcoin's programmability different from that of paypal or stripe dollars? Those moneys are flowing across outdated financial infrastructure that has been built over the past 50 years. The bank's ledgers are fragmented, slow, inefficient, can easily be tampared with and are very limited with regard to the scope of their programmability. Bitcoin on the other hand allows for the safe and definitive execution of financial transaction logic nobody can tamper with. The inner workings of such a transaction program are transparent and verifiable for everyone, so that it can be proven that a given program works the way it's supposed to. Bitcoin allows for micro transactions, payment streaming and simple, self executing financial contracts such as escrow agreements and lending agreements. However, Bitcoin's programmability is limited relative to Ethereum, Cosmos, Near and other alterantive protocols that are taking a more generalised approach towards smart contracts (execution of transaction logic). With the introduction of central bank digital currencies the trait of 'programmability' might upgrade fiat currencies in the near future. Programmatic money and assets will fuel the rise of the machine economy (IoT, drones, autonomous vehicles, virtual reality payments etc.) and come with incredibly strong network effects.
Universal access: Fiat money can only be held by people with physical access to cash notes or a bank account what currently excludes billions of people from the financial system. Even central bank issued digital currency is expected to only be available to people that are registered (KYC, AML, passports) while Bitcoin is open for everyone with an internet connection, 24/7. Similarly, the intranet of corporations was permissioned only to certain individuals and groups what made the open internet so attractive for the world.
Bitcoin is still in its infancy what exposes investors and users to a variety of remaining risks.
Intrinsic value: Gold and other precious metals are used in manufacturing processes or jewellery while Bitcoin remains an object of financial speculation without ‘intrinsic value’. But does it? The Bitcoin network can and will be used for a variety of use cases that don't necessarily relate to financial activity. E.g. it can be used as a programmatic notary to timestamp any data entry with high accuracy and reliability - think of certificates, business documents or IP rights. These use cases will increase Bitcoin’s utility value. <50% of gold are used for jewellery and most of that is actually held as a store of value that can be liquidated anytime by its owner. Fiat and some of the ancient monetary assets like rocks or miniatures don't have any intrinsic value either what tells us that the concept of 'intrinsic value' as such is rather subjective anyways.
Energy: Bitcoin is often criticised for its vast energy consumption that is needed to maintain and secure the network. Bitcoin's energy consumption is high but relative to what? Looking at how current financial infrastructure is run and secured we'd need to take into account the energy costs of physical bank branches, their employees, cloud infrastructure, fraud detection software and more. Besides that Bitcoin is built as a modular, layered stack of different technologies that have the potential to increase transaction throughputs significantly going forward. The energy per transaction ratio will come down. Bitcoin mining is an extremely competitive, low margin business resulting in 1) access to cheap energy and 2) advantages in chip manufacturing being key success drivers. Bitcoin miners are highly mobile and incentivised to find the cheapest electricity on the planet, often in remote areas - hydro, solar, wind, water. With rising Bitcoin prices it becomes more worthwhile to explore these energy sources what eventually spurs massive growth in green energy production.
Technology: Bitcoin's security has been battle tested for the past 11 years and it becomes less likely to be cracked every day. Quantum computation is an abstract risk at this stage and won't be available any time soon. Even if it was there are ways to upgrade Bitcoin's consensus algorithms accordingly. Bitcoin's pseudo anonymity allows for the de-anonymisation of its users and transactional context by combining transaction graphs with external data points (e.g. IP addresses) what prevents enterprises and financial institutions to use it in meaningful ways. The challenge could be addressed by adding privacy across different layers of the Bitcoin stack.
Economics: Bitcoin's block reward is distributed among miners as an incentive to secure the network. Once all 21 million coins are mined (>100 years from now), miners need to be incentivised otherwise what can only be achieved through trade offs. Transaction fee markets are broadly discussed as one potential solution besides an increase of the total supply (highly controversial). Miner centralisation bears the risk of an oligopolist mining market structure and related collusion. Enormous investments in infrastructure and electricity make 51% attacks economically unfeasible for miners.
Volatility: Bitcoin is known for its high volatility which has decreased over the past 10 years in line with the rise of its market capitalisation. The monetisation of a brand new asset class won't happen over night and might take decades. Wildly swinging investor confidence and prices are inherent to Bitcoin's adoption cycles and will remain until the asset is supported by deeper liquidity and more efficient price discovery. Only then might it slowly evolve into a store of value before the means of exchange functionality can be unlocked.
Regulation: Bitcoin provides an alternative currency and payment system that is unrelated to the existing ones, hence cannot be controlled by any government directly. However, governments are able to regulate physical access points to the network like the mining industry or custodial exchanges. Broad societal consensus about the utility, power of innovation and usefulness of Bitcoin is likely to be the strongest mitigation factor for regulatory risks.
Competition: Bitcoin's code base is open sourced and everyone can analyse and use it to run alternative implementations - what happened dozens of times in the past. Monetary systems come with strong network effects as the utility of money increases with every party joining the network. Code can be forked but mining infrastructure, exchanges, wallets, users and investors cannot. Central bank issued cryptocurrencies might increasingly resemble Bitcoin in terms of programmability but they will continue to be subject to government control, censorship and debasement what makes it unlikely for them to compete with Bitcoin's gold like and permission-less nature.
Estimating Bitcoin's potential future market size is challenging because of its diverse nature and broad use cases.
Digital Gold: As a starting point we might compare it to gold which has a total market cap of about $9 trillion split between jewellery (47%), private holdings (22%), central bank reserves (17%) and other forms. Bitcoin demand might exceed that of gold if the IMF decides to add Bitcoin to its basket of reserve assets of $13 trillion that is currently comprised of foreign currencies (86%), gold (11%) and IMF related assets (11%).
Sound Money: Its high divisibility and portability allow Bitcoin to be held by a factor of people who are able to hold gold today. With deeper liquidity and more stable purchasing power Bitcoin might increasingly be used as a means of exchange, eventually eating into subsets of the $90.4 trillion money market (physical: $7.6 trillion, narrow: $36,8 trillion incl. physical plus checking deposits, broad: $90.4 trillion incl. physical plus narrow plus market accounts, savings and time deposits). Continuous monetary policy (quantitative easing) could also be taken into account. Real estate, collectibles and art are often held in portfolios to store value what makes them a further market Bitcoin might capture at least partially.
Final settlement: The invention of digital scarcity powered by Bitcoin is a paradigm shift. It has the potential to let any existing and new assets be represented and transacted with digitally - stocks, derivatives, debt, virtual worlds and more. If Bitcoin is used as a final settlement layer for these types of transactions demand might increase further, though it is difficult to define how much value might be captured thereby.
From these data points the reader is invited to draw her own conclusions about Bitcoin's potential upside and future market size potential.
After 11 years of existence Bitcoin's market cap hovers around $200 billion with a user base of around 100 million. It is in its infancy. Users are exposed to a variety of existential risks that are likely to be mitigated over longer time spans. Its inherent principles of radical openness, censorship-resistance, scarcity and programmability sparked controversy not just in the world of finance. These very controversies make it a contrarian investment asset with asymmetric upside potential that can barely be compared to any other asset in existence.
Disclosure: the author holds Bitcoin. Informative purposes only, no investment advice.