Bitcoin: A New Type of Money
How bitcoin derives its value
Summary:
Bitcoin represents a new form of money, one of only three ever conceived
Bitcoin as a savings vehicle compares favorably to the U.S. dollar and gold
Bitcoin is transitioning from infancy to adolescence as it approaches its 18th birthday—widely known, but still lightly owned
[six minute read]
Introduction:
If I could summarize the value of blockchain technology in one word, I would choose:
Cooperation
In one sentence:
Blockchain technology derives its value from enhancing our ability to cooperate.
Cooperation is the single most important contributor to human progress.
Observe ants cooperate to source food or defend their colony and you will be entertained.
Observe humans cooperate in combat, divisions of labor, or global supply chains and you will marvel in awe.
Cooperation
How does blockchain technology enhance our ability to cooperate?
In three primary ways:
Disintermediation—participants interact without a central intermediary
Distributed Consensus—participants agree without a central intermediary
Self Governance—participants set the rules and govern themselves
The Coordination-Power Paradox
The challenge with cooperation is that it requires centralization.
A centralized entity is needed to coordinate and govern cooperating parties, and centralization introduces opportunity for abuse.
This dilemma is known as the coordination-power paradox:
The same mechanism that enables large-scale cooperation also creates a concentration point for abuse.
“Because you cannot trust yourself or other people, there must be some superior authority to keep us all in order. If it is true that we cannot trust ourselves and others, it follows that we cannot trust the superior authority which we ourselves conceive and obey.” —Alan Watts
The coordination-power paradox was solved with the creation of bitcoin in 2008.
The Byzantine Generals Problem
The Byzantine Generals Problem is a classic thought experiment in computer science illustrating the challenge of achieving consensus in a distributed system where some participants may be malicious.
Satoshi Nakamoto solved this problem with Proof-of-Work cryptography.
The bitcoin protocol acts as a coordination mechanism as follows:
Independent actors broadcast transactions
Different independent actors confirm the validity of those transactions
It costs more for malicious actors to confirm false transactions then they stand to gain, rendering an attack economically prohibitive
Three Types of Money
“At its core, money is a ledger.” —Lynn Alden
In her excellent book ‘Broken Money,’ Lynn Alden establishes that only three types of money have ever existed:
Fiat
A fiat currency is issued by a government, declared legal tender, and has no intrinsic value or physical backing.
The U.S. dollar became a fiat currency in 1971 when the United States federal government ceased convertibility into gold.
Fiat is a Latin word that translates to ‘by decree.’
In other words, because I say so.
The U.S. dollar system suffers from the coordination-power paradox.
What areas of abuse may exist?
Unconstrained deficit spending to finance political agenda
Financial repression (keeping interest rates below inflation)
Privacy violations through transaction monitoring
Politically motivated transaction censorship
Bitcoin vs. The U.S. Dollar
When comparing bitcoin to the dollar, it’s important to clarify the use case:
Medium of Exchange: The dollar is a superior medium of exchange for transactional activity due to its long history, network effects, international recognition, mature payment infrastructure, and low volatility.
Store of Value: Bitcoin is a superior store of value for wealth preservation across nearly all relevant categories:
Gresham’s Law
Gresham’s Law states that “bad money drives out good.”
When two currencies compete, people spend the lower-quality money and hoard the higher-quality money.
This happens because individuals naturally prefer to keep the asset with greater intrinsic or future value.
The Roman Empire famously debased its gold aureus coins by mixing in base metals like copper.
Roman citizens, aware of the debasement, transacted and paid taxes in the alloy coins while hoarding the solid gold coins which gradually disappeared from circulation.
The implications for bitcoin are clear.
Bitcoin vs. Gold
Let’s next compare bitcoin to gold across relevant categories:
Across asset classes, value is steadily migrating from analog forms like gold to natively digital assets such as bitcoin.
At current prices, bitcoin is valued at roughly 1/10th the market cap of gold.
Bitcoin compares favorably to gold across many categories, suggesting significant potential future upside potential.
Inelastic Supply
A unique characteristic of bitcoin when compared to nearly all other assets is its inelastic supply.
If the price of gold increases, miners are incentivized to extract more gold.
Deposits that were previously too deep or uneconomic become profitable to extract.
Improvements in extraction technology can impact supply as well, like we have seen in the U.S. tight oil market through horizontal directional drilling over the last several years.
This is true for all commodities.
Aside from rare art, certain collectibles, or fully developed rare parcels of land, no other asset has the supply inelasticity of bitcoin.
During bull markets, it takes significantly higher prices to ‘unlock’ supply from long term holders.
Supply inelasticity largely explains bitcoins high volatility and rapid price appreciation during previous bull markets.
Conclusion
Bitcoin is a compelling new form of money that compares favorably to both the dollar and gold as a tool for wealth preservation.
I’m often asked by prospective investors if it’s too late and they missed the opportunity to own bitcoin at an attractive price.
Some perspective is helpful.
Gold has been used as a form of money for nearly 3,000 years.
The U.S. dollar has been in circulation for 233 years.
Bitcoin turns 18 years old this January.
According to a recent study by River Financial, global ownership of bitcoin is estimated at just 4.0%.
Over the last 10 years, bitcoin has been the best performing major asset, generating average annual returns in excess of 70% per year.
Broader adoption of bitcoin as a vehicle for wealth preservation would support continued long-term price appreciation.