Note: I am long on Bitcoin. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice. Before you proceed further, please see Disclaimer at the bottom of this post.

This is first of my two part series on my understanding Bitcoin as an Asset. You can find the second part here.

What is Money?

Money has to be one of the greatest human inventions. It unlocked human potential to cooperate leading to acceleration of further innovations and thus leapfrogging humans ahead of all other species on this planet.

Human needs have evolved from food & shelter to innumerable conveniences that are part of our lifestyle today. This is possible because we as humans figured out how to exchange one valuable goods to another (barter system). Because of cooperation, different person can specialize and pursue different skill and still have their needs met by exchanging the goods they produced with ones they need. This has led to continuous innovation by humans as species taking us from hunter-gatherer days to species capable of exploring outer space.

But this system works only if any two people involved in trade have coincidence of wants. Let’s take an example, of person A who has chicken farm and person B who has a cow. Person A can exchange with B some (agreed upon) number of eggs in return for some milk. This trade will only work if B needs eggs. However, if B only needs (values) wheat, then A has to find a third person (C) who has wheat and values eggs, and then exchange wheat for milk with B.

This model of trade is not scalable once number of involved parties increase. It becomes too complex to find a counter party to your trade. This is because not every one values same good. Which brings to first property of medium of exchange:

1. It must be valued/desired by all parties in a trade

Another important criteria for this trade to happen is, coincidence of wants at same time. My hypothetical trade above only works if C is in need of eggs right now. If they need it a month later, this trade is not valuable to them, because eggs will be rot by then. Which brings to second required property of money or any medium of exchange:

2. Must retain value over time

It doesnt stop with this. It is quite possible that A might think 2 eggs is too much for a pound of wheat. While C might think 1 egg is too little for the trade. So A and C need to figure out a way to divide the egg. But your cant really break a raw egg into two. Even if you think we can cut it after boiling, what if the trade involves a chicken instead of egg. How can you cut chicken into 2 pieces. This leads to third property need for medium of exchange:

3. Must be divisible

It doesn’t stop with this either. What A and C and far away from each other? It must be possible for A and C to carry their goods to agreed place of exchange. Which is why a house as a medium of exchange is not a feasible. This leads to fourth property for a medium of exchange:

4. Must be carryable across space

There are many other ways (and many properties) to define money but for me these four are main ones.

Gold as Money (and then store of value)

If we study human history from early days of our evolution, we can find long list of experiments with different forms of money. There were attempts to use commodities like cattle, wheat and even coca as money. But these experiments kept failing because these commodities did not have some (or all) of the properties above.

As human skills advanced, we got good at producing metals from ground. These metals proved to be good choice for money over commodities because they are easier to carry over larger distances (property #4), divide into smaller pieces (humans figured out how to weigh metals. property #3), and their durability over time (property #2). While many metals were experimented with, ultimately Gold won because it was much rarer than most metals at same time more durable. This naturally made Gold a more desirable metal (property #1).

Because of this perceived value, gold became even a signal virtue (ornaments) which further propelled gold’s value. Through innovation humans figured out how to mint raw gold into coins, where each coin representing certain quantity of gold (humans figured how to weigh things). Many empires and governments through history standardized on government minted coins as agreed “money”.

But over a period of time, these empires misused their power as sole authority to mint these coins. In the quest to propel their economy, these governments started minting more coins (with reduced amount of gold per coin). While this increased money supply created a vibrant economy for a while, without proper control, this inflation soon became uncontrollable because of the greed of the empires. Soon, these empires became unstable because of loss of trust in currency and thus led to their eventual decline.

But the perceived value of gold never changed. It continued to be rare material which was treasured by humans, leading to continue to be a store of value.

Paper Currency (Fiat Money)

Paper currency was adopted my multiple governments and empires as better form of money. This paper money was durable over time (to an extent), was easier to carry over longer distances and also it was easy to print money in different denominations (divisibility). However, it lacked the fundamental property of perceived value (it is neither rare nor as durable as metals). And also, early incarnations of paper money had trouble with adoption, because people did not trust government printed money.

Governments were able to get around this value problem by pegging the paper money to Gold. Meaning, it was possible for anyone to bring their money to government and exchange for gold. This increased adoption of paper money. This is called “Gold Standard”. This standard continued for hundreds of years. Over a period of time, confidence in paper money increased. People no longer really redeemed gold from their currency making government printed paper as the de-facto money.

As is often case in human history, power leads to abuse. In early 1900s countries like Germany, started abusing this power and started printing more currency (than amount of gold they had). While this circulation of money improved commerce and propped up the economy, it eventually led to inflation (much like Gold era above) and eventual crash leading to 1929 great depression (history may not repeat but it rhymes).

In 1944 after the World War II, all of the allied nations met to solve the problem of currency inflations. This meeting took place in Bretton Woods, New Hampshire and hence the name – “Bretton woods agreement”. Under the agreement, all central banks would maintain fixed exchange rates between their currencies and USD (which was pegged to gold. US had control of lot of gold reserves at Fort Knox). This would mean, any inflation would essentially devalue the currency in relation to USD (and Gold). A side affect of this agreement is that USD became a de-facto global currency.

This eventually failed in 1971. In 1971, United states started seeing slowing economic growth and recession. To prop up the economy, USA had to increase money supply. This led eventual drop in value of USD with respect to Gold. This meant people started redeeming their USD for gold. To avoid this, President Nixon made a historic choice to unpeg USD to gold. This pretty much ended Bretton woods agreement (and Gold Standard).

Without this peg to Gold, governments were able to print more money into system leading to inflation in currency. So Gold’s perceived value continued to rise. To this day, gold is traded in most stock markets. See below chart from which shows increase in Gold value related to USD over last 5 decades.

Bitcoin – Digital Currency and Store of Value

In early 1990s, with explosion of internet it soon became evident that commerce will move over to internet. Many people started seeing the need for a digital currency which can power commerce on internet. But creating a digital currency met with multiple challenges.

• Who would authorize this digital currency? Physical money had centralized trusted authority (Central banks) to validate its authenticity. A digital currency is arguably global because of unique power of internet but there is no clear answer on which centralized entity can validate & control this currency.
• How do avoid double spending? Without central authority how can we ensure that individuals are not double spending they money? Who maintains the ledger for the available balance of each individual?
• How to maintain Security of the ledger? In traditional money, banks are responsible for securing your assets. Without centralized entity to hold your money, securing the ledger becomes a unique challenge .
• How to create digital scarcity? Digital items are by very nature easier to copy. Look no further than music, movies and all the piracy on internet. This exposes any digital asset to massive re-production and duplication leading to inflation.

While these problems remained unanswered for a while, e-commerce continued to prosper. Banks started supported wire transfers; Visa, Mastercard etc built out massive payment networks acting as centralized authority to validate purchasing power (whether individual has money) of individuals. This was all backed under the hood by same physical currency. These payment networks and banks enabled these micro transactions between individuals and behind the doors doing a large settlements between the banks (once a day etc).

But the answer to a true digital global currency was left answered until 2009, when an anonymous hacker Satoshi Nakamoto published a seminal paper on a decentralized digital currency based on purely peer-to-peer technology which he coined as Bitcoin.

Satoshi used a combination of game theory, cryptography and peer-2-peer networks to solve the problem of creating digital scarcity, authorization, a decentralized ledger. While technical details of beyond the scope for this post, let us briefly look at how these problems are solved.

Authorization

Bitcoin leverages public key cryptography to solve the authorization issue. Using this technology each individual has two digital keys – private and public. As name indicates private key is a secret which is only known to the individual, while public key is available for everyone to see. Uniqueness of this technology is that a key which is signed & encrypted with private key can only be unlocked with public key. This helps ensure that money was spent by the rightful owner of the money.

Decentralized Network to Maintain Ledger and avoid double spending

Bitcoin leverages peer-2-peer network in which multiple volunteers maintain a copy of the ledger (balances and transactions). These volunteers are called miners (a term copied from Gold miners). To verify balance and whether a person initiating payment has right balance, majority of the volunteers needs to agree on the balance.

Through this unique insight and reliance on decentralized peer-2-peer network Bitcoin removes the need for a centralized trusted party. It is these centralized trusted parties that repeatedly through the course of history caused downfall of various forms of money.

Incentives as way to issuance and establish security

In bitcoin, the security of network is proportional to number of miners. So, in order to incentivize more minters to participate, the algorithm will issue certain amount of Bitcoin to miner who authorizes transactions. This is how new money is generated in the system and at same miners are incentivized to participate. Miners are also eligible to receive certain % of transaction amount as fee (much like visa or mastercard does today). The side affect of this incentive structure is increased security of the network. For any one to attack the network (and create unauthorized transactions), they need to own 51% of nodes in the network. Bitcoin’s unique incentive structure meant this is virtually impossible given the number of miners competing to validate the transactions in the network.

Difficulty Adjustment as a way to Scarcity

Any currency should have scarcity in order for its value to retain or appreciate. Bitcoin has a fixed number of bitcoins – 21 million. Its algorithm has fixed schedule in which new bitcoins are issued. Every 4 years, the reward given to the miners to validate transaction reduces by 50%.

The way this schedule is maintained is through Difficulty Adjustment algorithm. Every miner has to solve a cryptographic puzzle along with validating transactions to win the bounty. This puzzle is a cryptographic problem which is very difficult to solve requiring lot of computational resources. If more miners are attempting to solve the puzzle (to increase the supply of bitcoins), the difficulty automatically goes up to make sure schedule is maintained. This ensures only once every 10 mins a puzzle can be solved in the entire network maintaining the supply of bitcoin.

All the above 4 properties of the Bitcoin protocol makes it one of the most sound money ever invented. A money which is decentralized & trustless, a money that is secure through its network affect, and money whose supply is controlled.

Over the last 11 years, these properties helped increase bitcoin adoption both in developer community and usage as a digital cash. All this while it has proven to be censorship resistant, secure and reliable. As I write this blog bitcoin has a market cap of ~350 billions.

But it is not without any limitations

Current LImitations

Scale Issue

Bitcoin’s protocol dictates steady creation of supply. As we saw earlier this is achieved through the cryptographic puzzle which needs to be solved to validate transactions. Multiple transactions are grouped together into 1 block. Currently, each block creation takes 10 mins and blocks have a size limit of 1 megabyte. This means bitcoin’s rate of transaction is at best 6-7 transactions per sec.

This limits bitcoin’s usage as basic medium of exchange. Today Visa can process close to 4000 transactions per second. Its multiple orders of magnitude higher than what bitcoin’s protocol can potentially every achieve.

Today, majority of Bitcoin transactions are carried out off‐chain, and settled on‐chain on infrequent schedule (once a day). For example Coinbase (a crypto currency exchange platform), processes all transactions in a local network within their data centers. Coinbase eventually settles these on main bitcoin network at a later time.

There are really interesting initiatives like Lightening network which hope to increase the scale of bitcoin by running several orders of magnitude. The fundamental insight is to create several dedicated networks (block chains) where people can transact bitcoin for specific purpose. These chains will settle the money eventually on the main bitcoin network once a day. This is a very interesting space to watch.

Transaction Costs

Due to the current scale limitations, several transactions need to compete with each other to be included in a block. Due to the nature of free market’s this gives power for miners to charge higher transaction fees. This is much higher than transaction fees associated with traditional money.

These high costs make bitcoin prohibitively expensive for mainstream usage today.

Regulation

Bitcoin as an asset is still not regulated by SEC and other commissions. Because of this there is isnt yet adoption of Bitcoin in mainstream like fidelity, vanguard etc.

Steep On Ramp for Mainstream Adoption

Owning a Bitcoin is not straightforward today. In order to own a Bitcoin a individual needs to maintain hardware wallet which needs to be securely stored. Not many people have these technical abilities. While exchanges like Coinbase, Robinhood etc have made it easier to create account and buy and own bitcoin, there is still a lot left to be done to educate mainstream people on concepts of bitcoin and why it needs to be bought.

All these factors have for now limited Bitcoin to a digital cash or store of value. Because of its scarcity and potential of usage in future, bitcoin is largely viewed as digital gold. Bitcoin has become a prominent reserve asset and hedge against inflation.

In the next post in this series, I will lay out my understanding of Bitcoin as an Asset.

Disclaimer

I am long on Bitcoin. I might sell Bitcoin in future anytime. This post is NOT a recommendation to buy, sell, or hold Bitcoin. I wrote this post to organize my thoughts about Bitcoin and shared it so that you might find it useful. I am not a registered Security analyst. Views in this post should NOT be taken as an Investment advice.

References

1. Inflation-QE-Lemonade-Economy-Government-Central-bank
2. The Bitcoin Standard – By Saifedean Ammous
3. How Currency Works – howstuffworks.com
4. Macro Impact On Bitcoin :: Pantera Blockchain Letter, April 2020
5. Bitcoin as Reserve Asset
6. Blockchain Basics – Coursera
7. Bullish case for Bitcoin – Vijay Boyapati
8. Bitcoin Paper – Satoshi Nakamoto