Bitcoin is all the rage (again) in 2020, but the cryptocurrency space is still widely misunderstood. From a technological perspective, blockchains are a remarkable innovation. They’ve been applied by many projects and companies, and led to the development of the crypto industry. However, bitcoin’s place as a financial asset is less clear. Some believe it’s the greatest financial instrument ever created, while others view it as nonsensical or worse, a scam. My aim in this post is to share my framework for understanding where it is as of late 2020 – as both a technology and an asset.
Bitcoin as a Technology: a Primer
Satoshi Nakamoto, bitcoin’s mysterious inventor, was clear in the title of the project’s whitepaper that it was designed as a protocol for peer to peer electronic cash. He might not have expected his solution to the problem of digital cash to spawn an entire industry. Blockchains became a flashy technology in the 2010s. New crypto projects were introduced daily and corporate innovation departments started investing in blockchains. This was all for good reason – blockchains are a clever creation that will form a new layer of the internet. We’re still in the early innings, but we’ll continue to see new applications. The 2020’s might be a big decade for crypto. I won’t go into painstaking detail on the bitcoin blockchain in this article, but I do need to point out some key features that are relevant to understanding it as an asset.
The most important aspect of cryptocurrencies as a technology is that they allow us to exchange value without the need of a trusted 3rd party. In other words, they don’t require us to rely on a government or financial institution to secure our monetary system.
In centralized, traditional finance, banks and governments hold their own ledgers of transactions in databases. These transactions are centrally processed, and we trust institutions to be good stewards of the system. If banks were to be hacked, the integrity of transactions and the financial data stored in those databases would be at risk. Likewise, if a government were to act irresponsibly or in bad faith, it could damage the people using that nation’s currency.
With bitcoin, this process is decentralized. The ledger of transactions is completely open source. The bitcoin network compensates individuals called ‘miners’ who compete to process transactions on their own. For a new set of transactions (a block) to be added to the ledger, miners must solve a complex math problem that takes tons of computing power to complete. This process makes it nearly impossible to reverse transactions. Changing blocks would require widespread cooperation of many of the individual nodes in the network, and an impractical amount of computing power. Furthermore, if any miner were to attempt to corrupt the network, they would be disproportionately harm themselves. They would likely be committing a form of financial suicide by crushing the price of bitcoin if they were successful.
Anyone can download the bitcoin ledger right now, and anyone can participate in the network. The reason why people maintain the network is that they have an economic incentive to do so. Miners are compensated with bitcoin transaction fees and ‘block rewards’ for securing transactions. There is a bitcoin-mining industry that uses specialized computer hardware to do this.
The ability to transact without a trusted 3rd party is a big deal. We’re fortunate in modern times to have widespread financial stability, especially in 1st world countries. But what if we could no longer trust the US government to maintain our financial system? We would need an alternative.
There are already many countries with unstable financial environments. Venezuelans, Argentinians, and Zimbabwaeans have all seen their currencies collapse within the last 20 years. To them, crypto is an attractive alternative to the system. If you have an internet connection, you have a chance to protect yourself from your government’s financial decisions.
Because of its open source nature, cryptocurrencies are resistant to censorship by nation-states. They’ve turned money into computer code. And code is simply speech.
This is why people get so excited about crypto. When you first encounter these ideas, it’s easy to get lost in the rabbit hole of potential use cases they could apply to. We can decentralize many things that we currently use on the web using blockchains. Today, there are projects working on decentralized file storage, web browsing, and even social media. There’s even an entire decentralized finance (DeFi) movement that is seeking to create an alternative, cloud based Wall Street.
Crypto has been misunderstood to this point because it’s quite different from anything we’ve seen before. It’s also place where bad actors have made money off of people who come to the industry without enough background knowledge. When people invest heavily into things they don’t understand, money is lost.
People get excited when they first encounter the idea of censorship resistant money. They become dogmatic and can’t evaluate new projects effectively. It’s a fascinating technology to be sure, but we need a framework to think about these things within the context of where the world is today. Even though many people believe in the power of crypto, it doesn’t mean that the powers that be understand it yet. This creates an excellent opportunity for investment, but it also creates risk. We need a way to understand and evaluate these projects from first principles. In the second half of this post, I’ll walk you through my thought process on bitcoin.
Bitcoin as an Asset
This is one question that many people new to bitcoin ask: what is it used for?
While bitcoin is accepted as payment in many places around the world, it’s not widely accepted enough to be used as a common form of currency. It’s also too volatile to be used in this way now. A common debate in bitcoin circles is whether it’s meant to be a digital currency or a digital store of value (or both). To understand this dynamic, we first have to ask ourselves the question that most people who get into crypto eventually ask: what is money?
At it’s most fundamental level, money is a story. There is nothing about dollar bills in their physical or digital form that is intrinsically valuable. We value them because we share a collective belief in their value. This doesn’t mean that money is not real. It’s extremely real, and one of the greatest inventions of our species.
In the hunter-gatherer days, we were forced to trade physical goods with one another. This required us to get lucky – we each needed to have something that the other person wanted. Economists call this a ‘coincidence of wants.’ Consider this lunchroom analogy:
Imagine you’re at the grade school lunch table, and you want to trade your peanut butter sandwich for a friend’s turkey sandwich. If they don’t want to make that trade, you’re out of luck unless you have something else they want. He may want your pretzels, but if you’re not willing to trade away the pretzels, then you’re back at square one. This is a tragic situation – you each want something that the other has, and are willing to trade. Your desires are just misaligned.
Over time, we began to assign value to inanimate objects that could be used for trade. This money would be used as both a store of value, and a medium of exchange. If you had cash in your pocket at the lunch table, it would’ve solved your problem. You could give your friend a dollar for their sandwich, and they could use that money to get their pretzels from a vending machine. This dollar is valuable because both you and your friend believe it is. Your society shares a collective belief in their utility. Currencies themselves are a deep field of study, but an important feature of them can be likened to the growth of any network.
If you’ve ever studied internet companies, you may be familiar with something called ‘network effects.’ A network effect states that each new member in a network makes the value of the current network grow exponentially. Certain things have properties of network effects: social media is the perfect example of this. But languages also have network effects: the more people who speak English, the more valuable knowing the language becomes, which in turn leads more people to speak English. Eventually, the majority of the world ends up speaking english. Network effects apply to money as well.
If a widespread group of people on the planet believe that bitcoin is valuable, it will be valuable. If they’re willing to buy it from you, you can sell it. The more people who collectively believe in bitcoin, the more valuable it will become.
Bitcoin the currency & store of value
The issue with bitcoin as a currency is its speed. The bitcoin network processes between 2 and 5 transactions per second on average. Visa is much faster – processing thousands of transactions per second. This difference in speed will make it difficult for bitcoin to compete head to head for the millions of transactions that happen around the globe every day. The network would be flooded, and transactions would be settled slower than we’re accustomed to. However, this doesn’t mean that some merchants wouldn’t be willing to accept slower speed in exchange for universal utility. This is why many people have begun to consider bitcoin as a store of value vs a pure currency at this time.
When bitcoin is argued to be a store of value, it’s often compared to gold. On many fronts, bitcoin is superior to gold for storing wealth. It’s far easier to store and transport bitcoin than rare metals. Bitcoin has a fixed quantity, whereas new gold can be physically mined. Gold’s advantage is that it can be used for industrial uses, and has a longer history of perceived value. The story of gold as a store of value is an ancient one that is not liable to go away any time soon. Gold’s use as a raw material technically gives it an intrinsic value as well, although it does not serve as a proper rationale for most of the value invested in gold. The gold market cap would be far lower than it currently is if it were viewed as an industrial material vs a store of wealth. Bitcoin is different from gold, and it should be viewed that way. Its qualities give it a wider range of uses.
So why are people buying bitcoin? In my view, there are currently 3 good reasons to be long bitcoin:
- To hedge against the system.
- For a Swiss bank as a service.
- Because you’re speculating on price.
1) You want a hedge against the current fiat system.
This is one that you see a lot on twitter, especially now. Every time there’s been news in 2020 that’s shown incompetence of elected officials, bitcoin proponents often tout how it doesn’t need a government to be used. Down with the establishment!
This is true. Bitcoin works regardless of who’s president or chairman of the federal reserve. It works no matter what monetary policy decisions the country makes. If politicians were to drive the financial system into the ground, we would still have bitcoin. This is perhaps bitcoin’s greatest potential use case – it’s day of greatest utility. If the global financial system found itself in ruins. It’s quite likely that bitcoin would become one of the most valuable assets on earth.
Crypto attracts an anti-establishment, libertarian leaning crowd because of this. Crypto is trying to build a parallel Wall Street. It might be good to move some of finance into the cloud. However, to those who want to see bitcoin become the world’s leading asset:
Do you really want this to happen?
If we see the days of bitcoin at $1,000,000, where it becomes the world’s leading currency, we have to remember that it’s likely because we’ve also seen the downfall of the dollar and other fiat currencies around the world. As Ray Dalio has pointed out in his LinkedIn series, part of the US’s dominance is due to the fact that the dollar is the world’s reserve currency. The country that can print the world’s reserve currency holds remarkable power. The US (and other countries) will not give up this power without a fight. If they give it up because they lose control, it will probably be because something in the current system broke.
Naval Ravikant has often said that the ‘final boss’ for bitcoin and crypto will be regulation. If we view cryptocurrencies as something meant to replace fiat, then it will have to fight an ideological war with governments.
It seems like bitcoin won’t be able to replace fiat anyways due to its speed and volatility. Stablecoin projects are more likely to do this, but they have their own risks. These projects can either break, die due to bad monetary policy by the network, or, if they’re good, be regulated out of existence. As Naval has said
2) Financial privacy. You want a Swiss bank as a service.
One of the biggest critiques of bitcoin and crypto so far is that it economically enables criminals. Bitcoin is used for illegal activities, but a common misconception is that it’s a completely anonymous cryptocurrency. It isn’t. There are advanced algorithms that people & governments have created to help link public keys back to individual people. These are far from perfect, but it is possible to triangulate who owns a given Bitcoin key. The best money for illicit activities is a privacy focused cryptocurrency like Monero, or hard cash. Crypto proponents view this anonymity through the lens of financial privacy. Bitcoin and other crypto is better for financial privacy than digital fiat money.
If you need to flee the country as a political refugee, it’s going to be quite difficult to lug around all of your live savings in cash. The problem with hard cash is that it’s difficult to transport. The best thing to do would be to use that cash to buy something like bitcoin as soon as possible, memorize your keys, and flee. Rather than having to cross boarders with bags of cash, you can cross boarders with money in your head. Then, once you arrive at your final destination, you can find a local community of bitcoin advocates with whom you can sell your coins individually, or create a new coinbase or kraken account to trade it online. Hopefully no one reading this is ever put into this position. But for people living in unstable political climates, having the option to store bitcoin before fleeing the country is a big advantage.
3) You think the price will go up
Buying an asset because you think the price is going to go up is a rational decision. Bitcoin is still quite small within the realm of the global financial markets. It’s current market cap is roughly $300B in 2020. If we consider the market cap of gold is $9T, and you believe that bitcoin is comparable to gold in its use, it’s quite possible that bitcoin will appreciate in price.
Bitcoin is not as easy to buy as many other financial assets. New tools have emerged that have only recently allowed people to buy bitcoin in their retirement accounts, and there isn’t even a bitcoin etf yet. Institutional investors are still figuring out what the technology is, and determining whether or not it makes sense to hold as a part of their portfolio. Some big named investors like Mike Novagratz, Michael Saylor, Chamath Palihapatyia, and Paul Tudor Jones have recently either invested in bitcoin or recognized its value in public. However, many others believe that it’s a ‘bubble’ or that it will be regulated out of existence. If you believe that institutional investors will eventually come around to bitcoin, it will be a huge boon to everyone who currently holds some. The decisions of institutional investors cause the majority of market movements. If trillions were put into bitcoin, it could 10x in price.
Bitcoin has a major advantage in its community. Assets go up in price because people collectively think they’re valuable. Bitcoin has an army of investors who double as one of the greatest word of mouth investor relations teams in the world. People have found a sense of identity in being a ‘bitcoiner.’ People fight to push the bitcoin message out because they’re directly incentivized to do so on both an emotional and financial level. If they spread the bitcoin message and convert new believers, they make money because the price goes up, and they’re identity as a bitcoin guy or gal gets more valuable.
Remember that money is a story. As long as there are people who believe bitcoin to be valuable, accept it as payment, and are willing to buy it, it will be worth something.
What Bitcoin Lovers Might Be Missing
There is no free lunch. If you buy bitcoin because you think the price will appreciate, you might be wrong. Bitcoin is the longest running blockchain project in the world, and thus the most robust to failure at this time. But, if a bug is found in the system and the network experiences a technical failure, that can send the price into free-fall – even to zero if it’s bad enough. This is unlikely, but technically possible.
Bitcoin is also vulnerable to regulatory risk. Will governments attempt to limit how big bitcoin can get? It will be quite difficult to censor out of existence (recall that cryptocurrencies have turned money into speech), but its price could still be slashed in the short term by government intervention.
There are also other cryptocurrency projects besides bitcoin. Eventually, we may see a new project build a better form of digital currency, and it may replace bitcoin on a long enough timeline. People who are extremely pro bitcoin are sometimes dogmatic about bitcoin as the one and only relevant cryptocurrency. Although it’s the longest lasting and currently most powerful, that doesn’t mean this will be so forever. It’s ability to function as a currency for everyday use will be limited by its transaction speed, but it could find a lasting place for itself as an alternative reserve asset for the world. But this doesn’t mean it will be the only reserve asset either.
The final message I have for bitcoin super-advocates: do you really want to see fiat currencies burn? Do we really want to see the downfall of the dollar, euro, and yen? What would have to be true for this to happen? I for one am not eager to see the system fail and send the world into chaos. I love that bitcoin has given us insurance and an alternative, but I’m into peace and stability.
We don’t know what bitcoin’s long term future will be. I am personally bullish, but that doesn’t mean you need to be. It’s a near certainty that blockchains will form a new layer of the internet that we’re only beginning to understand. But time alone will reveal the extent of its impact on the world.
Disclaimer: None of this is meant to be read as investment advice. I currently hold bitcoin, but don’t necessarily believe that you should. This post was meant for educational purposes only.