I and a few others have recently been posting on a variety of different bitcoin related threads, and Brendan asked me if I could make the case for bitcoin with a single comprehensive post to kick off a new thread. I think that's a good idea, so here we go...
Disclaimer
This post is specifically explaining the reasons why people find value in bitcoin and therefore has a pro-bitcoin bias. I have not written much about the risks, threats or limitations of bitcoin or cryptocurrencies in general. This post is NOT a recommendation that you buy bitcoin but moreso an explanation of why others, including me, have.
Brief technical background
I don't want to delve into the technical details about what the bitcoin blockchain is and how it works here, firstly because it's complicated and can't be done concisely, and secondly because
this thread already has many comprehensive posts on the first page covering the main concepts. I'll add that if you're comfortable with a bit of maths, and want to dive deeper into this aspect there's a good 25 minute
youtube video here by the popular maths channel 3Blue1Brown
The rest of this post assumes that you know the gist of what bitcoin is and what it can do, but I'll reiterate some important points:
- Bitcoin is an internet protocol which allows a distributed ledger to be updated and shared in a reliable and immutable manner between peers without relying on trust or third parties.
- The balances on the ledger, are denominated in bitcoin units, which are capped at a maximum of 21 million, and each is currently divisible to 8 decimal places. The balances have no value beyond what the participants collectively believe they represent.
- It is an open system which people voluntarily participate in. It is not a company, or a product. There is no central authority in charge of bitcoin.
- You do not need permission to participate, bitcoin is available to anyone regardless of age, status or geographical location as long as they can run software that speaks bitcoin and they've an internet connection.
- The ledger is public and all transactions can be verified by anyone who chooses
- The code is public and not copyrighted, anyone is free to make improvements or build on top of it.
- Despite being digital, bitcoin has a lot in common with physical cash (both good and bad), it is a bearer instrument so you are free to transact with whomever you choose without risk of further transactions without your consent. If you lose it or are conned out of it, no one is going to reimburse you. It can be secured well, but it is not fool proof and will not prevent you from securing it poorly.
- Bitcoin has been running for 9 years, with plenty of people trying to break it by finding flaws in the concept or the code. There have been bugs, particularly in the early days, but it seems pretty mature and stable by now.
What gives bitcoin its value?
This is the main focal point of this post. A lot of what I say below was already said on the "
Bitcoin is not like gold" thread, which meandered a lot, but it's important.
The first thing to consider is that when a system is open and decentralised different people may use and value it for different reasons.
If you ask 10 people what use the internet is to them you might get ten different answers, and none of them may be things that the inventors even considered when they were creating the protocols that act as the foundation of the internet. We don't know what people will build using blockchains in future, and I don't even know for sure everything people currently do with them, but a good place to start is with the use as money.
To make the case for whether bitcoin can be considered money, I need to go into the fundamentals of the concept of money itself and its history.
Defining Money
Money is defined by its function, not its form. From wikipedia: "The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value.... Any item or verifiable record that fulfills these functions can be considered as money.
Also via wikipedia: "Money is historically an
emergent market phenomenon establishing a
commodity money, but nearly all contemporary money systems are based on fiat money." So for much of human history, what was money was not necessarily dictated from a position of power, but instead emerged from the ground up.
Even just considering gold and euros as two types of money, we can say some things about money:
- Money does not need to have physical form (most euros exist as entries in a digital database)
- Money does not need to be endorsed or backed by a government (gold is decentralised)
- If something can fulfill the functions of money, that is enough to use it as money, it does not need to serve any other purpose (basically the intrinsic value argument, euros are only useful as money)
What properties are useful for fulfilling the functions of money, why did gold win?
So the history of money is that various civilizations used all sorts of things, some were commodity moneys, things used as money that also had other utility other than being money such as bronze, salt and gold. Other things didn't have much or any commodity value such as cowry shells, rai stones, tally sticks.
Why did gold emerge as the clear winner over everything else that people tried? The first answer you usually get is 'because it has intrinsic value, it has industrial uses, and it's desirable for jewelry". Fine, but lots of things have intrinsic value, and many are more useful and important than gold, like food. Diamonds are arguably more desirable in jewelry and also have industrial uses, but they are not used as money to the extent that gold is. (see also:
Paradox of Value and
Subjective Theory of Value)
The reason I propose is that gold, of all naturally occurring things in the world has the best combination of properties that help make something fulfill the functions of money:
- portablity
- fungiblity
- robustness
- verifiablity
- scarcity
- divisibilty
Do you agree that the better something is in terms of all of those properties, the better it can work as both a store of value and medium of exchange? Can you find any other element in the periodic table that has a better combination? Can you think of anything else in the natural world that does? If not, do you think this is a coincidence?
Thought experiment: Is it possible that gold became used as money purely because in the absence of mankind being able to create a purpose-built monetary system gold was the best available thing to use as money and that the industrial and decorative uses are coincidental?
Why did gold get mostly replaced by fiat?
Horses were the main mode of transport for 1000s of years, the best naturally occurring thing that people could use for the function of transport. Then people eventually figured out how to create a a purpose-built technology that fundamentally improved on it and that was pretty much the end of horses.
Eventually people figured out purpose-built technologies for money too. Fiat, and especially digital fiat drastically improves the portability, verifiabilty and divisibility aspects of gold, making it way more practical to use as a medium of exchange. The trade offs are that fiat is not as robust (your digital accounts have counter-party risk) and more importantly fiat does not have absolute scarcity, meaning that fiat is worse as a store of value.
Bootstrapping and confidence
Whenever you accept money as payment or use money to store value you do so with the expectation that at a future date someone else will accept it as payment from you i.e. you never accept money to consume it (or we would consider it barter not money). That means you need to have enough confidence that there will be continued widespread demand for the money.
When all monetary systems start they face a bootstrapping problem, why would the first person accept something as money when they don't know if anyone else will in future? While something might actually be capable of fulfilling the functions of money, if it cannot reach a critical mass of users it may never actually be used as money.
I think for gold it makes sense that the intrinsic value helped bootstrap it. It's less risky to accept something as money when you know it will always at least have industrial uses in future. For fiat it can be bootstrapped by the government endorsing it as legal tender, coercing the population to use it by forbidding other money and forcing payment of taxes in it.
The conclusions drawn from the above lengthy post are:
- Money is anything which can function as money
- Something with the combination of properties that mean it can best fulfill the functions of money will emerge as money and eventually succeed over worse forms of money.
- Gold became the main global money because it had the properties which made it better than anything else at being money (intrinsic value is coincidental, but helped bootstrap it).
The Bitcoin thought experiment
Then we arrive at Satoshi's proposal:
As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties: - boring grey in colour - not a good conductor of electricity - not particularly strong, but not ductile or easily malleable either - not useful for any practical or ornamental purpose and one special, magical property: - can be transported over a communications channel If it somehow acquired any value at all for whatever reason, then anyone wanting to transfer wealth over a long distance could buy some, transmit it, and have the recipient sell it. Maybe it could get an initial value circularly as you've suggested, by people foreseeing its potential usefulness for exchange. (I would definitely want some) Maybe collectors, any random reason could spark it. I think the traditional qualifications for money were written with the assumption that there are so many competing objects in the world that are scarce, an object with the automatic bootstrap of intrinsic value will surely win out over those without intrinsic value. But if there were nothing in the world with intrinsic value that could be used as money, only scarce but no intrinsic value, I think people would still take up something. (I'm using the word scarce here to only mean limited potential supply)
And that is what bitcoin ultimately is, putting the above thought experiment into practice in real life and seeing how it plays out.
Comparing Bitcoin, Fiat and Gold in terms of the functions of money
To understand why over the last 9 years since it launched that this experiment has been growing in users and therefore value, I will revisit the three functions of money mentioned earlier and rate how well bitcoin, fiat and gold fulfill them:
Medium of Exchange
Gold is clearly the worst, it's the least portable, it's hard to divide, it's also arguably harder to verify, it's not widely accepted.
Fiat is the best for the vast majority of cases, especially where you have access to the best fiat (dollars, euros) and 1st world financial services.
Bitcoin is the best when fiat is forbidden, it can also be cheaper and faster in cases where you want to send money across international borders or there are other frictions with fiat.
Bitcoin cannot currently handle transactions at any significant global scale. This MUST improve for bitcoin to ever have any widespread use as a medium of exchange. BUT IF the lightning network or other such layers on top of bitcoin provide a real solution to this there is potential for instant secure cheap transactions without geographical boundaries, there is potential for micro-payments on a scale we've never seen - it may be better than fiat in many ways, but it does not work yet and may not.
Store of Value
This is where it gets interesting, but firstly I want to clarify what we mean by the "store of value" function of money here: It's acquiring something with the sole intent of later exchanging it for something else, i.e. not for any intrinsic usefulness of the item itself. Of course one hopes that what they have chosen as a store of value maintains or increases its value over time but no store of value guarantees this in real terms, and the risk/reward is variable between different stores of value.
I think there are two aspects to the store of value function this which I'll address separately:
1) is it likely to maintain it's real value over time
Gold is probably the winner here, it's definitely the winner in terms of robustness, it has a long history, it's recognized globally, it has no exposure to failure of a single state, it's limited in supply by the laws of physics, it has some non-monetary value to provide an almost certain floor as a consolation prize even if its use as money dwindles.
Fiat varies from country to country. In Argentina,or Venezuela it's terrible. USA and Europe not too bad, for now. I guess people thought GBP was not too bad, and then Brexit happened, so you never know. Will the euro exist in 5 years? probably, 20 years? maybe 100? I don't know, not many have lasted that long.
Bitcoin is new with a short history, most would say it has more potential upside and downside than both fiat and gold. There's no non-monetary use to provide a floor. Like gold it is not exposed to risk of any particular state, but any other number of events can cause a loss in confidence. At first glance it's easy to consider it the worst of the 3 here.
2) how practical is it to use as a store of value
This is where I think bitcoin starts to show some advantages over both fiat and gold, and I think this is really important to make up for the other shortcomings of it:
- without counter-party risk you can secure it with a password
- without counter-party risk you can store it in a redundant manner in as many geographical locations as you want (and in sophisticated ways using multi-sig wallets).
- without counter-party risk you can store it cheaply in any amount.
- it is the most transparent, you always know the exact percentage of the total in existence that you hold, and you can verify this without having to trust anyone else.
- you can cross international borders with it undetected in any amount.
- you can prove you hold it without giving anyone else access to it.
- it is difficult for someone else to know that you hold it unless you reveal it to them.
Unit of account
Not much to say here, this is much less important than the previous two monetary functions and Fiat wins here. From what I can tell things are almost never priced in gold or bitcoin due to the volatility. This is not really a big deal for bitcoin as wallets can do the price translation for you automatically, prices and wallet balances can easily remain denominated in the fiat currency of your choice. Bitcoin of course has fungible standard units which can be used as a unit of account if desired, one niche example of this is that most exchanges price other cryptocurrenices primarily in bitcoin not fiat.
Final Thoughts
For some people bitcoin is a hobby, for others it's a speculative store of value, for others it's a useful medium of exchange for the niche cases where it's advantageous over competitors or is the only option available and for others it's an ideological movement.
I think bitcoin (or one or more other cryptocurrencies) will continue to have value as long as it fulfills the functions of money in unique ways that no other form of money does, and that there is demand for that.
There are many follow-up sections I considered adding to this post, but I think it's long enough already:
- bitcoin and bubbles
- The potential future value of blockchains beyond the functions of money (e.g. smart contracts)
- Limitations (e.g. scaling)
- Risks
- Competitors - other cryptocurrencies, centralised blockchains