Bitcoin
for
9 minute read
May 6, 2021
More and more people are beginning to realize the unique characteristics of Bitcoin that make it the soundest money ever created.
Despite its meteoric rise, Bitcoin still has a way to go before it becomes entrenched in the mainstream.
According to Glassnode, there are currently around 36 million Bitcoin wallets. If we make a generous assumption that each wallet has a unique owner, that would mean that less than 1% of the worldâs population have engaged with the Bitcoin network.
As Bitcoin continued its rise to prominence over the first decade of its life, many people found themselves asking this fundamental question in an attempt to understand the real value proposition behind Satoshi Nakamotoâs invention.
History of money
In prehistoric times, people relied on barter to conduct their business. A caveman specializing in hunting deer would exchange his deer meat for some fruit collected by the neighboring tribe.
Eventually, the cavemen realized that for commerce to scale, they would need a universal means of representing wealth that would allow them to buy and sell as they wish, without having to rely on direct barter.
Shells, beads, and other collectibles began serving as the way in which value was transferred.
People soon evolved into exchanging salt, grains, weapons, cattle, tools, clothes, and practically everything else, based on their perception of the exchanged itemsâ comparative value.
When gold came around in the fourth millennium BC, the shiny metal quickly displaced other forms of money as the preferred store of value, first in raw form and eventually as minted coins.
As a precious metal, it is not surprising that gold served as a reliable store of value and medium of exchange given its characteristics. Gold is durable, does not corrode or decay easily, highly malleable, and its extremely high stock-to-flow ratio.
The Stock to Flow (SF or S2F) model is a way to measure the scarcity/abundance of a particular resource. The ratio is the amount of a resource held in reserves divided by the amount it is produced annually. Gold was universally considered precious because the annual production is so low relative to the stock.
With annual production of gold averaging around 2,700 tonnes per annum and roughly 178,000 tonnes in existing supplies, goldâs stock to flow ratio is approximately 65. This means that it would take 65 years of annual production to match the existing supply of the precious metal.
The leap to layered money
Eventually, around the mid-17th century, European bankers began to realize the immense power they had over issuing notes that represented gold bars locked in a vault.
The earliest example of this was the establishment of the Bank of Amsterdam in 1609, which took deposits of bullion, giving each customer a receipt valued in bank money for a deposit of bullion.
The bank money proved to be much more convenient to handle than bullion and consequentially the Bank saw a massive increase in deposits of coin and bullion.
The Bank continued functioning this way until 1683 when deposits were no longer fully backed by bullion and silver due to massive lending to the Dutch East India Company - something which turned the bank into an issuer of fiat money, as central banks are today.
The Bank eventually met its doom in 1820 when the Dutch East India Company defaulted on large unsecured advances from the Bank. With the Bank's insolvency and several attempts to recapitalize, confidence with the Bank never recovered and ultimately led to its downfall.
This fundamental change in banking revolutionized money because it allowed assets other than precious metal to be added as a form of layer 1 money while maintaining second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal.
The birth of fiat money
Gold continued to be the ultimate form of money throughout the 18th and 19th centuries, and national currencies became a form of credit in the sense that they were promises to pay gold. This limited the supply of currency because it had to stay within a certain ratio to the supply of gold.
It wasn't until the 20th century, after the fallout of World War I that governments began suspending the convertibility of national currencies to gold, essentially violating the promise set by the gold standard.
The United States, however, did not suspend the gold standard during the war and went on to establish the Federal Reserve in 1913 in the hopes of alleviating financial and banking panics brought on by the worries of investors and the safety of their bank deposits.
The US's adherence to the gold standard prevented the Federal Reserve from truly expanding the money supply at will, but that trust was soon to be violated as well.
"Gold is money. Everything else is credit." âJ.P. Morgan to United States Congress in 1912
In 1929 the world saw the greatest economic depression, starting in the United States after a major fall in the stock market that would result in it losing 80% of its value. International trade fell by more than 50%, unemployment in the U.S. rose to 23%, and around 7,000 banks failed.
During this time period, aptly named the Great Depression, President Franklin D. Roosevelt began enacting a series of economic relief programs known as the New Deal to restore the American economic system.
FDR realized that he could not print enough money to pay for his spending programs, even by increasing taxes. The Federal Reserve Act of 1914 limited the amount of money that could be printed by the government as all Federal Reserve notes had to be backed by 40% gold.
Americans, fearful of a total economic collapse, began a run on the banks withdrawing their notes and gold from the banking system.
It was at this point that Roosevelt signed an executive order in 1933 requiring all US citizens to turn in their gold coins, gold bullion, and gold certificates at the rate of $20.67 per troy ounce, effectively making it a crime to own gold.
Violation of the order was punishable by fines of up to $10,000 or up to ten years in prison, or both. With the stroke of a pen private gold holdings were transferred to the United States government.
Once the government had acquired all the gold in the country, FDR revalued the dollar relative to gold so that gold was now worth $35 an ounce. By this simple decree, the US government had robbed millions of American citizens at a rate of $14.33 per ounce of confiscated gold. To this day, the Gold Confiscation of 1933 can be viewed as the single most draconian economic act in the history of the United States.
Nevertheless, with gold and paper money now separated, FDR was able to increase the federal deficit by issuing bonds (debt) in exchange for paper money. This newly introduced money was used to pay for the many programs he initiated as part of his New Deal program.
The world's first free-floating fiat currency
A decade after FDR's executive order, following the aftermath of World War II, numerous countries faced financial ruin. Countries did not have enough gold to keep their own currency pegged to the gold standard.
The only country which did have enough gold to back their currency at the time was the United States, holding over 70% of the world's gold reserves.
Thus, In 1944, world leaders gathered at a hotel in Bretton Woods, New Hampshire and agreed that all US dollars would be pegged to the value of gold (at the rate of $35 per ounce) while all of the other currencies in the world would be pegged to the US dollar.
After the US dollar was established as the world economyâs denomination: barrels of oil were priced in dollars, trade agreements were struck in dollars, and international bank balances settled in dollars.
The Bretton Woods Agreement, however, would not last. Foreign nations started a run on the US Central Bank and began depleting the United States' gold reserves, making it impossible to maintain a fixed price.
French President Pompidou sent a battleship to New York City harbor to collect his nationâs gold reserves from the New York Federal Reserve Bank, and the British requested the U.S. to prepare $3 billion worth of gold held in Fort Knox for withdrawal.
In 1971 the world witnessed the United States end gold convertibility for the dollar and foreign governments were caught by complete surprise. President Richard Nixon decided to unpeg the dollar from gold, creating the worldâs first free-floating fiat currency. The first currency backed by nothing with its value purely determined by government assurances.
The term fiat derives from the Latin word fiat, meaning "let it be done", which explains how this new form of floating money derives its value: by decree rather than by the market.
Fast forward to today and you don't have to look any further than the dot com bubble, 2008 financial crisis, and 2020 financial crisis brought on by COVID to understand the failures of unlimited credit expansion and quantitative monetary policies. During 2020 alone the Federal Reserve printed over 30% of the entire supply of dollars that have ever existed and US is facing a staggering $26.7 trillion in national debt.
The problem with fiat currency is that, absent a tangible commodity that serves as a peg, its supply can be endlessly inflated by reserve bank governors who are prone to political pressures and misjudgments.
âI donât believe we shall ever have a good money again before we take the thing out of the hands of government, that is, we canât take it violently out of the hands of government, all we can do is by some sly roundabout way introduce something that they canât stop.â â F.A. Hayek 1984
Bitcoin is evolving money
Bitcoin represents the next phase in the evolution of money - a fixed, scarce, corruption-proof digital asset with a predictable supply schedule that can be sent anywhere in the world without the help or control of governments and banks.
A money in which monetary policy is enforced programmatically and not controlled at whim by humans. A money that works on a peer to peer network that anyone can participate in.
A money that is open-source, open to the public, with no one entity or person controlling it. Arguably, these properties alone make it the most advanced money ever created.
Unfortunately, the abstraction of money brought about by Bitcoin is hard to grasp for most. Many people, especially those raised in earlier generations, have trouble understanding how something intangible can have any monetary value.
Even though most fiat money itself exists merely as digital 1s and 0s on a bankâs ledger, bills and coins give us a physical reference point to which we can ascribe value.
To begin understanding Bitcoin, it's important to understand the nuances of the technology.
Bitcoin, with a capital âB,â refers to the protocol and technology as a whole. With a lowercase âb,â bitcoin refers to units of the digital cash system.
Bitcoin is a network of computers (called nodes and miners) that record the transfer of value over a shared public and decentralized ledger. The value that is being recorded on this ledger are the balances and transactions of bitcoins.
The network was launched on January 3rd, 2009 by the pseudonyms creator Satoshi Nakamoto.
Satoshi brought life to the network by mining the first Bitcoin block, known as the genesis block, or Block 0. Embedded in this genesis block was the text:
The Times Jan/03/2009 Chancellor on brink of second bailout for banks
The text references a headline published by The Times on 3 January 2009 and can be interpreted as a convenient headline proving the validity of the first block's timestamp and also a nod to Satoshi's dissatisfaction with the existing financial system and the instability caused by modern banking.
Historically emerging from the ashes of the financial crises of 2008, Satoshi wrote in a blog post, âThe root problem with conventional currency is all the trust thatâs required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust".
The main properties of the system, Satoshi explained, would be that the electronic transactions would be peer-to-peer and would not need to be sent to a financial institution. The system was designed to be completely decentralized, meaning that the users of the currency would not need to repose their trust in a central authority, such as traditional central banks.
Satoshi decided on a fixed supply of 21 million bitcoins, which gives it anti-inflationary properties. The amount of Bitcoin supply can be audited at any time, by anyone, which makes Bitcoin provably scarce.
New bitcoins are issued by the Bitcoin network every ~10 minutes to miners who solve blocks. This is the only way bitcoins are created, which creates heavy competition around mining.
The Bitcoin network bundles individual transactions into blocks. Once a block is accepted and has several confirmations, it can never be changed again making Bitcoin immutable. This block gets added into the ever-growing Bitcoin blockchain (a term used to refer to the linking blocks by embedding a hash, also called digital fingerprint, of one block into the next one)
Another key aspect of Bitcoin that differentiates it from any other asset like gold is its 4 year halving cycles.
Every four years, the amount of new bitcoins issued is cut in half. For the first 4 years of Bitcoin's existence the block reward was 50. In 2012 this was cut down to 25 BTC, 12.5 BTC in 2016, and most recently 6.25 BTC in May 2020.
All Bitcoin halving cycles are predictable events, rather than unexpected shocks in supply.
The chart above illustrates the supply of bitcoin (blue line) against the rate of new supply of coins which diminishes over time (orange line).
Using the Stock to Flow model on Bitcoin as we did with gold, we see that bitcoin has a higher stock to flow ratio. But unlike with gold, we can also estimate Bitcoinâs stock to flow ratio for any year in the future. This is because we already know how many coins will be mined each year until the supply reaches 21 million bitcoin in the year 2140.
Bitcoin, touted as the world's only "digital gold" is a monetary technology not only disruptive to fiat currencies, but to gold as well.
Paul Tudor Jones, one of Wall Streetâs most successful hedge fund managers, announced the inclusion of BTC into his portfolio as an inflation-resistant asset. According to Jones, âBitcoin reminds me of gold when I first got into the business in 1976â.
Jones is not alone in his Bitcoin hedge. Most recently he has been joined by the likes of Elon Musk, Jack Dorsey, Michael Saylor, Stanley Druckenmiller, and Bill Miller. Alongside this juggernaut group of investors, many publicly-listed companies have added bitcoin to their treasuries in recent months.
Bitcoin represents an economic constant. Sound money is always fixed in supply because it acts as a measuring stick for the value of all goods and services in an economy. Better economic calculations can be made if the denominator of prices (bitcoin) is constant.
Furthermore, even for those who can conceptually wrap their heads around Bitcoin, the journey to buying, transferring, and storing (or even trading a futures contract is unfriendly to beginners. New technologies bring new learning curves.
New users exposed to Bitcoin for the first time are overwhelmed by the difficulties of navigating the various wallets, exchanges, and merchants in the space.
With the price of Bitcoin increasing some 200% since yearly lows, it's only a matter of time before the next cohort of users discovers the unique qualities of Bitcoin.