Bitcoin Foundations Without Tribalism

March 11, 2021

Diego Tremiterra

CRYPTO.

Key Takeaways

  • The story of Bitcoin is currently being written and no one knows with certainty what are the repercussions of its introduction in the financial system and, more broadly, the global economy. One should learn about the space with an open mind and without being overly tribalistic.
  • The Bitcoin narrative has changed significantly in the last decade. What Bitcoin was created to do (decentralized peer-to-peer payment system) and what major advocates currently say it should be used for (a network that stores value against other assets) are two very different things.
  • Bitcoin’s store of value narrative is valid, especially given its technological features (secure network and finite supply) and the current macroeconomic environment (worries about inflation picking up). That being said, there are many moving parts to this equation.

Bitcoin, and the entire crypto-space, is an emerging asset class that everyone has heard of by now (disclaimer – my mother owns a very small amount of bitcoin). This is a space that is crowded with a significant amount of new information that is intellectually challenging, and we don’t claim superiority in covering it. That being said, cryptocurrencies might be the most spectacular disruption, or financial bubble, that modern finance and economics have seen, and as such, we feel a duty to ride the crypto bus out of curiosity.

Different from many of the crypto-focused outlets out there, we’re not trying to change your mind, but rather put together some thoughts that are conversation starters rather than the end-points of a discussion. We, (Tim and Diego) own a bit of bitcoin, but we’re not banking our financial security, reputation, and future on it. (Just kidding, Tim 100% is)

In the coming weeks, we’ll lay out as concisely as possible what we believe are the most interesting aspects of the assets in the space and will continue to cover crypto (mostly bitcoin) as it develops. We will likely change our opinion as we continue writing about it – after all, this is a nascent space that merges technology, economics, entrepreneurship, political ideologies, finance, game theory, and much more, and we don’t believe many individuals are proficient in the intersection of them all – but whenever we do, we’ll make sure to highlight what’s changed. We think we can add value to our readers by talking crypto, and especially Bitcoin, in exactly the same way we talk about it when we discuss it with friends or colleagues. We don’t overdress it.

Let’s start with Bitcoin.

 

From Peer-to-Peer Payments to Store of Value

Bitcoin is currently 60% of the market cap of cryptocurrencies (historically, it bottomed at 32% and topped at 100%) and, most importantly, it has been the first and most dominant crypto since the successful invention of cryptocurrencies. It’s the Ayrton Senna of cryptos, which is why it tends to be the starting point for anyone who wishes to learn more about the space.

Bitcoin’s story is being written as we speak, and should it fail to be anything other than simply a story, it was at least a really entertaining one. The narrative (i.e. the arguments in favour of its value and adoption) has changed significantly since its creation in 2008, and we’re yet to understand what the ultimate purpose of this new asset is.

Bitcoin was initially created as a peer-to-peer payment system that focused on allowing network participants to transfer value across the internet without the need of a trusted intermediary (more specifically a “financial institution”) that certifies the system is not fraudulent. That’s where the word “decentralized” comes from – it does not depend on a central “clearing” institution. Make sure you read the white paper – it’s not the most obvious thing, but it represents the starting point of the entire Bitcoin conversation, and it’s a good foundation to have under your belt.

The current monetary system we operate in is based on transferring value through many financial intermediaries, all of which cover different aspects of the transactions. When you buy a coffee with your debit card, a certain currency (known as “token” in the crypto world), which generally sits in your bank, moves out of your account into the bank account of the coffee shop through settlement mechanisms that companies like Visa operate. A simple operation such as buying a locally roasted double shot of Panamanian coffee, delivered to you by your pretentious local barista, involves multiple financial institutions that certify that the operation, in and of itself, is not fraudulent.

Why would we not want a financial institution as an intermediary, you might ask? Realistically, regular people don’t really care if a financial intermediary or something else is certifying that the system is not fraudulent, as long as it works well. The vast majority of people have other things to worry about and the current system we operate in is not fraudulent in the overwhelming majority of cases. This would make the whole “decentralized” argument about Bitcoin optically seem like a solution for a problem that doesn’t exist, but that valid thought process fails to contextualize the ideological philosophy of the group of individuals behind the invention of Bitcoin itself – cypherpunks – who generally distrusted the current system (we’re oversimplifying here) and wanted to enable the exchange of money outside of the current infrastructure. We quote Satoshi Nakamoto, the anonymous founder of Bitcoin:

The root problem with conventional currency is all the trust that’s 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. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.”

Ideology aside, one of the most important inventions behind Bitcoin was that its protocol (i.e. the rules of its workings), explained in the above-mentioned white-paper, successfully solved the problem of double-spending (i.e. the risk that the same token/coin can be spent twice without the awareness of the network, making transactions fraudulent and the system worthless) for a currency that lives in the digital world.

Everything digital tends to be infinitely replicable at almost no cost – just think about memes on your WhatsApp groups and how quickly they’re shared among network participants. If a currency is infinitely replicable, it has generally no value, unless it is, for instance, backed by the government that enforces its use (the case with fiat currencies).

Bitcoin solved the double-spending problem in the digital world by creating a network based on blockchain technology with a proof of work verification system, making double-spending almost impossible. We will skip the technical part but have listed at the end of the article sources that explain this in detail. We believe that spending some time trying to at least understand this will help you build an informed opinion on the space.

The core feature of the technology is the transfer of trust from a central authority to the network itself. In the current system, we trust financial intermediaries that they’ll ensure our transactions are rightly executed; under Satoshi’s peer-to-peer network, we trust not a central authority, but that the rules and incentives design of the Blockchain technology with a proof of work verification is sufficiently good to ensure that transactions are rightfully executed. These rules are, once again, defined in the white paper and are explained in the videos that we’ve included below.

The solution that Satoshi Nakamoto idealized for this peer-to-peer payment network is the Bitcoin network (capital “B”).

One of the rules of Bitcoin (the network), and the reason why we write about it in finance, is that you can take on the responsibility of ensuring the well-functioning of the system and potentially be rewarded with a certain amount of tokens – bitcoins (lower “b”) – for doing so. Theoretically, all you need is a computer with internet access, and follow the rules of the game.

Those who decide to take on that responsibility are called “miners”, and they’re one of the most important features of Bitcoin as they are the guardians that certify the network doesn’t become fraudulent. Miners use computing power to ensure that Bitcoin works smoothly, and for that are rewarded with new bitcoins. What they do with those bitcoins is up to them. Importantly, this is how new coins are issued, and the protocol has a limit of 21 million coins (no further coins will be issued after reaching that amount), at a rate that halves every four years.

 

When we refer to bitcoin, we’re usually talking about the token and not Bitcoin (the network). The token is the currency that, nowadays, has fiat-denominated prices and that are exchanged among individuals. Bitcoin, the network, is the set of rules designed to transfer value across the internet without the need for a central financial intermediary. Both go hand in hand in the sense that one doesn’t have any value without the other, but it’s important to make the distinction.

Realistically, Bitcoin, at its inception, was a solution for a problem the vast majority of us does not have. Whilst an impressive technological feat, the use case of a peer-to-peer payment system with no intermediaries was suited for a marginal part of the population, and thus widespread adoption seemed unlikely. Bitcoin itself, as a network to transfer value, is not very efficient as its underlying technology focuses on security and decentralization and compromises speed (see the Blockchain Trilemma for more on this). Bitcoin processes 3  to 7 transactions per second (Visa can handle north of 65,000), confirmation time has averaged around 9-12 minutes most recently and transaction fees have been increasing with its price, making it useful mainly for larger transactions.

Since then, the narratives that attributed value to Bitcoin (and thus, to bitcoin since the token has value if the network has any purpose) have frequently been updated, making it hard to follow the space without being overwhelmed. This made sense since this new technology was developed by a small group of enthusiasts and was for years dominated by retail investors, meaning that it became widely discussed on open internet forums and social media without a proper understanding of the technology or its purpose.

After more than 12 years after its inception though, one narrative has risen to the top when attributing value to bitcoin (the token) – a medium to store value. This makes Bitcoin, the network, a system that is useful not in processing transactions, but rather in ensuring that its token successfully stores value against other assets. The core of the thesis behind this store of value narrative relies on two main ideas: the technical characteristics of bitcoin as a fundamentally limited (and thus scarce) asset, and the risk of fiat currency debasement (read inflation).

 

Scarcity

Scarcity has been one of the traits (although not the only one) that characterized sound money throughout history. Gold has historically been the most successful ‘money’ that we’ve ever dealt with given its technical features: it can be minted at reasonable temperatures, it’s widely distributed around the earth’s mantle, it’s durable, and, most importantly, we have, on average, only been able to add between 1.5% to 2.5%  of its total supply in new supply every year (i.e. inflation rate has been reasonable and constant). This has meant that, independently of gold mining activities around the world, we’ve not flooded the market with excessive quantities of gold, which has allowed it to retain its value across time (when something becomes abundant, its value tends to decrease unless demand increases even faster… just think Pliny the Elder versus Bud Lights).

According to some economists, scarcity can be quantified in the stock-to-flow ratio, which compares the total available stock of a certain asset (i.e. total supply) to its annual new production (i.e. new supply). Gold has the best stock to flow ratio of comparable “moneys”, which serves the narrative of it being “sound money”.

Similarly, bitcoin’s supply of new coins (i.e. the amount of new coins issued through the process of mining every year, when compared to the total outstanding stock) halves every four years, and total supply, unlike gold, is actually limited to 21 million bitcoins, meaning that beyond that point no further coins will be issued. This makes bitcoin’s stock-to-flow ratio similar to gold at current levels, and it will become comparatively better with time (as the rate of issuance of new bitcoins halves).

 

Risk of Fiat Debasement

Scarce assets that can hold value across time wouldn’t matter if the money we currently utilize carried no risk of oversupply.

Debasement of fiat currencies (which is the money we currently use in transactions) happens through inflation, and the case for inflation has been well broadcasted all over the media. We’ve been on a disinflationary trend for more than forty years now and velocity of money has been steadily declining since the mid-1990s. The fear of deflation (and the worries about its implied economic impact) led to a large volume of stimulus from Central Banks first, then governments later (especially in a post-Covid world), which has led to large amounts of new currency being issued, which theoretically should devalue the current stock of outstanding money. When money devalues, you need more of it to buy the same amount of things.

There are many moving parts to this, but in order not to digress too much, you can read more about inflation here (it is one of our main themes).

Fiat devaluation scares everyone because high inflation can, for example, quickly erode a life-time of savings (10% inflation for 5 years more than halves your cash savings assuming rates stay where they are), or because it makes future planning significantly more challenging. This leads investors to think about alternative ways to store their wealth in order to preserve value throughout time. Gold has been the preferred venue for many decades, and it’s within this context of finding an alternative medium to store wealth that bitcoin becomes attractive. Bitcoin offers some features that improve on gold’s value proposition as a store of wealth.

On the negative side, bitcoin lacks tangible demand from both industrial applications (some electronics) and jewelry, meaning that one can’t award it with any “intrinsic value”. That being said, bitcoin is still in its early innings, and it’s unlikely to behave (price-wise) as a store of value asset, as the potential for significant demand coming from the need to store value paired with limited supply promises to have a noticeable impact on its price. But the long-term adoption is dependent, as of right now, on the strength of this core narrative, and whilst price will swing independently of the rate of inflation, its adoption by the mainstream will most likely be correlated with it.

This is the short-summary introduction on why bitcoin has grabbed the attention of many investors, entrepreneurs, media outlets, politicians, and your grannys: there is a worry about fiat debasement and bitcoin seems to be a potential candidate to protect us from that problem. Whether or not it is successful at achieving this is fodder for our continued coverage of this space (Tim likes agricultural analogies, we apologize). So stay tuned.

 

Useful links

Technology: get a basic understanding of the underlying technology.

Libraries of knowledge: where you’ll find all the major content produced about bitcoin.