(1) Why does Bitcoin exist (2) How does it work and (3) Should you own it. Those are the three questions I aim to answer in this post.
Part 1: Why does Bitcoin Exist?
The Fiat Problem
The key feature of currencies around the globe (post-1971) is that they are not backed by any physical asset. Instead, they are worth what the institutions that create them, decree them to be. This is what is commonly referred to as Fiat Currency and as of today, all currencies across the globe operate in this way.
The fundamental problem with Fiat currency is that it centralizes power in the hands of banking institutions (that control currency supply and keep track of currency transactions). This is what Bitcoin tries to solve.
This is not a novel idea but it’s become more relevant as (1) Governments have printed more money (2) Money has moved online.
Governments print money for a variety of reasons. Some of these are often necessary to offset the harsh realities of recessions/economic crises but at other times, they can be heavily abused (to pay down unsustainable debts or to win political favors). The modern-day banking system compounds these changes through what is referred to as a Money Multiplier. Banks can give out more in loans than reserves they hold, so the actual money in circulation can increase by more than what the central banks inject. In the US, this multiplier is around 1.20x (so a $1 increase in the monetary base leads to a $1.20 increase in the amount of real money in circulation).
The ultimate outcome of this process, all else being equal, is that the value of the money in your pocket, declines – which is what is referred to as inflation. The supply of money in the economy and inflation, have continued to increase at a compounded rate for the last century (and astonishingly 22% of all $ ever printed were printed in 2020!). You can see how this can easily get out of hand….
The second shift taking place is the trend towards digital money. In fact, only 8% of total currency is held in cash today. Online payments are facilitated by a Central Payments Processors or ledgers, held by a bank or institution, to keep track of digital transactions (and to spot fraudulent activities). This has given more power to financial institutions to maintain, monitor and responsibly handle an increasing proportion of the monetary base.
The fundamental issue Bitcoin seeks to address is how to avoid a situation where the major institutions that we rely on today, abuse our trust or do something stupid. Whilst that sounds far-fetched, the two major trends of increased central bank ‘money printing’ and digitization of finance, have increased the power of these institutions to cause us serious harm. There are multiple examples of institutional mismanagement in the past, such as episodes of hyper-inflation (see table below) and financial scandals where banks have literally made-up fraudulent transactions (Well Fargo, 2016). There is no guarantee this will not happen again.
Part 2: How does Bitcoin work?
Bitcoin as the solution
Bitcoin was proposed in 2008 as a means of solving the above issues. Principally, it does this by (1) inherently limiting the amount of currency (Bitcoins) in circulation (2) decentralizing the ledger that keeps track of digital payments.
The first of these concepts is pretty simple; Bitcoin supply is capped at 21 million Bitcoins. This means that there will only ever, be 21 million Bitcoins in circulation; protecting the holders of Bitcoin from supply led devaluation (aka inflation).
The second, relies on a decentralized ledger to record financial transactions. Instead of having a bank do it, the responsibility to record who is spending what, is shared between everyone who is on the Bitcoin network.
How does Bitcoin work in practice? (Disclaimer: Gets Technical)
The above explanation is usually sufficient. However, if you’re like me and want to understand how this really works, I have laid out the key features of Bitcoin below.
- Decentralized Ledger
All Bitcoin transactions are stored on a decentralized ledger, which is called a blockchain. The blockchain is accessible to everyone and updated over 100x per day. The transactions on this blockchain are displayed pseudo anonymously in so far as they exclude personal details (such as name, address, items you purchased/sold) but they include account numbers, referred to as public keys.
- Transaction Verification
To avoid fraudulent transactions being shared on the network (such as User A taking money from User B without User B knowing about it), all transactions need to be verified by digital signatures belonging to the users in the transaction before they can be sent to the network (and added to the blockchain). This is a bit like signing a bill at a restaurant but far more secure and involves computer functions.
The way this works is that the user in question, has two identifiers for their Bitcoin account (referred to as a wallet). The first is a private key, which only they can see. The second is a public key, which everyone on the network can see.
To verify a transaction, a user would need to approve a transaction with their digital signature. The signature is generated by taking the user’s private key and the transaction in question and putting it through a computer function.
When a digital key accompanies a transaction, Bitcoin software can check it’s authentic (and not just made up by someone) by taking the published digital signature and the public key associated with the user’s account, and checking if this was in fact generated by the user’s private key. The output of this test is a simple True/False to confirm if a transaction is valid or not.
- Bitcoin Mining
The details of all verified Bitcoin transaction are posted publicly in the network in real time. Miner’s group these transactions together in what is referred to as a block (of normally 2,500 transactions). These blocks then get added to the ledger (following the previous block of transactions). This is why the ledger is referred to as a blockchain.
- Hash Function
To avoid a situation where miner’s try to fraudulently enter data or make an error, Bitcoin uses a ‘Hash Function’, which is basically a mathematic puzzle that miners have the solve before their blocks can be added to the blockchain. The role of the Hash Function (SHA-256) is to make it practically infeasible for fraudulent transactions to enter the ledger and resultingly, to create a consensus as to which transactions form the blockchain.
A Hash Function takes a specific input to create a string of data as an output. The two interesting things about Hash Functions are that 1) it is impossible to figure out what went into the function to create the output, without using trial and error and 2) any small changes in the input, cause large, random changes in the output of the function.
So how is this relevant?
After a block is verified, a miner needs to figure out what unique number needs to be added to the block of transactions, to solve the Hash Function (associated with that block). This requires a lot of computing power as it relies on trial and error to achieve. The first miner to solve this problem, gets a reward (more on that below). When they solve this, the unique number input (referred to as ‘Proof Of Work’) is added to the block of transactions, which then gets added to the blockchain.
If a miner tries to put in a fraudulent transaction in their block, they will have a different solution than the other miners for the Hash Function. If they were first to solve the Hash Function, they will have their block added to the blockchain. However, as more blocks need to be mined, it becomes statistically impossible for this miner to maintain their fraudulent version of the blockchain and ultimately their (fraudulent) version of the blockchain becomes discarded (in favor of other, correct, blockchains being solved by other miners).
The reason this works is because Bitcoin relies on the principle that the blocks with the most computational work (i.e. the most successful solutions to the Hash Function) be kept. As it is harder to keep solving the Hash Function when you have a fraudulent transaction, it restricts these from staying in the blockchain over time.
- Inherent balances
Bitcoin maintains a system of self-regulation through ingenious supply/demand balancing mechanisms.
To encourage enough miners to be on the network to verify transactions, they receive a reward (paid in Bitcoins + transaction fees) for their work. This is paid out to the miner that successfully solves the Hash Problem associated with their block the fastest (which is one miner every 10minutes on average). This insures that there is an incentive to mine, which maintains integrity of the network.
The number of Bitcoins given to miners for their effort halves approximately every four years. This helps Bitcoin reach its supply cap over time (predicted to be around the year 2140). After this point, there will be no way to increase the supply of Bitcoin (thereby protecting the value of Bitcoin from supply shocks).
Finally, mining difficulty is correlated with the number of miners in the system (which is set by the difficulty of the Hash Function miners need to solve). If fewer miners are on the network, the problem gets easier to solve, which makes it cheaper to mine and therefore, creates an economic incentive for more miners to join the network. Conversely, if too many miners join the network, it gets harder to solve the Hash Problem, which then means you need more computing power which makes it less economical for some miners. This system ultimately maintains a steady number of miners in the network.
Part 3: Should you own Bitcoin?
As a currency, Bitcoin needs to meet two use cases to be productive: it needs to be a means of exchange and it needs to be a store holder of wealth.
Bitcoin as a means of exchange
Bitcoin is a long way from replacing fiat currency as a means of exchange (supposing that it was ever allowed to achieve this objective).
- Transaction Inefficiency
The Bitcoin blockchain method is an inherently inefficient way to process transactions at scale which will limit its widespread adoption. Visa, a central payments processor can process 1,700 transactions per second compared to Bitcoins meagre 4.6 transactions per second.
The reason for this is because of the way Bitcoin has been hard coded from inception. Recall that miners add a new block of roughly 1mb (2,500 transactions) every 10mins to the network. (That number does not change even if more people are using or mining bitcoin!). To get even close to competing with Visa’s transaction speeds, the way Bitcoin fundamentally works would need to be changed, to either allow more transactions in each block (going from 1mb to 377mb per block) or to reduce the complexity of the Hash problem to allow miners to add one block every 1.6seconds.
Making these changes will be undoubtedly problematic as it opens up a bunch of existential issues for Bitcoin; such as who is in charge of making these changes and whether or not this compromises the security of the overall network. As Bitcoin will always have to solve for how to maintain integrity on a shared network (something central payments processors do not have to worry about), I am skeptical that Bitcoin can overcome this shortfall.
- Monetary policy
The second issue I have with Bitcoin is a textbook one. By capping the number of Bitcoins in circulation, you effectively remove one of the central pillars of modern-day capitalism i.e. the ability to give and receive credit. Without the ability to control monetary supply, economic recessions will arguably be more severe, wages will be sticky impacting unemployment and economic growth will likely be subdued. In fact, everything we know about economic theory would have to go out the window.
- Mining/Power concentration
I see the merits of decentralizing financial power but Bitcoin is far from being a decentralized utopia. 70% of the total Bitcoin mining capacity exists in China and half of the Chinese mining network, is controlled by only 5 companies.
I don’t think this is a coincidence. As Bitcoin gains traction, it will require more and more resources to be mined, meaning that the distribution of said mines will shift to locations where power is cheapest or most accessible. To put this into perspective, Bitcoin mining today, already consumes the same energy as 5million US households, or the entire annual power consumption of New Zealand or Hungary. At the same time, as Bitcoin increases in adoption (and value), more miners will be incentivized to join the network and resultingly, more computing power will be required to mine Bitcoins (see Part II for why this is the case). This tends more power to mining pools, or groups of miners operating under one collective.
We are already seeing both of these trends play out in China where mining is located principally close to cheap coal or hydroelectric power stations, and mining power is principally pooled together by large Chinese mining companies .
The problem with this is both a political and a cryptographic one. Politically, such large concentrations of mining power in specific countries, will work to limit the adoption of Bitcoin as a truly transnational currency (or it being perceived as such). Second, when any single mining group controls more than 51% of mining power, something which was initially assumed to be impossible, it makes it possible for these miners to override the security protocols behind Bitcoin (and effectively opens up Bitcoin to the same problems as Central Payment Processors).
Bitcoin as a store holder of wealth
It is tempting to buy Bitcoin when you look at the recent price action (or if you have ever used Twitter!). There is a lot of mistrust in financial institutions (66% Americans don’t trust the Fed) and Bitcoin feeds off that.
Nonetheless, I struggle to justify owning Bitcoin to protect wealth, when its one of the most volatile assets on the board; more volatile than the S&P, Gold, USD, Oil, Copper… the list goes on. (The standard deviation of daily returns for Bitcoin over the last 30 days is a whopping 4.63%).
Then there’s the fact that over time, the best store holders of wealth have been the asset classes which have productive use cases; something Bitcoin lacks.
- Stupidity Insurance
I am sympathetic to the argument that Bitcoin may act as some sort of stupidity insurance against a financial catastrophe or a black swan even, where the financial system as we know it, no longer exists. In this scenario, hopefully having a small (<2%) allocation of Bitcoin will more than offset the losses elsewhere in your portfolio (though if this happens, you will likely have plenty of other things to worry about). Bitcoin as an insurance policy is also easier to obtain and store (especially in non-fungible amounts) than alternatives such as precious metals (which have been taken out of private ownership multiple times by governments).
Seeing that Bitcoin is still largely concentrated in few accounts (95% of total owned Bitcoins are held by only 2% of accounts), even if the top 100 largest Asset Managers allocated 1% towards Bitcoin, we are likely to see a significant price appreciation in Bitcoin (potentially paving the way to +$500k).
Conclusion: Bitcoin as Stupiditity Insurance
This is the only convincing argument I see for Bitcoin. Principally, that it is a form of Stupidity Insurance. If enough people see it this way, you may even make money in the short term on your investment (but that should not be the objective). The questions this leaves me with are: (1) Do I want to own stupidity insurance now (2) How much do I want to pay for this.
Bitcoin is already up 350% in the last year and has yet to prove its productive use case. This price action is not being driven by people wanting to insure their portfolios but by speculation. Institutional ownership of Bitcoin remains low, and most Bitcoin holders don’t even hold their own Bitcoins (they leave them with exchanges or third party ‘hot wallets’). Meanwhile, the Fed is effectively back stopping financial securities and interest rates are basically at zero, making it far easier (and safer) to just be long equities as insurance against Central Bank stupidity.
Sure, if we see a sharp correction in Bitcoin (sub $20k), improving user adoption or I get to the point where I’m happy to write off some of my stock profits in Stupidity Insurance premium, then I’m happy to allocate 1% of my portfolio to Bitcoin. However, for now – I see better value keeping my money in the stock market and Bitcoin as nothing more than expensive stupidity insurance.