Having introduced a few friends to Bitcoin and cryptocurrencies in general, I have come to realize it is hard to describe a cryptocurrency, like Bitcoin, in a way that does not take too long time and also confuses your listeners to oblivion. Fairly often I end up encouraging them to watch the great talks by Andreas Antonopoulos instead. But in order to understand one, not the, tale of why cryptocurrencies in general should hold value, some basic intuition about cryptocurrencies is needed. So with no shame, I introduce you to a creative summary of Bitcoin, written in 2010 by Satoshi Nakamoto, the supposed inventor(s) of Bitcoin.
“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
I will skip over a detailed description of Bitcoin, with more complicated concepts like peer to peer electronic payment system, public ledger, private- and public keys etc. The intuition of what the Bitcoin network can do will be enough for now.
So lets instead continue the short tale that Satoshi started; a tale of newly discovered grey metal veins with chemical element Ip, named for its transportability over the widely used Internet Protocol. It is still today sprawling randomly just under Earth’s cooling crust, accessible to all that put work into mining it. Carrying little or no value the first few years after discovery in 2009, miners initially focused on other metals like gold and silver. Unlike the Ip metal, gold and silver were hugely valuable already and used in practice for, among other things, jewelry and reserve assets. The Ip metal on the other hand had no practical use. Sure, the fantastical transportability property was creating a buzz initially, but established metallurgists soon concluded that the property was near useless since the metal itself was useless: not pretty, not very strong, not good for anything practical really. What good then was the ability to be able to transport it over communications channels like the Internet?
Despite the dismissal, a few people, mostly weird geologists and metallurgists, continued to mine or collect Ip ore. And today, almost 10 years later, most of it has been mined already. But not all; it is just harder nowadays to find any since the shallow, large veins are depleted and more people and even large corporations are mining it. Actually, the mining is so competitive now that the best way of obtaining Ip metal is by buying it from someone. So we con… Wait, corporations are mining it? Why would profit maximizing companies throw money on a hobby metal with no practical use?
Its time to explore why the early explorers and collectors were right, why the lone miners with pick axes from the fringes of society sacrificed time and money to obtain this metal while the few leading experts who even bothered to comment, laughed. Satoshi, finish the tale of the new metal.
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.”
A circular value creation is as good estimation as any of what actually occurred with Bitcoin during its early days. No divine power suddenly decided to set that value — humans did and it was probably a highly uncoordinated and spontaneous event, not dictated from any kind of authority. Similar spontaneous events of various magnitude probably occurred historically; the first barter of sea shells, Yap island stone wheels, silver and gold nuggets, or even the famous and more recent POW-camp cigarette trade. Note that the property of value in such examples are helped sparked into life by the fact that these objects are useful, or pleasing to the human eye. The spark, like that of a newly lit fire, can die unless proper tinder is used. It has to catch on to the three essential properties of money. All the above historical examples of money and value are fulfilling these properties to various degrees.
So in other words, paradox-like spontaneous or semi-spontaneous births of value for even rather useless objects have occurred throughout all of history, but with the Bitcoin network, the transportability property in particular releases stronger forces in the wild, themselves creating vastly more value in a somewhat circular fashion. Let’s map these forces. Let’s move from short fable to a reality that could do with some magic metal.
Satoshi’s example of usefulness, with the condition that the metal holds non-zero value, is a good example of a circular force where value breeds more value. To see why, let’s look at remittances. Remittances are money transfers usually conducted by immigrants, from the country that they work in, to their families in the country of origin. A good example is Latin Americans working in the US.
Looking at a recent report from the World Bank, we find:
Migrants are now sending earnings back to their families in developing countries at levels above US$441 billion, a figure three times the volume of official aid flows. These inflows of cash constitute more than 10 percent of GDP in some 25 developing countries and lead to increased investments in health, education, and small businesses in various communities. The loss/benefit picture of this reality is twofold: while the migration of highly skilled people from small, poor countries can affect basic service delivery, it can generate numerous benefits, including increased trade, investment, knowledge, and technology transfers from diaspora contributions.
In the context of this post, the information of importance above is the number USD 441 billion. A not unsubstantial portion of this will be lost to transaction fees — fees that are paid to banks like Western Union for providing the financial service. The report continues:
In 2015, worldwide remittance flows are estimated to have exceeded $601 billion. Of that amount, developing countries are estimated to receive about $441 billion, nearly three times the amount of official development assistance. The true size of remittances, including unrecorded flows through formal and informal channels, is believed to be significantly larger.
The USD 441 billion number is only for developing countries. Including other countries as well, the relevant number is USD 601 billion. The two countries that receive the most remittances by far are China and India, over USD 130 billion together.
Now, how much is reportedly paid in fees? The report continues:
The cost of remittances is the highest in Sub-Saharan Africa and in the Pacific Island countries (for example, it costs more than 20 percent to send $200 from Australia to Vanuatu, and 19 percent from South Africa to Zambia). As of the third quarter of 2015, the average cost worldwide remained close to 8 percent — far above the 3 percent target set in the Sustainable Development Goals.
These numbers are extremely high, and the reasons are bad financial infrastructure, high barriers to entry, AML-checks (anti money laundry) etc. Bitcoin on the other hand transfers any amount of value, from person to person, for a very low price. And it costs the same to send USD 10 that it does sending USD 10 million.
So how do we translate the opportunity of drastically reduced remittance fees to a circular effect on the actual value of Bitcoin? In a scenario where Bitcoin manage to eat away from the yearly amount of possibly USD 50 billion in remittance fees, while other forms of value transfer services fail to do this, the total value of Bitcoin should be heavily affected. The discounted value of all future fee savings would amount to an enormous sum of money, possibly 10–30 times the market value of Bitcoin, which is around USD 65 billion. We can of course not translate this cost reduction straight to increased market value, since it is the immigrants, not the owners of Bitcoins, that are directly benefiting from the actual fee savings. Instead, we should see an indirect effect due to increased usage. All else being equal, increased usage of Bitcoins in remittance corridors do not affect the balance between demand and supply as the initial demand increase is offset when the receiver exchange for fiat money. But all else is not equal.
As we look further what increased usage does, we should discover a second more direct effect that influences the Bitcoin price. Usage itself is a prerequisite to the second parameter I call legitimacy. Users who currently have no need of the remittance friendly properties of Bitcoin may have use of other properties, like low inflation or confiscation resistance. I will touch on the subject of gold later , but one pillar of why gold holds value is because people universally use gold for various reasons (where store of value arguably is the main usage). The same is true for Bitcoin. An increased usage gradually equals increased legitimacy which, I argue, given the general properties like scarcity, divisibility, security, transportability, gradually fulfills the three essential properties of money. If people are more or less certain the usage need is there tomorrow as well, and the next month, and the next year, there is less risk of storing value on digital coins that no one suddenly wants.
The first two properties of money are rather straight forward and the relevant connection to widespread legitimacy is easy to understand. For something to be a medium of exchange as well as a unit of account, it certainly implies in both of those concepts some kind of well-established social consensus between two or more actors. The third property of money, store of value, is what need to be more deeply analyzed. Does Bitcoin earn that property as well? If yes, Bitcoin is money and thus holds value.
Bitcoins are really scarce. The hard coded cap of 21 million Bitcoins makes it extremely unlikely that the network would experience large monetary inflation. This cap cannot be changed other than with the help of a large majority of so called miners. The miners have low incentives to do this since their income depends on the value of a Bitcoin today. Changing the 21 million cap would crash the Bitcoin price, immediately resulting in lower revenues. Depreciation against other currencies through market forces is of course possible, but outside the scope of this post.
A large number of developing countries suffer from systemic or periodic inflation. Argentina is a good historical example. Individuals can in such crises for example buy gold, or USD on the black market. Some people who can afford it resort to buying real estate. All of the above carries a measure of risk, be it financial or physical (robberies, home invasions etc.). But despite the risks, there are valid inflation hedging assets out there. Why then, if there are alternatives, is Bitcoin needed as a store of value asset?
There is a store of value argument for Bitcoin with regards to safety. Unlike gold, no one can steal it (unless you mistreat your private key/password). Unlike property, no one can burn it up. The state can’t confiscate it. Despite this, however, this post would argue that the main store of value argument for Bitcoin is its money-like properties that other inflation hedge assets don’t have to the same degree, as well as strong defenses against actions that diminish those same money properties. The supply of fiat money can be inflated through central authorities and has been for a very long time. The housing market has costs in the form of deterioration of building materials, and it is also very illiquid and not divisible. Let’s instead look at gold to better understand the store of value property of Bitcoin.
The total market cap of all gold that was ever mined is estimated to over USD 7-8000 billion. Some gold has been lost since mined, but there is no doubt the total value is dwindling high. Gold has arguably a quite low intrinsic value, if any. Its long usage in jewelry, by central banks, or in some other industries add to what this analysis earlier defined as legitimacy — a signal to gold holders that the important store of value properties are safe behind the history of use. Bitcoin, like fiat money and gold, has a low if any intrinsic value, and its value is indeed derived from, by its continuous increasing usage and legitimacy, slowly fulfilling the three properties of money towards their optimal limits. The value of all gold is a good proxy of what sum, collected by the human species over the past centuries, could be stored for future consumption with means of cryptography instead of steel vaults.
An argument about value can be made from a relative perspective as well. Even if you, the reader, do not accept this posts proposition of value creating usage and legitimacy properties of the world’s first inherently scarce digital asset, you would still have to explain the enormous value of all gold. Bitcoin, with its finite supply, is remarkably similar to gold, so it would be up to you to define why some, by any means not all, of that value should not go into a safe Bitcoin network. If all its properties were extremely similar to gold, that itself might not be enough for an asset to steal a lot of value. There are metals with finite supply that holds little value. But by enhancing mainly the transportability property of the equation, but also the security property, that surely should be enough to capture a piece of the golden pie.
How the tale of the boring grey metal will end, no one really knows. The Bitcoin network is permissionless and can be used by anyone, so we are all co-authors of the next pages. But if this boring grey metal really is sound money, it can be of interest to understand that the market cap of all Bitcoins is barely USD 70 billion, or around 0.1% of the world’s broad money supply.