What Gives Bitcoin Value?

(To read this post in parts, check out part 1 on Medium.com)

The following is from an email exchange with a friend who is skeptically interested in Bitcoin and Cryptocurrencies. It’s been formatted and edited to better stand on its own, with headers added for clarity and the original questions that are being responded to in blockquotes.

The major friction point as I understood the questions is a matter of what makes money valuable. In the specific case of Bitcoin, the question is how can a cryptocurrency hold value when it exists as code that can be easily duplicated an infinite amount of times, e.g. what’s stopping me from starting a BuckCoin and using that instead of Bitcoin, which then makes the potential money supply of all cryptos infinitely large (this won’t be a new concept to anyone familiar with ICOs and the token economy)

On to the email…

Currency and Trust

All currencies, including clams and dollars, are subject to the same rule: people have to believe in them, they have to trust. The more the trust, the more the value, the longer lasting the currency.

I agree with the idea that people have to trust a medium of exchange for it to be adopted and be effective. When I claim that Bitcoin is a trustless system however, what I am addressing is the flaw in the systems that we’ve have had until now, which is that while the medium itself must be trusted that it will be accepted elsewhere, the systems relied upon for exchanging them typically still require a trusted third party for their free flow and I’m arguing that this is a technical point of failure.

For example, with gold, we typically had to trust the goldsmiths or the mint of the reigning world economic powers (e.g. Byzantines, Romans, Chinese). If you had an ounce of gold stamped with their seal, you could trust with a reasonable amount of certainty that it was actually worth an ounce of gold. Even these systems were vulnerable to a breakdown of trust, however, and thus eventually a breakdown of the systems they propped up in the long run. What happened with the Romans or Medieval kings in Europe was that when their treasuries started to run low, bits of gold would be shaved off the edges of coins, melted down, and new coins minted at an imperceptibly lighter weight. Over time, as with any inflation meant to manipulate people and markets, this eroded the market’s trust in the currency and the governments backing them crumbled. Paper currencies, of course, are essentially designed to optimize this process of devaluation. I haven’t come across a good argument as to how what we’re doing now is any different or better than shaving off bits of gold off coins. It seems to me that we are just better at obfuscating the debasement and ultimately kicking the can down the road.

So, while Bitcoin must follow the same rules of trust as other monies, i.e. I have to believe that other people will accept my Bitcoin just as I know people will accept a nugget of gold or a US treasury note, I no longer have to rely on trusting a third party to not debase the treasury note or to correctly weigh the nugget of gold or to transmit my transaction (as with credit cards/bank transfers). This characteristic alone is what gives/gave Bitcoin the initial trust as a medium of exchange. As soon as one tries to debase or inflate Bitcoin, you’re kicked off the network and your new currency won’t be accepted as Bitcoin anymore. More on this later, but the primary innovation of Bitcoin, which has been built upon by other cryptos, is that it created, for the first time ever, a verifiably scarce digital resource. This single characteristic alone has opened up the floodgates for a host of other innovations and efficiencies.

Is the USD where Bitcoin derives its value?

If you think about it, the single element that gives bitcoin the most credibility and value, is, also paradoxically, the USD. (A currency it may one day replace?)

I do not think it makes sense to equate denominating Bitcoin in USD with USD giving it value. The only thing the USD really does is provide a point of reference for quantifying its value, not what gives it its value in the first place. That would be like saying that the USD is what gives oil its value or the Euro its value since that is how we predominantly denominate those commodities as well. Exchange rates are simply points of reference. In fact, in China, where Bitcoin trading volumes are the greatest in the world, they primarily denominate it in RMB (as you can imagine, crossing the ¥8,888 mark was a big cognitive milestone in those markets even though it was meaningless when converted to the USD rate). Further, there are now exchanges and markets that are purely cryptocurrency where no fiat is involved at all. Because anyone in the world can use, trade, and transmit cryptos, this means that these are markets that enjoy global participation, are running 24/7, and are completely outside the realm of the USD, or any other fiat currency. The alternative digital currencies are even all denominated in Bitcoin (and sometimes each other) rather than USD!

Instead, what gives Bitcoin its value is that it is a verifiably scarce digital resource as mentioned above. Additional value is gained by the fact that, as a result of its relatively wide level of distribution and acceptance now, the network that secures this resource is also the most powerful (and distributed) computer network in the world, over 40,000 times more powerful than the top 500 most powerful super computers in the world combined. This also makes the Bitcoin network the most secure networked resource in the world. This characteristic means that it is also being used beyond currency to do things like digital notary services where you can prove ownership over physical assets through timestamps on the Bitcoin Blockchain (an Austin based company, Factom, is actually working on this problem, including with the Chinese government on their smart city initiatives). The societal and legal implications of this are astronomical and these additional use cases further compound the value of the underlying token (and sets up a higher barrier of entry for my “BuckoCoin” to compete).

It is also worth noting that Bitcoin didn’t just come out of thin air. As mentioned in my talk at Hack Reactor, this came from a computer science problem that had been under investigation for decades with several attempts at solving it falling flat (including even PayPal and as bright and innovative a mind as Elon Musk trying to make a digital currency and eventually giving up). The fact that Bitcoin was able to solve this problem of digital scarcity is what gave it it’s initial level of trust and allowing it to grow from a 9-page white paper written by an anonymous individual on online message boards to a global economic system worth over $70bn in just under a decade. The point is that the trust was very much earned through the gauntlet of both the market and academia.

Need & Trust

Is there a need for Bitcoin?

NEED: We have the USD, which most people trust. Why is there a need for an alternative? Or put it another way, to what extent would our world have to change for that need to become imperative? To what extent would our world have to stay the same? (i.e. Crypto currencies require the internet, so the assumption is that the internet will never go away.) (And the next question is: is that future world likely?)

I’ll take these one at a time:

Why is there a need for an alternative?

The need for an alternative is two-fold, need in the developed world and need in the developing world.

The need in the developed world comes from the fact that the fiat system is incredibly inefficient and insecure. Billions of dollars a year are spent in administrative costs simply to verify settlements between large financial institutions. The SWIFT network was hacked three times last summer alone resulting in the theft of millions of dollars and an increase of security measures that added weeks to processing times of large amounts of funds*. The cost of this security per transaction in Bitcoin is trivial. Credit card processing fees, while they may feel free to the consumer, the fact is that from anywhere from 1–10% is added on top of everything we buy with them because merchants have to pay processing fees and because of the very large risk of charge backs. A practical example of this is a company founded a few years ago called Gyft that allowed for the purchase of gift cards. They almost had to shut down as a result of the amount of fraud resulting from credit card chargebacks. The CEO discovered Bitcoin (then still in the early days) and switched over to that as a payment system. Chargebacks and fraud went down to almost zero and the company became profitable and successful. Purse.io similarly takes advantage of this feature, among others of Bitcoin, in allowing mediated purchases of anything on Amazon to anywhere in the world.

In the developing world, you’re already seeing the need for decentralized currencies. In Venezuela right now, Bitcoin and cryptocurrencies are one of the only ways that citizens can get their hands on physical goods like toilet paper, milk, or clothing. They are actually using services like Gyft and Purse, purchased using cryptocurrency since all fiat currencies are on full lock down, to buy things on Amazon. There is a very interesting story on this from Reason magazine about Bitcoin mining in Venezuela. Particularly striking to me is the story of one man who had his mining rigs confiscated only to have the officials that took them from him start mining for themselves!

It’s not just Venezuela though. With bank wire costs getting as high as 10–20%, opportunities in remittances with Bitcoin are huge. BitPesa is a company in Africa that helps overseas workers send money home to family. I have a friend from Hack Reactor that moved to Manila to work for a company called Coins.ph doing the same thing in SE Asia. You can now use their app to exchange Bitcoin in convenience stores all over the Philippines, which has one of the largest overseas migrant populations in the world. In the developed world meanwhile, the Swiss have made Bitcoin ATMs available in train ticket machines across the country and in Japan, some of the biggest retailers and convenience store chains in the country now accept Bitcoin for payment directly. Even in our developed world, the ability to pay a distributed team spread across several continents at almost no cost since we all get paid in Bitcoin relieves us as a small company of a huge administrative burden freeing up resources to focus on other things. This is also why when I freelanced while still in China, I offered a discount for payment in Bitcoin.

Or put it another way, to what extent would our world have to change for that need to become imperative?

As I think the examples outlined above demonstrate, I don’t think the world needs to change much for there to exist some imperative. I think there are already plenty of real world use cases. If the question is when does Bitcoin become a global currency on par with USD, EUR, RMB, then the answer is probably whenever a major crisis of faith happens in any of those major currencies. If Greece’s bill finally comes due and it’s no longer feasible or politically palatable to keep bailing them out (e.g. like when Cyprus confiscated 10% of citizens’ bank accounts or when Greece shut down their banking system for 2 weeks in 2013/2014) or if the private and local debt levels in China become unsustainable, or the US can’t extend any more debt on the anywhere from $20tr — $200tr amount of unfunded liabilities currently on the books, then we will see a return to the historical norm of using a deflationary commodity backed monetary system. Right now, Bitcoin is far better positioned to accommodate our digital and global world than gold and so I think is more likely to step in if that were to happen. Those scenarios still seem unlikely however so in the meantime it will be gradual through specific use cases where it has built in technological advantages.

To what extent would our world have to stay the same? (i.e. Crypto currencies require the internet, so the assumption is that the internet will never go away.) (And the next question is: is that future world likely?)

I would argue that our current financial system also requires the internet. The M1 money supply, the most liquid “denomination” of our currency, is a small fraction of the total fiat money available, especially in the U.S. system. Just $1.4 trillion out of the total $13.6tr (M1 + M2) available is paper currency as of July 2017. Most of the rest is in security, debt, loans, mutual funds, etc that exist in digitally, centrally stored ledgers both heavily reliant on our networking technologies and vulnerable to attacks on it. Take the existing payment infrastructure that’s developed in China in recent years. Moving from RMB payments to Bitcoin payments in WeChat pay would take almost no technical or cognitive change for users. Scan a QR code and receive funds credited to your account. Gold meanwhile is more like Bitcoin however extremely difficult and expensive to transport and requires a high level of trust for systems like arbitration and dispute moderation.

So I would say that Bitcoin needs the internet as much as the USD and the rest of our modern economy does and is actually more suited to todays world than most legacy systems. In fact, Bitcoin can actually be more resilient to something like an EMP attack or other network failures, and is far more resilient to hacking, due to its distributed nature. It only takes one hard drive to recover the entire Bitcoin network. Target a few data centers though and you can do a far greater amount of damage to our legacy system. Something I can do with Bitcoin that I can’t do with any other monetary system is to make multiple backups of my wealth. I can carry hundreds of thousands of dollars around on a USB drive to anywhere in the world. If that drive is stolen or lost (or confiscated), in the time it takes for the encryption to be hacked, I can recover it on another device from backups stored in geographically distributed locations. Bitcoin companies (and individuals) are thus able to create higher levels of security and redundancy in their internal systems than can be done with fiat money in either the world as it exists today or in a world with a much less robust internet, and certainly more than one where there are network disruptions or hacks.

Can Bitcoin earn the TRUST necessary for a currency to operate?

TRUST: That is the fundamental concept. As the world is changing (And indubitably, it is changing, very fast, and in unpredictable ways) the people of the world also change, and, presumably, what they trust changes too. But trust in a currency has to be hard earned. Ideally, it has to be tested, hard, through a long period of time. (Think recessions, inflations, wars..)

Trust in crypto currencies is based on the blockchain concept, as you said, it comes from “faith in a stable and a predictable supply is baked into the protocol itself and audit-able by anyone with access to the internet and some ability to read code”. I am on board with that, but that is not enough. BuckoCoin would presumably also fit the above description, it would be just as valuable as Bitcoin — as long as people jumped on the bandwagon. In other words, crypto currencies become valuable because of the above + good marketing + the existence of the internet.

– Not unique. If Bitcoin was all the above AND unique, not duplicatable, that would make it more enticing. The point of my previous email is that it is not unique. If you can create a good crypto currency like the Bitcoin, that means you can create many. In fact, presumably, as many as you want. In other words, the supply is endless, and one would think that would have an inflationary effect. Which would erode trust.

In other words, if the concept of Bitcoin can be duplicated, then it is very vulnerable: the only thing that holds it together is marketing, reputation, the fact that is it the first to have become accepted. And that element seems fragile to me.

All of this seems to me to come to the point that since anyone can create a crypto currency how will anyone trust in its scarcity enough to use it as a medium of exchange. Frankly though, I don’t see this as a defining feature of a currency or monetary system. Rather than thinking of the analogy as “Bitcoin is to Fiat…”, we should be making the comparison- Bitcoin is to cryptocurrencies as the USD is to fiat. If Argentina can create a legitimate currency out of thin air that is accepted and traded on global markets and exchanged for goods domestically without affecting the legitimacy of the USD, why does creating another cryptocurrency delegitimize Bitcoin? (Note: I deliberately picked Argentina for my comparison because despite how historically weak it’s been in having its currency maintain value it continues to be reincarnated**.) Sure I could create my own cryptocurrency based off of Bitcoin, but I can’t create more Bitcoin out of thin air, and that’s the point. I would have to convince other people to use it, merchants to accept it, software and hardware developers to build infrastructure for it, etc. etc. Why would anyone invest in a new coin that offers no new inherent value over the Bitcoin system when all of that exists and is growing already for existing coins?

This is where cryptocurrencies have the edge. Fiat currencies only have value because governments back them. Governments back them because it gives them power. Governments maintain that power at the end of a gun. This is accomplished ultimately by requiring that only their currency be used as “legal tender for all debts, public and private”*** under penalty of law. This makes it a far more brittle system as we have seen by how frequently fiat systems crumble. Cryptocurrencies, on the other hand, exist in a constantly adversarial environment where they have to compete in the open marketplace. The longer one survives, the more faith it earns, and the stronger it becomes and thus they are far more resilient as a system. If we believe in the free market for goods, services, and even governments (U.S. federalist system), why shouldn’t we expect the same of our currency?

This is actually how many of the founders envisioned our country having a more robust financial system in the long run. Banks in the US used to issue their own bank notes that could be used as currency. It was widely feared that a fully debt-backed system would result in corruption in the government and weaker political system by the likes of Jefferson, Madison, and to a lesser extent Benjamin Franklin (who was quoted as saying “When the people find that they can vote themselves money, that will herald the end of the republic. Sell not liberty to purchase power”).Even Hamilton, who started the U.S. treasury, had a deep distrust of a fully centrally controlled monetary system backed by an interminable lien of debt****. I would argue that the fiat system we have today would not have even possible without the over a century and a half of proven performance by our government and economy before we fully moved away from the gold standard in 1971. Sadly, that trust, I feel, is being rapidly eroded away.

So yes, I can start my own cryptocurrency called BuckoCoin. But I could also start my own fiat currency called Buck’sBucks (what an appropriate name I was given for this conversation! :D). It’s also worth acknowledging that this parallel already happens in today’s world. What else are airline points than a fiat currency backed by the good faith of the airline? What about Amazon gift cards, which is one of the most widely distributed (but least liquid) “digital” currencies in the world? Fun fact actually (and this happens to be a total coincidence not a deliberate choice on my part), the place where I proposed to my wife in the Berkshires in Massachusetts is known for having their own local currency (I imagine the feds just turn a blind eye to it) called BerkShares which are printed locally and accepted at almost all local establishments. Our hotel even had a sign up saying they accepted it!

What makes good money?

As a closing point, I wanted to go a bit deeper into something that I start my Hack Reactor talk with as I think it goes to the heart of your misgivings: the characteristics of what makes good money.

As both historically and academically understood, money should be:
1) Fungible
2) Non-counterfeitable
3) Portable
4) Divisible
5) Durable

Less important but still vital are:
6) Widely accepted (or have a history of acceptance)
7) Limited in quantity

Historically speaking, holding a monopoly over a medium of exchange, which is how I would characterize your distrust in it being duplicatable (note that the system can be duplicated but a unit of Bitcoin itself is harder than almost anything in existence to duplicate, i.e. counterfeit), is not one of the primary characteristics of making good money. In reality, I think it’s more accurate that that virtual or perceived monopoly (which not even the USD fully has) comes about over time, earned through its relative strengths in the above 7 characteristics.

How does Bitcoin stack up then?
Compared to fiat, Bitcoin is either equal to or superior to fiat currency in the first 5, far behind in #6, which naturally must be earned over time anyway (and continues to gain with each day it survives), and far superior at #7.

Compared to Gold/precious metals, Bitcoin is behind in 6 (as is fiat), equal in 1, 5, and 7, and superior in 2, 3, and 4.

How does Bitcoin stack up?

As I see it, the two biggest obstacles for future global adoption of Bitcoin specifically are either another superior crypto system coming in and taking its place or just the factor of time (i.e. it has to earn #6). Technologically speaking though, digital currencies backed by cryptographically secure and auditable code is a far superior system to paper money as it is cheaper, safer, and more efficient to use than what we have today. Just as publishing, music, movies, and even politics had to come to terms with “the democratization of information” as I called the effects of the Internet in my talk, so will the financial institutions, markets, and governments have to learn how to co-exist with the “democratization of value”. Frankly, with new ETFs being proposed every week, governments like Japan and Australia now officially recognizing Bitcoin as a currency, banks integrating crypto holdings into their legacy accounts, and crypto-backed IRAs coming onto the market, I think we’re a lot closer to that happening than many might think.

Gold backed systems took hundreds of years (and militaries) to earn trust. USD fiat took a couple hundred years of stable politics and a few false starts to earn the trust it has today, with full fiat USD having a continuous track record now of around 50 years.

It’s true that Bitcoin is young, still just less than 10 years old. It was a completely novel kind of currency hypothesized by a pseudonymous identity going by the name of Satoshi Nakamoto, presented as a white paper on online Cypherpunk forums in 2008. In January 2009, the Bitcoin Genesis Block was mined kicking off the Bitcoin network and launching what will likely be seen as one of the greatest financial experiments in history, but at the time was just a few servers in someone’s garage. New users joined the network voluntarily, contributing computing power, adding to its security and decentralization and becoming increasingly more distributed due to its reliance on decades old computer science research and proven cryptography. On May 22, 2010, Bitcoin was attributed a dollar value for the first time ever when a user on the forum Bitcointalk.org, developer Laszlo Hanyecz, paid 10,000 BTC to another user for two large Papa Johns pizzas worth $25, giving it a value of about a quarter of one cent per Bitcoin (May 22nd is now celebrated as “Pizza Day” by many Bitcoiners). Today, Bitcoin has grown into one of the most widely distributed currencies in the world, with a market cap of over $75bn at an exchnage of ~$4,500/1BTC and an M1 money supply (as denominated in USD) ranking in the top 50 by value of all global currencies (sitting around #43–45 with Vietnam, Morocco, and Israel as of August, 2017). You can purchase it and exchange it in most major countries around the world, buy anything on Amazon with it, and even spend it with a Visa backed debit card!

Overall, I’d say the trend is looking pretty positive.

* Meanwhile, in the 24 hour MVP app I built at Hack Reactor you can see live transactions being sent on the blockchain in real time, worth anywhere from $1 to hundreds of thousands of dollars, sometimes millions. http://btc-live-transactions.herokuapp.com/
** Brazil too is an interesting case in that they actually named their currency “real” to have people have faith that it was “really” worth something
*** quote directly from all US legal tender

**** Hamilton in his “Report on Public Credit”: “Persuaded as the Secretary is, that the proper funding of the present debt, will render it a national blessing: Yet he is so far from acceding to the position, in the latitude in which it is sometimes laid down, that “public debts are public benefits,” a position inviting to prodigality, and liable to dangerous abuse, — that he ardently wishes to see it incorporated, as a fundamental maxim, in the system of public credit of the United States, that the creation of debt should always be accompanied with the means of extinguishment. This he regards as the true secret for rendering public credit immortal.”