Making Sense of Bitcoin
The other day, a friend asked me “What do you think of Bitcoin, Amar?” I gave her my perspective and my friend loved the explanation. So, I thought of writing a simple yet insightful piece on Bitcoins. There is so much to write on the subject that several books have been written extensively on Bitcoins. I however attempt to give you a fresh perspective to what you might already know. Pardon me if this is a little bit longer than my usual ones.
Before you learn about any subject, a little bit of history helps. On November 1, 2008, a computer programmer with the pseudonym Satoshi Nakamoto (we don’t know if the name is a She, He or Multiple People) sent an email to a cryptography mailing list announcing the birth of a new peer to peer electronic payment system that required no trusted third party. Bitcoin offered a payment network with its own native currency to its members. The most important and differentiating thing (compared to previous attempts of digital currency) was that it provided a mechanism to verify transactions in a decentralized way (without a bank) and without having to trust any member of the network (or giving any member of the network control). The next important part of the Bitcoin was that the supply would be finite and limited to 21 million Bitcoins that would be mined (remember gold mining except bitcoins are not mined from the ground but by powerful computers that use a lot of computing power and electricity) by 2140. This means only 21 million Bitcoins would ever be in circulation. As more and more people get into Bitcoins, what do you think will happen from a value perspective if supply is restricted. In cases where supply is finite, but demand is high, the value of any currency or asset should go up. This is huge from an inflation perspective, but you may ask “What was the thought behind Bitcoin?”
Look at the announcement date and you will see that this became a reality right after Lehman Brothers went bankrupt. The trust in the banking and financial services industry was extremely low. The thought behind Bitcoins was the formation of a decentralized system without any control by one single entity. Today we live in a centralized society where the central bank of a country decides the monetary policy of the country. This means the central bank decides about the interest rates in the economy, the need to print more money (similar to the one the US Fed has done in this crisis printing trillions of dollars effectively increasing the supply of money), managing the currency rate and many others. The commercial banks beyond deposits and lending control the payments made in the country. This is a very critical distinction as you are dependent on banks to make or receive payments. This is the nature of centralized societies where a few have tremendous control over everyone else. Thus, there was always a strong case for decentralized payment networks and currencies. It so happened that the birth of the internet had made eliminating the gatekeeper (bank in this case) possible. Thus, when the creator of Bitcoin managed to crack the code of creating a decentralized payment system with its native currency without any one person having control, it started gaining popularity.
The first bitcoin was issued at a predetermined rate to reward the members who spent their processing power on verifying the transactions. In October 2009, an internet exchange sold 5050 bitcoins for $5.02, at a price of $1 for 1006 bitcoins, to register the first purchase of a bitcoin with money. The price was typically calculated by measuring the value of electricity needed to produce a bitcoin. Sometime in 2010, someone paid 10000 bitcoins to buy 2 pizza pies worth $ 25. This will go down as the “costliest pizza” ever consumed in the history of the world. Bitcoin had now become a medium of exchange. The reason I say the costliest pizza is fast forward September 15, 2020 and the price of 1 bitcoin is $10694. Thus the 2 pizza pies came at today’s value of $100 million.
Now for a little definition of money and the function it serves in our lives. Money is not a piece of paper nor is it gold. It is simply a record keeping device (and thus ledger which is a record keeping device). Like I mentioned above, the banks were in charge of this ledger and they have made fortunes off managing this ledger (through centralized institutions and control). Bitcoin makes both things go away while ushering in a world of Decentralization (no control by any single member and no relying on any third party). Additionally, before the invention of Bitcoin, a consensus of virtual asset ownership could be only reached through centralization (remember ledger through an institution had an exclusive right to keep these records).
Money serves 2 functions in our lives:
- Store of Value (anything that you can sell and generate liquidity)
Any store of value has to have demand for it to be a store of value. If you have something for which there are no takers, then there is no store of value. Gold is now an established asset that can be liquidated quickly but imagine when gold was first discovered, would it have value if there were no takers. I doubt so and know that value is established over a period of time as it did for Gold. The costliest pizza example above amply demonstrates Bitcoin’s Store of Value till it had adoption by many people. Now you can feed your next 7 generations pizza every day and still have a lot of money left. Bitcoin adoption now is much higher than what it was in 2010 and this is what makes it valuable (network effects because of the number of people adopting it and supply remaining fixed).
- Medium of Exchange (buying and selling things)
Once there is established demand, there must be an easy way to invest and redeem that store of value as well as buy and sell things with that store of value. You cannot go to Starbucks and buy a Latte with your gold ring. Nor can you go to an Apple Store and buy the latest iPhone with your gold coin. The same is true for Bitcoins today. However, like gold, it has a store of value and thus is called digital gold. At the same time, some people are accepting money in bitcoins as there is an established exchange rate set for bitcoin.
Is Bitcoin then a Currency or An Asset or something else?
Gold is not a currency, but it used to be a currency at some point of time in the past. One could only print currency that was backed by Gold. This is history but gold according to me is an asset class that can be quickly converted into Cash (currency that can be used as a medium of exchange). Bitcoin on the other hand is not only an Asset which essentially has its own peer to peer payment system and a currency.
Bitcoin = Asset (Store of Value) + Currency + Payment System (You do not need anyone to settle your purchases made with Bitcoin in the virtual world.)
Like I have mentioned earlier, the best part about Bitcoin is the limited supply (because if there is heavy demand over the next 30 years, you can imagine the prices would be headed upwards. However, because of fixed supply, and low volume the prices of Bitcoin can be extremely volatile. On October 6, 2014, when only 26000 Bitcoins (it is a large sell order in the Bitcoin space) were offered for sale on an exchange, the price of Bitcoin slid by approximately 10%. Besides this, there are other problems such as electricity consumption, regulatory hurdles, and political challenges.
In March 2020, the Supreme Court of India struck down the curb by RBI on cryptocurrency trade and this made Bitcoin legal in India. I guess this is an idea whose time has come but we have a long way to go.
Bitcoin has survived the last 12 years and now has a track record to show for. Nevertheless 12 years is considered to be too short a track record by many. The legendary Warren Buffett has blasted Bitcoin as worthless and vowed he will never own a cryptocurrency. One thing we have all learned is “Never Say Never“.