Welcome to Bitcoin Explained. Today I’m going to cover Bitcoin and explain its role in the monetary system. I’ll explain what Bitcoin is, what its role is as a monetary unit and how it has and continues to be used as a store of value. I’ll compare it to fiat currencies (government-issued money) and gold to highlight its financial use-cases and potentiality for adding upon or even replacing these mediums of exchange in the future.
Bitcoin is a digital currency that was created to address problems related to centralised currencies. Most modern currencies such as fiat currency are centralised to banks and regulated by the government. As such, banks and governments can heavily influence these currencies’ values through things such as inflation and taxes. Bitcoin was created to be a decentralised currency, where there is no bank or central authority to govern them. Instead, Bitcoin relies on a network of users who verify the monetary transactions. The result is an easier, cheaper and quicker way to spend money.
Many transactions that occur with fiat currencies are processed digitally. Wages are issued electronically; bills are paid digitally and online shopping is becoming more prevalent. However, these digital transactions are known as intermediated payments. Intermediated payments require a trusted third party to handle the money transfer between two parties. Cheques, credit cards, debit cards, bank wire transfers and apps such as PayPal are all utilise intermediated payments.
Bitcoin alternatively, is decentralised and doesn’t rely on a centralised third party such as these traditional monetary systems. Instead, Bitcoin relies on a peer-to-peer network where every member on the network can verify Bitcoin transactions. As such, Bitcoin is the first example of true digital cash that doesn’t rely on a trusted third-party intermediary.
By their nature, a third party adds security weaknesses. By involving an extra party into the transaction, there are inherently more possibilities for theft and technical failure. Intermediaries also increase vulnerability to surveillance and bans by political authorities. For example, political authorities can stop payments under pretexts of security or money laundering.
Additionally, there is a heightened risk of fraud which in turn increases transaction costs and can delay settlements of payments. For these reasons, many people naturally prefer decentralised digital currencies. As the Proof of Work (PoW) system eliminates this need for trust, Bitcoin is a faster, more efficient and more trustworthy digital cash.
With Bitcoin, all transactions can be recorded by every member on the network. This is done so that they all share a common ledger of balances and transactions. When a member of the network transfers to another member, all members of that network can then verify that the sender has a sufficient balance. Nodes then compete to be the first to update the ledger with the new block of transactions. This occurs every 10 minutes.
This involves processing power and electricity on behalf of the node, as it needs to solve a complicated mathematical problem. The problem is difficult to solve, but the correct solution is easy to verify. This is what is known as the PoW system. For the PoW system to work, a correct solution must be committed and verified by all participating network members. The node that commits a valid block of transactions receives a block reward in the form of new bitcoins which has been added to the supply along with transaction fees. This is known as ‘mining’ as it requires physical time and resources (electricity) to extract the resource (Bitcoin).
The nature of having a difficult problem to solve that is easily verifiable has been chosen for specific reasons. Firstly, by making it hard to solve the problem, nodes have to compete to solve it promptly. This requires a lot of processing power and electricity on behalf of the node. It is this processing power that gives Bitcoin an intrinsic value, as it is linked to the time and processing output required to mine the new Bitcoin.
Secondly, under the PoW system, all participating nodes on the network verify that the correct solution has been committed. PoW makes the cost of writing a block extremely high, yet the cost of verifying its validity is extremely low. This in turn eliminates the incentive for anyone to try and create invalid transactions. If someone were to try, they would be wasting electricity and processing power without receiving the block reward. As such, Bitcoin can be understood as a technology that converts electricity into truthful records of transactions through the expenditure of processing power.
Bitcoin shows a lot of promise in replacing traditional forms of money. It has been used extensively in countries whose fiat currencies have failed or continue to be hyper-inflated such as Venezuela and Nigeria. However, in recent years, Bitcoin has shown a greater potentiality for being used as a store of value, due to its strict scarcity.
Nevertheless, Bitcoin was introduced as an alternative to traditional forms of money and continues to be used as one to this day. To truly understand Bitcoin and how it fits in the world of money, it’s important to explore the history and role of money.
The quintessential function of money is its ability to be a medium of exchange. A medium of exchange is an intermediary instrument that is used to facilitate the purchase, sale or trade of goods between parties. To enable a medium of exchange to be successful, it needs to represent a standard of value that is accepted by both parties.
Throughout history, many mediums of exchange have been utilised to facilitate trade. These include seashells, stones, beads, salt, silver, gold, gold-backed government money and government-provided legal tender (fiat currency). Each one of these mediums of exchange at some point in time possessed the key property that leads to a good being adopted as money – salability.
According to Carl Menger, the father of the Austrian school of economics, salability refers to the ease with which a good can be sold on the market whenever its holder desires, with the least loss in its price. However, three key components enable optimal salability. These components are salability across scales, across space and across time.
A good that is salable across scales can be conveniently divided into smaller units or grouped into larger units. This alteration of units enables the holder to sell it for whichever quantity is desired. This is why fiat currency consists of coins and notes, as it would be unfeasible to pay for something such as a house using coins. As such, salability across scales is essential in ensuring that the good can be used for all transactions, regardless of their size.
A good that is salable across space is one that can be easily transported or carried by the possessor. This is why good monetary media typically have a high value relative to their unit of weight. For example, paper currency holds high value despite weighing virtually nothing. Salability across space has been further enhanced through money becoming digitalised in recent years. Instead of freighting money internationally (a costly and time-consuming practice), billions of fiat currency can be digitally sent at the click of a button.
A good that is salable across time is one that retains its value into the future. These goods need to be immune to rot, corrosion and other types of deterioration. Therefore, should a good not deteriorate over time, it can be used as a store of value. By being a store of value, the holder is incentivised to hold onto or save the asset. This ensures that the good remain valuable over time and enables it to continue being a viable form of money. The previous two components of salability can be relatively easy to implement. However, salability across time remains an issue for most stores of value, including fiat currency.
Fiat currency is essentially paper money, as it is not backed or guaranteed by a commodity. Traditionally, government currencies were backed by gold (the Gold Standard) and as such, that currencies’ value was inextricably linked to gold. Under the gold standard, citizens of that country were able to exchange paper money for gold, which was kept in banks. This gave paper money an intrinsic value, as it enabled the direct exchange of gold at a rate set by that country’s government. The Gold Standard era ended during the first world war. As governments were printing money at astronomical rates to fund war efforts. These conditions made it impossible to maintain gold convertibility and over time, countries abandoned gold-back government currencies.
Fiat currency gradually overtook traditional forms of money such as cattle, seashells, rocks, gold-backed government tender and precious metals due to its salability. Being easily divisible (notes and coins) and able to be transported electronically, it possesses high salability across scales and space. Although, an issue lies in fiat currency’s salability across time. While it is true that paper currency can rip and deteriorate over time, it’s not the physical integrity of fiat that results in its loss in value over time. Instead, it is the government’s ability to generate endless supplies of fiat that damages its salability across time.
For a good to maintain its value, it can’t increase too rapidly during a set period. As such, it has been a common characteristic throughout time for money to have some mechanism of restraint on the production of new units. Such a restraint helps maintain the value of existing units. For example, gold cannot be printed or created out of thin air (alchemists may disagree). Instead, there is a finite supply in circulation and a finite supply that can be mined. While the supply can increase over time through mining, it is an expensive and time-consuming process. This is what has enabled gold to maintain its store of value for thousands of years.
Contrastingly, it is extremely easy for governments to simply have more money printed. It is an automated and inexpensive process that can be done indefinitely. This process of printing money can result in hyperinflation. The real cost isn’t the direct cost of running the printing presses. Instead, it comes at the foregone economic activity that would have occurred through the exchange of goods to acquire the fiat. Additionally, the sudden influx in the supply of a nation’s fiat currency devalues that currency in relation to foreign currencies.
This has catastrophic consequences for that nation’s economy, as import costs rise significantly, resulting in diminished business returns and higher rates of unemployment. As such, hyperinflation constitutes a complete breakdown of the economic structure and production built by a society over centuries and millennia.
Following WW1, Germany discovered that it was unable to pay its war reparations set forth by the Treaty of Versailles. With Belgian and French armies occupying the most productive, industrialised areas of Germany, the German government resorted to mass printing their fiat currency, the Papiermark. They then exchanged the Papiermark for foreign currencies to cover their war reparations.
This severely damaged the value of the Papiermark. Before 1923, the largest denomination was $50,000 but this later climbed to 1 Trillion by 1923. The Papiermark became so devalued due to hyperinflation that people began using it to heat furnaces. As it was considered more efficient to burn the currency for warmth than it was to use it for trade.
Between 2008-2009, it is estimated that Zimbabwe had a monthly inflation rate of around 80 billion per cent. This resulted in workers being unable to afford basic goods, as prices rose faster than wages. Subsequently, the term ‘poverty billionaires’ was termed, as workers may have had a one-billion-dollar salary yet couldn’t afford a two-billion-dollar loaf of bread.
Hyperinflation devalued the Zimbabwe dollar to such an extent that bartering became common practice for the first time in centuries. In 2015, the Zimbabwe 100-Trillion-Dollar Note was worth approximately USD 0.40, causing potentially irreversible damage to the Zimbabwean economy.
|Peruvian Sol and Inti|
Each Bitcoin contains 100 million Satoshi’s. This high degree of divisibility makes Bitcoin the most scalable medium of exchange in recorded history. As such, even if the value of Bitcoin were to hit astronomically high prices, it can still be used for day-to-day transactions. For this reason, Bitcoin has immensely high salability across scales.
Bitcoin and all cryptocurrencies are exceedingly salable across space as well, due to being digitalised. While it can take weeks to transport gold internationally and days to transfer fiat electronically, Bitcoin can be sent anywhere across the globe. This is usually achieved within a 10–20-minute time period, as that is how long it takes to validate the blockchain. Smaller transactions have been processed in a manner of seconds, making it one of the most salable mediums of exchange across space.
Salability across time has always been an issue for various forms of money. In some instances, such as with food, salability across time is impossible due to rot and deterioration. Sometimes, salability across time is unachievable due to the ease in which new monetary units can be produced. Forms of money that require minimal effort and resources to produce such as fiat currencies are prone to hyperinflation. To combat this, a mechanism of restraining new units is imperative to prevent an over-abundance of that monetary asset.
A form of money that is hard to produce is referred to as ‘hard money’. Money’s hardness can be understood through the stock-to-flow-ratio. Stock in this instance refers to the existing supply which consists of everything produced in the past minus what has been consumed or destroyed. Flow refers to the extra production that will be made available in a given period.
Bitcoin has a finite supply of 21 million. This means that no matter how much the demand for Bitcoin grows, there can only ever be a total amount of 21 million in existence. Of that figure, there is a black area of missing Bitcoins that are no longer in circulation. There are numerous reasons as to why the actual Bitcoin supply is lower than 21 million.
These include: incorrect transactions to the wrong address, owners who died without passing on Bitcoin, seized Bitcoin by government entities/law enforcement and wallet owners who lost their seed phrases among others. For this reason, the actual supply of Bitcoin may be much lower than 21 million. This creates scarcity, which aids Bitcoin in retaining and even growing its value over time. However, perhaps the most useful feature of Bitcoin for preserving its salability across time is the difficulty associated with creating new units.
All Bitcoin transactions are recorded by members of the network to ensure that everyone shares a common ledger of balances and transactions. Whenever a member of the network transfers a sum to another member, every member of the network can verify that the sender has a sufficient balance. Nodes then compete to be the first to update the ledger with this new block of transactions. This is what is known as proof-of-work (PoW) and it is crucial for ensuring that Bitcoin remains a legitimate and accountable medium of exchange.
PoW involves network members competing with one another to solve mathematical problems. These mathematical problems require time and electricity, which gives Bitcoin its inherent production value. The first node to produce the correct solution broadcasts it to network members, who then verify its legitimacy.
Once verified, the transactions are then committed to the new block and the node that commits the valid block of transactions receives a block award consisting of new bitcoins added to the supply in addition to the transaction fees paid by the people who are transacting. This PoW system is akin to mining, as it rewards miners (network members) with Bitcoin (gold) as compensation for the resources they committed to PoW.
Subsequently, Bitcoin mining helps ensure that Bitcoin remains hard money, as expenditure of electricity and processing power is quintessential for producing new coins. The high expenditure of these resources also incentivises nodes to not include invalid transactions, as it is far cheaper to verify transactions through PoW than it is to solve the PoW.
As such, nodes that enter invalid transactions are almost guaranteed to be rejected, resulting in no rewards for the expended processing power and electricity. For these reasons, Bitcoin mining is one of the fundamental drivers for ensuring that Bitcoin remains hard money and that it stays salable over time. However, there is an additional component of mining that enhances salability over time – the halving.
The following is an exert from The Bitcoin Standard by Saifedean Ammous
Bitcoin blocks are added to the shared ledger roughly every ten minutes. At the birth of the network, the block reward was programmed to be 50 bitcoins per block. Every four years, roughly, or after 210,000 blocks have been issued, the block reward drops by half. The first halving happened on November 28, 2012, after which the issuance of new bitcoins dropped to 25 per block. On July 9, 2016, it dropped again to 12.5 coins per block and will drop to 6.25 in 2020. According to this schedule, the supply will continue to increase at a decreasing rate, asymptotically approaching 21 million coins sometime around the year 2140, at which point there will be no more bitcoins issued.
To put this into perspective, imagine if the rate in which gold could be mined halved every four years. There would be a higher demand for it due to its new relative scarcity. Bitcoin halving is a similar phenomenon that has traditionally resulted in parabolic price increases. With each halving, Bitcoin becomes harder to mine which in turn increase its value. Due to an increase in value, more miners compete for a smaller Bitcoin yield. The increase in competition for a scarcer resource, drives up value, as more electricity and processing power is needed. Additionally, the added number of miners results in a more efficient PoW system, as more people can verify transactions.
Due to the unique features that make Bitcoin salable across time, namely, it’s finite total supply, the cost and effort required to mine it and the halving, Bitcoin has the potential to retain its value almost indefinitely. As such, it is currently the most salable currency in human history and its most promising store of value.
Until Bitcoin’s invention, all forms of money were unlimited and thus, were unable to effectively store value across time. Bitcoin’s finite supply combined with its continuously diminishing mining rate makes it have an exceptionally high stock-to-flow ratio. It is this stock-to-flow ratio that ensures that Bitcoin remains hard money and organically grows over time. Bitcoin is designed to not only retain value over time but to increase in it. As such, Bitcoin is perhaps the cheapest way to buy the future, due to its unmanipulated, organic growth throughout history.
Before the inception of Bitcoin, numerous issues plagued various forms of money and other stores of value. Things like hyperinflation, a lack of salability, physical deterioration, counterfeiting, security and centralisation have proven fundamental flaws in these various mediums of exchange. However, Bitcoin solves all of these problems and more due to its well thought out design.
It is decentralised and operates under a PoW system that not only gives Bitcoin an organic, inherent value but incentivises network members to increase its security by verifying correct transactions. Being digital and divisible into a hundred-million units, it is the most salable medium of exchange across space and scale. However, what particularly separates Bitcoin from traditional stores of value is its immense salability across time.
Bitcoin is finite, its stock-to-flow ratio is immensely high, it is hard money and over time it gets more expensive and harder to produce. These unique features such as mining, halving and decentralisation make Bitcoin the first true form of digital cash and the most promising store of value in human history. For these reasons, Bitcoin is perhaps one of, if not the greatest way to invest in the future.
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