You don’t understand Bitcoin because you think money is fake
As Bitcoin continues its wild roller coaster ride and seems to keep climbing higher, I meet more and more people talking about investing in Bitcoin. There are advocates on both sides, some claiming that fiat currencies are dead and cryptocurrencies will replace all other forms of money, while others state that it is a speculative bubble that will pop when people realize there is no underlying value in this new fangled idea.
In order to understand which perspective has more merit, or more concretely, to determine whether or not to invest in Bitcoin, we must understand two things. The first is how and why fiat currencies work (money backed by governments and banks), and second how Bitcoin works. We can then compare and contrast these to understand their respective merits. Excited? Me too!
A common case against Bitcoin is that it has no intrinsic value, no underlying asset of value to support it. The argument goes that because there is nothing of substance under the hood, it is doomed to fail. In response, some contend that fiat currencies are equally without substance, and rely on the same shared belief in a common fiction, referencing a truly excellent fiction in its own right, the book Sapiens.
Looking first at fiat currencies, I came across a blog post that states “A U.S. dollar is ‘backed by’ ‘the full faith and credit of the United States.’ But what exactly does this mean?” (link). It seems that people are unsure what ‘the full faith and credit’ of US government means, so let’s take a quick tour. The federal government has the power to invest in infrastructure, healthcare, retirement, military, and other services. Infrastructure projects result in very real roads, bridges, buildings, and parks that benefit society. Healthcare accounts for 29% of the federal budget, and social security 24% (that’s more than half of the budget). These services save countless lives and provide for basic needs for millions of retirees. These too seem like very real capabilities. The military represents 15% of the budget, and its capabilities are readily apparent (link). So when we say that the U.S. dollar is backed by the full faith and credit of the United States, it means that the single most powerful entity in the world, one that in principle and practice has a real and significant impact on the world, supports the dollar. The guarantee of such an organization to make good on commitments should not be taken lightly and carries extraordinary weight.
What about Bitcoin? What is the foundation that it stands on? By design, it does not rely on any organization or power to make good on its promises, but it does have the blockchain! What is the blockchain again? Okay, grab a cup of coffee and try to stay awake for this part.
The blockchain is a list of records(!). The technology required to create this kind of record has been around years and is used to securely log into bank accounts, among other things. So what makes the blockchain so special? The idea is that no authority manages the integrity of the network. The network manages itself by crowdsourcing decisions. Wait, how does that work if nobody is in charge? Thanks for asking, let’s continue (sip coffee here).
The Bitcoin network agrees on decisions by playing a pointless guessing game that is designed to take about 10 minutes, no matter how many machines play (fun, right?). The winner of this pointless guessing game wins the right to place a new record on the chain. If the network accepts your answer, the record itself is the ‘Bitcoin’. As long as at least half of the computers on the Bitcoin network are well behaved, everyone can trust the registry. Wait what? I’m confused, go back. The ‘Bitcoin’ is a record of the answer to a pointless guessing game. Really? Yup, really. The reason it works is that while it takes billions of guesses to find the right answer, once someone has found it, it is easy for others to check the answer. When a player broadcasts the correct answer to the network, other nodes confirm it and add the record to their chain. The network agrees that the longest chain on the network is the winner, which means the first person to guess the answer will win. So you’ve won… a record on the chain… that is part of the chain… so now you’re part of the chain. Wait what were we talking about? Oh yeah, Bitcoin. So lucky you, you got yourself a Bitcoin (because you won the guessing game).
It’s worth noting that it is trivial to create one of these signed, secure, records. Computers could create billions of signed records at so fast that the network couldn’t possibly keep up. What is the value of a record so easy to generate? I do not know, ask Nate the Great. In order to counteract the absurdity of this revelation, Bitcoin had the profound insight to agree to play the pointless guessing game (to slow things down). If we slow down how fast records can be created, then the records are now rare. Because the game says so. So it’s still a meaningless record, but you can only make one once every ten minutes. So now it’s valuable. Because it’s rare. Because of the guessing game. By the way, would you like to purchase some bubblegum? I chewed it myself, so it’s one-of-a-kind. I will even provide a certificate of authenticity signed by a private key that only I have so you can be sure that it really is the gum I chewed. Wait where were we? Oh yeah, Bitcoin.
So, let’s zoom out for a second. One of my least favorite buzzwords in Silicon Valley is the term disruption, which is the idea that an upstart company provides a service so much better than the current solution that it takes down the multi-billion dollar incumbent that has become fat and slow. And ugly. As coined by Clayten Christensen in his 1997 book the Innovator’s Dilemma, the concept is fine, but man do I hate buzzwords. Anyways, disruption. Is Bitcoin disrupting fiat currencies? Common convention within the Valley suggests that a product has to be 10 times better to qualify as a disruption. It has to be so much better, faster, and cheaper, that people will overcome their general tendency to avoid change at all costs, and adopt the new thing. After a while, the disrupting innovation will reach a tipping point where rapid adoption occurs, the new product wins, and David slays Goliath. After that David grows up into a slow, fat, (ugly) multi-billion dollar incumbent whose products become ripe for disruption. So the cycle goes. What were we talking about again? That’s right, Bitcoin.
Is Bitcoin a disrupter? With regards to speed, costs, and reliability, the answer is no. Remember when we discussed that the network has to artificially slow itself down to make the pointless records rare? Well that same restriction makes actually performing transactions on the Bitcoin network very slow. So slow, in fact, that there is a lively debate going on about ‘scaling’ Bitcoin. I find this idea rather absurd, because the technology has been intentionally hamstrung in order to give itself a (sort of) plausible explanation of value. Don’t worry though, the rock star leadership team over at Bitcoin are sure to come up with a sound solution. Oh wait, who’s in charge of this thing? Oh yeah, nobody. So what if one faction thinks that the Bitcoin network operates too slowly and it should be sped up, while another faction feels like everything is fine? Oh that’s right, that has already happened. One faction became so convinced of their position that they cut out and made their own, similar-but-faster version of Bitcoin called Bitcoin Cash. Okay let’s make sure you got that. A group of the Bitcoin peeps decided to take their ball and go make a new playground. A faster playground with faster balls. It would be like the president printing his own bills with his head on them and telling everyone that Drumph dollars are better dollars than other dollars. And by design, nobody could stop him. And then somebody could make Hillary dollars. In fact, anyone can make infinity new kinds of dollars (these are called ICOs). So which one is better? Which one should you invest in? Which one represents a better store of value? Is one of them bad? I do not know, go ask your dad.
Some people say that Bitcoin is a commodity, others a store of value, others a chance to make mad cash $$$$. So which is it? Well it’s really quite strange, because Bitcoin is a list of records of the answer to a pointless guessing game that was invented to make the records rare, so that they wouldn’t be pointless, which makes them valuable, because they are rare, because we made them slow, because that makes them rare, because that makes them valuable… wait what were we talking about again? A store of value means a place to… well… store value. It’s like the spot in your attic you keep those first edition Star Wars Episode 1 comics that will one day be worth billions. Most people store money in the bank, because the bank offers protections to keep your money safe, with an added promise by good ol’ Uncle Sam to make good on your savings even if the bank does something stupid. Is that a store of value? As long as the full faith and credit of the US means something, which today it really, really does, then yes that qualifies as a store of value. So how about Bitcoin, does that qualify? Well, if it’s the case that society as a whole agrees that Bitcoin has value, then Bitcoin has value, and you can keep it stored. In your Bitcoin wallet. So that’s good. But what kind of guarantees are there? Can I sell my Bitcoin for parts? What if people stop believing in Bitcoin? How will it feel if today my stored value is worth $1,000, tomorrow $2,000, and the next day $500? What if people decide they like Bitcoin Cash, and switch to the other? I do not know, go ask your mother.
What about the black market? I heard people use Bitcoin on the black market. Sounds pretty legit. Despite being slower, less convenient, less transparent, and providing a mystifyingly circular answer to the question of what value it represents, Bitcoin does have one thing going for it. Bitcoin can be transferred anonymously. The way the cryptography works, everyone can confirm the Bitcoin record is valid, but only the owner can unlock its secrets and see what’s inside (remember there is nothing inside other than the answer to that pointless guessing game). This does provide a truly unique advantage compared to fiat currencies. This is the single strongest use case for Bitcoin and I imagine the black market might be a large market. If you’re interested, my cousin sells cocaine and is looking for a business partner. I hear the margins are excellent!
So let’s wrap this up. What is the intrinsic value of Bitcoin? To find out, collect a small bundle of sticks from a virgin apple tree and cast them into a river under the light of the new moon. Take a picture of their arrangement in the river exactly 13 seconds they cast, and send it to my aunt Margaret for interpretation (she accepts Bitcoin). It may sound hard to believe that society could became obsessed with investing their life savings in tulip bulbs, but it can be hard to resist what seems like free money.
“Never invest in a business you cannot understand.” — Warren Buffett
