What Makes Bitcoin Valuable?Look past the hype and understand the fundamentals that Bitcoin was built on
A friend of mine recently contacted me and told me that he wanted to buy some Bitcoin but didn’t know where to start.
He was a recent convert.
It took many hours and cups of chai to go over monetary history, Bitcoin’s philosophy, and its technological robustness before he was finally ‘orange pilled’.
It didn’t hurt that over the course of these conversations Bitcoin skyrocketed from $16,000 to $28,000. FOMO likely played a part in his decision to finally move some of his savings to this very volatile asset.
Getting his journey started down the Bitcoin rabbit hole involved setting him up with a reputable exchange, a hardware wallet (or ‘cold storage’), and briefing him on the importance of guarding his private keys.
Looking on was his neighbor and friend, Simone, who was in the twentieth year of a successful career in Finance.
She wasn’t part of our earlier conversations and had heard about Bitcoin primarily from mainstream news channels. To her, Bitcoin was only used by North Koreans and criminals.
Back to my friend – once the rigorous KYC (“know your customer”) process was complete, we had his account on the exchange set up and loaded with US dollars.
A few clicks later and poof! Just like that, all the money disappeared. In exchange, my friend was now the proud owner of magical internet money.
Simone looked on horrified. I knew she would have questions but I was occupied with getting his cold storage set up and had to half-bake my answers.
Simone: “But who says this is worth anything?! At least my dollars have a government backing them!”
Me: “Just like gold, Simone. It isn’t government-backed but you could use it to store your wealth and exchange it for other value.”
Simone: “Yes, but at least I can see and touch my gold. These are just numbers on my screen that make little sense to me. I can’t go out and buy a packet of milk or fuel my car up with this.”
Me (taking the last sip of my cold chai): “Simone, I’m going to have to write to you about this. For now, I need to hand over this gentleman’s private keys.”
Simone, this one’s for you.
To understand what gives Bitcoin its value, you have to first understand what money is, and the characteristics of ‘good money’.
Humans have always looked for a means to trade and exchange. Barter is extremely inefficient and impractical at a large scale for reasons that I hope are obvious, so I’m not going to get into that.
We’ve always needed a representation of the value we produce with either our products or time.
We’ve experimented with countless mediums of exchange. To name a few: seashells, beads, livestock, parmesan cheese (I couldn’t believe it either), and the most fascinating - Rai stones of Yap Island.
All came and went because they failed one or a few tests of sound money.
For a medium of exchange to work, it needs to be durable. Oranges would make for terrible money because it doesn’t allow me to save them. I would have to spend it all before they go bad.
Divisibility is the next marker of sound money. You have to be able to splice down or multiply the unit without losing value in order to transact at different scales. For example, a piece of furniture loses all its value when broken down from its whole.
Money has to be uniform. It would be very difficult to trade using emeralds. Each gem has a different size, form, cut, and tint that gives each one a unique value.
Anything to be considered valuable has to be limited in supply. When glass beads were considered scarce and used as a medium of exchange in West Africa (300–1900 CE), their manufacture in Europe - and subsequent use to trade slaves and precious resources - hyperinflated the currency until it became worthless.
Next, sufficient people have to find the value acceptable. If my shells are not deemed valuable in my neighboring country I couldn’t buy anything with it.
How about land?
A piece of farmland can be divisible, it’s intrinsically scarce, one can argue that it’s uniform, easily passes the durability test, and since there are many uses of land it would be widely accepted.
Unfortunately, the land is not portable. My piece of real estate in Chile is of no value to the cardamom trader in India.
Over centuries of global trade, we’ve come up with solutions to this ‘medium of exchange’ conundrum. Government-backed currencies and gold have been the most lasting and robust forms of money, even though they don’t perfectly pass each of these tests satisfactorily.
Let’s start with Gold.
Gold is easily divisible, uniform, durable, and widely accepted.
However, the argument that gold is truly scarce is up for debate.
It’s alleged that there’s $150 Trillion worth of gold sitting under the ocean bed. At the time of writing this, Gold’s market cap sits a little over $13 Trillion. That easily doubles the amount of gold currently in circulation.
Is this a precursor to another epic story of hyperinflation akin to the glass beads of West Africa? We haven’t even mentioned the Asteroid we will one day be able to reach containing precious metals, including gold, worth more than the entire global economy.
Secondly, gold is very difficult to transport.
Imagine a world with transoceanic trade in the billions, with tons of gold lugged around. It would be a security and logistical nightmare. This is why we have the current financial system with banks at the center of it.
Banks took on the job of storing the gold and created certificates of ownership that were then used for trade.
This was the early beginning of modern-day, central bank-issued, government-backed currencies.
The US dollar originated from an innovation to make gold more portable. Each unit of the currency was backed by its equivalent amount of precious metal. It could be redeemed at the rate of $35 per ounce.
The dollar became the soundest money ever created.
Unfortunately, this didn’t last very long. In 1971 Richard Nixon announced that the dollar was no longer going to be backed by the metal. Almost instantly, he took away a key characteristic of sound money - scarcity.
You see, the government needed funds for the war effort and other spending. A currency backed by gold was hindering their ability to come up with the resources, so they took control of its supply.
The government detached the dollar from gold in order to print more of it. And print they did. In 2023, there is 4,100% more currency in circulation than there was at the time of Nixon’s announcement.
Now that we understand what sound money is and we have taken a look at how gold and government-backed currencies perform in comparison, let’s look at Bitcoin against each of these tests:
- Divisibility - One bitcoin is made up of 100 million satoshis (“sats”). Just like you have dollars and cents, bitcoin can be transacted in both small and large amounts with equal ease.
- Uniformity - This is an easy one. A bitcoin or sat is standard in value just like traditional currencies.
- Acceptability – Bitcoin is still in its infancy and the technology is evolving to make it easier for small businesses and individuals to use it as a viable method of payment. Currently, Bitcoin (and the overall cryptocurrency market) is at the same level of adoption as the internet was in 1998 but growing faster each year (at an annual compounded rate of 56.4%). It is expected to have 850 million users globally by 2030. That’s 10% of the population. 72% of its users are below the age of 34, with time its adoption has only one way and that is up!
Who knows, this number could grow even faster as more currencies inflate and lose value.
- Scarcity - The algorithm that governs Bitcoin is set up to release Bitcoin into the network every 10 minutes in the form of rewards for miners that maintain the network. There will only ever be 21 million Bitcoin produced, of which 19.2 million have been mined as of January 2023. The amount of Bitcoin released into the network reduces by 50% every four years and it will take until the year 2140 for the last Bitcoin to be mined.
- Durability - Bitcoin transactions are recorded on a decentralized digital ledger. Miners are in charge of verifying and recording transactions and they’re located across the globe making this a highly secure network. It’s deflationary in nature, so its value goes up with time rather than down (see the scarcity attribute of Bitcoin below).
- Portability - Bitcoin is a global network. The Bitcoin ledger can be updated, with value moving from one wallet to another, in a matter of seconds – no geographic limits apply.
The internet turned the postal service digital with email, made retail stores obsolete with e-commerce and now it’s the turn for banks and money to be affected by the digital revolution.
Bitcoin is sound money created by digital technology that solves the problems of traditional fiat currencies. It is both a medium of exchange and payment infrastructure (like SWIFT) which makes it all the more powerful.
Nobody should go out and buy Bitcoin without doing their research. Before it achieves its full potential it has challenges to overcome. Adoption is still in its early stages, it sits in a legal grey area in most jurisdictions and there’s a steep learning curve with managing the private keys which ensure ownership.
Despite these unresolved issues, there’s no denying that Bitcoin is an elegant monetary technology that finally resolves mankind’s quest for creating sound money.