What is Bitcoin? According to many in governments around the world, in central banking, in law enforcement, it’s a nuisance. It allows pseudonymous actors to transfer supposed value from one side of the planet to the other, across borders, with no 3rd party involvement and without permission of the authorities. It’s volatile, opaque, mysterious, and confusing, and in equal measure, hated. Bitcoin the physical network, and bitcoin the ‘digital asset’ are often confused or conflated by many, with the fiat price being the focal point of discussion to the uninitiated.
What was initially labelled a cryptocurrency has taken on meaning for many people that generate it, use it and hold it. Either as an escape from the modern banking system, a way to move value around the world, or for the very early adopters, as an exercise in technology innovation. The most vocal and ideologically puritan of the bitcoin users would be the ones that believe it is the next universal money.
So let’s dig in.
“While perhaps intended as an alternative payment system with no government involvement, it has become a combination of a bubble, a Ponzi scheme and an environmental disaster,”
Agustin Carstens – General Manager – Bank for International Settlements
The Network Effect
Bitcoin the network is a globally interconnected series of computers (ASICs), whose sole role is to provide probabilistic finality of settlement on a decentralised ledger of transactions (the blockchain). Or simply put, people participating in the network as ‘miners’, compete against each other, using computing power (algorithmic hashing), to be the ones to propose transactions to be added to the ledger by the nodes. The node runners maintain a copy of the ledger independently and cross verify with each other to ensure legitimacy.
This work imposes large costs on the creator as CAPEX and OPEX, and thus incentivises them to publish honest information. In return they are rewarded with new bitcoin as per the scheduled issuance, as well the sum of the transaction fees that users pay. You can read a little bit more detail on the issuance of bitcoin and its programmed decrease in Chpt 29: Grey Area.
Bitcoin the asset is an entry (UTXO) in this decentralised ledger of transactions, the provenance of which is agreed upon by all non economic network participants (node runners). This combination of ‘proof of work‘ (algorithmic hashing & energy use) and a decentralised ledger, solved what is known as the Byzantine General’s Problem. A game theory problem, which describes the difficulty decentralised parties have in arriving at consensus without relying on a trusted central party.
The access to your part of the ledger is controlled and secured by public and private key cryptography (think of it like a public postal address and a house key). This private key is more than just a password; it’s a critical element in blockchain transactions, used to sign and validate transactions, thereby proving ownership. It is nearly impossible for unauthorised parties to guess or brute force private keys with current technology.
It is a global distributed database, with additions to the database by consent of the majority.
Satoshi Nakamoto
Why is a secure entry in a digital ledger worth exchanging my hard earned money for? Well, that’s entirely up to you to determine the price you are willing to pay. At the time of writing (Block height 836367 – 26th Mar 2024) the price in USD is $70,730. That’s the price for one whole Bitcoin. When the network first emerged it was worth $0.00 for the first 18 months before it gained any monetary price at all. (Bitcoin Pizza Day)
In the same way that the growth of any network technology is predicated on the number of connected nodes, the use case value of Bitcoin the network rises with the number of participants. This is known as the Network Effect and forms the basis of Metcalfe’s law. Metcalfe’s law states that the value or influence of a network is proportional to the square of the number of connected users of the system (n2). This network growth can be observed in the adoption of many technologies that rely on human interaction; mobile phones, the internet, social media, Venmo and PayPal. But in the world of economics, value doesn’t dictate price, the market does, and how much your willing to pay for it defines how much you value the inherent properties.
Innovation makes the world go round. It brings prosperity and freedom.
Robert Metcalfe
So Is It Money?
Strictly speaking, no. It is arguably undergoing a process of monetisation, but is not yet the ubiquitous internet native monetary system as envisioned by some. One of the first questions anyone learning about bitcoin might ask themselves is, ‘what is money?’. Far greater minds than mine have stumbled over this most basic of questions and in far greater depth than I will ever be capable of. Digging into the history of money is a fascinating subject that covers thousands of years of human progress.
Proponents of bitcoin as a monetary good tend to align heavily with the Austrian School of Economics, a counter theory of Keynesian Economics. It is Keynesian Economics which is taught and used today as the basis of the global economy. These competing schools of economic thought can be considered as the difference between money chosen by free peoples for their benefit (sound money), and money mandated, manipulated and created by the state for its benefit (fiat money).
The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.
Satoshi Nakamoto
Throughout history, many goods have been used as ‘money’. Most of these arose spontaneously, be it beads, shells, beaver pelts, commodities such as wheat or corn or livestock. They were a medium of exchange between two or more parties who needed what another person had. This system of barter had shortcomings as society grew larger. It is difficult to solve the ‘double-coincidence of wants‘, as defined by Carl Menger. Instead, people settled on a common media of exchange through a competition of monies in the free market. Precious metals rose to the top by being portable, homogeneous, divisible, durable and scarce. They became the most marketable commodity.
Sound money in the form of precious metals and coinage is not immune to manipulation. I discussed in Chpt 37: Break Even the issues arising from seignorage, which is effectively a hidden tax by debasing the precious metal content in coinage. Verifying the purity of precious metal today takes some amount of time and effort, and even seasoned investor can be fooled. Assaying one’s gold provides a quality check to make sure that the gold purchased is not only at the purity level that it claims to be, but also that it meets the standards set by the bar’s mint.
Bitcoins have no dividend or potential future dividend, therefore not like a stock. More like a collectible or commodity.
Satoshi Nakamoto
So let’s clarify the properties of bitcoin in terms of a monetary good:
- Portable – As a digital good, you can transfer it globally, or memorise your own private keys and walk over a border
- Homogeneous – Each subdivision of bitcoin (a Satoshi) is treated equally by the network
- Divisible – Bitcoin is infinitely divisible (Chpt 29: Grey Area)
- Durable – You cannot destroy a bitcoin, but you can lose access to it
- Scarce – The protocol has a limit of ±21 million bitcoin, agreed by all the network participants
- Verifiable – The network will not accept ‘fake’ bitcoin or fake transactions.
- Auditable – Anyone at any time can verify the total supply of bitcoin in circulation
Money is simply technology by which we arrange the division of labor, moving economic value through time and space, between the time of production (earning it) and the time of consumption (spending it). If the commodity we use as money has an outsised use case as something other than money, then it will trade at a higher relative price than its non-monetary use warrants. This difference is what we call monetary premium. Bitcoin, as a result of having no alternative use case other than as money, is 100% monetary premium.
The price of bitcoin is entirely driven by price discovery. It is pure, free market economics of supply and demand. Never before has the market had to price a demonstrably finite and scarce asset, digital or otherwise.
So is it Money? No, it’s probably better classed as an intangible asset undergoing monetisation.
A rational market price for something that is expected to increase in value will already reflect the present value of the expected future increases. In your head, you do a probability estimate balancing the odds that it keeps increasing.
Satoshi Nakamoto
So it’s an Asset?
Regulatory clarity is a confusing thing when defining bitcoin the ‘asset’. Currently the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) define bitcoin as a commodity within the USA. It is traded and regulated as a commodity on the US markets. In the UK it falls under a nebulous category of ‘crypto assets’ and no delineation is made between it and other digital assets / networks.
An asset can be defined as “a useful or valuable thing“, which bitcoin invariably is. It can also be “an item of property owned by a person or company, regarded as having value“. We define ownership of bitcoin through possession of the private key to a public key. If you can sign a message using the private keys to a public address this is enough to confirm ownership of that specific bitcoin address. In this situation, it is truly the first property or asset that one can own without counter party risk.
Gold and silver are tangible assets, but are also considered commodities. A commodity can be defined as “a substance or product that can be traded, bought, or sold“. Given that there is no protocol layer differentiation between the individual units of bitcoin, and that each ‘miner’ on the network produces economically indistinguishable units, we can define it as a commodity.
One differentiation between bitcoin and other commodities is that it has no ‘use value‘ outside of its use as a monetary good. In this sense, the typical sound money enthusiasts (gold or silver holders) criticise this lack of function. Gold has underlying economic demand for use in jewelry, dentistry and electronics. Gold and silver are commodity monies even if they are no longer used as money by the majority. However, this underlying economic demand skews our perception of its value and subsequently the price, or it distorts the monetary premium of gold and silver.
It’s more typical of a precious metal. Instead of the supply changing to keep the value the same, the supply is predetermined and the value changes. As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop
Satoshi Nakamoto
So it’s an Energy Commodity?
When we discuss economics the term commodity is used specifically for economic goods. Things which from the view of the market have substantial fungibility (individually equivalent or equal to any other instances). Soft commodities are goods that are grown, such as wheat, rice or coffee beans. Hard commodities are typically mined; gold, silver, metal ore. Energy commodities include electricity, gas, coal and oil. While there are variations on the quality or origin of the commodities, they are invariably treated and traded equally, and have no brand or product differentiation.
While the terminology for the issuance of new bitcoin is mining, it is better understood as a distribution process. The fairest way of distributing bitcoin is by having the miners compete. They do not receive it for free, they have to provide proof of work to the network. You cannot turn the electricity used in the distribution process to turn bitcoin back into electricity. Energy is never destroyed, in this case it is turned into heat as a byproduct of the computational process. This is the The law of conservation of energy.
So in this sense, bitcoin is not an energy commodity. You could perhaps best describe it as a record of potential economic energy. A way to store your own economic energy without suffering the effects of entropy, a transmutation from one economic force, to another. Energy is the master resource of human civilization and we should always be aspiring to become better masters of energy. Bitcoin allows producers of energy to arbitrage costs against regular grid use. Bitcoin miners are the potential buyers of last resort for wasted energy globally as they compete to find the lowest cost energy available.
Conclusion
Bitcoin, whilst a recognisable name, is not a brand as such. There is no CEO, no management structure, and no single company which controls bitcoin the asset, or the network. It is free open source software, meaning anyone can audit the code that is being run globally.
This article barely scratches the surface of the discussions around bitcoin and money, but I hope that it has provided a slim framework into understanding what bitcoin might be to some people. In discussing how it might be money one day, or that it’s currently better money for some in countries with collapsing fiat values, is a long topic. Discussing how most people don’t understand the difference between money and credit is also a topic for another day. This is even before we discuss the ethics of money production.
What I want to put across is that defining it as money is difficult because it does not fit traditional definitions of anything that has come before. Is it capital? Is it high powered money, or day to day currency? Is it economic energy? Is it property? Is it a Veblen Good? Is it an inflation hedge or a long term store of value?
I have not touched on the volatility, the fairness of distribution, or the potential for the technology that can be built on top of a truly decentralised network of equal participants. I have not discussed property rights, freedom of speech, human rights, energy use and economic incentives. All of which end up being bitcoin adjacent topics.
To me, buying bitcoin today is like buying a piece of Manhattan in the 1900’s or buying a piece of the infrastructure of the internet back in 1990’s.
What price you put on that will be a nuisance to calculate.
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Further Reading:
The Quality of Money – Philipp Bagus
Stable Money: Myth and Reality – Thorsten Polleit
Sebag and Natural Money – Joakim Book