What Gives Bitcoin Value (Pt. 2) — Need and Trust

How “Need” and “Trust” factor into a currency’s usefulness

This is part 2 of 3 of a series answering a common question I’ve heard from people who are new (and even old) to the world of cryptocurrencies: what gives something that is purely digital enough value to be considered a currency? This started as a long email exchange with a friend, which I decided to convert to this series of posts. The original questions are highlighted in blockquotes.

Part 1, on what generally gives a currency value and how that applies to Bitcoin, can be found here. Part 2 is on how “Need” and “Trust” factor into a currency’s usefulness and whether those allow Bitcoin to fit into today’s world. The final part is on what makes good money and how Bitcoin stacks up.

Need & Trust

IS THERE A NEED FOR BITCOIN?

NEED: We have the USD, which most people trust. Why is there a need for an alternative? Or put it another way, to what extent would our world have to change for that need to become imperative? To what extent would our world have to stay the same? (i.e. Crypto currencies require the internet, so the assumption is that the internet will never go away.) (And the next question is: is that future world likely?)

I’ll take these one at a time:

Why is there a need for an alternative?

The need for an alternative is two-fold, need in the developed world and need in the developing world.

The need in the developed world comes from the fact that the fiat system is incredibly inefficient and insecure. Billions of dollars a year are spent in administrative costs simply to verify settlements between large financial institutions. The SWIFT network was hacked three times last summer alone resulting in the theft of millions of dollars and an increase of security measures that added weeks to processing times of large amounts of funds*. The cost of this security per transaction in Bitcoin is trivial. Credit card processing fees, while they may feel free to the consumer, the fact is that from anywhere from 1–10% is added on top of everything we buy with them because merchants have to pay processing fees and because of the very large risk of charge backs those merchants have to bear.

A practical example of this is a company founded a few years ago called Gyft that allowed for the purchase of gift cards. They almost went out of business as a result of the amount of fraud resulting from credit card chargebacks. The CEO discovered Bitcoin (then still in the early days) and switched over to that as a payment system. Chargebacks and fraud went down to almost zero and the company became profitable and successful. Purse.io similarly takes advantage of this feature, among others of Bitcoin, in allowing mediated purchases of anything on Amazon to anywhere in the world.

In the developing world, you’re already seeing the need for decentralized currencies. In Venezuela right now, Bitcoin and cryptocurrencies are one of the only ways that citizens can get their hands on physical goods like toilet paper, milk, or clothing. They are actually using services like Gyft and Purse, purchased using cryptocurrency since all fiat currencies are on full lock down, to buy things on Amazon. There is a very interesting story on this from Reason magazine about Bitcoin mining in Venezuela. Particularly striking to me is the story of one man who had his mining rigs confiscated only to have the officials that took them from him start mining for themselves!

It’s not just Venezuela though. With bank wire costs getting as high as 10–20%, opportunities in remittances with Bitcoin are huge. BitPesa is a company in Africa that helps overseas workers send money home to family. I have a friend from Hack Reactor that moved to Manila to work for a company called Coins.ph doing the same thing in SE Asia. You can now use their app to exchange Bitcoin in convenience stores all over the Philippines, which has one of the largest overseas migrant populations in the world. In the developed world meanwhile, the Swiss have made Bitcoin ATMs available in train ticket machines across the country and in Japan, some of the biggest retailers and convenience store chains in the country now accept Bitcoin for payment directly. Even in our developed world, at Purse where I currently work, the ability to pay a distributed team spread across several continents at almost no cost since we all get paid in Bitcoin relieves us as a small company of a huge administrative burden freeing up resources to focus on other things. This is also why when I freelanced while still in China, I offered a discount for payment in Bitcoin.

Or put it another way, to what extent would our world have to change for that need to become imperative?

As I think the examples outlined above demonstrate, I don’t think the world needs to change much for there to exist some imperative. I think there are already plenty of real world use cases. If the question is when does Bitcoin become a global currency on par with USD, EUR, RMB, then the answer is probably whenever a major crisis of faith happens in any of those major currencies. If Greece’s bill finally comes due and it’s no longer feasible or politically palatable to keep bailing them out (e.g. like when Cyprus confiscated 10% of citizens’ bank accounts or when Greece shut down their banking system for 2 weeks in 2013/2014) or if the private and local debt levels in China become unsustainable, or the US can’t extend any more debt on the anywhere from $20tr — $200tr amount of unfunded liabilities currently on the books, then we will see a return to the historical norm of using a deflationary commodity backed monetary system. Right now, Bitcoin is far better positioned to accommodate our digital and global world than gold and so I think is more likely to step in if that were to happen. Granted, I acknowledge that those scenarios still seem unlikely so in the meantime, the transition will be gradual through specific use cases where it has built in technological advantages.

To what extent would our world have to stay the same? (i.e. Crypto currencies require the internet, so the assumption is that the internet will never go away.) (And the next question is: is that future world likely?)

I would argue that our current financial system also requires the internet. The M1 money supply, the most liquid “denomination” of our currency, is a small fraction of the total fiat money available, especially in the U.S. system. Just $1.4 trillion out of the total $13.6tr (M1 + M2) available is paper currency as of July 2017. Most of the rest is in security, debt, loans, mutual funds, etc that exist in digitally, centrally stored ledgers both heavily reliant on our networking technologies and vulnerable to attacks on it. Take the existing payment infrastructure that’s developed in China in recent years. Moving from RMB payments to Bitcoin payments in WeChat pay would take almost no technical or cognitive change for users. Scan a QR code and receive funds credited to your account. Gold meanwhile is more like Bitcoin however extremely difficult and expensive to transport and requires a high level of trust for systems like arbitration and dispute moderation. Imagine having a payment system with the structural advantages of gold plus the technological capabilities of something like WeChat pay!

So I would say that Bitcoin needs the internet as much as the USD and the rest of our modern economy does and is actually more suited to todays world than most legacy systems. In fact, Bitcoin can actually be more resilient to something like an EMP attack or other network failures, and is far more resilient to hacking, due to its distributed nature. It only takes one hard drive to recover the entire Bitcoin network. Target a few data centers though and you can do a far greater amount of damage to our legacy system. Something I can do with Bitcoin that I can’t do with any other monetary system is to make multiple backups of my wealth. I can carry hundreds of thousands of dollars around on a USB drive to anywhere in the world. If that drive is stolen or lost (or confiscated), in the time it takes for the encryption to be hacked, I can recover it on another device from backups stored in geographically distributed locations. Bitcoin companies (and individuals) are thus able to create higher levels of security and redundancy in their internal systems than can be done with fiat money in either the world as it exists today or in a world with a much less robust internet, and certainly more than one where there are network disruptions or hacks.

CAN BITCOIN EARN THE TRUST NECESSARY FOR A CURRENCY TO OPERATE?

TRUST: That is the fundamental concept. As the world is changing (And indubitably, it is changing, very fast, and in unpredictable ways) the people of the world also change, and, presumably, what they trust changes too. But trust in a currency has to be hard earned. Ideally, it has to be tested, hard, through a long period of time. (Think recessions, inflations, wars..)

Trust in crypto currencies is based on the blockchain concept, as you said, it comes from “faith in a stable and a predictable supply is baked into the protocol itself and audit-able by anyone with access to the internet and some ability to read code”. I am on board with that, but that is not enough. BuckoCoin would presumably also fit the above description, it would be just as valuable as Bitcoin — as long as people jumped on the bandwagon. In other words, crypto currencies become valuable because of the above + good marketing + the existence of the internet.

– Not unique. If Bitcoin was all the above AND unique, not duplicatable, that would make it more enticing. The point of my previous email is that it is not unique. If you can create a good crypto currency like the Bitcoin, that means you can create many. In fact, presumably, as many as you want. In other words, the supply is endless, and one would think that would have an inflationary effect. Which would erode trust.

In other words, if the concept of Bitcoin can be duplicated, then it is very vulnerable: the only thing that holds it together is marketing, reputation, the fact that is it the first to have become accepted. And that element seems fragile to me.

All of this seems to me to come to the point that since anyone can create a cryptocurrency how will anyone trust in its scarcity enough to use it as a medium of exchange. Frankly though, I don’t see this as a defining feature of a currency or monetary system. Rather than thinking of the analogy as “Bitcoin is to fiat…”, we should be making the comparison- Bitcoin is to cryptocurrencies as the USD is to fiat. If Argentina can create a legitimate currency out of thin air that is accepted and traded on global markets and exchanged for goods domestically without affecting the legitimacy of the USD, why does creating another cryptocurrency delegitimize Bitcoin? (Note: I deliberately picked Argentina for my comparison because despite how historically weak it’s been in having its currency maintain value it continues to be reincarnated**.) Sure I could create my own cryptocurrency based off of Bitcoin, but I can’t create more Bitcoin out of thin air, and that’s the point. I would have to convince other people to use it, merchants to accept it, software and hardware developers to build infrastructure for it, etc. etc. Why would anyone invest in a new coin that offers no new inherent value over the Bitcoin system when all of that exists and is growing already for existing coins?

This is where cryptocurrencies have the edge. Fiat currencies only have value because governments back them. Governments back them because it gives them power. Governments maintain that power at the end of a gun. This is accomplished ultimately by requiring that only their currency be used as “legal tender for all debts, public and private”*** under penalty of law. This makes it a far more brittle system as we have seen by how frequently fiat systems crumble. Cryptocurrencies, on the other hand, exist in a constantly adversarial environment where they have to compete in the open marketplace. The longer one survives, the more faith it earns, and the stronger it becomes and thus they are far more resilient as a system. If we believe in the free market for goods, services, and even governments (U.S. federalist system), why shouldn’t we expect the same of our currency?

This is actually how many of the founders envisioned our country having a more robust financial system in the long run. Banks in the US used to issue their own bank notes that could be used as currency. It was widely feared by the likes of Jefferson, Madison, and to a lesser extent Benjamin Franklin that a fully debt-backed system would result in corruption in the government and weaker political system (Ben Franklin was quoted as saying “When the people find that they can vote themselves money, that will herald the end of the republic. Sell not liberty to purchase power”). Even Hamilton, who started the U.S. treasury, had a deep distrust of a fully centrally controlled monetary system backed by an interminable lien of debt****. I would argue that the fiat system we have today would not have even possible without the over a century and a half of proven performance by our government and economy before we fully moved away from the gold standard in 1971. Sadly, that trust, I feel, is rapidly being eroded away.

So yes, I can start my own cryptocurrency called BuckoCoin. But I could also start my own fiat currency called Buck’sBucks (what an appropriate name I was given for this conversation! :D). It’s also worth acknowledging that this parallel already happens in today’s world. What else are airline points than a fiat currency backed by the good faith of the airline? What about Amazon gift cards, which is one of the most widely distributed (but least liquid) “digital” currencies in the world? Fun fact actually (and this happens to be a total coincidence not a deliberate choice on my part), the place where I proposed to my wife in the Berkshires in Massachusetts is known for having their own local currency (I imagine the feds just turn a blind eye to it) called BerkShares which are printed locally and accepted at almost all local establishments. Our hotel even had a sign up saying they accepted it!

I hope you enjoyed the second part of this post! The third and final part on what gives Bitcoin value goes into the definition of money and how Bitcoin stacks up against fiat and gold.

*Meanwhile, in the 24 hour MVP app I built at Hack Reactor you can see live transactions being sent on the blockchain in real time, worth anywhere from $1 to hundreds of thousands of dollars, sometimes millions. http://btc-live-transactions.herokuapp.com/

** Brazil too is an interesting case in that they actually named their currency “real” to have people have faith that it was “really” worth something

*** quote directly from all US legal tender

**** Hamilton in his “Report on Public Credit”: “Persuaded as the Secretary is, that the proper funding of the present debt, will render it a national blessing: Yet he is so far from acceding to the position, in the latitude in which it is sometimes laid down, that “public debts are public benefits,” a position inviting to prodigality, and liable to dangerous abuse, — that he ardently wishes to see it incorporated, as a fundamental maxim, in the system of public credit of the United States, that the creation of debt should always be accompanied with the means of extinguishment. This he regards as the true secret for rendering public credit immortal.”