What Gives Bitcoin Value (Pt. 1) — The Value of a Currency
What gives currency value and how does this apply to Bitcoin?
The following is Part 1 of an email response to a friend who is skeptically interested in Bitcoin and Cryptocurrencies. There were several questions asked and, for the sake of readability, I’ve split these up into multiple posts by topic/question. This post touches on what generally gives a currency value and how that applies to Bitcoin, part 2 goes into how Bitcoin fits in to today’s world, and part 3 closes out with the fundamental characteristics of money and how Bitcoin stacks up. The following has been formatted and edited to better stand on its own, with headers added for clarity and the original questions that are being responded to in blockquotes.
The major friction point is a matter of what makes money valuable. In the specific case of Bitcoin, the question is how can a cryptocurrency hold value when it exists as code that can be easily duplicated an infinite amount of times, e.g. what’s stopping me from starting a BuckCoin and using that instead of Bitcoin, which then makes the potential money supply of all cryptos infinitely large (this won’t be a new concept to anyone familiar with ICOs and the token economy)
On to the email…
Currency and Trust
All currencies, including clams and dollars, are subject to the same rule: people have to believe in them, they have to trust. The more the trust, the more the value, the longer lasting the currency.
I agree with the idea that people have to trust a medium of exchange for it to be adopted and be effective. When I claim that Bitcoin is a trustless system however, what I am addressing is the flaw in the systems that we’ve have had until now, which is that while the medium itself must be trusted that it will be accepted elsewhere, the systems relied upon for exchanging them typically still require a trusted third party for their free flow and I’m arguing that this is a technical point of failure.
For example, with gold, we typically had to trust the goldsmiths or the mint of the reigning world economic powers (e.g. Byzantines, Romans, Chinese). If you had an ounce of gold stamped with their seal, you could trust with a reasonable amount of certainty that it was actually worth an ounce of gold. Even these systems were vulnerable to a breakdown of trust, however, and thus eventually a breakdown of the systems they propped up in the long run. What happened with the Romans or Medieval kings in Europe was that when their treasuries started to run low, bits of gold would be shaved off the edges of coins, melted down, and new coins minted at an imperceptibly lighter weight. Over time, as with any inflation meant to manipulate people and markets, this eroded the market’s trust in the currency and the governments backing them crumbled. Paper currencies, of course, are essentially designed to optimize this process of devaluation. I haven’t come across a good argument as to how what we’re doing now is any different or better than shaving off bits of gold off coins. It seems to me that we are just better at obfuscating the debasement and ultimately kicking the can down the road.
So, while Bitcoin must follow the same rules of trust as other monies, i.e. I have to believe that other people will accept my Bitcoin just as I know people will accept a nugget of gold or a US treasury note, I no longer have to rely on trusting a third party to not debase the treasury note or to correctly weigh the nugget of gold or to transmit my transaction (as with credit cards/bank transfers). This characteristic alone is what gives/gave Bitcoin the initial trust as a medium of exchange. As soon as one tries to debase or inflate Bitcoin, you’re kicked off the network and your new currency won’t be accepted as Bitcoin anymore. More on this later, but the primary innovation of Bitcoin, which has been built upon by other cryptos, is that it created, for the first time ever, a verifiably scarce digital resource. This single characteristic alone has opened up the floodgates for a host of other innovations and efficiencies.
Is the USD where Bitcoin derives its value?
If you think about it, the single element that gives bitcoin the most credibility and value, is, also paradoxically, the USD. (A currency it may one day replace?)
I do not think it makes sense to equate denominating Bitcoin in USD with USD giving it value. The only thing the USD really does is provide a point of reference for quantifying its value, not what gives it its value in the first place. That would be like saying that the USD is what gives oil its value or the Euro its value since that is how we predominantly denominate those commodities as well. Exchange rates are simply points of reference. In fact, in China, where Bitcoin trading volumes are the greatest in the world, they primarily denominate it in RMB (as you can imagine, crossing the ¥8,888 mark was a big cognitive milestone in those markets even though it was meaningless when converted to the USD rate). Further, there are now exchanges and markets that are purely cryptocurrency where no fiat is involved at all. Because anyone in the world can use, trade, and transmit cryptos, this means that these are markets that enjoy global participation, are running 24/7, and are completely outside the realm of the USD, or any other fiat currency. The alternative digital currencies are even all denominated in Bitcoin (and sometimes each other) rather than USD!
Instead, what gives Bitcoin its value is that it is a verifiably scarce digital resource as mentioned above. Additional value is gained by the fact that, as a result of its relatively wide level of distribution and acceptance now, the network that secures this resource is also the most powerful (and distributed) computer network in the world, over 40,000 times more powerful than the top 500 most powerful super computers in the world combined. This also makes the Bitcoin network the most secure networked resource in the world. This characteristic means that it is also being used beyond currency to do things like digital notary services where you can prove ownership over physical assets through timestamps on the Bitcoin Blockchain (an Austin based company, Factom, is actually working on this problem, including with the Chinese government on their smart city initiatives). The societal and legal implications of this are astronomical and these additional use cases further compound the value of the underlying token (and sets up a higher barrier of entry for my “BuckoCoin” to compete).
It is also worth noting that Bitcoin didn’t just come out of thin air. As mentioned in my talk at Hack Reactor, this came from a computer science problem that had been under investigation for decades with several attempts at solving it falling flat (including even PayPal and as bright and innovative a mind as Elon Musk trying to make a digital currency and eventually giving up). The fact that Bitcoin was able to solve this problem of digital scarcity is what gave it it’s initial level of trust and allowing it to grow from a 9-page white paper written by an anonymous individual on online message boards to a global economic system worth over $70bn in just under a decade. The point is that the trust was very much earned through the gauntlet of both the market and academia.
To keep reading about what gives Bitcoin value, checkout Part 2 covering how “Need” and “Trust” factor into a currency’s usefulness and whether those allow Bitcoin to fit into today’s world.
