An In-depth Discussion On The Investment Logic of Bitcoin

Louis Liu
Louis Liu
Sep 23, 2019 · 13 min read

The purpose of this article is to make every reader properly understand Bitcoin as an asset class. The article will evaluate Bitcoin in three aspects, based on my meeting experience with cryptocurrency fund managers and startups over the past two years at Family Office.

▪ The Uniqueness of Bitcoin

The Social Value of Bitcoin

The Investment Value of Bitcoin


The Uniqueness of Bitcoin

First, to understand Bitcoin, you have to know what has changed. The technologies used in Bitcoin, such as public key, private key, cryptography, distributed ledger, public databases, proof of work, tokens, etc., have been around for years. The only thing that Bitcoin has changed is that it has combined all these technologies in a smart and ingenious way, creating the first computer-sovereignty platform and separating the currency from the state. Before that, Kings, Queens, the national government and the federal government were the representatives of sovereignty. What they all have in common is the right to coin or print money. The emergence of the Bitcoin blockchain is the first time in human history that sovereignty is truly represented by a computer platform, the universal currency of which is bitcoin.

Sovereignty

Bitcoin as A Decentralized Sovereignty

Bitcoin’s sovereignty is decentralized in nature. This means that Bitcoin does not need third-party verification to determine the authenticity of transactions. Nodes and miners are the two key factors to maintain the decentralized sovereign of Bitcoin.

The degree of decentralization of the Bitcoin blockchain can be determined by the number of nodes. Nodes are key points for creating, receiving or transmitting messages to propagate transactions occurring on the Bitcoin blockchain. It allows Bitcoin transactions to be carried out in a peer-to-peer manner without third-party verification. In the case of a software upgrade, each node decides for itself whether to accept the change. Until now, Bitcoin is still one of the most node-populated blockchains, with nearly 10,000 nodes (20% higher than Ethereum, which comes in second).

Bitcoin Node, The Impenetrable Fortress (Source: Medium Blog)

The security of Bitcoin blockchain and the authenticity of on-chain transactions are protected and verified by Bitcoin miners. When mining bitcoin, miners need to provide computing power to “package” the blocks. In return, the Bitcoin blockchain will reward miners with bitcoin as compensation. If bitcoin was removed from the Bitcoin blockchain, miners will lose the incentive to maintain it, and its security and sovereignty will vanish as a result. Today, Bitcoin mining is consuming more than 7 GW of electricity a day, equivalent to Switzerland’s daily electricity consumption. Compared with 2017, Bitcoin’s computing power has reached an all-time high, currently at 100 quintillion hashes.

Bitcoin’s Hash Rate(Source: Blockchain.com)

The greater the computing power means the more people are investing in capital to mine bitcoins. As computing power increases, the Bitcoin blockchain also becomes safer. Many people criticize Bitcoin’s power consumption as harming the environment. These criticisms are too exaggerated to be true. According to Coinshares, nearly 74.1% of Bitcoin’s power comes from renewable energy sources (interestingly, 60% of the Bitcoin’s power comes from China). The value of Bitcoin is directly proportional to the computing power it requires. Miners need to invest a certain amount of electricity to mine bitcoins. If Bitcoin does not consume any electricity, its security will disappear, causing the network to be hacked. When Bitcoin loses its computing power, it ceases to be a sovereign computer and eventually loses its value.

Global Renewables Penetration in Bitcoin Mining (Source: Coinshares)

If someone wants to destroy Bitcoin maliciously, they need not only to invest capital to buy mining machines and also to get enough electric power. At the current scale of Bitcoin’s computing power, they need more electricity than Switzerland uses every day to do so. As computing power increases, Bitcoin becomes harder to destroy. So far, Bitcoin has been attacked by many hackers, but none of them are successful. This proves the security of Bitcoin. In the future, we can expect that countries and enterprises may attack Bitcoin for reasons such as that it is a threat to their power. At that time, only time will prove the security and sovereignty of Bitcoin.

The Blockchain Myth

Valuable blockchain technologies need to conform to two characteristics. First, the value of blockchain technology lies in its “decentralization”. That is, no one or organization can easily change the transactions that take place on the blockchain or its infrastructure. If the information on the blockchain can be easily changed, it is not a decentralized system, and it will lose the point of using this technology. “Decentralization” is the ultimate goal of blockchain. In Bitcoin’s case, “decentralized” means that Bitcoin has achieved its ultimate goal: “decentralized sovereignty, people’s money.” The only innovation in blockchain is the establishment of decentralized sovereignty in the virtual world. Moreover, the autonomy, stability, and scarcity of monetary policy affect the value of blockchain. When the currency is applied to the blockchain, once the currency loses its value, the blockchain will lose its meaning. Bitcoin’s monetary policy and money supply have never been miscalculated in the past 10 years. A stable and predictable money supply plus a limited amount of money gives bitcoin its value. Most “blockchain technologies” or “cryptocurrencies” on the market don’t have either of these features. At present, only Bitcoin can achieve these two points on a real scale. You can’t have one without the other.

Bitcoin, Not Blockchain

Many people still misunderstand Bitcoin and see blockchain as a more disruptive technology than Bitcoin. Blockchain is not a world-changing innovation. It is a Buzzword created by investors and start-ups through various marketing and hype. Many start-ups have raised hundreds of millions of dollars from investors who don’t understand blockchain. The phrase “Bitcoin, not Blockchain,” is perfect for correcting today’s unbalanced and miseducated market. The real disruptive innovation is not blockchain, but Bitcoin (currency) and the Bitcoin blockchain (platform).

Bitcoin, not Blockchain (Source: The Bitcoin Standard)

The Social Economic Value of Bitcoin

Comparison of Bitcoin, Dollar, and Gold

Because Bitcoin is not a company, it does not generate profits or dividends, so it has no intrinsic value. Bitcoin can be considered a currency, and like most currencies, it has no intrinsic value. Gold, dollar and national currencies are useful because of the state-directed monetary policies behind them. The biggest challenge for Bitcoin is how to successfully build a broad social recognition, a radical challenge, but one worth trying.

Logical Next Step in Money Technology (Source: PlanB)

So far, it has been possible to do value exchange and settlement globally through Bitcoin. It follows the same logic as gold for the past 2,000 years and the dollar for the past 70 years as universal currency. Bitcoin is even better than gold and the dollar as a currency because it is scarcer, more open and peer-to-peer. Bitcoin is scarce because the code sets the number of bitcoins produced at 21 million, and changing that number requires the consent of 51% of the network’s members, not just a few. What’s more, Bitcoin cannot be regulated by third parties. No one can change the transactions that are already happening on the Bitcoin blockchain, and no one can stop others from using it. This has brought unprecedented economic freedom to the world, just as the Internet brought freedom of information to society. The advantage of gold is that it is a valuable asset, most people recognize its value, and it has been around for thousands of years. Bitcoin cannot be compared to gold in history or reputation. The advantage of the dollar is that it is now the global currency and has network effects that bitcoin does not. These advantages are not something that Bitcoin can replace in a short time. Still, perhaps one day we will understand the value of Bitcoin, a currency that cannot be augmented and controlled by third parties.

Bitcoin Versus Dollar and Gold (Sourcet: Kitco)

Bitcoin as An Intermediate Currency And A Non-political International Clearing Standard

If Bitcoin succeeds, it won’t necessarily replace any national currency. It could become an intermediate currency, on top of the national currency, as a neutral monetary clearing system and value standard. We already have globalized, non-political metrics, such as miles in length and kilograms in weight. These measures will not change for political reasons, but since we have abandoned the gold standard, there has been no basic standard to measure the value of money. Even though the world’s currency is based on the US dollar, it is not perfect in value measurement due to its vulnerability to political influence and monetary policies and the long-term depreciation of the dollar. A non-political monetary value standard is what we need in today’s world of excess money.

In the same way, Bitcoin has the potential to become a non-political international clearing standard. Currently, only Banks can participate in international or regional clearing networks (SWIFT, Fedwire, ACH, CHAPS, Visa, and Mastercard). Individuals, businesses and governments can only participate in these clearing networks through Banks. Using these clearing networks for remittances can take days, the process is opaque and costly, and sometimes political factors will affect access. Imagine an open platform where individuals, businesses, and governments can do peer-to-peer clearance 24/7, regardless of time, location, amount, race, and political ideology, with moderate and transparent cost. This will disrupt money as the Internet disrupts information dissemination.

In the Bitcoin world, all currencies will be based on bitcoin and satoshi (the smallest unit of Bitcoin, about $0.0001). When your grandfather asks you how much the dollar is worth in bitcoins? You could say one dollar equals to 9718 satoshis. Oil prices? 19000 satoshis. America’s GDP? Five million bitcoins. Taiwan’s national reserve? 100,000 bitcoins. These values will then be based on Bitcoin and used for any exchange of money-related values.

If the monetary foundation of the future were based on Bitcoin, the world as we know it would be very different. When the currency only depreciates, people tend to spend more. Because if you don’t spend it, it won’t be worth as much as it was yesterday. Today’s financial institutions, to ensure that their clients’ assets hold their value, encourage them to invest because investing in non-monetary assets is the only way to fight inflation. Today’s financial institutions are so large and influential that they cannot escape the national monetary policy behind them. If the monetary system is based on non-inflationary money, people’s consumption habits will change. They would prefer to save capital rather than consume it. As capital becomes conservative, investment in the future will be more cautious. As a scarce currency in an era of capital inflation, Bitcoin can be a tool to fight inflation.

The Investment Value of Bitcoin

Bitcoin is an open-source protocol. Unlike the history of the company, the history of the protocol does not have prosperity, innovation, competition, and disruption (e.g., amazon overturning traditional retail, Apple replacing Nokia). Once a protocol is established, it is very difficult to change it. For example, we use IP (Internet Protocol) to transfer data over the Internet (CISCO tried different protocols in the 1990s, but eventually IP became the best choice). Today we only use one Internet protocol. So far there have been attempts to invent a better one, but we may have never heard of it. Once the protocol is established and has a certain network effect, it is difficult to be replaced by other new protocols. For now, the Bitcoin protocol is the standard for the internet of money, and no other protocols have reached a sufficient market scale to replace Bitcoin.

TCP/IP

Winner takes all

The logic of the Winner takes all would be even more obvious in a decentralized world. At present, many interesting blockchain technologies and applications are being tried out by new startups. However, even if they succeed, they are unlikely to replace Bitcoin. There are more than 1,000 cryptocurrencies on the market, most of which have no significant trading activity, high-quality engineers, or large community, and some are already dead. Bitcoin, by contrast, has worked well over the past decade (24/7). So far it has more than 60 million holders and is growing by an average of 1 million people a month. Bitcoin’s network process billions of dollars in transactions every day. The total number of users of other cryptocurrencies is less than 5 million and their networks process less than 1 percent of bitcoin transactions each day (nearly 92 percent of the transaction fees on-chain are on the Bitcoin blockchain).

Bitcoin Dominance in Cryptocurrency Market (Source: @ceterispar1bus)

Now, Bitcoin has achieved some network effect, so trying to replace it is not economically efficient. You need to invest a huge amount of capital, electricity, talent, and hardware to replace the existing Bitcoin blockchain. Building on Bitcoin, by contrast, is a cost-effective way. For example, the speed and cost of Bitcoin transactions have been criticized by other blockchain companies. The Bitcoin blockchain can only process 3,000 transactions every 10 minutes. Users have to wait 10 minutes before the transaction is recorded in the Bitcoin blockchain, and it takes an hour for the transactions to be irreversible. Then, a transaction fee of about half a dollar or more would have to be paid to the miners. The emergence of Lightning Network technology has solved the problems of slow transaction speed and high transaction cost of Bitcoin. The Lightning Network is a layer two decentralized network built on top of Bitcoin. It incorporates the underlying security of Bitcoin while supporting thousands of transactions per second and reducing transaction fees to one satoshi ($0.00001). Similarly, other layer two solutions such as RSK enable Bitcoin to incorporate function as Ethereum’s smart contracts without sacrificing security. Liquid is a side chain of Bitcoin blockchain that also can issue smart contracts (Tether is already on Liquid). As long as the security and sovereignty of Bitcoin are not compromised or controlled, it is expected that more layer two technologies will be transferred to Bitcoin and more companies will involve in the establishment of Bitcoin’s ecosystem. The growth of Bitcoin ecology will bring more value and practicability to Bitcoin.

Bitcoin’s ecosystem (Source: The Block)

The Historical Price and Trend of Bitcoin

The ICO bubble of 2017 was exactly the replica of the Internet bubble of 2000: the short-term technical value and outlook were grossly overvalued, and prices reflected the temporary pessimism of investors. Interestingly, unlike the dotcom bubble, Bitcoin has experienced three price crashes since 2010, with an average decline of 79%. Every time the price collapses, a new wave of price increase will follow. The 2017 price crash, like the previous two, was a cyclical correction in the market that didn’t affect Bitcoin’s long-term trajectory. With Bitcoin bottoming out at $3,200 and rising to $10,000 in 2019, it’s a great sign that the market is out of the bear market. Then, on April 30, 2020, Bitcoin’s output will be halved for the third time, which means the number of bitcoins generated per block will decrease from 12.5 to 6.25. If the price effect of each halving event is taken into account which averages 5439%, 2019 is a good time to buy bitcoins.

Bitcoin’s Price Historic Chart

The Market Size of Bitcoin

The total market value of Bitcoin is about $180B ($18M bitcoin times $10,000 each). Currently, Bitcoin accounts for just 0.09% of the gold and fiat currency market. If Bitcoin ends up becoming an international value standard and clearing network, it will be worth far more than gold. Gold’s overall market value is around $8 trillion. Conservatively, if the market value of Bitcoin is the same as that of gold, one bitcoin will be worth $300,000. If you compare Bitcoin to the narrow money in circulation (currently valued at $40 trillion), one bitcoin would be worth $2 million. The reason why this is considered a conservative calculation is that the total amount of Bitcoin is limited and the total amount of legal tender is unlimited.

Bitcoin Dominance In Money Market

The Value of Bitcoin as Digital Gold and Uncorrelated Asset

Bitcoin as digital gold and uncorrelated assets is a hedge against financial risk. In today’s turbulent world, the trade war between China and the United States, bloody protests in Hong Kong, and other geopolitical risks will further drive up the price of Bitcoin. Traditional assets like stocks, bonds, and real estate don’t have much upside in the current market environment. It is even harder for investors to find an asset that is undervalued and has asymmetric risks and returns. Across all major asset classes, Bitcoin has the highest Sharpe ratio when it comes to measuring the return on risk.

Bitcoin’s Sharpe Ratio compares to other assets (source: @woobull)

Conclusion

Bitcoin was born in the 2008 financial crisis, and the message “The Times 03/Jan/2009 Chancellor on brink of second bailout for bank” offers a solution to the decline of the financial industry and the central bank’s loose monetary policy. Ten years later, our social problems and financial risks remain. As the new round of economic crash was unfolding, Bitcoin’s price reacts strongly. It may be humanity’s only hope of escaping the reckless monetary policies of central banks and the excessive expansion of government credit. If Bitcoin succeeds, those early investors who have built up their knowledge and intuition will have an advantage over others. Their understanding of the digital world of the future will lead to today’s society forward. Bitcoin is a world-changing invention with far more power and imagination than a tulip. Bitcoin opens up another possibility for the society: a decentralized, peer-to-peer, digital, limited, transparent, and open monetary system.


*Disclaimer: This article is not an investment advice*

Louis Liu

Written by

Louis Liu

Investor. Associate at BlockTower, Venture Partner at Alpha Square Group and Bitcoin Advisor at Magi Capital Group.

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