Bitcoin, explained to a friend

I have spent thousands of hours studying cryptocurrencies this year, and this is what I learned. This article was first written to my friends who are asking me about the evolution of cryptocurrencies, the blockchain and, most importantly: what is happening with Bitcoin’s price?

Disclaimer: I studied finance but I am not a financial advisor. Read this at your own peril. Also, it’s [almost] 2018, so don’t hesitate to highlight any section of this document to ask a question or tell other readers what you think. Learning together.

This is a long article because it is a dense subject. It is fascinating. It is about the future. So before starting to read it, I would like you to take a deep breathe, close your eyes, and accept that you are going to travel through time, to a world that will start to feel like science-fiction. Because the future may be coming at us faster than we predicted — and yes, robots will replace us, AI and Blockchains will take our jobs, and VR will help us not get bored. The future is strange and wobbly, so you need an open mind to see it.

The world we live in

We are living through exceptional times. The world is changing at a fast pace through the abundance of knowledge (through the Web) and capital (through financial markets, venture capital and crowdfunding), while globalization is increasing competition between companies, states, nations and people.

Now, how do you explain that the Bitcoin, a digital notion with no underlying asset, pretends to be a new currency, and everybody starts to believe it, even though practically no one has ever bought anything in the real world with it? Utter nonsense! Right?

Brief history of money (boring part)

The core function of a dollar bill is to serve as credit between two persons. A dollar bill is a credit letter from the Treasury that stipulates that if I want to exchange this dollar into gold I could. Since the Gold standard, the exchange rate to gold is fluctuating. Therefore, we no longer believe that the value of the dollar (or any other currency) is actually linked to a specific underlying asset.

Today currency has only a perceived value, and the key benefit is that this perceived value is widely uniform across the globe and it does not change too much over time (we predict and refrain inflation). We have strong belief that we could wake up tomorrow and buy something else with that dollar bill. In other terms: the “Credit” (i.e. “Belief in Tradability”) moved from me and the bank, to me and everybody else in society. Also, with the advent of information technology, the majority of money flowing in the economic system is now scriptural, not in print.

There is no need for a currency to have an underlying asset. All you need to have is commonly-held belief among people that you can exchange a dollar into any other tradable asset at more or less the same price today and tomorrow.

Money has two uses: enabling transactions and storing value. Given inflation, we tend to use other assets to store value over time (e.g. real estate, stock portfolio, bonds). National currencies tend to depreciate.

Bitcoin was originally designed to serve both uses.

Enters Bitcoin

Bitcoin was designed by Satoshi Nakamoto in the midst of the 2008 crisis, when banks were falling, and governments had to use tax money to guarantee bank reserves and refrain people from triggering bank runs. Governments were basically printing money to save Wall Street, thus making everyone a little less rich to avoid a total collapse of the banking system (and thereby the economy). That was smart, but maybe a little unfair for the majority of tax payers.

On its white paper, the purpose of Bitcoin is to create a currency that is not backed or controlled by a government. The concept is made possible by several phenomenal inventions that are brought together by Satoshi (he deserves a Nobel in my view):

• Complex mathematical equations are used in order to create currency serials: a single problem with a defined number of solutions (21 million) that need to be impossible to guess, thus requiring a lot of time to “find” or “mine”
• A Public Ledger is used in order to recognize the first persons who find each solution of the equation, and thereby claims the ownership of the bitcoin. The same Public Ledger is used in order to record any transaction done with the Bitcoin (or any divisible part of it)
• Server mirroring technology enables multiple servers to replicate the Public Ledger in thousands of nodes, making it quasi-impossible to attack or bring down
• Conflict resolution algorithms are created in order to define which server is right when there are conflicting transactions across the network of servers
• Cryptography is used in order to execute transactions securely — basically creating digital property
• Game theory and probabilistic calculus is used in order to police the execution of good behavior between servers and stakeholders
• Business sense is used in order to reward servers for processing transactions
• Political theory is used to define a balanced political system that allows the network to build consensus and implement changes for the benefit of the system

Read The Blockchain Disruption to understand what a Blockchain is. Just do it!

As anyone can tell, Satoshi is one of the finest brains in this world, and he created two of the most amazing inventions of our era: blockchains and cryptocurrencies.

We do not know who exactly is Satoshi Nakamoto, it could be a group of several people, but the intrigue only makes Bitcoin more special. Check this documentary if you are more interested in the history of Bitcoin.

Why does Bitcoin’s price keep going up?

Bitcoin will be scarce, whatever the price

With inflation, your dollar could get you 20 cokes in 1930, 5 cokes in 1970, 1 coke in 2000, and half a coke today. That’s due to the fact that the Treasury and the Fed are printing money, not to the fact that we create less value in the world.

Satoshi designed Bitcoin as a currency with a finite number of bills in order to have it increase in value as more people get to use it.

With this inherent scarcity, Bitcoin was designed to be a strong currency to hold value. This scarcity is driving value because we have more people willing to hold Bitcoins than people willing to sell. This situation creates speculation, as people start to hold Bitcoins with the expectation of increase in value. It actually became the key reason to invest in cryptocurrencies. To speculate. Should you do it too?

Scarce, but rewarding for the risk takers

By fixing the number of potential Bitcoins existing in the world, every net additional person that would like to join the community of Bitcoin holders needs to pay more for another person to release it’s holding position. Scarcity drives the price up, and thus rewards the early adopters.

Hockey stick on a hockey stick

Rewarding early adopters makes sense in any system that is built around network effects: more people hold the currency, more applications get built to use it, more uses the currency gets, more people try to hold the currency.

Satoshi designed a positive spiral for a self-fulfilling prophecy: move everyone out of fiat currencies and into cryptocurrencies. Cryptopunks named this movement “The Exodus”.

The Exodus

The founder of Bitcoin was fully aware of the risk that such a system would drive speculation on the price of Bitcoin, but that didn’t bother him. Why? Because the aim is to continue to drive adoption of the Bitcoin until the latter becomes to main currency of the world. A currency that, if it replaces all others, may be valued around $1 million per Bitcoin (value of all currencies assumed to be ~21 trillions, maximal number of discoverable Bitcoins being set at 21 million).

Because there is no necessary underlying asset to set the value of a currency (but the widespread belief in the transactability of the currency at the recognized value), there would not be a big crash where the value of the Bitcoin would get back to its initial value of $0.01 in 2009.

The “Exodus” scenario could be modeled with an S-curve, where we get to an exponential growth (cf. recent trends), and as we pass the inflection point when Bitcoin becomes the largest currency in the world, starts to stabilize as potential for both upside (all the wealth in the world is already stored) and downside (the belief in it as a currency is widespread) diminish.

This scenario assumes that Bitcoin will become the standard — which is not certain. Also, this scenario does not mean that while Bitcoin is gaining market share, we don’t experience big crashes due to speculation. Greed vs. Fear.

Another way to look at this bubble.

What’s the Intrinsic Value of Bitcoin?

Let’s look into the value that Bitcoin has vs. other currencies in order to understand whether there is mostly speculation or intelligent expectation of a future that is coming closer.

Strengths and uses of Bitcoin

• Bitcoin is an innovative form of currency that has existed since 2009, that proved to be liquid, secure and global
• Bitcoin can be used to store value without money-printing-induced inflation (assuming that the net inflows remain nil between the time of purchase and the time of sale)
• Bitcoin can be used to get exposure to the potential for an increase in the number of people wanting to hold bitcoins (and thereby also an exposure to the negative case where people would be willing to sell it)
• Bitcoin can be used for portfolio diversification, as it was designed to be resilient to global economic meltdown, government risk and systemic banking collapse, and thereby may have a negative beta if more people use it (like they use gold today) in order to store value in moments of panic
• Bitcoin has proven to be a efficient means for settlements, as transactions are executed within the hour, whereas it takes a couple of days for most banks
• Bitcoin has proven to be an efficient means to exchange currencies, as transactions costs from any currency to Bitcoin is about ~0.02%, whereas exchange rates through banks are still around 2%

Note: Bitcoin is even more useful when it comes to exchanging two minor currencies, as, for example, if you need to exchange your West African Franc CFA you kept from your last trip in Cote d’Ivoire into a Costa Rican colon, you may have to exchange into Euro, then US dollar, then colon, thereby paying ~6% in commissions.

• Bitcoin’s dominance (see market capitalizations of cryptocurrencies) is reinforced by the fact that it is the main entry point to all other cryptocurrencies.

Note: Because all markets are designed as exchange places where you exchange or trade two specific items, if you want to exchange any two cryptocurrencies, you will always find an exchange option through Bitcoin (Ethereum is a great challenger here) but it will be extremely rare to find an exchange through two cryptocurrencies.

• Bitcoin cannot be forcefully taken by any jurisdiction. There is no government recourse on the funds held on a blockchain. This is an important feature that bears a lot of value for cryptocurrency holders. It means that it is now possible for a moral or physical person to completely shield some liquid assets from judicial powers.

Explanation: This is the dark part. Assume for a moment that you are Bernie Madoff, that you made billions through a Ponzi scheme, and that you don’t want to give access to your money to the government, the IRS or, for that matter, any judicial system: if you hold dollar bills, you need to hide them, and someone will find them. If you have scriptural dollars, your bank will have to respond to Justice. The Blockchain, however, only has to respond to the algorithm and rules already put in place. And because the servers are decentralized, and that transactions need to be cryptographically approved to be registered on the Ledger, then only a person with the code can move money.

An interesting list. Now, let’s see how these uses evolve over time.

Opportunities ahead

• Discoverability: Bitcoin is definitely known by many people today, and with Coinbase, more and more people start to have access to it. Access is driving demand for Bitcoin, and will thus keep the price up until demand decreases. Therefore, the question is: how many people do you think would like to buy Bitcoins for one of the uses mentioned above, and do not have any? Hidden in this first question is a secondary question: When will the music stop? Some people think people are just greedy and we already started to just speculate. Some people believe that this is just the beginning of the global exodus from our national currencies to cryptocurrencies. The tech-optimists say the music won’t stop. We will just move to a new currency, and every Bitcoin will have about a $1m value.

• Inflation offsetting: the inflation of Bitcoin is predictable through the analysis of mining power, and is handled automatically by the system as each time a Bitcoin is found and claimed by a miner, the probability of discovering another Bitcoin decreases… until the day we mine the last Bitcoin. On that day, there won’t be any more printing of Bitcoin money, and thus inflation will be stopped. We will still have the increases and decreases in value, but those may stabilize as the adoption develops.
• Portfolio diversification tool: given the naturally negative beta of this asset class, I expect Bitcoin to be a great bet in case of recession, as it was designed during an economic crisis and because of systemic banking freeze in order to have a place to store value and keep transacting without banks. Effective.
• Market demand: the couple of trackers that are meant to represent the price of Bitcoin on stock exchanges are so much bought that their prices generally trade at 35-85% premium above their underlying assets. This means that investors are ready to lose over 35% of value to get access to Bitcoin surge exposure. Would you buy a tracker for gold that is valued at 1.35x the price of gold? Certainly a case for arbitrage.

• FinTech competition drives democratization: a secondary network effect appears when FinTech companies realize that the greatest unicorns will be valued based on their cryptocurrency exposure. Democratizing Bitcoin on their app becomes a necessity to protect market share and keep access to venture capital, and outshine competition. Square thus had to add a new use case for its Cash app with the introduction of BTC transfers, because Coinbase was becoming too large a FinTech competitor.

• Legitimacy: Bitcoin futures were just introduced in Chicago Options Exchange (CBOE), and other exchange around the world, from NYC to Tokyo, have cleared Bitcoin Options for trading in the coming months.

• Currency exchange use: A phenomenal startup was created by Elizabeth Rossiello, Bitpesa, that helps companies deliver transactions through Africa, using Bitcoins as currencies, check it out! This is a key pain point for any company or person that wants to transact across national borders, so with a globalizing world, I do not expect this trend to decrease.

• Transactions use: Bitcoin is still an efficient way to transact, but Ethereum is making it possible to develop smart contracts (i.e. transactions with specific rules, such as escrow before payment, validation before retransfer, etc.) and Litecoin developed blockchains that can deal with a larger number of transactions per second.

Note: There are several stronger cryptocurrency alternatives that are better suited to this use than Bitcoin. The cost of having a transaction recorded by a mining server into the blockchain is also getting higher over time as more and more transactions compete for the computing power, and that is why Bitcoin cannot remain the only blockchain and cryptocurrency for all applications

• Entry point to other currencies: Ethereum is also strongly competing in with Bitcoin in order to become the central point of exchange for other cryptocurrencies. At this stage, I think Bitcoin dominance on exchange volumes is at ~75–80%, Ethereum ~15–20% , and the rest with the rest.
• Shield vs jurisdiction: this is a key driver for demand in the years to come in my view. About $7 trillion of liquid assets are held in Tax Havens today. If 10% move to cryptocurrencies, that would represent a tripling of current crypto market cap ($440bn). Assuming the same Bitcoin dominance over time (i.e. split BTC vs rest of Cryptocurrencies in Market Cap), that would represent a Bitcoin price at ~$45k.

Obviously, I have presented here a very partial view. I just try here to explain what may make sense in the madness that we have experienced with regards to the increase in Bitcoin’s value over the last month.

For this article to be complete, I should provide more information about the weaknesses and potential threats to Bitcoin. Yet, I prefer to skip the question entirely, because I don’t want to focus on the question of whether we are living through a bubble or not.

Bitcoin IS a bubble, like all currencies.

If you are trying to determine that value of a currency that may act as gold and the Swiss franc, yet that is tied to no nation and no organization, that has great potential with strong network effects already in place, that faces strong competition from the cryptocurrencies that depend on it… I wish you good luck!

But could you invest without figuring it out? Maybe. The story continues with Cryptocurrency Investing, explained to a friend.