The Biggest Misconception About Bitcoin
Understanding Bitcoin is hard. I have sucked down the rabbit hole in 2017 and two years of non-stop research later I’m only now starting to grasp its deeper implications.
So it shouldn’t come as a surprise that for most people — who may have only heard of it in passing once or twice — Bitcoin is still a completely foreign concept.
And when something is poorly understood it becomes so much easier for misinformation to spread.
Patterns and Robotics: A Complex Reality | Data Driven Investor
Hayek's famous work 'The Theory of Complex Phenomena' (Hayek, 1964) delves into the topic of complexity and asserts…
A fundamental misunderstanding of Bitcoin is that its primary use case is for payments.
And this stops people from understanding Bitcoin’s true purpose.
What do I mean by this?
If you ask most people on the street (if they’ve heard of Bitcoin at all), they’ll tell you that it’s a different way to buy your coffee or pay for a service.
And most people who think of Bitcoin like this will dismiss it because it’s not actually better than PayPal, Apple Pay or credit cards at making everyday transactions easier.
People hear about the 7 transactions-per-second limit, the high fees and the irreversibility of transactions, and naturally, conclude that Bitcoin sounds pretty limited.
And then on top of that, you throw in that it sprung out of thin air 10 years ago, and that its price can fluctuate wildly day-to-day, and you can see why the idea of Bitcoin is so easy to dismiss.
From here it’s easy to state all the reasons why Bitcoin won’t work.
People ask why more isn’t being done to scale up its transaction rate, and, if this isn’t possible, why we’re not moving to another cryptocurrency where it is.
But the problem with this idea of ‘Bitcoin as payments’ is that it’s completely wrong.
For now, Bitcoin doesn’t need to have a high transaction rate, because it isn’t competing with PayPal or Apple Pay.
For now, Bitcoin is competing with the U.S Dollar.
It isn’t another form of payment, it’s a completely new form of money.
If you’ve never thought about what your money actually is, then that last sentence might hurt your brain a bit.
Without droning on, let’s have a 60 second (and far too simplified) explanation of money.
What is money?
Money has existed in numerous forms throughout human history — it is one of our oldest technologies.
Beads, shells, skins, stones, livestock, weapons, salt, metals, and paper have all been used as money extensively by human societies.
These objects worked as money as they were — above all — reliably scarce in human environments.
There was no point in using sticks or leaves as money as people didn’t desire these things.
A handcrafted metal dagger, on the other hand, a beautiful string of beads or a useful animal hide were very difficult for people to produce, and therefore their rarity gave them value.
Eventually, some of these rare objects began to be accepted not for the attainment of the thing itself, but as an intermediary in a transaction between two other goods.
For example, if I wanted to buy the deer you just caught, but I only have an axe to trade, the potential difference in the value of these items makes the transaction difficult.
Therefore a third valuable item that is easily portable and divisible can be used to calculate the value of the deer, and I can pay you in that instead.
The items that function best for this purpose need to do three things:
They need to be perceived as valuable by those who use them and tend to hold their value over time (store of value).
They are used as an intermediary in an exchange between two other items and aren’t used up in the process (medium of exchange).
And because they are used as a medium of exchange, they gradually become the default way to measure value, i.e. that deer is worth 20 gold pieces (unit of account).
Thus, through these three functions, these items become what we know as money.
So what has this got to do with Bitcoin?
Well like I said earlier, Bitcoin — like the beads, shells, and pieces of metal that came before it — is a new form of money.
And the reason why people are still talking about it 10 years after it was invented is that it’s the best form of money we’ve ever had.
That statement basically needs a whole book’s worth of explaining (which Saifedean Ammous’ ‘The Bitcoin Standard’ does brilliantly), but I’ll sum it up quickly here.
Essentially, something can only function as money if its users think it is valuable. And that thing’s value is directly tied to how hard it is to produce.
The reason gold is the most valuable of all the metals is overwhelmingly determined by two things: how much we have already mined (its stock) and how much we dig out of the earth every year (its flow).
That’s essentially it.
Copper, tin, lead, bronze and silver all have far greater industrial demand than gold, but gold is far more valuable.
It comes down to this stock to flow ratio (SF).
The amount of new gold we dig out of the earth in any given year is roughly 2% of its existing stockpiles, giving it an SF of roughly 50.
Having such a high SF means that you can be confident when buying gold that if the supply suddenly spiked, the price of your investment wouldn’t be sent plummeting.
Even a doubling of gold production, which is incredibly difficult, would only increase the flow from 2% to 4% of the stock, which is hardly enough to make a noticeable impression on the metal’s price.
From ‘The Bitcoin Standard’:
“It is this consistently low rate of supply of gold that is the fundamental reason it has maintained its monetary role throughout human history.”
A high SF gives you confidence in the rarity of that item, thus fulfilling the first function of money: being a consistent store of value over time.
And no other object throughout history has had such a consistently high SF as gold.
The cap on Bitcoin’s total number, as well as the ever reducing supply schedule mean that Bitcoin is well on its way to being the most scarce thing humans have ever produced.
Currently, 12.5 bitcoins are created every 10 minutes and awarded to the miner who solves each new block.
(If that sentence made no sense, here’s brief overview of how Bitcoin works.)
That puts Bitcoin’s SF (as of August 2019) at 22.7.
In May 2020 that supply is cut in half to 6.25 Bitcoin per block, rocketing up the ratio to 55.
This process of halving the Bitcoin supply occurs every four years, and was built this way to emulate the scarcity of gold.
This supply halving will continue until 2140, when, once the total number of bitcoins in circulation reaches 21 million, it is programmed to stop, and no more bitcoins will ever be produced.
So we can see that even by next year, Bitcoin’s SF will closely match that of gold (55 for Bitcoin, 50–60 for gold).
But by the next halving, Bitcoin’s shoots up to over 100, doubling again every four years after that.
The takeaway from this is that in a few years time, Bitcoin will be reliably scarcer than anything human society has ever managed to produce.
That’s a big deal.
History has shown us time and time again that when multiple forms of money are used in parallel, it’s the hardest (or most reliable) money that wins every time.
And Bitcoin is the most reliable money we’ve ever invented.
Store of value
Okay, so the theory says that Bitcoin should be a good store of value. But what does reality say?
Well, considering Bitcoin has been the best performing asset in the world over the last 10 years, I’d say that reality agrees.
People point to the huge run-ups and crashes of Bitcoin’s price and say it’s too volatile to be a good store of value and that it’s a bubble, but there are two problems with this argument.
The first is that a good store of value isn’t meant to be consistently stable in the short term. Housing and stock ‘bubbles’ occur with amazing regularity, but nobody says that they’re a poor store of value, and Bitcoin is no different.
Every time it has had a run-up in price, the subsequent crash has always ended at a higher low than the previous cycle, meaning that it is consistently gaining in value over time, even with this price volatility.
And second, speculative bubbles burst and never re-inflate. The speculative tulip mania of the 1630s that people love to compare Bitcoin to didn’t spring back to life a few years later. Neither did the South Sea Bubble in the 1720s, or any other speculative bubble in history.
But bubbles that form around new technologies that are fundamentally useful always recover. Think of the dot com crash of the early 2000s, the railway mania of the 1800s or any stock market crash. These are caused mainly by the irrationality of human nature, and are surprisingly predictable if you know what to look for.
And since Bitcoin’s market size is still relatively small, it is very prone to massive swings from over-exuberant or pessimistic investors.
A good store of value is something that holds or increases in value over the long term — decades to centuries. Short term fluctuations are completely irrelevant at this time scale.
Other properties of money
Okay, so it’s pretty safe to say now that Bitcoin is a good long-term store of value. But does that mean that it’s automatically money?
No, not yet.
As we said earlier, for something to function as money it also needs to function as a medium of exchange and a unit of account.
And since Bitcoin isn’t widely accepted by merchants or used to calculate the price of goods and services, we can’t yet say that Bitcoin fulfills all the functions of money.
And this is where naysayers get caught up. They see Bitcoin as being slow and volatile and see that not many people are using it to buy things, so they believe that they never will, and something else should be used for this function instead.
But the issue with this line of thinking is that it’s exactly backward.
You would be just as unlikely as our ancestors to accept a stick from me as payment because you both understood that a stick is worthless, and therefore a bad deal for you. If I told you that the stick was ‘secured by a blockchain’, I might be a little more likely to dupe you into thinking it is valuable, but at the end of the day, it’s still a useless stick.
You might be able to see where I’m going with this. Claiming that other cryptocurrencies function better as money than Bitcoin completely misses the most important thing about money: it needs to be a store of value first.
Every item in human history that ever functioned as money followed this same pattern:
First, it started as a collectible. People accumulated these things out of some sort of interest — they were rare, and generally either pretty or useful or both.
Because they were hard to produce, and people saw them as valuable, they gradually became a store of value — people still desired them across long spans of time.
Because they were desirable, they started to get traded between individuals and groups, eventually becoming both a medium of exchange and a unit of account.
This is an ancient and time-tested process, and not something that can just be upended by a few catchy buzzwords.
So, no, Bitcoin doesn’t function well as money right now, but it is well on its way to doing so.
The more people view it as a store of value, the more will want to hold it.
The more people who hold it, the more stable its price eventually becomes.
And the more stable it becomes, the more people are likely to use it to transact.
And that’s how it becomes a medium of exchange and a unit of account.
Extra layers of functionality like the Lightning Network will allow for greater scalability of transactions than is possible today, just like extra functionality in the early days of the internet allowed the clunky TCP/IP protocol to scale up from a few kB capacity to high speed streaming to billions of users.
These extra layers will facilitate the scaling of Bitcoin, until one day none but the largest and most vital transactions will occur on Bitcoin’s base layer.
The everyday payments will occur on layer 2 (like Lightning) or even layer 3 technologies.
And that’s the point.
The Bitcoin we know today isn’t set up to handle thousands of transactions per second, as well as being cheap, stable and secure.
No cryptocurrency can do all of that.
There’s a massive trade-off that occurs between security, price stability, and speed. If you want a super-fast network, it needs to be heavily centralized by design, so therefore it isn’t secure. It will never be a store of value if its supply schedule can not be relied on.
And you can’t have a cryptocurrency that is decentralized and secure, but also super fast with cheap transactions. You need the validation from thousands of nodes and expensive mining to secure the network.
But the history of money shows us that the most reliable store of value eventually wins out over inferior kinds.
So no, Bitcoin isn’t very good for payments at the moment, but that’s not what it’s meant to be right now.
Bitcoin isn’t a better PayPal, it’s a better Dollar.
Originally published at https://simplebitcoin.co.