Bitcoin Economics 101
The Supply and Demand model of Bitcoin.
Let’s dive into the world of Bitcoin. Introduced in 2008 with Satoshi Nakamoto’s paper “Bitcoin: A Peer-to-Peer Electronic Cash System”, Bitcoin is the first cryptocurrency to be widely accepted all around the world as a medium of exchange of value. The fear of central bank servers being hacked and the anger towards government for controlling the nation’s currency impulsively, made people believe in this hack-proof technology as a great medium to transfer funds to someone securely and without anyone being able to spy on them. Bitcoin works on a transparent set of rules and is built on top of the blockchain technology, therefore it is distributed, decentralized and public.
Before starting today’s discussion, we must know what drives the value of a fiat currency. Throughout history, the exchange rate of a nation’s currency is primarily driven by the gold reserve that the nation holds. For example, assume the USA and India both hold 1 Kg of gold in reserve. If the USA prints $100 and India prints Rs. 10,000 against their reserves, then the exchange rate between two currencies will be $1=Rs.100. Similarly, all the nations around the world which have their currency, hold Gold in their reserve, which decides the exchange rate of their currency. Printing more currency against the reserve to support the nation’s economy, devaluates the currency. Similarly increasing the reserve, strengthens the currency. Several other factors like import-export and FDI also affect the exchange rate of a currency.
But when we talk about cryptocurrencies like Bitcoin, there are some important questions to think about. Is there any reserve to back its value? If yes, who holds the reserve? If no, what decides the value of Bitcoin? What factors lead to changes in the price of Bitcoin? Who decides which transactions are valid? Who decides when new Bitcoins shall be mined? (Just as a currency is printed, Bitcoins are mined. Consider bitcoin mining as printing new bitcoins for now).
Bitcoin is a digital platform. We know that blockchain is a distributed system and does not have any central authority that can claim rights over it. Thus, there is no advisory which maintains a Gold reserve to back the price of Bitcoin, because holding a reserve would essentially mean claiming rights over the currency. So where does the Bitcoin get its value from? Well, the trust of the people and their will to get ownership over a bitcoin at a certain value drives the price of Bitcoin. Consider the limited edition car ‘Sweptail’ by Rolls Royce. There is only 1 of its kind and was sold for a whopping $13 million dollar to an unrevealed man (Let’s call him X). Thus the value of the car can be considered to be $13 million. If tomorrow, someone named Y purchases the car from X at $15 million, the value of the car increases to $15 million. Y’s will to gain ownership of the car caused the value of the car to rise by $2 million. Similarly, the price of bitcoin rises/drops depending upon the trust of people in the system and their will to gain ownership over a bitcoin. A simple “demand and supply” model dictates the price of bitcoin. An increase in demand and the trust of people towards the system were two of the reasons for the sudden surge in the price of bitcoin up to $19,000 in the period between December 2017 and January 2018. Thus, the demand arises when people want to buy more coins in the system.
But what about the supply of bitcoin? When are new Bitcoins mined and released for circulation in the network?
While discussing the working of a blockchain in the previous blog, we saw that there are several nodes who validate the information in a blockchain network and add them to their copies of the blockchain. Just as the banks, these nodes validate our transactions by verifying if we own the money that we wish to transfer and add the transaction (if valid) to their copy of the blockchain. If a transaction gets verified by at least 50% of the nodes in the network, it is considered to be a confirmed transaction (that is, the funds have been transferred from the sender’s account to the recipient’s account). These nodes are known as miners and their primary responsibility is to maintain the bitcoin network by validating unconfirmed transactions.
But validating a transaction is a computationally heavy process in Bitcoin. A lot of computer resources (such as RAM and GPU) are utilized to validate the transactions generated on the network. And this consumes a lot of electricity. To support the costly process of validating transactions, the Bitcoin network rewards some bitcoins to the miner, who first confirms a set of transactions (also known as a “block”). These bitcoins are newly created coins, which never existed in the network before. This is how bitcoins are mined (that is, created) in the bitcoin network. Thus, “Mining” in bitcoin means racing with other miners to validate a set of unconfirmed transactions, to win new bitcoins as a reward. The rules of mining are dictated by the “Bitcoin Consensus” algorithm. Understanding this algorithm is not as important right now, so consider it for granted.
Side Note: Anyone in the world can become a miner and earn the block reward by simply downloading the bitcoin core software. All that is required to become a miner is a computer to run the “Proof-Of-Work” algorithm.
Thus the supply of bitcoins increases whenever new bitcoins are created. But this causes a situation where there is an unlimited supply of coins, as there will always be new transactions created, waiting to be confirmed, as and when people use the system. And basic economics rule dictates that something having an unlimited supply will never hold value for a long time. To overcome this situation causing inflation in the value of bitcoin over time, Satoshi came up with a brilliant solution: The number of bitcoins awarded for mining a block shall be halved every 4 years. He implemented this rule within the bitcoin software. In 2008, 50 BTC (symbol for bitcoins) was awarded to the miner for mining a block. This reward was halved to 25 BTC in 2012. Since 2016, 12.5 BTC is being awarded for each block mined. This year, sometime in 2020, the reward will fall to 6.25 BTC. This technique ensures that there remains a limited supply of bitcoins. Knowing the consensus algorithm and doing some math can verify that the total number of bitcoins that can ever exist in the system is about 21 million. As the demand for bitcoins continues to grow, the limited supply for bitcoin ensures that the value of the currency grows.
However, halving the reward for confirming new transactions, can demotivate the miners to carry out the expensive mining process. To continue mining even with reduced rewards might lead to losses for miners, who had joined the mining network with the motive to create more money. To prevent the price of the currency from destabilizing and promote new miners to join the network, Satoshi provided an option for every transaction to include a transaction fee. Users can include an optional transaction fee with their transactions. These transaction fees are similar to the taxes that we pay while using credit cards. Miners get these transaction fees as an additional reward for validating the transactions.
But don’t forget the fact that all this is only because people trust the currency for transactions and want to buy more even though it does not have any reserve backing its value as in the case of fiat currencies. Many Economists argue that this is why we cannot trust the currency. They believe that any day could be doomsday for Bitcoin, and that day, there will be neither any authority nor any reserve to repay the users of bitcoin. But it is the trust of the people in blockchain technology that helps maintain the value of Bitcoin.
Other players like the Government, the payment gateway services and the Investors (people who buy the currency as an investment, in the hope to sell it in future when the price increases) also affect the value of bitcoin. We have already covered a lot of ground today so we will continue our discussion in upcoming blogs.
Something to think about: With no authority responsible for bitcoin, and no reserve to back the value of the currency, why do people still trust the system and invest heavily in it?
To quickly summarize this blog,
- Unlike fiat currencies, the primary value of bitcoin is completely guided by the fact that people trust the system and want to buy new bitcoins, thus creating demand.
- The supply of new bitcoins into the system is controlled by halving the number of bitcoins awarded to the miners every 4 years.
- This supply and demand model plays an important role in deciding the value of bitcoin.
