What The Hell Is Bitcoin?
Taking a look from first principles
From trading at just a few hundred dollars per coin in 2015 to more than $60,000 in April, and back down to $34,000 at the time of writing… Bitcoin has had a hell of a ride. It’s been lauded as an inflation hedge, a digital gold and a currency all at the same time, but has also been criticized as too volatile and “contrary to the interests of civilization”. So, what is it really? This article takes a deep dive into Bitcoin to try to figure it out from first principles.
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The argument for bitcoin as an inflation hedge stems from the idea that, unlike fiat currencies such as the dollar, bitcoin cannot be “devalued” by a central bank or government arbitrarily increasing supply. This is because bitcoin is decentralized and the supply is limited to 21 million coins.
Unlike more traditional inflation hedges such as real estate and dividends that grow with company earnings, there is no direct causative link between inflation and a rise in the price of bitcoin. Bitcoin’s price is determined entirely by people’s willingness to hold it, and in this sense, bitcoin is narrative-driven. Put simply, bitcoin is only an inflation hedge if enough people believe it is an inflation hedge.
For example: suppose people think that inflation is going to increase over the next few years and they want to hedge against the impact of rising prices. Having heard that bitcoin acts as an inflation hedge, they may well buy. If enough people follow this process, the price of bitcoin rises on the increased demand, so then it actually does hedge against inflation, reinforcing the pre-existing narrative of bitcoin as an inflation hedge. The illustration below demonstrates this cycle:
The problem here for bitcoin is that it has only been around for a decade and hasn’t really been tested in an inflationary environment. The narrative that bitcoin acts as an inflation hedge is only just emerging after years of low inflation rates, and hasn’t had the opportunity to reinforce itself. Enough people need to deem bitcoin an inflation hedge for it to actually be an inflation hedge. It’s not yet clear whether this is the case. Yet being the operative word.
So, what do I think?
I don’t think it makes much sense to buy bitcoin as a pure-play inflation hedge. There are better financial instruments with longer track records. Rather, I think that by buying it for this purpose you are speculating on it becoming an inflation hedge and benefiting from the capital appreciation along the way.
Another argument is that bitcoin acts as a tail hedge against central bank failure and potential hyperinflation (no, I don’t think we’re headed for hyperinflation). This would require bitcoin to act as a safe-haven store of value, modelled as a kind of “digital gold”.
The logic behind this argument is the same as the argument that bitcoin is an inflation hedge - purely narrative-driven. The only way in which bitcoin could serve as a store of value is if enough people believed in its ability to hold its value.
The same, however, is true of gold. Beyond its limited industrial uses, the only reason that gold is a “store of value” is because of the belief that it is a store of value. However, gold has a 5,000 year history of fulfilling this role, allowing the narrative to reinforce itself with each iteration. This is not true of bitcoin, which has been in existence for just over a decade.
I think that the substantial volatility of bitcoin demonstrates that it isn’t a store of value yet, and in buying it, you’re speculating on it becoming a store of value, and benefiting from the capital appreciation along the way.
Looking ahead, however, I think that bitcoin actually has an advantage over gold in this respect. Generally speaking, gold can be owned in one of two ways:
Physical gold: No third-party risk. Illiquid.
Some financial contract (certificates, ETFs, futures): Third party risk. Liquid.
In contrast, a digital asset like bitcoin can be owned and stored directly on a personal hard drive, cutting out third-party risk whilst remaining highly liquid. It’s the best of both worlds.
On May 22nd, 2010, a software developer from Florida, Laszlo Hanyecz, bought two pizzas for 10,000 bitcoins. At the time of purchase, the value of 10,000 bitcoins was around $41. Today, it’s ~$360 million - making it the most expensive pizza ever.
Since then, more institutions have opened up bitcoin transactions, with Tesla offering the option of bitcoin payments (although this was later retracted, citing environmental concerns). It’s clear that bitcoin can be used as a method of payment, but I’m not convinced it will ever be widely used as a currency for the following reasons:
Medium of exchange: The average energy consumption for one single Bitcoin transaction in 2021 could facilitate several hundred thousand VISA card transactions. Although CoinShares estimates that the bitcoin network gets 74% of its electricity from renewables, so perhaps the environmental impact is not as extreme as feared, it’s still a tremendously inefficient medium of exchange.
Unit of account: With most goods and services sold, and salaries paid, in U.S. dollars, we’re a long way away from the price of coffee ever being listed as 0.00011 bitcoin.
Store of value & method of deferred payment: I’ve discussed the store of value question above, and concluded that it isn’t one yet. Bitcoin is notoriously volatile. 10% movements in a single day aren’t uncommon. With prices shifting so radically, it’s simply too risky to price forward contracts in bitcoin.
This is not to say that the cryptocurrency space cannot ever produce a widely used currency. It is possible that a stablecoin with much higher energy efficiency than bitcoin could emerge as a viable and widely used currency. But I do not believe that bitcoin, in its current format, can fulfil this role.
So, what the hell is it?
Bitcoin is just that - bitcoin - and has to been seen as an entirely different sort of asset. We can use gold and other commodities to help model and frame our understanding of the various narratives that drive it, but in reality, bitcoin is far more than just an “inflation hedge” or a “digital gold”. It’s a tool for speculating on the hope of its eventually fulfilling one of the desired narratives. But it isn’t any of these narratives yet. The bull case is to benefit from the capital appreciation along the way to becoming a useful tool, either as an inflation hedge, or a store of value, or a currency, or something in-between. I think Tracy Alloway says it best:
“The list of Bitcoin's purported uses goes on and on, and every time an obituary for Bitcoin is written, a new use case or bull argument steps in to to take its place. I used to think this was a weakness since Bitcoin could never be all these things at once. But the more I think about it, the more I realize that it's actually a strength. Bitcoin is a thing on which people can project their hopes and dreams — whether it's for a fairer society, a more inclusive financial system, or simply more money. Since hopes and dreams are endless, there will always be a fresh bull case for Bitcoin waiting in the wings. In that sense, it's really the perfect post-modern financial asset for a post-modern financialized economy.”
Things We’re Reading:
“Crypto Long & Short: What I’ve Learned in the Past Five Years” - Coindesk
“UK police surprised to learn energy-intensive weed farm is actually a Bitcoin mine” - The Verge
“Bitcoin’s Energy Consumption Is A Highly Charged Debate – Who’s Right?” - Forbes
“Bitcoin: Focus on the Halving Cycle” - The Lykeion
“Power to the People - The Revolution of Retail Investing” - GRIT Capital
“No, Millennials Aren’t Poorer Than Previous Generations” - Nick Maggiulli
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