With the price of Bitcoin soaring to its highest level in 2021, the bullish case for investors may seem so obvious that it no longer needs to be discussed. It may seem rash to invest in a digital asset not backed by any commodity or government. Price rise has prompted comparison to the old days of the tulip obsession or the dot-com bubble. That’s not entirely true; there are compelling factors that support optimism about the future growth of Bitcoin’s value. Clearly, there are significant risks to investing in Bitcoin, but there are also enormous opportunities.
Nothing in history has allowed us to transfer value between distant people without relying on trusted intermediaries. Satoshi Nakamoto’s solution to the creation of Bitcoin and the system he built allowed, for the first time, any amount of value to be transferred quickly, over great distances, without a third party. The consequences of the creation of Bitcoin are so profound for both economics and computer science. Nakamoto should be the first person to qualify for both the Nobel Prize in Economics and the Turing Award.
For an investor, the important fact about Bitcoin’s invention was the creatingof a rare new digital commodity. Bitcoin is a transferable digital asset created on the Bitcoin network in a process known as “mining.” Bitcoin mining is roughly similar to gold mining, except that Bitcoin production follows a designed and predictable schedule. By design, only 21 million bitcoins can be mined. At the time of writing this article, approximately 19.2 million bitcoins have already been mined.
Unlike stocks, bonds, real estate, or even commodities like oil and wheat, Bitcoin cannot be valued using standard discounted cash analysis. Bitcoin belongs to an entirely new category of goods, known as monetary goods, whose value is determined theoretically. Each market participant values the goods based on their assessment of ifand how much other market participants will value it. To understand the game-theoretic nature of monetary goods, we need to explore the origins of money.
The Origin of Money
Over the millennia, as human life grew and trade routes developed, the stores of value that emerged in individual societies competed. Traders would choose whether to keep the proceeds of their trade in their own proto-money or the proto-money of the society in which they traded, or a balance of both. Traders who kept savings in foreign deposits also had the incentive to encourage their adoption in their own society, as this would increase the purchasing power of their savings.
The benefits of imported stores of value accrued not only to the importing traders but also to the society itself. Two societies agreeing on one store of value would see a substantial decrease in the cost of completing a trade with each other. This would result in an accompanying increase in trade-based wealth. Indeed, the 19th century was the first time most of the world converged on a single store of value – gold – and this period witnessed the greatest trade boom in world history.
Attributes of a Good Store of Value
When stores of value compete with each other, the attributes that make the best store of value enable an asset to compete with others at the margin and increase its demand over time. While many goods have been used as stores of value or “proto-money,” attributes emerged that were specifically demanded, allowing goods with these attributes to compete with others. The ideal store of value is:
- Durable: the item should not be damaged or perishable.
- Portable: the goods should be easy to transport and store. Making it possible to safeguard them from loss or theft and allowing it to facilitate trading over long distances.
- Interchangeable: a good store of value should be interchangeable with another of the same amount.
- Verifiable: goods should be easily identified and quickly verified as genuine.
- Divisible: the goods should be easily subdivided. This division will facilitate smaller transactions.
- Scarcity: goods should not be abundant or easy to obtain or produce in large quantities.
- Established history: the longer the goods have been considered valuable by society. The greater the appeal as a store of value.
- Censorship resistance: how difficult is it for external parties, such as corporations or the state, to prevent the owner of the goods from keeping and using them?
Bitcoin excels at most of the attributes listed above, allowing it to outcompete modern and ancient monetary items at the margin and providing a strong incentive for its increasing adoption. In particular, censorship resistance and absolute scarcity have been strong motivators for investors to allocate a portion of their wealth to the nascent asset class.
The Evolution of Money
There is an obsession in modern monetary economics with the role of the medium of exchange. In the 20th century, countries monopolized the issuance of money. They continued to undermine its use as a store of value, creating a false belief that money is essentially defined as a medium of exchange. Many criticize that Bitcoin is not a substitute for money because its price is too volatile to serve as a medium of exchange. However, money has always evolved gradually. The role as a store of value precedes that of a medium of exchange. Simply put, money has always evolved in the following four stages:
- Collectible: In the earliest stages of its evolution, money would have a market demand based on its distinctive properties, usually the owner’s whims. Shells, beads and gold were all collectables before moving into the more familiar role of money in the present day.
- Store of value: Once demanded by enough people for its distinctiveness, money is recognized as a tool to preserve and store value over time. As it becomes more widely accepted as a suitable store of value, its purchasing power increases with more people demanding it for this purpose.
- Medium of exchange: When money is fully established as a store of value, its purchasing power will stabilize. Once stabilized in purchasing power, the opportunity cost of using money to settle trades will decrease to a level suitable for use as a medium of exchange.
- Unit of account: When money is widely used as a medium of exchange, goods will be priced accordingly. That is, an exchange-to-money ratio will be available for most goods.
In the process of monetization, monetary goods will surge in purchasing power. Many have commented that Bitcoin’s increased purchasing power creates the appearance of a “bubble”. While this term is often disparaging, suggesting that Bitcoin is overvalued, it is unintentionally accurate. A characteristic common to all monetary goods is that their purchasing power is higher than can be justified by their use value alone.
Even without external factors such as government intervention or competition from other monetary goods, the monetary premium for new money will not follow a predictable path. The monetization process is game-theoretic; each market participant tries to anticipate the aggregate demand of other participants. Since the monetary premium is not tied to inherent utility, market participants tend to follow past prices when determining whether monetary goods are cheap or expensive and whether to buy or sell them. The relationship of current demand to past prices is known as “path dependence.” It is probably the biggest source of confusion in understanding the price movements of monetary goods.
Shape of Finance
While there are no existing rules about the path monetary goods will take when monetized, a curious pattern has emerged over Bitcoin’s relatively short monetization history. Bitcoin’s price seems to follow a fractal pattern of increasing magnitude, where each fractal iteration matches the classic shape of the Gartner hype cycle.
Only some people who participate in an iteration of the Gartner hype cycle will correctly anticipate how high the price will go in that cycle. Prices typically reach levels that seem absurd to most investors in the early stages of the cycle. As the cycle ends, the media usually blames popular causes for the crash. While the stated cause (such as an exchange failure) may be a triggering event, it is not the fundamental reason for ending the cycle. The Gartner hype cycle ends due to the depletion of reachable market participants.
Since the inception of the first exchange-traded price in 2010, the Bitcoin market has witnessed five major Gartner hype cycles. With hindsight, we can precisely identify the price ranges of previous hype cycles in the Bitcoin market. We can also qualitatively identify the cohort of investors associated with each previous cycle’s iteration.
$0-$1 (2009-March 2011): The first hype cycle in the Bitcoin market was dominated by cryptographers, computer scientists, and cypherpunks. They were ready to understand the significance of Satoshi Nakamoto’s groundbreaking discovery and pioneering work in building a Bitcoin protocol free of technical errors.
$1-$30 (March 2011-July 2011): The second cycle attracted both early adopters of new technologies and a stream of ideologically motivated investors fascinated by the potential of stateless money.
$250-$1100 (April 2013-December 2013): The third hype cycle saw an influx of early retail and institutional investors. They were willing to challenge the highly complicated and risky liquidity channels where Bitcoin could be purchased.
$1100-$68.000 (2014-2022): At the time of writing, the Bitcoin market is experiencing its fourth hype cycle. Participation in the current hype cycle is dominated by what Michael Casey describes as the “early majority” of retail and institutional investors. As sources of liquidity deepen and mature, large institutional investors now have the opportunity to participate through regulated futures markets. The availability of regulated futures markets paved the way for the creation of Bitcoin ETFs, which will usher in the “late majority” and “laggards” in the next hype cycle.
While it is impossible to predict the exact magnitude of the current hype cycle, it is reasonable to surmise that it peaked at $20,000 to $68,000. Much higher than this range and Bitcoin would command a significant portion of the entire market capitalization of gold. At the time of writing, gold and Bitcoin would have a market capitalization equivalent to a Bitcoin price of around $380,000.
The Influx of Nation-states
Bitcoin’s final Gartner hype cycle will begin when nation-states start accumulating it as part of their foreign currency reserves. Bitcoin’s current market capitalization is too small to be a viable reserve addition for most countries. However, as private sector interest increases and Bitcoin’s capitalization reaches 1 trillion dollars, it will become liquid enough for most states to enter the market.
The entry of the first state to officially add bitcoin to their reserves will most likely trigger a stampede for other states to do so. The earliest states to adopt Bitcoin will see the greatest benefit to their balance sheets if Bitcoin eventually becomes a global reserve currency. Unfortunately, the states with the strongest executive powers – dictatorships like North Korea – may move the fastest in collecting Bitcoin. The reluctance to see such countries improve their financial position and the weak executive branches of Western democracies will cause them to be hesitant and sluggish in collecting bitcoin for their reserves. As this article is being written, El Salvador and Central Africa are the two countries that have made Bitcoin a legal tender.
Most of this article has focused on the monetary nature of Bitcoin. With this foundation, we can address some of the most common misconceptions about Bitcoin.
Bitcoin is a Bubble
Bitcoin, like all market-based monetary goods, displays a monetary premium. This premium gives rise to the common criticism that Bitcoin is a “bubble.” However, all monetary goods exhibit a monetary premium. Indeed, it is this premium (the excess of the use-demand price) that is the defining characteristic of all money. In other words, money is always in a bubble everywhere.
Bitcoins are Too Volatile
Bitcoin price volatility is a function of its birth. In its first few years of existence, Bitcoin behaved like a penny stock, and any big buyer — like the Winklevoss twins — could cause a big spike in its price. As adoption and liquidity have increased over the years, Bitcoin’s volatility has decreased correspondingly. When Bitcoin reaches the gold market cap, it will exhibit a similar level of volatility. As Bitcoin surpasses gold’s market capitalization, its volatility will decrease to levels that make it suitable as a widely used medium of exchange.
Transaction Fees are Too Expensive
Recent critics of the Bitcoin network say that the increase in shipping fees for Bitcoins makes them unsuitable as a payment system. However, cost growth is healthy and to be expected. The root of criticism of Bitcoin’s “high” transaction fees is the belief that Bitcoin must first be a payment system and then a store of value. As we have seen with the origins of money, this belief places the cart before the horse. Only when Bitcoin has become a highly established store of value will it become suitable as a medium of exchange. Furthermore, once the opportunity cost of Bitcoin trading reachesa suitable level for a medium of exchange, most trades will occur on a “second layer” network at a much lower cost than the Bitcoin network. Currently, the Lightning Network is available as the second layer of Bitcoin, which allows Bitcoin to be a transaction tool with very low fees and a fast transaction process, like digital money in general.
A common investment criticism is that Bitcoin cannot maintain its value when competitors can easily be created, incorporating the latest software innovations and features. The fallacy of this argument is that Bitcoin has created scores of competitors over the years that lack the “network effect” of the first and dominant technology in the space. Network effects for Bitcoin include:
- Its market liquidity,
- The number of people who own it, and
- The community of developers who maintain and improve its software and brand awareness.
Although the common criticism of Bitcoin found in the media and the economics profession is misplaced and based on a misinterpretation of money. here are real and significant risks to investing in Bitcoin. It would be wise for potential Bitcoin investors to understand and weigh these risks before considering investing in Bitcoin.
Bitcoin Protocol Risks
Protocol risk was highest in the early years of Bitcoin development, when it still needed to be made clear that Satoshi Nakamoto had found a solution to the Byzantine General’s Problem. Concerns about serious flaws in the Bitcoin protocol have been dispelled over the years. Still, given the nature of the technology, protocol risks will always exist for Bitcoin, if only as outlier risks.
Being decentralized in design, Bitcoin has shown extraordinary resilience in the face of assorted attempts by various governments to regulate or shut it down. However, the exchanges where Bitcoin is traded for fiat currency are highly centralized and prone to regulation and shutdowns.
The open and transparent nature of the Bitcoin blockchain allows countries to mark some Bitcoins as “tainted” because of their use in illicit activities. Bitcoin’s censorship resistance at the protocol level allows these Bitcoins to be transmitted. However, if regulations emerge prohibiting the use of such tainted bitcoins by exchanges or traders, they could become worthless. Bitcoin would then lose one of the essential properties of monetary goods: fungibility.