Investment at its most basic is just deferred consumption. Like other financial assets, Bitcoin requires market participants to defer their consumption today by investing in something they believe will allow for additional consumption in the future. This is the implicit idea behind almost every investment. Why would anyone invest if they weren’t expecting their wealth to grow as a by-product of making that investment? In reality, all investments are speculation, a weighing of probable futures voted on with money. As investors, we need to weigh the future probability of bitcoin’s failure verse its probability of success.
We need to ask ourselves whether bitcoin is one of two things, a symptom or a solution to the current state our macro-economic system finds itself in. There’s no doubt that fiat currencies have sworn in an age where hyperinflation is commonplace. Since the fiat standard was established in 1971, the world has seen a significant increase in hyperinflationary events.
Fiat, like all money, is a good used as a medium of exchange and store of value. Every fiat economy wages war on the value of their local currency to promote investment and redistribute wealth. Fiat money is used as a tool by governments to provide goods and services for the people, and it has done a brilliant job in certain parts of the world.
As it stands, the cost of capital worldwide has taken a nosedive in both nominal and real terms; in fact, in many parts of the world, the cost of capital is deeply negative. When the cost of capital is zero or negative, it breeds malinvestment because deferring consumption is almost always a good idea as the cost of capital is so low. Manipulating the cost of capital to zero introduces a game of musical chairs, where market participants jump from narrative to narrative, attempting to find a home for their rapidly devaluing fiat money. Almost everything becomes a better store of value than money itself, whether it be property, stocks or even magic internet money.
Toward the end of every empire that has collapsed due to monetary manipulation (the debasement of local currency to pay for things we can’t afford) comes perceived wealth creation. Financial assets skyrocket due to the ever-lowering cost of capital and increased monetary stimulus; investors feel wealthy as everything they touch often turns to gold. These are symptoms of a struggling financial system. As investors, we need to decide if bitcoin is just another example of this malinvestment and misallocation of capital, or perhaps there is more than meets the eye?
What Is Bitcoin?
Bitcoin is both a network and an asset. The Bitcoin network is a real-time gross settlement system comparable to Fedwire (US) and Target (EU). Settlement systems are the base layer of any financial system, and they leverage net settlement systems built on top to scale and provide utility to the day-to-day user. The Bitcoin network requires miners to contribute resources to process, execute, and settle transactions. Performing these actions is costly, and miners are rewarded with bitcoin, the asset, for their participation. Bitcoin is the first example in history of a global settlement system that possesses no single point of failure. Participants can reach an agreement on who owns what and how much of it they own without the need for centralised, coordinating entities.
Bitcoin, the asset, is a commodity on the Bitcoin network, it can be transferred across the world, and you require it to pay the network’s fees. It is fungible, divisible, durable, portable, verifiable, scarce, and has additional censorship and seizure resistance properties. Bitcoin also provides the user with high levels of certainty over its future dilution. Unlike fiat money, the issuance of bitcoin is codified and enforced by changes in the difficulty adjustment. This codified approach means bitcoins supply is impervious to changes in its demand.
The Supply Side of Bitcoin
Bitcoins supply-side equation differs significantly from comparable commodity monies like gold and silver. Commodities like gold have been tremendously successful in storing wealth due to both natural and production limitations, making it very difficult to rapidly dilute the existing stock. The metric that comes to mind when thinking about potential future dilution is the stock to flow ratio. Stock to flow tells us how many years it would take to replenish the existing stock of any given commodity; in the case of gold, the dilution in a typical year ranges from 1,5% to 2%. Gold’s stock to flow at these issuance levels is around 65 years.
Interestingly, when studying fiat money, a similar relationship exists, one where the most favoured is also the one with the highest stock to flow. Maybe this is just our natural Darwinian propulsion at play; we are drawn toward money that stores our wealth better over time. A core ingredient in this is the implicit assumption that our wealth can’t be dissolved; that’s what brings trust to money. My whole life, my parents, who were born and lived in Zimbabwe, referred to the US dollar as “hard money”, in hindsight I can understand why they held this belief as so many do today. They looked up to and respected the United States’ power; they trusted that the freest country on planet earth would respect money’s social contract.
Regardless, all these commodities and fiat monies had supplies that could be significantly affected by changes in demand. In the event that demand for gold rises, it pushes the price of gold to levels that make mining more, even at a higher cost, worthwhile. A similar dynamic exists with fiat when liquidity disappears; it creates a hole. However, instead of expending expensive resources, this hole can immediately be filled by the stroke of a keyboard. The point is that both commodity money and fiat money can experience rapid events of dilution for current holders, albeit fiat much more than commodity.
Bitcoin is unique in the sense that its supply is impervious to changes in its demand. This is not a fluke but rather a design feature called the difficulty adjustment. To understand the difficulty adjustment, we need to talk about how bitcoins come into existence in the first place. To participate in bitcoin mining, you need to buy specialised hardware and expend electricity in order to earn the right to process, execute and settle transactions. As a miner, you are essentially providing the service of redundancy and tamper resistance to users of the bitcoin network.
Bitcoin’s issuance schedule aims to keep block the time between blocks at ten minutes. Every ten minute period represents a possible chance to earn the right to provide work to the bitcoin network and add a block of transactions to the blockchain. Suppose blocks are being mined faster than ten minutes. In that case, it means bitcoins are being mined faster than their predetermined codified issuance schedule and will reach its 21 million total supply more quickly than intended.
This is where the difficulty adjustment kicks in. When referring to “difficulty”, we are referring to the difficulty of a mathematical problem miners are solving to earn the right to provide work to the Bitcoin network. If blocks are being mined too fast, it means that there is too much computational power in the system relative to the difficulty of the problem being solved, and therefore, the difficulty needs to be adjusted upward to bring issuance back in line with the issuance schedule. The difficulty adjustment is codified and occurs every two weeks or 2016 blocks.
Together cryptography, Proof of Work and the difficulty adjustment create the most deterministic form of money the world has ever seen. A commodity money whose supply is inelastic and impervious to changes in demand. No matter how much the demand for bitcoin grows, whether it be 10x, 100x or 1000x, bitcoin holders will not experience a dilution that deviates from their expected rate of dilution. Bitcoin provides certainty in the social contract that is money; one bitcoin will always equal one bitcoin.
In summary:
- When analysing commodity money, the best store holds of wealth are those with the highest stock to flow ratio.
- Even fiat money illustrates a similar scenario in that individuals favour the social contract that has the highest stock to flow.
- Fiat currencies have sworn in an era of hyperinflations worldwide or at the very least increased the probability of such events occurring.
- Unlike commodity money or fiat money, Bitcoin provides certainty over future issuance due to the difficulty adjustment, which makes bitcoins supply impervious to changes in demand.
- Bitcoin offers more certainty over future dilution events than both commodity and fiat money.
The Demand Side of Bitcoin
The most apparent source of demand identified for bitcoin is the idea of becoming wealthy; it is not often we see an asset post 200% annualised returns, and when we do, the crowd arrives with the expectation that this could go on forever. It’s irrefutable that a large portion of bitcoin’s demand is driven primarily by fast money trying to get rich quickly. This, however, shouldn’t detract from the market need that bitcoin is and will continue to serve. Whilst there is plenty of fast money moving ferociously in and out of bitcoin attempting to time the swings of the most volatile asset class on the planet, there is also the other side of the coin.
Free market competition is a mechanism used by humanity to establish truth, truth being the best way to service any given need or want. Just like the premier league is designed to seek truth in establishing who is the best football team. Through competing entrepreneurs, products and ideas, the free market aims to find the best solution to a need or want. To understand where demand for bitcoin comes from, we must focus on the need or want it addresses.
Before discussing the market needs satisfied by bitcoin, we need to remind ourselves of an age-old truth about money. Money isn’t a winner take all scenario; humans have always had many monies that coexist with one another. Bitcoin can and most likely will coexist with currencies like the US dollar, Euro and Yuan. The point is that bitcoin is not the enemy of fiat currency; fiats biggest weakness is that it is engineered to trend toward zero over time; its biggest enemy is itself.
Market Need One: Apolitical Settlement Infrastructure
Our interaction with financial networks is becoming exceedingly politicised; the jurisdiction you were born in ultimately determines your ability to transact value globally. This introduces the need for something fairer and apolitical in nature. Reaching settlement in transactions of value shouldn’t be influenced by your race, religion or place of birth. Just because there are bad actors within a system doesn’t mean the system in its totality is bad. Bitcoin removes the ability of bad actors to incur zero-sum outcomes over those they govern.
Bitcoin as a settlement system gives everyone the power to trust but verify, as the ledger itself is as accessible as a Google search. This power will help enable business models we haven’t even invented yet. It will make access to financial networks a basic human right and at the same time remove the liquidity and credit risks associated with interbank and cross border transactions.
The growth of bitcoin as a settlement system has been incredible, especially when you consider the fact that bitcoin isn’t a company or organisation with central leadership or coordination.
Market Need 2: Non-discretionary Monetary Policy/Asset
Central banks across the globe continue to wage war on their local currency; bitcoin simply introduces an alternative for citizens. Traditionally we would point to assets like gold as the go-to alternative. The problem with gold is that it’s not that easy to get your hands on. You can buy physical gold and store it yourself, or you can buy a derivative of gold and trust an institution will maintain adequate reserves and refrain from rehypothecation. These two options are either expensive or carry unnecessary risk to the individual.
There’s not a shadow of doubt that gold is highly liquid. Arguably though, bitcoin, which is accessible to anyone with an internet connection, is far more liquid and accessible for people looking to store “small” amounts of wealth. It’s easier to buy $1 billion dollars worth of gold than bitcoin, but it’s significantly easier to buy $1 of bitcoin than $1 of gold. Bitcoin is accessible to those that need it the most. It doesn’t need to be adopted by the developed world’s global superpowers and most likely won’t be, where it will thrive, however, is in the developing world.
Latin America and Africa stand the most to gain; bitcoin offers them a life raft that firstly protects them from the devaluation of their own local money and secondly eliminates the need to sacrifice monetary sovereignty to dollarisation. The moves we are witnessing in Latin America is only the beginning of a much larger trend of nation-states adopting an alternative monetary standard, one that is not controlled and dictated by the west. An asset with liquid trading pairs in almost every country in the world.
Market Need 3: Certainty
Financial markets are at peak froth. Monetary tools that were once emergency measures are now commonplace; concepts like Modern Monetary Theory are now playing out in real-time as we stand and witness the marriage of government fiscal policy and central banking monetary policy. We don’t know where all of this madness goes, history offers precisely zero examples of this ending well, but maybe this time is different…
What is certain today? What markets can we go to in order to express our bullishness on certainty in a time of global uncertainty? Famous macro investor Paul Tudor Jones articulates this point on bitcoin.
“I like bitcoin … Bitcoin is math, and math has been around for thousands of years,” Tudor Jones told CNBC. “I like the idea of investing in something that is reliable, consistent, honest and 100% certain. So bitcoin has appealed to me because it’s a way for me to invest in certainty.”
Bitcoin’s “certainty” has nothing to do with its dollar-denominated value and everything to do with its supply side. One bitcoin will always be worth one bitcoin; this is more than we can say about any fiat money.
In summary:
- Bitcoin, the network, is an apolitical settlement infrastructure. Even the greatest enemies can trust that Bitcoin as a settlement system favours no single entity or nation-state.
- Bitcoin unlocks an alternative monetary asset for those who can’t get their hands on alternatives like gold due to the cost of doing so or where there is a lack of accessibility to traditional options.
- Latin America and Africa are where adoption really matters.
- Bitcoin is a way for you to express bullishness on maths verse human beings and certainty over human emotions and decision making.
Conclusion
This article is meant to provide the reader with a framework for investing in bitcoin. The framework is simple but powerful. It requires you as the investor to consider two outcomes of the bitcoin movement. The first outcome is that bitcoin is simply a symptom of a deeper problem in our financial system, one that breeds malinvestment and speculation. The second outcome is that bitcoin is a solution to the problems of our financial system and that over time bitcoin serves as a global reserve asset or as pristine global collateral.
As an investor, the framework asks one thing: weigh up the probability of outcome one versus outcome two. Right now, it would be remiss of us to claim that the likelihood of bitcoin being a solution is greater than the odds of it being a symptom. There is still so much to be done, so much infrastructure to be built and plenty of education required before these probabilities flip to favour bitcoin as a solution.
Having said that, we are investors. Investing is the art of weighing risks and rewards and allocating capital to get the most out of every unit of risk we take. The probability that bitcoin is a solution is non-zero; there is a chance, whether it’s a 1%, 10% or 50% chance, that’s up to you to decide. This chance, however, represents an incredibly asymmetric opportunity for investors as the total addressable market for bitcoin as a solution is $10 trillion on the bottom end and $100 trillion at the top.