Why Bitcoin.
There will only be 21 million Bitcoin. Built on a foundation of cryptography and game theory, Bitcoin is digital gold, a provably scarce asset in a world of unlimited money printing. It is the hardest money ever invented and is poised to become the global standard for storing and transmitting value. As an emerging store of value, it is being adopted by the smartest investors and business executives in the world. Sometime over the next few years it will find its way onto the balance sheets of central banks, thereby emerging as a unit of account for world trade. Bitcoin is still early in its lifecycle, but those individuals and businesses who don’t adopt it will eventually be left behind.
Table of Contents
What is money?
There will only be 21 million Bitcoin. It’s an odd choice of number, to be sure. However, it is the very first time in history that any currency has had a hard limit on its production, which has profound implications. To understand these implications, it’s useful to ask the question: What is money?
Money emerges naturally between individuals and is a key mechanism supporting cooperation between very large groups. Barter is incredibly inefficient because it requires the two parties to want exactly what the other person is offering. This is called the “double coincidence of wants” problem. Money solves this by allowing any two parties to trade with one another via a common medium of exchange. Solving the double coincidence of wants problem has allowed humans to engage in large scale cooperation well beyond anything seen in any other species. Along with our ability to use language, it is what has allowed us to construct vast, complex civilizations and maintain all of the standards of living that we currently enjoy.
Various choices of money have been selected by groups over time. Certain west African tribes used small glass beads, while in Micronesia the Yap islanders used extremely large stones (Rai stones) that weighed up to eight thousand pounds each. In each case, the local currency was initially selected due to its difficulty to produce, which allowed it to maintain its value. This ability to store value supported the local economy through trading and commerce. However, in each of these cases the local currency was ultimately debased by the introduction of a technology (glassmaking; explosives) that allowed unlimited production of the local currency. This debasement was accompanied by widespread economic destruction, and in the case of the African glass beads, directly resulted in a dramatic increase in slave trading and untold human suffering (Breedlove 2020).
Gold is another monetary technology that has been in use for thousands of years. It has been selected as money by many different groups over time due to its difficulty to produce, which allows it to keep its value well over time. Currently, new production of gold increases the supply by about 2% per year, which means that it will take about 50 years to double the world’s supply of gold. The measure of a money’s production rate is related to its “hardness”. Money that is very difficult to produce, like gold, is called “hard money”, while money that is easy to produce is called “soft money”. Until recently, gold was the hardest form of money ever discovered due to the inherent difficulty of the gold mining process and the energy required to produce it.
The monetary technology that most people are familiar with is called fiat currency, because they are created by fiat (from the Latin, meaning “let it be done”). These are the modern day dollars, Euros, pesos, and rubles. It used to be that dollars and other fiat currencies were backed by gold and could be converted into gold upon demand. However, in 1971 President Richard Nixon abandoned the so-called “gold standard” and ever since the world’s fiat currencies have been free floating and the softest monetary technology ever used.
As with any monetary technology, the value of fiat currency is directly related to the amount in circulation. Modern central banks can print new currency with the press of a button and, as such, the value of a particular fiat currency can vary substantially as a government changes their rate of money creation. This can be observed in dramatic fashion today in countries like Venezuela and Turkey, which are experiencing hyperinflation and currency failure. In an ideal world, money would maintain its value and purchasing power over arbitrarily long timescales.
What is Bitcoin?
Bitcoin is a digital currency, a piece of software that it can be run by anyone with a computer and an internet connection. It is both open source, which means that anyone can download the code and run it, and decentralized, meaning that no one person or organization has control over its design.
Bitcoin users can conduct economic transactions (buying and selling goods and services) just like any other currency. Approximately every 10 minutes, these transactions are blocked together by another set of users called miners who compete to create a block of transactions by solving difficult mathematical problems and are then rewarded in Bitcoin. Other users called validators confirm each block of transactions is valid according to the rules of the software. Together, the miners and validators implement a process called “proof of work” that secures the Bitcoin network against any attackers who try to create fraudulent transactions (the so-called “double spending problem”). The Bitcoin network is currently protected by over 130 million exahashes of computing power per day, and consumes more than seven gigawatts of electricity (more than Switzerland). To create a fraudulent transaction, an attacker would need to harness 51% of the available computing power, representing more than 3.5 million gigawatts of electricity. As a result of this energy protection mechanism, the economic incentives are more aligned with protecting the network than attacking it.
Currently, 6.25 Bitcoin are created every 10 minutes to reward the miners protecting the network, and over 18.5 million coins have been produced since 2009. However, every four years the Bitcoin software reduces the number of rewards by half in what has come to be known as the Bitcoin Halving. Each halving event (the last of which happened in May 2020) significantly reduces the rate of newly created supply, and this has always resulted in a corresponding price increase (see Figure 1).
Figure 1: Bitcoin price strongly appreciates after each halving event, indicated by the red vertical dotted lines. The last halving occurred in May 2020. Price is plotted on the Y-axis on a log scale. Credit: TradingView.
Additionally, the software mandates that only 21 million coins will ever be created, with the last coin currently slated to be issued in the year 2140. This 21 million cap means that Bitcoin is the hardest form of money ever invented, and its decentralized, open source nature means that anyone can read the code and audit its records to verify this fact for themselves (Rochard 2020).
Bitcon is the dominant digital currency and exhibits what are called network effects, which means that its value increases with the number of users. Just as Facebook and Twitter become more valuable as more and more users join their network, Bitcoin becomes more valuable as more users join the Bitcoin network. As Satoshi Nakamoto, Bitcoin’s pseudonymous creator, said in 2009: “As the number of users grows, the value per coin increases. It has the potential for a positive feedback loop; as users increase, the value goes up, which could attract more users to take advantage of the increasing value.” (Nakamoto 2009). The four-year Bitcoin halving cycle interacts with these network effects to drive the price higher every four years. This process has resulted in the price of Bitcoin going from less than $0.01 per coin in 2009 to over $20,000 per coin today.
Bitcoin also exhibits path dependence, which means that it is increasingly difficult for anyone to duplicate its achievements, even though the software is available for anyone to download and copy (Breedlove 2020B). As of today, there are over 25 million unique Bitcoin addresses collectively storing over $500B in value. Any competing monetary network would need to convince these users, the miners and validators, and the Bitcoin software developers that it had a superior value proposition. This possibility becomes less and less likely over time as the number of users grows, the computing power protecting the network increases (see Figure 2), and the value of the currency goes up.
Figure 2: The total computing power protecting the Bitcoin network over the past three years. One exahash (EH/s) equals 10¹⁸ computations per second. Credit: Blockchain charts.
Why now?
We are living in an extremely interesting time in history. The global population is suffering from the first pandemic in over a century, which has caused governments around the world to deliver unprecedented levels of economic assistance to their citizens in the form of cash transfers. This in turn has caused central banks around the world to print money hand over fist in support of these government interventions.
All of this is happening while debt levels around the world are reaching unsustainable proportions. Even before the novel coronavirus, governments were borrowing more and more money to fund their operations, and central banks were printing money to accommodate. Entitlement programs alone, such as Medicare and Social Security, currently represent over 60% of the US Federal budget as of 2016. This pattern of spending has resulted in the United States debt level reaching over 130% of GDP today, saddling future generations of Americans with a heavy burden that they must one day repay. And while some politicians pay lip service to the idea of a balanced budget, neither political party has shown any appetite for reigning in the US budget deficit.
In Ray Dalio’s book, Principles for Navigating Big Debt Crises, he outlines the idea that debt is created and destroyed in cycles. There is the standard business cycle, with its typical booms and busts, which occurs every eight to ten years. Then there is the debt supercycle, which is more foundational than the business cycle and which happens about every 80 years. Mr. Dalio hypothesizes that we are currently living through the late stages of a debt supercycle that began after World War II.
In the United States, you can see this debt supercycle in the ratio of debt to GDP (Figure 3). U.S. debt levels first peaked at 120% in 1950 after the Great Depression, and then declined for over thirty years before increasing again. In 2020, U.S. debt to GDP is expected to reach 136%. Debt levels around the world have also skyrocketed, with economists expecting global debt levels to reach $277 trillion, or 365% of world GDP by the end of 2020. In other words, the world has gone $3 into debt to create less than $1 worth of economic growth. It’s difficult to see how this trend continues much longer.
Figure 3: U.S. Debt to GDP ratio over time. Credit: TradingEconomics.
These extraordinary levels of debt are happening just as central banks around the world are running out of ability to stimulate their economies by lowering interest rates. In the U.S., interest rates are near zero (Figure 4), while the European Central Bank has implemented negative interest rates since 2014, which means that savers are penalized while borrowers are being paid to take out loans.
Figure 4: U.S. central bank interest rates over the past 100 years. Rates were once over 15% in the 1980s (the debt cycle boom) are now close to zero (the debt cycle bust). Credit: Ray Dalio.
In summary, countries around the globe are saddled with historic levels of debt not seen in 80 years and central banks are unable to stimulate their economies via further reductions in interest rates. However, governments and central banks have one last tool in their arsenal to service their debt while simultaneously attempting to boost economic growth: printing massive amounts of money. Money printing has reached epic proportions this year, with the world’s five biggest central banks (the Federal Reserve, the European Central Bank, the People’s Bank of China, and the Bank of Japan and Bank of England) collectively printing over $5.7 trillion in new currency in 2020. This pattern of government spending and central bank money printing shows no sign of slowing down, and some observers believe we are about to enter a dangerous new period of competitive currency devaluations around the world. If this is true, it would mean the dollars in your pocket are about to lose a whole lot of their value.
What is it worth?
Bitcoin was purpose built for this moment in time. It is harder to produce than gold, and exponentially harder to produce than fiat currency, yet it can be transmitted around the world at the speed of light. These characteristics, along with each Bitcoin’s divisibility into 100,000,000 units called Satoshis, mean that it is well poised to become the global foundation for storing and transmitting value in the next global economic cycle.
But how can Bitcoin be valued? As of today, Bitcoin’s market capitalization sits at over $500B. For comparison, gold’s market capitalization is currently estimated at over $9T and many observers believe that Bitcoin’s superior monetary characteristics will eventually lead it to overtake gold. This could happen by directly taking some of gold’s market capitalization, as well as by money inflows from corporations, global equities and bonds. There are currently over $100T in global equities, as well as $100T in bonds being managed by institutional investors, many of which are currently yielding negative interest rates.
Why would institutional investors allocate a portion of their assets to Bitcoin? Because it has the largest Sharpe ratio of any asset class (Figure 5). The Sharpe ratio measures the risk-adjusted return, meaning that it adjusts the returns for a particular asset by its underlying risk, or volatility. One criticism of Bitcoin is that it is highly volatile, which is appropriate given its current status as an emerging store of value. However, its Sharpe ratio indicates that this volatility is associated with outsized returns over time.
Figure 5: Sharpe ratios over time for various asset classes. Credit: Woobull.
If corporations and institutional investors were to allocate just a few percentage points away from fiat, gold, equity and bonds and toward Bitcoin over the next 5 years, this would push Bitcoin’s market capitalization up over $5T. At this price, each Bitcoin would be worth $270,000, up over 10x from today’s price of $25,000, which would make it the investment of the decade.
Who else is in?
Until 2020, Bitcoin’s price was driven primarily by individuals rather than corporations and institutions. This was due to the fact that it was difficult to purchase and custodial solutions were not yet in place. However, the Bitcoin financial ecosystem has greatly matured over the past few years and 2020 has seen institutional investors entering the space, which has helped drive the price from $7200 on January 1st to over $26,000 on December 27. Many high profile money managers began accumulating Bitcoin and making large bets, including Paul Tudor Jones and Stanley Druckenmiller. In addition, the biggest wealth management institutions are now offering Bitcoin exposure to their wealthy clients, including Fidelity, Citibank and JP Morgan. (Bitcoin service provider Casa keeps a running list here.) This is what these institutional money managers have to say:
“At the end of the day, the best profit-maximizing strategy is to own the fastest horse. Just own the best performer and not get wed to an intellectual side that might leave you weeping in the performance dust because you thought you were smarter than the market. If I am forced to forecast, my bet is it will be Bitcoin. Bitcoin reminds me of gold when I first got in the business in 1976.” -Paul Tudor Jones
“I have warmed up to the fact that Bitcoin could be an asset class that has a lot of attraction as a store of value to both millennials and the new west coast money… It’s been around for 13yrs, and with each passing day, it picks up more, more of its stabilization as a brand… Frankly if the gold bet works, the bitcoin bet will probably work better.” -Stanley Druckenmiller
2020 also saw Bitcoin start to find its way into the corporate treasuries of publicly listed companies. US companies alone are sitting on over $4T in cash reserves and liquid investments, which are slowly melting away due to inflation. MicroStrategy (ticker: $MSTR) made the first bold move, making Bitcoin its primary treasury reserve asset and converting $250M from US dollars to Bitcoin. It then doubled down a few months later, issuing $650M in low-cost debt to buy more Bitcoin, making it the first known large-scale speculative attack on the US dollar.
Here is what Michael Saylor, CEO of MicroStrategy, said at the time:
“This investment reflects our belief that Bitcoin, as the world’s most widely-adopted cryptocurrency, is a dependable store of value and an attractive investment asset with more long-term appreciation potential than holding cash. Our decision to invest in Bitcoin at this time was driven in part by a confluence of macro factors affecting the economic and business landscape that we believe is creating long-term risks for our corporate treasury program ― risks that should be addressed proactively. Those macro factors include, among other things, the economic and public health crisis precipitated by COVID-19, unprecedented government financial stimulus measures including quantitative easing adopted around the world, and global political and economic uncertainty.”
Other publicly listed companies are now following suit, including Square, Jack Dorsey’s financial payments company. You can bet that the chief financial officers at Tesla, Apple, Facebook, Microsoft and Twitter are taking note. How soon until these companies start converting a portion of their treasuries to Bitcoin? This process always starts slowly, with one or two companies taking the risk to try something new, but once the rest of the pack sees that MicroStrategy and Square have doubled their investment in just months, it is going to build quickly.
Where is this all going?
The final chapter in the Bitcoin saga will involve the central banks themselves. Bitcoin has been called the decentralized alternative to central banking. Like gold, it is a pristine balance sheet asset, meaning that unlike treasury bonds it is not anyone else’s liability. This fact, along with the price appreciation that is going to occur over the next few years means that Bitcoin will eventually find its way onto the balance sheets of central banks. The first central banks to accumulate Bitcoin will do so quietly before publicly announcing their positions, just like the traditional money managers have done. However, just like the corporate CFOs, game theory predicts that once the first domino falls, the rest will quickly follow.
In short, it is not too early to enter into Bitcoin. Indeed, we are still in the early innings of this ballgame. However, just like technology itself, Bitcoin adoption is moving quickly and it is important to become informed and make the decisions now that will impact you, your family, and your organizations for years to come.
