Bitcoin is an asset that has attracted critical attention from some commentators, especially those in finance and markets. The uninformed desire to see the asset fail is sometimes bizarre, even pathological. A lot of the criticism is not analysis and is written as if the opinion itself carries weight into the essence of the idea behind Bitcoin – that it might affect the mechanics of Bitcoin, that they themselves could perhaps will it into destruction with their focused mind and needy, damaged reputation.
In fact, the value-proposition of Bitcoin is not a secret.
If we take a look at the following 3 things and discover that they are true, then Bitcoin has value, will continue to have value and may be the source of value for a new, decentralised global financial system.
The value proposition of Bitcoin can be understood through the following 3 components of it.
- Nick Szabo’s Philosophy of Monetary Value
- Adam Back’s HashCash Proof of Work
- Satoshi Nakamoto’s Bitcoin Protocol
- Nick Szabo’s Philosophy of Monetary Value
Throughout his work Nick Szabo asserts that monetary value is a thing that exists, which he defines as a social phenomenon. In our opinion this is the most revolutionary aspect of Bitcoin and yet it is often overlooked.
Nick Szabo states it matter-of-factly in his Bit-Gold piece. Viz –
‘Precious metals and collectibles have an unforgeable scarcity due to the costliness of their creation. This once provided money the value of which was largely independent of any trusted third party. Precious metals have problems, however. It’s too costly to assay metals repeatedly for common transactions. Thus a trusted third party (usually associated with a tax collector who accepted the coins as payment) was invoked to stamp a standard amount of the metal into a coin… what’s worse, you can’t pay online with metal.
Thus, it would be very nice if there were a protocol whereby unforgeably costly bits could be created online with minimal dependence on trusted third parties, and then securely stored, transferred, and assayed with similar minimal trust. Bit gold.’
He has discussed it at length elsewhere – Nick has put significant thought into money and monetary value.
His casual acceptance of his own, astoundingly now correct conception of what constitutes monetary value is why we believe he is a large part of the Satoshi Nakamoto equation. To put this into context, barring the failure of Bitcoin, this philosophy reflects a greater understanding of the essence of money than the “Worlds Greatest Investor” Warren Buffet, Nouriel Roubini, Citadel CEO Ken Griffen, Nobel Prize winning professor of Economics at Yale, Robert Shiller, Bill Harris of Intuit and Paypal, Jamie Dimon the JP Morgan & Co CEO, a legend of Institutional Banking and of course the list continues of highly intelligent experts in the field of finance, economics, politics and banking.
2. Adam Backs HashCash Proof of Work
The second part is the ability to represent that philosophy of monetary value in the digital world.
Adam Back created the Proof of Work concept to bring a cost to un-metered internet usage such as spam email. A major principle of this concept is an easy to verify but expensive to compute mathematical function. Using cryptographic algorithms to calculate solutions to mathematical problems, Bitcoin creates unforgeable costly bits in building the blockchain, these are then easy and cheap to verify in checking the blockchain. In doing so it reproduces the philosophy of monetary value with a digital method.
3. Satoshi Nakamoto’s Bitcoin Whitepaper
The third part is to place the digital representation of the theory of monetary value into a working system.
This was the achievement of Satoshi Nakamoto, who created Bitcoins system in the Bitcoin Whitepaper. This is an open system – it does not attempt to provide a strict overarching structure to predict human behaviour. Rather it remains open to failure but incentivises the behaviours that contribute to the successful operation of the system. This goes against typical attitudes towards risk – these are of greater oversight, greater management and more intervention. Building an open system appreciates that an overly rigid structure must eventually break.
Some of this is game theory / behavioural finance type ideas
‘(The good/bad actor) ought to find it more profitable to play by the rules, such rules that favour him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.’
Also worth looking at is section 11. Conclusions in the Bitcoin whitepaper.
In our opinion the value-proposition of Bitcoin is dependent on the idea, the digital manifestation of the idea and the execution of it and it is so far, so good.
If it is not the conceptualisation and mechanics of the idea behind Bitcoin, successful criticism must reflect a failure in assuming the support of the subjective opinion of the marketplace.
Therefore the risk that people are concerned about of the Bitcoin protocol is not a factor of one of these three elements. They are considering Bitcoin validated or invalidated by the market performing price-seeking behaviour. Is that reasonable?
The question becomes – is Bitcoins open market – the decentralised market of a closely held asset that has exploded in speculative use far before it developed similar practical use– a threat to the survivability of the project?
After peaking at a value of a market cap of almost US $420 billion in a retail-hyped parabolic curve late 2017, the asset lost something like 84% of its value and was called “dead” by many in an event known as “Crypto Winter”. Well, Spring ended up coming around in 2019 and the price of the asset spiked again in another beautiful parabolic curve, this time to a lesser degree.
But Bitcoin had been “boom and bust” from day one, first existing as a humble proposition, dipping the tip of its toe into the financial universe. The idea was so fascinating and powerful that it willed itself into existence. Every algal-bloom like buying event spread it further and further into the ecosystem.
It’s not strange that higher prices validate even higher prices. That is reflexivity, natural market mechanics well covered by top investor George Soros in his book on the subject. Higher prices are a proposition to the market of a new paradigm. Sometime the market accepts the paradigm and the prices stick. Sometimes it rejects the paradigm and the new higher prices fail. However, the higher prices are also a proposition of ‘higher prices’ and they drive parabolic type moves by their nature.
The reflexive boom spreads the idea as the number of people involved increase and the dollar value attracts the attention of more serious individuals.
But it is the bust where the asset cuts its teeth. Each bust experience puts the entire protocol under pressure and under the microscope, with each new iteration of holders, every wave more serious and motivated than the last, poking, prodding and examining the operation of the protocol to examine it for failure.
In fact, there was a time somewhere around 2015 where the project looked vulnerable. Transactions had become expensive and from an admittedly low-information view it seemed like there could be a lower-bounds price below which the project could be killed, where it was vulnerable to terminal decline. If possible, the cost of killing the project was obviously higher than the threat it had been perceived to be to the global financial system – asymmetric losses on bad actors is a feature of the assets game theory. Perhaps the savages of global institutional markets had not had their eye on it yet; or perhaps global institutions are confident in competing with Bitcoin when the time arises.
In the meantime, Bitcoin has been developing an intrinsic value where usage of the asset as a reference rate to Digital Assets and Digital Asset projects creates a natural demand for transactions that create inertia within the price-seeking mechanism. This transactional inertia increases as usage of Bitcoin for non-speculative reasons increases.
Perhaps there is a ratio of speculation over transactional volume that shows the protocols survivability – maybe the question is, does the game theory of Satoshi Nakamoto’s Bitcoin Whitepaper take the overwhelming weight of speculative leverage and downward pressure with its reflexivity into account? If the asset can be shorted below a level where it becomes a terminal proposition, it will be.
Notwithstanding that risk, the types of individuals who can properly assess the asset for institutional use and know what to do with it will improve the market mechanism the next couple of years.
The life-cycle of Bitcoin has already seen it become many different things. The wild success as a speculative asset was initially experienced by retail punters, by the early cypher-punks, anarchists, dark-web drug dealers, libertarians and so on. These people experienced the price rise of Bitcoin as validation for the way that they viewed it and the way that they viewed the world.
It’s not that they are wrong, but they are smaller fish in the scheme of the global financial markets. At some point the market got big enough to attract small professionals, large professionals and professional trading groups and as this happens people who understand the financial system and the nuanced problems behind it start to look at the protocol with a professionals view.
It is incorrect to say that in the finance world, that economists etc are not acutely aware of the problems in the financial system. Bitcoin “Maximalists” who “press blue button, number go up” are not necessarily financial revolutionaries. The existing financial system has a structure that has been functional, and the rest of the global economic system still has a dependency on it (that the financial sector leverages shamelessly) – this dependence may even increase as it heads deeper into Frankenstein territory. The financial system is embedded within the economy, creating internal inertia that allows the bloated financial system to interact with a lot of non-speculative physical things, assets, events, people and transactions. So although it looks like it is inevitable, and perhaps time is up now – it isn’t predictable and those in finance are aware of the death march of federal reserve currency interventions.
But for now the Bitcoin market is full of professional traders, and that is reflected in the way it moves. Price moves occur in their own time-frame, dependent on calculations of which way market participants are holding their asset. For example, if high-leverage, low time-frame participants have accumulated similar positions, the market will move against them, if enough professionals manage to figure out how to calculate that and take positions, it might even move against those people as well.
But this is just trading, and although it motivates the price-seeking mechanism, it does not offer a fundamental perspective of why the thing has the value that it does. We hope that the first half of this piece illuminates that answer somewhat, or at least helps us develop an idea of what the thing is, what it could be used for, where it might be valuable, and that it helps us continue to build working systems.
Written By: Thomas Kuhn, CFA
Thomas is a 12-year veteran of financial markets working to bring digital assets into the fold of traditional financial markets. With an interest in fundamental analysis with a technical overlay, Thomas actively takes positions in the markets he covers. As well as producing education for traders, Thomas writes for Mine Digital, CFA Asia-Pacific Research Exchange and Hackernoon.
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