I was going to do a piece of bitcoin as an asset class but this morphed into a very long piece so I’m splitting this up into two parts. This part covers what bitcoin is and the economics of money as applied to bitcoin. Part 2 is up.

First of all, bitcoin (or any other cryptocurrency) isn’t blockchain.

My thoughts are on bitcoin* which refers to the unit of currency and not Bitcoin which refers to the blockchain technology that the currency rides on. There is a difference and I believe blockchain has its uses but what I’m more interested in is bitcoin (as a proxy for cryptocurrencies) because that’s where people are putting their money into which has caused the price of bitcoin to be up some 700% this year alone.

First, what is bitcoin?

bitcoin is a digital token created by an unknown person or person(s) with the alias Satoshi Nakamoto. bitcoin can be used for electronic transactions and is created when computers (mining rigs) solve complicated mathematical problems.

As such, no one controls the supply of bitcoin and the theoretical maximum number of bitcoins is 21,000,000 bitcoins. Facilitating the transfer of bitcoins is the decentralised network that bitcoins transact on. People with mining rigs power the network in the same way people distribute content via a torrent file. Their systems provide the computational power needed to update the records anytime someone transacts using bitcoin. For this, the quickest one that solves the computational problems needed to confirm the transaction get bitcoin. This is essentially the process of mining bitcoins.

Bitcoin is set up to reward users for verifying transactions. Miners who package transactions into “blocks” receive two kinds of rewards: The additional Bitcoin they produce by using their hardware to solve mathematical problems (an income stream that will eventually cease since 21 million bitcoins are the maximum that can be mined) and the transaction fees paid by users to get their payments into blocks. – Bloomberg

In short, bitcoins are a digital form of currency just like how you would spend cash (e.g. USD or SGD) to buy virtual currencies in a game (e.g. “gold” in the mobile game, Candy Crush) which you can then use to purchase things. The only difference here is that it’s possible to use bitcoin to pay merchants that accept them rather than being restricted to only using “gold” (the candy crush currency) to buy power-ups or items in Candy Crush.

When making payment using bitcoin, the Bitcoin (deliberately using capital “B” here) network facilitates the transaction and every computer on the network gets updated with the same record of which account the bitcoin now belongs to.

Supporters of bitcoin champion bitcoin as a new currency for the following reasons:

  1. No one entity controls bitcoin and hence, can’t cause a debasement of the currency through undisciplined expansion of the money supply.
  2. It’s relatively anonymous because bitcoin addresses aren’t tied to a real-world address or name, although the public ledger will show how many bitcoins are held by a particular bitcoin address.
  3. A transaction is supposed to be fast and low-cost.

The economics of bitcoin

The problem with bitcoin is that being a digital currency, there is no shortage of other competing currencies. Existing competitors include all the other currencies in the world and there aren’t many technical barriers to entry for other digital currencies to enter the space. At last count, there were more than a 1000 cryptocurrencies in circulation.

bitcoin’s only advantage is the first-mover and top-of-mind recall when it comes to cryptocurrencies. In order to become a viable alternative, it will also need existing currencies to become shaky enough that they find alternatives. What comes to mind are countries that are experiencing bouts of inflation due to the government mismanaging the local currency. Even then, bitcoin has to contend with major currencies like the USD and Euro.

As a form of money, bitcoin may be portable (all you need is to connect to your digital wallet) and divisible (see here) but the first point requires internet access which could be stumbling blocks in countries where internet access is expensive.

Also, transaction costs for bitcoin do not seem to be as low as it’s touted to be. Due to the nature of how transactions get recorded, much computational power is required to solve the mathematical problems needed to record a transaction. Depending on the volume of transactions (which vary), this can cause bottlenecks and those with the computational power are starting to charge different prices in order to facilitate transactions. As I write this, the median transaction fee for a size of 226 bytes is 103,960 satoshis** or 8.30 USD. Try convincing merchants to accept or people to pay for a coffee, beer or sandwich using bitcoin if that’s the processing fee.

The biggest issue so far is whether bitcoin qualifies as a store of value. In economics, anything considered money should be a good store of value. Simply, this means that if I can buy 10 beers with 1 unit of this currency, I should be able to buy roughly the same amount of beers with the same unit of currency a week, month, or even, a year later.

And this is where bitcoin truly fails. In fact, the only reason most people have suddenly sat up and taken note of bitcoin is due to the fact that bitcoin has increased some 700% relative to the USD within this year alone. And within weeks of hitting 7000 USD, it fell to 6000 USD and then within a few weeks, shot up to 8000 USD.

While the increase in the price of bitcoin is good for holders of bitcoin, we have to remember that those who sold their bitcoin is kicking themselves in the foot. From a medium of exchange point of view, someone who used a bitcoin to buy a computer earlier in the year is kicking himself because he or she can now buy 7 while the merchant who accepted bitcoin (hopefully he/she didn’t use it to pay off a supplier) has now seven times more profit as compared to the start of the year by doing absolutely nothing! What kind of viable currency causes such changes in purchasing power?

While bitcoin, if accepted, will reap network economics (one phone is useless on its own but as more people have phones…), it seems unlikely to me, at this point in time, that bitcoin is going to be a viable alternative to a shitty currency.

Stay tuned for part 2.

Update: Part 2 is up.

snarky notes:

*Or any other cryptocurrency for that matter but bitcoin is probably the most prominent and manic example right now.

**Another reason why bitcoin is a terrible currency is due to the notion of divisibility. People hate decimals and having to come up with names like ‘satoshi’ for a fraction of a bitcoin just makes everything more confusing when thinking of the value of one thing relative to another. i.e. which looks like a better price for a pint of beer? 10 USD, 126,105 Satoshi or, 0.00126105 BTC?