Why Bitcoin is valuable and why demand will increase for this virtual currency
In last week’s episode of Blockchain for Grandma, I provided a brief overview of bitcoin’s development, explored the difference between bitcoin and blockchain, explained how blockchain works, and earned a few good laughs…okay….eye rolls. Unfortunately, the response from grandmas was mediocre at best. So this week, now that we have a bit of a foundation of understanding, I’m going to address some of the most common questions I hear about bitcoin.
Why is bitcoin worth anything?
One of the best parts of having money is being able to spend it. It doesn’t take an economics major to see that. Unless it’s beside copious amounts of cocaine, there’s not much incentive to keep stacks of money lying around the house. And in our consumerist, capitalistic, money rules society, there are a lot of ways to spend money. From new cars and shiny watches, to steak dinners and that inflatable squeaky toy that your dog just had to have (yes, that’s a luxury item too), there are endless ways to burn through those beautiful bills. So why spend it on bitcoin? Well, we buy bitcoin because either there’s a great darkweb deal on heroin or because we believe the price will increase. If the price doesn’t jump, you might as well spend your money on scratch tickets. And to understand if bitcoin will increase, we need to understand why it’s valuable in the first place.
INTERESTING SIDETRACK — skip this if you’re sitting at an intersection and the light is about to change — also…don’t drive and use your phone!: because bitcoin uses blockchain technology and blockchain is — say it with me kids: immutable, irrefutable, and transparent — anyone can see the transaction history. Law enforcement views bitcoin and the blockchain as “prosecution futures.” Even in 20 years, bitcoin transactions will be public. While there is no identity required to transact on the network (thus why people think it’s safe to use for illegal activity), the only way to purchase bitcoin today is through exchanges — and those exchanges do require personal information. If law enforcement wants to see how you spend your bitcoin, all they need to do is get your address from an exchange and track your transactions through the blockchain. While they don’t have this ability yet, they will someday. If you really want to stay off the network, buy your bitcoin with cash from someone, or use Zcash or Monero. If you’ve already made this mistake, hopefully you didn’t purchase anything too illegal, or at least you’ve got another 10 years (or 20 years if American bureaucracy has anything to say about it) before you’ll need to “relocate” to Thailand.
I think this question about the value of bitcoin is what people most struggle to wrap their heads around. They understand that bitcoin is worth something — the news circulating the internet is undeniable — but don’t understand why. And for those who have bought, the question then becomes, how do I justify this purchase to my significant other (or parents)?
There are two ways to look at bitcoin’s valuation. One is that bitcoin has a functional utility. The second is that bitcoin is digital gold.
The bitcoin utility argument
First let’s examine the utility argument. Bitcoin’s utility is as a currency. For it to operate as a currency, it needs to have cheap transaction fees and fast confirmation times. People use Visa and MasterCard because the confirmation time (time for transaction) is virtually instant and the fees negligible (most retailers pay the fee from their own profits). Bitcoin has 1MB block sizes and 10 minute confirmation times. If you remember how blockchain works — or at least return and reread that part of my last article — blocks of transactions are added to the blockchain by miners. A 1MB block size means that about 2,000 transactions can be included in each block. Miners have to solve a mathematical formula to place the block. 10 minute confirmation times means that the math formula is custom created to take 10 minutes. But I‘d like to see a computer try to solve the formula during finals week, sleep deprived, stressed, and after a 15 page essay. And they say robots will someday replace humans…
A few years ago, there were so few transactions being conducted on the network that all transactions were included in the next block. But today, there are so many people trying to place transactions on the network that it might take 6 blocks to process a transaction. That’s an hour! 10 minutes, let alone 1 hour, is not fast enough for day-to-day transactions. No one is going to wait that long for their cup of Starbucks coffee — even if it is a Pumpkin Spice Latte and you can only buy them one season per year!
1MB (2000 transactions) every 10 minutes is achingly slow. It’s the line at Costco the day before Superbowl Sunday slow. It’s download speed at grandma’s slow. 1MB/10min translates to .00167mbps (MB/second). Try watching Netflix on that speed. Singapore, with the fastest internet speeds in the world, averages 154mbps — that’s 92,000 times faster than bitcoin’s speed. Visa is 7,200 times faster at processing transactions than bitcoin. Ouch. That’s sloth from Zootopia slow…okay, I’m done.
Bitcoin did devise this system intentionally. Longer block times prevent mining disputes (a very technical rabbit hole) and 1MB block sizes prevent centralization. If blocks could hold 100,000 transactions — which, in technical language is…a TON of data — then only the most powerful computers in the world would be able to process them. That would leave the control of bitcoin in the hands of the most powerful and wealthy — sounds kind of like the dollar, right? But the creator of bitcoin had no idea that adoption would happen so quickly. 1MB block sizes were thought to be more than big enough for the foreseeable future.
A second hurdle bitcoin must overcome in its quest to be a legitimate currency is its high fees. There are costs associated with verifying transactions on the network. Miners buy expensive mining rigs (just specialized, powerful computers which solve those math formulas) and electricity ain’t free — or at least that’s what my dad always told me when he’d yell at me for leaving my lights on. So miners need incentive to mine. And apparently, being able to tell girls at bars, “Yeah, well I mine bitcoin” isn’t motivation enough.
As I mentioned before, miners get bitcoin when they successfully confirm a transaction. But this is only part of the reward. On top of this, people include a small fee (in the form of a little extra bitcoin) when they send a transaction. This fee is claimed by the miners. The higher the fee, the more incentive there is for that transaction to be confirmed in the first block. It’s like if the waiter knew you would be tipping 40% to show off to your date. Suddenly, you’re the new favorite customer. But if everyone is tipping 40%…now you need to tip 60%. Thus, since there are so many transactions competing for so few transaction spots, the fees can get pricey. Imagine a block as the available seats at Fenway Park. You can’t increase the number of seats. When the Red Sox are playing the Miami Marlins during the dog days of July, tickets are cheap. But come October when the Yanks are in town and Hanley is finally out of his two year long slump, you’ll need to sell your first born kid to get a seat. Bitcoin fees for any transaction today can reach $7, and they’re not percentage based. The fees for a $1 transaction are the same as for a $1000 transaction…so that better be one damn good Pumpkin Spice Latte.
The digital gold argument is more compelling in my opinion because of the above mentioned limitations. Gold is valuable because gold is scarce and people value scarcity. Gold is the kind of scarce that doesn’t rely on centralized bodies to keep it scarce. If tomorrow the U.S. Treasury decides to pay off the national debt, your dollars will be worthless. Unless alchemy suddenly becomes a legitimate science, gold is going to stay scarce. Why do Picasso paintings and Ted Williams autographs sell for millions? Because there’s a demand, the item is scarce, and the demand is higher than the supply. The minute we can reanimate Ted William’s frozen corpse and he still has good penmanship, I would assume his autographs will depreciate in value. Bitcoin was the first entirely digital commodity that was scarce. As I said last week, code can be copied. Pictures of Emma Watson and this Office GIF can be copied.
Bitcoin can’t be copied. There will only be 21 million bitcoins. It’s finite, scarce. If everybody and their mother someday wants bitcoin, laws of supply and demand dictate the price will rise. And since user mistakes can and do result in the loss of bitcoin wallet passwords, it’s actually a deflationary commodity/currency.
“When I first heard about bitcoin, I thought it was impossible. How can you have a purely digital currency? Can’t I just copy your hard drive and have your bitcoins? I didn’t understand how that could be done, and then I looked into it and it was brilliant.” — Jeff Garzik
Gold is also valuable because it has a historical precedent for holding value. People trust it. Bitcoin might be a baby compared to gold, but digital years are like dog years. Bitcoin has survived eight years — that’s a hundred years in the digital world. People already trust it, especially compared to other digital commodities. As long as a commodity is scarce and people want it, it will have value.
So why would someone want bitcoin?
You and your good questions. Actually, if you’re anything like me, the real question you’re asking is why am I reading this article right now when I have leftovers in the fridge and fresh pita on the counter? Great question. Go get yourself some food…I’ll wait.
Welcome back. So more people might want bitcoin someday because bitcoin solves its scalability issue and becomes functional for everyday transactions (more on that later). More people might want bitcoin someday because they see value in storing money in something that cannot be stolen and can be accessed from their phone. More people might want bitcoin because their national currency is as valuable (and unfashionable) as wallpaper…
…and bitcoin offers them a stable and safe way to store value; a place away from the incompetent and greedy hands of their government. This is already happening in Venezuela and Zimbabwe. More people might want bitcoin because international money transfers can be conducted cheaply and in under an hour versus the industry standard of huge fees and agonizingly long wait times. People might want bitcoin because Kim Kardashian starts tweeting about it for a week. And if there’s one thing I’ve learned from my 22 years on this earth, it’s that if celebrities endorse it, I gotta have it.
Paraphrasing Nick Szabo here, a brilliant computer scientist. One good way to estimate the potential of bitcoin is by asking how many people can use it? The dollar, though widely adopted, can’t be used by everyone. Bitcoin however, can. From a New York penthouse to a small African village, as long as there is a phone and a data plan, bitcoin is utilizable. And already, smart phones are in nearly every pocket, even in Africa, and worldwide internet might already be on the horizon.
Who is the head of bitcoin?
Well, no one is the head of bitcoin…and everyone is. Bitcoin’s governance is like that of a classroom with a teacher who believes discipline and structure is detrimental to kids’ developing “creative abilities.” With this setup, the likelihood of these kids achieving anything more collaborative than large scale crayon fights and collectively raiding the goldfish stash is low. The likelihood of them colluding, organizing, and overthrowing the school is also incredibly low. Their inefficiency and communication limitations protect the institution — which in this metaphor is the school. With a central figure like a teacher, we’re trusting them to use their power responsibility. One malicious teacher could conceivably raise a rabble of organized, violent students with chaos on their minds (just take a look at most public schools). That’s the difference between centralization and decentralization. Centralization requires trust. Trust in a government, trust in a third party, trust in a person, trust in an institution. Not like that’s every backfired (*cough* Bernie Madoff, ’08 crash, Enron…).
Bitcoin is decentralized. Trustless. Decisions regarding the future of the currency are made collectively by the miners, users, and other participants. Language, culture, time zones, motives, and lack of collective incentive keep them generally honest. The massive amount of computing power required to overwhelm the network prevents corrupt single powers from ruining it for everyone. Though the system is inefficient, just like in the classroom, the likelihood of all of them working together in some malicious manner is nearly impossible. Just like how the Founding Fathers crafted Congress to be intentionally inefficient in order to prevent rogue players from causing catastrophic harm, bitcoin’s inefficiency is its strength.
I can’t stress this point enough. I will devote another article to it specifically as we move past bitcoin and into blockchain applications. Decentralization is the most secure security method. It is the backbone of blockchain.
How can bitcoin change?
The fact is that bitcoin will need to scale and change, so decisions will need to be made. And this is a central question in the bitcoin community. How should bitcoin scale? By scale, I mean how should bitcoin grow and evolve to accommodate the influx of new users and investors. If it can’t scale, it can’t be a currency. Since no central figure makes these decisions, it falls on the shoulders of the community — and just like anyone who has volunteered for their school board knows — community decision making can get ugly.
So when bitcoin wants to change, it’s called a fork. On a side note, there is such thing as both a hard and soft fork. For simplicity’s sake, when I say fork, I’m referring to a hard fork. I’ll explain the difference at a later point.
A fork is a change to the bitcoin code. The analogy I like is that of an iPhone update. When a new iOS comes out, it’s not like the old iOS stops working. Check out your parents’ phone for an example of this. Those who like the new iOS update their phones. Those who don’t like it (or don’t understand how to use iTunes) can keep using the old one. However, unlike with iOS where two phones running different iOS still are compatible and can talk to one another, bitcoin cannot. When bitcoin updates, it effectively creates both a new and old bitcoin. They aren’t compatible, but both can still be used.
So how do we decide which bitcoin is the real bitcoin? Well, it depends which bitcoin gets the most use. Because a symbiotic relationship exists between users and miners, and they both rely on exchanges to offer bitcoin for sale to the public, which bitcoin gains dominance depends on which one users, miners, and exchanges use. If they both get a significant following, then we get two bitcoin (usually one with a slightly different name).
The major debate right now is between whether bitcoin should scale to be a usable currency or maintain its status as a stable, decentralized, digital asset. While most agree that bitcoin must undergo some changes, how exactly those changes should happen, and who should make the proposals, is controversial.
Ah, the summary. Where I validate myself for writing such an informative article and you realize how little of what we covered you actually understood. Today I hope we learned why bitcoin is worth something, the major debate within the bitcoin community, some of bitcoin’s limitations, who leads bitcoin, and how bitcoin can change and scale. Not everyone who invests in bitcoin understands these topics — I would even say most don’t. But I think there is a huge advantage to those who do. So pat yourself on the back, pour yourself a glass of wine, and climb into that bubble bath…you’ve earned it.
FOLLOW me on Twitter: @noamlevenson
Disclaimer: This is not investment advice. Do your own research.
Hold down the clap button if you liked the content! It helps me gain exposure. Clap 50 times!
I love getting questions or suggestions, so comment away!