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Thoughts on Bitcoin

2021-06-12, Michael Thompson

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Thoughts on Bitcoin

We’re in the midst of another volatile year for Bitcoin. After substantial inflation in fiat money supplies, the need for scarcer stores of value has strengthened. While gold has played this role historically, many believe a cryptocurrency could take its place. It certainly seems like cryptocurrencies have more convenient properties including better control of scarcity and more convenient transferability and storage. However, will enough people trust a cryptocurrency to become the primary store of value? If so, will it be Bitcoin?

I'll start with my pros and cons of buying Bitcoin, sorted from most to least important. Additional details are included later.

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There is theoretically an infinite supply of cryptocurrencies in general, with little cost to create new currencies and coins. Currencies like Dogecoin have even been created as a joke.

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It’s hard to imagine a more convenient mechanism for storing and transferring wealth than cryptocurrencies (not necessarily Bitcoin specifically). Some reasons are cited as specific pros below.

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Bitcoin is the original cryptocurrency and the clear leader in the space, now and for the foreseeable future.

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Bitcoin may be rendered obsolete by a superior cryptocurrency (or other technology) (think about MySpace, 3G, Netscape, …).

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Hard limit on Bitcoin supply. While there are some caveats in the details below, there will likely only be 21 million Bitcoins, ever (and over 3 million are believed to be lost).

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Lack of intrinsic value. Unlike oil, Bitcoin can’t power a machine. Unlike a farm, it can’t produce food. Unlike shares of a business, it’s not a claim to other assets or production. There’s nothing to keep the price from collapsing to 0 if interest wanes.

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In 2020 more mainstream investors bought into Bitcoin, including Bill Miller, Staney Druckenmiller, and Paul Tudor Jones.

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Bitcoin mining consumes significant energy. Negative effects of this can be limited/prevented by using energy that would otherwise be wasted. There are also alternate consensus mechanisms that could be added in the future.

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It’s easily divisible—I can pay you with a fifth of my Bitcoin, or a tenth, ... all the way down to one hundred millionth of a Bitcoin (a so-called “satoshi.”) This is less true of comparable assets like a gold coin or real estate.

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Bitcoin is relatively easy to secure and store in large amounts, with minimal 3rd party risk. You don’t need a vault with an armed guard as is done for large amounts of gold.

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Bitcoin is easy to transfer to another person in another physical location, even internationally. You don’t have to pay to send it on a ship and risk theft (or pay insurance) to transfer it to someone overseas. Even credit cards and PayPal typically cost about 3x as much (the precise number fluctuates).

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Bitcoin wallets can be lost (hard drive or other storage media can be lost, corrupted by a virus, or fail). In such cases, there's no third party to help you recoup your losses—your Bitcoin is gone forever.

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Lack of buyer protection. The lack of third party oversight has disadvantages. If you accidentally send someone 1 Bitcoin instead of 0.1 (or a crooked seller rips you off) there's no bank or government to revert the transaction or pay you back. This can be remedied using a third party service, but then you lose some of the benefits of using Bitcoin in the first place.

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While they may not be able to stop the Bitcoin network, a group of nations could effectively destroy Bitcoins’ use as a currency or even a store of value. They may take such action to retain control over their monetary system.

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Privacy. You don't have to tell your bank (or anyone) how much Bitcoin you own or how you spend it. (If your address is revealed, however, anyone can see all of your transactions on the ledger.)

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Independence from bank and political control. Although rare, governments have been known to seize assets like bank accounts (see this story about Alexei Navalny). Banks (even in the US) have also been known to prevent customers from buying certain things (like cryptocurrency itself in 2018). No business or government can control your Bitcoin transactions in this way. Although, if you hold crypto on an exchange you could be subject to the rules of that exchange and the government under which it operates.

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The price has been very volatile historically. This will likely continue for some time. If you can’t handle losing 50+% of your investment, it may not be wise to hold Bitcoin. Even if you’re able to handle the volatility, you must realize that many others cannot, which will limit demand in the short-term (and add volatility as weak hands “sell into dips”).

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Bitcoin lacks physical limitations. For example, if you own a farm or a building in California and the state decides to impose a large land tax you’re stuck (you can’t move these assets to another jurisdiction).

Fixed Bitcoin supply

The current implementation of Bitcoin limits the supply to 21 million coins. Although changes to the Bitcoin code are continuously being proposed and enabled, it currently seems unlikely this would change. For investors, this is an attractive contrast from currencies like the USD, the supply of which sometimes increases substantially (and worse yet, unpredictably). It’s even better than precious metals like gold where the supply can change with improved mining technology and discovery.

However, the supply of cryptocurrencies (in general) is unlimited. So the market may be flooded with an astounding number of alternatives like Dogecoin. It’s relatively easy to make a new cryptocurrency, and there’s a threat that a better one eventually overtakes Bitcoin. Presumably this threat decreases as the market cap of Bitcoin increases.

Convenience

Bitcoin could play the role of gold better than gold (and other precious metals). For one, it's supply is better controlled as already pointed out. It’s also more easily divisible. It’s not as easy to sell or trade part of a gold coin, but a Bitcoin may be readily subdivided into “satoshis”—one hundred millionth of a Bitcoin. It’s also easier to trade/sell a Bitcoin electronically and to store it. These things may be accomplished to some extent with “paper gold” or gold certificates, but those require you to pay and trust a third party to store/secure the gold. This introduces counterparty risk and may invalidate the investment in exactly the emergency scenarios where you may need it most (e.g. I may not accept your gold certificate in a trade if I’m not confident it’s legit).

Let’s say the world mostly decided that Bitcoin is the new gold, which is not too far fetched. Gold currently has a market cap of 4.4T USD. If that value were transferred to Bitcoin it’s market cap would grow from 0.7T to 5.1T USD—a 600% increase. This is a bull case worth consideration.

Bitcoin as a currency

Bitcoin may have been intended as a currency, but I don't see that happening now, at least to the degree of something like the US dollar. For one, the inability to create new Bitcoins, while great for storing value, limits nations’ ability to apply monetary controls. While this has benefits, it is a weakness as well. There are scenarios where excess money gets locked up in too few hands and the ability to inflate the monetary supply is helpful. In addition, nations will likely develop their own digital currencies (China already has) which will enable substantially more monetary controls. For example, future stimulus could consist of digital tokens with an expiration date to boost short-term spending. It’s hard to imagine nations forfeiting this power to the Bitcoin network. For such reasons, nations may group together to enact laws making it exceedingly difficult to use Bitcoin as a currency. If that weren’t enough, Bitcoin’s technology isn’t able to process even a small fraction of all the transactions in today's economy. People are working to increase the scalability, but it won’t be there in the foreseeable future.

Unproductive Asset

Bitcoins don’t produce anything of value like a stock, bond or farm which generally produce (intrinsically) valuable goods/services. Gold has this same weakness. The downside to such assets is that there’s nothing to support their price. If the stock of a useful business drops significantly, there will be pressure to buy it since it can be used to make useful goods/services (and it probably owns useful assets). However, if people decide they don’t like Bitcoin anymore, there’s nothing to support its value, it can literally drop to 0.

Of course, Bitcoin itself may be valuable in that people trust it to store value, and that it has the many convenient properties discussed above. This is EXTREMELY valuable. The problem is that technically only one such store of value is necessary. If people decide Bitcoin is not it, it doesn’t have any intrinsic value to support its price.

Volatility

The price of Bitcoin has been extremely volatile. In 2017 it gained substantial popularity with a 1200% rise to almost 20K USD per coin, only to lose 80% of that value later. In early 2020 Bitcoin traded for 5K USD, but soared to nearly 65K in April 2021, only to drop back to 32K USD in early June 2021. Such volatility scares many people away, limiting demand and therefore price. It can also make it difficult to use for trade, further reducing demand.

Summary

In short, Bitcoin’s fixed supply along with ease of transfer, storage and divisibility, could make it an excellent store of value, better than gold. The missing component in my view is trust. People have trusted gold to store wealth for thousands of years. On one hand, it seems silly/archaic to continue using a rock to store wealth, but on the other hand it’s scary to trade it for something less proven.

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