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What Makes Bitcoin Valuable

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@markkujantunen
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I thought I'd write a post about what makes Bitcoin valuable in the current financial environment. The price and market cap of any asset is a function of demand for it and the supply of it. The same goes for Bitcoin and all the other cryptocurrencies.

Bitcoin's guaranteed scarcity

Bitcoin is not a security. It has no underlying asset that it represents and that may or may not have value. Bitcoin is just Bitcoin.

Bitcoin is a solution to the problem of how to create artificial scarcity without resorting to having a central authority as an arbiter of truth. In having no central authority, Bitcoin differs from all the other private electronic cash systems prior to it. Governments put an end to all of them eventually and that is a good thing from a consumer protection point of view. Centralization is an anathema in the crypto sphere and for a good reason.

To solve the problem of maintaining consensus without a central authority, Bitcoin's creator(s) used a data structure called the blockchain based on a more general data structure called Merkle tree invented by a cryptographer called Ralph Merkle decades earlier. In a Merkle tree (and in blockchain), data are added in blocks that contain a hash (= you can think of it as a kind of complicated checksum) of the previous block. A blockchain is add only. The idea is that checking whether anything in the chain has been changed is fast and easy because calculating each single hash is fast but that adding new blocks is difficult and time consuming. The difficulty is ensured by demanding that each block only contain a hash that has the right number of zeros in front of it. A block contains not only the transactions but some header information as well as a parameter called the nonce. The nonce is what a bitcoin candidate block signer (a miner) varies in a process of trial and error when attempting to produce the right kind of hash. This is called Proof-of-Work. It's purpose is to force each miner to pay an upfront cost before being eligible for receiving a reward for mining a block. The system is completely permissionless meaning that anyone can freely decide to participate in the network without asking anyone's permission.

Bitcoin has no governance structure. This is a feature, not a bug. The Bitcoin ecosystem is made up of miners, Bitcoin full nodes that outsource mining to specialized miners but verify transactions (verification blocks is fast but creating them is slow and a lot of work), Bitcoin developers, large token holders and other users of the network. When the protocol needs an update network prominent participants meet and discuss alternatives and may or may not come to agreement. In case of a disagreement, a hard fork may ensue which is when the chain sprouts a new chain that shares a common history with the old chain up to a point but goes its own way after that. There is no way to force anyone to use any particular version of the chain. It is a network of volunteers.

An important consequence of Bitcoin having no governance structure is the difficulty of changing the protocol which the original chain runs.The above is vital because it allows the user community to trust that the monetary policy of the chain be constant over a long term.

It is the constancy and the game theoretical incentives to run keep running the original chain that really set Bitcoin apart from the all the more agile projects that use some other, permissioned consensus mechanism as a store of value coin.

The demand side

In the current financial environment, central banks are forced to observe a very light monetary policy. This is because of the heavily debt ridden state of all the major economies of the world. Partially this is results from many key economic inputs such as working age population having the right education and the right skills having become scarce while the number of the elderly being at record levels as a proportion of the population. The USA, the EU and Japan have had loose fiscal and monetary policies in the hopes of spurring economic growth, which has failed. Because money is debt in a fiat monetary system, injecting more money in to the system has resulted in even more debt than before while failing to stimulate as much real economic growth as necessary. Cheap imports from developing economies and increasing automation have kept consumer price inflation in check together with much of the inflation remaining in the financial markets.

The pandemic has only exacerbated the situation. The stock market has come completely divorced from reality. There are 40 million unemployed in the US alone while the stock market is going up with public corporations buying their own stock. Because sensible investments have increasingly become like parking spaces in New York while the money supply has increased, it is hardly surprising that a new asset class like cryptocurrencies that has an exciting narrative challenging the old system has attracted a lot of attention.

If the money central banks are forced to keep pumping into the economy to keep kicking the can of catastrophic collapse ahead is like torrential rain causing a deluge, then cryptocurrencies are like barrels useful for collecting the torrent of new fiat money. The entire space is driven by money invested in the scarce, permissionless and decentralized asset that Bitcoin from which it flows into the lower market cap coins as speculators go for even larger gains. In a high-inflation environment such as the current one, it is not surprising that asset valuations become unanchored to reality and that novel ways to secure a slice of the inflation are invented. That is the other half of the value winning proposition of Bitcoin.