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Everything Perth

Focussing mainly on issues relevant to Western Australia, Everything Perth is a blog by Jason Smith. His posts explore modern society, culture, law, politics and family through the lens of a life lived in Perth. 

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Why does Bitcoin have value?

In this short essay I’m going to explain to the reader why Bitcoin has value. While you may be familiar with some of the technical terms surrounding Bitcoin, like blockchain or cryptocurrency, this won’t be a deeply technical dispensation. I will cover the basics for those who are curious.

Before I start keep in mind the word Bitcoin means two things, and I use it interchangeably below. Sorry for any confusion. Bitcoin can refer to

  1. The Bitcoin Network (the various computers that run Bitcoin node software)

  2. The Bitcoin token (the actual money)

Why do things generally have value?

To understand why Bitcoin has value, you need to look at why other things of relatively little practical use have intrinsic value. Things like glass beads, rai stones, Michael Jordan rookie cards, and of course Gold, found their value in two simple facts: they were scarce, and people waned them.

Once there is a level of base demand for a good, that is, someone somewhere wants it for whatever reason, and by way of either nature or human choice that good is observed as rare, that good will tend to have value. If it meets a few other criteria, such as fungibility (each one of the things is the same as other ones of the things), it has a chance of becoming “money” for a group of people.

Not everything that starts out as rare and precious remains rare and precious. In the 19th century aluminium was more valuable than gold and silver, due to it being so difficult to obtain. Sure, it technically was plentiful within the earth. But it was not able to be easily extracted, and thus a great desire for the product grew. In 1884 the USA capped the Washington Monument in aluminium (I’m sure they called it aluminum) to, as this Slate article puts it, “show off their industrial prowess.” But you know how that story ends. Someone figured out how to use electricity to seperate aluminium from dirt and now we use it for disposable containers to hold our Coke.

Glass beads were popular in areas of Africa, until western merchants flooded the region with them, as they had figured out how to make their own at mass scale. Rai stones shared a similar fate to the glass beads. While they were scarce for the locals, visitors could harvest them elsewhere with great ease.

Gold has held its own for thousands of years, as the total supply usually doesn’t grow by much more than 2% in any given year.

If you’d like to understand more regarding what makes money money, I’d love it if you read this article by Nick Szabo, one of the key people in the creation of ideas behind Bitcoin.

A very, VERY, brief overview of Bitcoin

Without getting overly technical, the magical breakthrough of Bitcoin by Satoshi Nakamoto was that what we call the “double spend” problem was solved. That is, if I send you a Bitcoin, I can’t send that same Bitcoin to someone else.

Another key feature of Bitcoin is the fact that no-one is in charge. There’s no company, foundation, or organisation who can change the rules. (There’s no official website for Bitcoin, noone you can call if you lose your money. No-one who can go to jail if the whole thing breaks either.) Rules concerning how Bitcoin works can really only be changed if the overwhelming majority of people agree to update the code they use when running their Bitcoin nodes. No-one gets paid for contributing to Bitcoin’s code, as there is no-one to pay them. (That said, there are businesses who have a vested interest in Bitcoin’s ongoing success that do employ staff to contribute to Bitcoin).

Mining Bitcoin

You may have also heard about this thing called mining. In a simplified way I will try to explain mining.

Mining is the name given to the process of creating transactions on the Bitcoin network. A miner essentially wants to get given some Bitcoin. If they create a “block” of transactions on the Bitcoin network, they are awarded with all the transaction fees that they include in their block, along with a “block subsidy” of fresh, brand new Bitcoins, currently 12.5 Bitcoins.

The goal of the miner is to spend less in electricity costs than they receive in awarded Bitcoin. If their electricity costs more than the value of the Bitcoin they find, they tend to stop mining.

In order to win the prize of creating a block on the Bitcoin network, the miner must create a valid '“hash”. A hash is essentially just the answer to a maths question. It’s harder than it seems though. Here’s what happens.

A miner gets all the data they want to include into their “block”. This includes all the transactions they want to process, and the previous block’s “hash”.

Then they have to put all that data through an algorithm (essentially a complicated mathematical equation) called SHA-256. SHA-256 is so complicated that you cannot reverse engineer it.

A “target” number is set automatically by the Bitcoin network. It’s a hexadecimal number. Currently it is: 0000000000000000002819a10000000000000000000000000000000000000000’

The goal of the miner is to process all the data for their block through SHA-256 then come out with a number, or “hash” that is LOWER than the target number.

To do that, there is one more bit of data a miner adds to their block. It’s called the nonce.

The nonce is the variable that the miner changes over and over to help them find a valid hash.

Now remember, there’s no way humans know of to reverse engineer the SHA-256 equation. So you can’t just choose a low hash and calculate the equation backwards. The only way to find a valid hash that is lower than the target number is to simply change the nonce over and over and over, and keep guessing until you find a magically low hash.

If you want a visual explanation this video is amazing.

A $500 dedicated Bitcoin mining machine you can buy today is able to calculate about 13.5 TRILLION hashes per second. A human takes about a day and a half to calculate a single SHA-256 equation on paper.

So once a miner finds a valid hash and creates a valid block full of transactions waiting to be processed, it gets added (or chained) to the previous block, all the other nodes on the Bitcoin network check to make sure that miner was telling the truth (they can calculate if it’s a valid block and hash in a fraction of a second), the winning miner pockets their 12.5 Bitcoins plus any transaction fees, and the race to find produce NEXT block begins afresh.

Now because each block includes the hash of the previous block, no-one can change a single digit of any previous transactions to try and cheat the network. If they do this, it will cause all the hashes of every other block to become invalid. Chaining the blocks together this way is a clever way to prevent people from lying about how many coins they have. All nodes can see the full history of the blockchain, so they know if you’re lying. (Now you can see where the term “blockchain” comes from. It literally means “chains of blocks”.)

One of Bitcoin’s killer inventions that often gets overlooked is the way the target difficulty gets adjusted. That long, complicated number we saw earlier, changes roughly every 2016 blocks, automatically. The goal of the Bitcoin network is for blocks to be created every 10 minutes. So roughly every two weeks, the Bitcoin software looks back at the previous 2016 blocks, works out if the blocks were being found too quickly or too slowly, then lowers or raises the target number accordingly. It’s all done in the code, no human intervenes in the process.

The result of this practice is that adding more mining machines to the network will not increase the number of Bitcoin’s that are created each day. If the entire world today all started mining with every computer on the planet, blocks would be found much quicker than every 10 minutes, but within 2016 blocks, the network would adjust and it would go back to every 10 minutes.

On to Bitcoin’s scarcity

So now that we know how Bitcoin works, it’s easier to see why Bitcoin might be considered a scarce digital good. It doesn’t matter how high the price goes, there will only ever be 12.5 new Bitcoins created every 10 minutes.

Consider an asset like gold. Lets say the price of gold goes up to $4000 per ounce. What will happen? Miners will start digging deeper, fines that have low quantities of Au will be processed because it is now viable, and a lot more gold will thus be dumped onto the market. Same with wheat. If the price goes up, farmers grow more of it, and that pushes the price back down. If the price goes up for canola, they’ll stop planting wheat and grow canola instead.

This phenomenon can’t occur with Bitcoin. There’s no market response mechanism to create more than (currently) 12.5 Bitcoins every 10 minutes (which works out to be 1800 per day).

But it gets even better.

Remember I told you the current block subsidy (what the miner gets paid) is 12.5 Bitcoins.

Every 210,000 blocks, that block subsidy (some people call it the block reward) gets cut in half. When Bitcoin started in 2009, the block subsidy was 50 Bitcoins. Then in late 2012 the first “halving” occurred, dropping the block subsidy to 25 Bitcoins. In 2016 it halved again, dropping the subsidy to 12.5 Bitcoins. The halvings occur roughly every four years, so we can guess the next halving will happen around May 2020.

So in less than two years, the number of new Bitcoins that get created each day will drop in half from 1800 to 900. In four years after that, it will only be 450 per day. By the time I reach retirement age the number of new Bitcoins minted will only be about 7 per day.

The net effect of this is that eventually the block subsidy will be too small to keep halving, and it will stop, with just shy of 21 million Bitcoins having been created. Miners will then only be rewarded with the network’s transaction fees.

Once someone understands how Bitcoin actually works, it easy to see why Bitcoin is scarce, how no-one is in control and can change the rules, and how there’s no way to create extra Bitcoins.

So what makes Bitcoin valuable then?

There are a lot of people on the planet now that understand how Bitcoin works and that its supply is capped. But there’s lots of things that are scarce. Cabbage patch dolls from the 1980s are scarce. No-one is planning on using them as money any time soon.

Now, as far as I can tell, other than being an intangible digital good, Bitcoin does have one actual practical use besides being money. When you send a transaction you can include a bit of data that gets recorded on the blockchain. This can be anything from an obituary notice, a link, a joke, or anything you like. So Bitcoin is also, essentially, a way of publishing material in a completely un-censorable manner. But few people know of this, and I don’t believe it’s where Bitcoin finds its true value. (It’s called op_return if you want to nerd out and learn about it).

As a payment system, the Bitcoin blockchain is slower than Visa or Mastercard. It’s great for sending money overseas to staff or friends. But it’s not really more convenient for the average person. And you can’t get your money back easily like you can with Visa. Once you send a Bitcoin, it’s gone. If you lose it, it’s gone (just like cash). While in the early days of Bitcoin many people proclaimed that Bitcoin would be how we pay for everything everywhere, lots of Bitcoin owners these days don’t actually think that way at all. They think it is more like a base layer, and will have other payment solutions built on top of it.

So Bitcoin certainly doesn’t find it’s value in convenience.

Bitcoin’s value proposition is that it can’t be censored, the government can’t reach into your Bitcoin wallet and take your coins, (a $5 wrench to the side of the head may entice you to hand them over though), and the fact that the supply rate is fixed in (metaphorical) stone.

There’s a growing understanding within the network of those who own Bitcoin that while the supply of new Bitcoin is currently increasing at a pretty high inflation rate of 4 - 5%, once that number drops lower in a few halvings time, Bitcoin will essentially become a deflationary money, comletely different to what we have been used to up until now.

Imagine your money in your bank account actually INCREASING in spending power year after year, instead of going down.

Since we left the gold standard and adopted a “fiat” money, one that exists by nothing other than government decree, governments around the world have been able to print money to their hearts’ content, essentially deflating the value of any cash you or I hold on to. That, combined with our system of bank loans where money is essentially created out of thin air each time a financial institution issues a loan, we’ve built a financial system that essentially relies on more and more people getting in to more and more debt, and governments trying to encourage people to spend their money on useless crap to keep the economy ticking rather than saving their money for valuable investments. And why WOULD anyone save? Any cash you hold standing still is essentially losing spending power by the day.

One grand hope of the Bitcoin experiment is to end this “Keynesian” way of thinking about the world, and entice people to save for their investments, rather than reward those who don’t think about tomorrow and just get into more and more debt.

But in reality, we don’t know the future and all of that is conjecture.

The essential reason Bitcoin has any value at all is because there are enough people who believe it does. These people vary in their faith in Bitcoin from “cult-like - Bitcoin will become the global currency” to “who knows maybe I’ll just hang on to some” to “I have some Bitcoin somewhere but I don’t really think about it much”.

Bitcoin’s price in Dec/Jan touched nearly $20,000 USD per coin. Since then it has “crashed” to $6000 per coin (one of many many crashes Bitcoin has endured, and not the largest by % either). Despite this, the network continues to grow. More and more miners have joined the network to compete for those scarce new coins. Bitcoin holders are still buying Bitcoin, and many are even happy that they can get it cheaper. The network hasn’t missed a beat. Large institutions are investing in Bitcoin, Bitcoin infrastructure, Bitcoin mining, and Bitcoin trading platforms. This year the price has dipped below $6k USD several times, but keeps bouncing back above $6k. Long term advocates of Bitcoin are still out there preaching the merits of Bitcoin. More people are realising how useful Bitcoin is to store and move large quantities of wealth. For several countries that are experiencing hyper-inflation, such as Venezuela, Bitcoin has been a life saver, giving people a tool to hold some value or get their wealth out of their corrupt countries. More and more people are willing to accept Bitcoin for real world purchases; just jump on Gumtree and do a search for the word “Bitcoin” and you’ll find a large number of people selling cars, boats and more, who are more than happy to accept Bitcoin. Many people are figuring out that there are over 7 billion people on earth, but only 21 million Bitcoins. They do a little back of the envelope math, and concluding “maybe I should get one of these just in case.”

As of today, over 17,000,000 of the total Bitcoin supply has been mined. It is estimated that around 4,000,000 of them are lost forever, due largely to people discarding them or being careless with them back when they were relatively worthless.

The current price of Bitcoin, despite having fallen from $20,000 USD, is holding around $6000 USD per Bitcoin.

That means the market has been able to absorb around $10,000,000 USD of Bitcoin on average each and every day so far this year. (1800 daily coins x $6000 USD).

The number of Bitcoins being minted each day will be 1800 for less than 2 years. Then it gets cut in half.

So to sum up why Bitcoin is valuable: The volume of people/new money that thinks Bitcoin is valuable is increasing every day. The number of new Bitcoins available keeps decreasing every day.

But isn’t it risky?

Yes. There’s lots more to learn about Bitcoin. The risk doesn’t appeal to everyone. You could lose everything if you don’t know what you’re doing. This is just an intro essay to explain some basics. There will be lots more bubbles and crashes before the Bitcoin story is finished, and Bitcoin takes its ultimate place in our lives. Lots of people will predict its doom. Lots of people will promise you’ll get rich. People will say “I told you so” when the price spikes. Other people will say “I told you so” when the price crashes again. Ignore all of them and do some homework youself if you’re interested in knowing more.

What about all those other cryptocurrencies? Aren’t they valuable too?

Bitcoin had something of an immaculate conception. It was born without a father (Satoshi Nakamoto is a pseudonym and he checked out in 2010). It is controlled by no-one. It is the original crypto currency. It is the currency that all other crypto currencies are denominated in.

Virtually every other cryptocurrency or digital token is backed by a company or person who decides what will happen with the code that runs their coin. They miss the EXACT THING that makes Bitcoin valuable and resistant to being controlled or shut down.

Maaaaaaaaaaaaaaaaybe, someone will find a use for another cryptocurrency. But many people investing in them don’t really understand what they’re buying. They essentially see that some people bought Bitcoin for 30 cents, now it’s worth $6000, and they hope to invest in the “next Bitcoin.” Take “Ethereum” for example. It’s currently the second largest crypto currency by market capitalisation (a terrible metric, but what I’ll use nonetheless). Lots of folks invested in it thinking it would overtake Bitcoin, and one day there would be an event called the “flippening”. But Ethereum’s total supply is not capped like Bitcoin. It’s essentially infinite. The Ethereum code will essentially create more ETH for the rest of eternity. Every Ethereum fan I’ve spoken with cannot explain to me why on earth I’d ever want to invest in something that is the opposite of scarce, where my holdings are guaranteed to be diluted for all time.

Add to this the fact that the total supply of “altcoins” (as in “alternative coins” - that’s the polite term people give them 💩) is essentially infinite, and you can see why there are so many people who think there is Bitcoin, and nothing else worth knowing about.

If you look at the list of altcoins from 2013 (here’s a link), every coin other than Bitcoin is worth a fraction (measured in BTC) of what it was 5 years ago. In other words, if you had chosen any altcoin instead of Bitcoin to invest in, you would be regretting your decision.

There’s now well over 3000 “altcoins” all claiming to be a harder/better/faster/stronger version of Bitcoin. But they all fail to see that it’s the scarcity that gives Bitcoin it’s value. There’s also thousands of currencies known as “tokens” which the creators sell to bamboozled VCs and members of the public, using buzzword salad and nonsensical economics. They claim their token is going to revolutionise the energy/realestate/food/political sector using some handwavey bullcrap, yet everyone who ACTUALLY understands the technology can’t figure out how their token is going to achieve anything.

History tells us people tend to settle on one thing as money. And it’s usually the scarcest, or hardest to produce, good. Currently, Bitcoin is the hardest digital currency to create. And nothing is even close to how much electricity miners are throwing at it, or close to it’s value.

As I write this, every single other silly cryptocurrency combined is not even worth half of what all the Bitcoins are worth. (This is using market cap, not the best metric. The situation is even more dire for altcoins as there is virtually no liquidity for most of them, thus if any large coin holders actually tried to sell their coins the value would tank even more. The market cap (total supply x last sale price) they DO enjoy is largely wishful thinking.)

I am of the very strong opinion that the likihood of a “next Bitcoin” is about as probable as there ever being a “next internet”.

Will Bitcoin always be the biggest cryptocurrency by market cap? Who knows? It’s a stupid metric. The USA government, or Facebook, or Twitter, or Reddit, or Epic Games (Fortnite) could create a cryptocurrency tomorrow that they run and print 10 trillion of them, sell 5 million of them for $1 each, and technically it would have a market cap larger than Bitcoin.

What’s important is that no-one can inflate the supply of Bitcoin.

I expect people will try, of course. If Bitcoin does continue it’s march north, eventually large institutions will build services on top of Bitcoin. They’ll hold your Bitcoins for you, and issue you a Bitcoin substitute which they guarantee they will swap for a real Bitcoin when you choose. It will be tempting for governments and institutions to permit more fake Bitcoins to be issued than real Bitcoins that actually exist. Time will tell if this actually backfires on anyone who tries it.

One other note

For those who were wondering, you CAN purchase less than a full Bitcoin. It’s divisible to 8 decimal places, the smallest unit being called a Satoshi. Currently BTC Markets (an Australian exchange I believe to be pretty reliable) will allow you to purchase as little as 0.001 Bitcoins at a time.

So you want to learn more?

An economic overview: I recommend a book called “The Bitcoin Standard” by economist Saofedean Ammous.

A technical understanding: Any videos on YouTube from Andreas Antonopoulos, or his book called Mastering Bitcoin.

A general overview: The literature and info written on the Nakamoto Institute website is all great reading. Start with the Bitcoin Whitepaper by Satoshi Nakamoto.

I want to buy some Bitcoin

I have found Coinbase to be very reliable. If you’re in Australia, I also suggest you check out BTC Markets, or a website called Independent Reserve. They’re a tiny bit trickier to learn than Coinbase, but the fees are much lower, and if you take your time to understand what you’re doing you’ll be ok.

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