Recently, I’ve gotten a number of questions regarding cryptocurrency of late. So, for today’s post, I will attempt to explain bitcoin since they are getting so much press these days.
I will illustrate the various pieces of this prominent cryptocurrency using the board game Monopoly as a basis for comparison. Let’s get started.
Bitcoin: The Creation of the Rule Book
Bitcoin was created by Satoshi Nakamoto in January 2009. There is quite a bit of mystery around who Nakamoto is much like there is quite a story behind the creation of Monopoly.
Bitcoin’s creation was based on a paper titled, Bitcoin: A Peer-to-Peer Electronic Cash System. This is sort of like the rule book that each Monopoly board set comes with. It lays out exactly how the transactions occur, how these transactions are to be documented and how the underlying technology works.
Bitcoin: Scarcity as a Value Proposition
As we all know, Monopoly comes with a specific amount of fake money that is required to play the game. Now, imagine for a moment that Parker Bros, the creators of Monopoly, cannot produce any additional Monopoly (fake) money needed to play the game ever again. This would mean that the only Monopoly money that will ever exist is already somewhere in the world today. Parker Bros. could continue to create the board itself and all other necessary pieces (other use cases), but the money supply itself is limited to what has already been created. Because the Monopoly money would be a finite resource needed to play the game, it seems likely that the value of these dollars would rise in value in accordance with their scarcity as long as more and more people desire to “play the game.”
Scarcity, in other words, a finite quantity, is one of the building blocks of bitcoin and is one of the core tenets presented by bitcoin advocates as to why it will become more valuable over time. Let’s ignore the fact that it was created out of thin air, just like the Monopoly money that was printed, but things have value because people assign a value to them, not because we believe an asset is or isn’t valuable. To this point, mass bitcoin adoption has led to significant increases in its value just as its advocates have professed.
Bitcoin: Understanding the Blockchain
Now that we’ve discussed the scarcity value proposition, let’s move to the transaction piece of the bitcoin puzzle. Imagine that each and every one of the Monopoly dollars that Parker Bros. printed has a unique code that is available via a public ledger. Because of this unique code, other owners know that each Monopoly dollar is authentic. Other owners don’t know the identity of the other owners, but they can tell – based on the code – when someone else has an official Monopoly dollar.
Each time a Monopoly dollar is traded digitally, a new mark is inscribed on the dollar so that the specific dollar’s history can be traced back through time. No small feat. This identification and authentication process – via a unique code that changes as the dollar changes hands over time – is called the blockchain.
Because the code for each Monopoly dollar is openly maintained via a public ledger (maintained through the blockchain), this acts as an accountability measure by ensuring that the dollar itself and its owner cannot be altered in any way by any central bank or any user. The fact that it is an open ledger means any and every person can see and verify the transactions. People who verify the transactions are called “miners.” This open-ledger process is what keeps bitcoin from being manipulated by any central authority. This feature is known as decentralization and is a core piece of the value of cryptocurrency.
Bitcoin: Finiteness and Human Psychology
As we discussed, because Parker Bros. cannot manufacture any additional dollars and because it appears that more people and institutions are desiring to “play the game,” each dollar now has value and that value is discussed in actual dollars (U.S. fiat currency). Because there is a finite quantity and demand is high, this “fake money” becomes more and more valuable in real dollars as more people want to play the game.
In a twist of human psychology, because the price of these fake dollars is publicly available – most of the time broadcast in your face every 20 seconds or so on CNBC – people who don’t even own a Monopoly game board want to own some of this Monopoly money for fear of missing out. This FOMO causes the prices to inflate further because people who actually own the game boards need the money, while people who don’t even own a game board keep “buying the money.” As this cycle perpetuates, prices shoot through the roof as we have seen over the past 10 years as broad adoption has occurred.
This marks the end of my Monopoly example. Let’s take a look at bitcoin’s primary use case, investment thesis, and the primary headwind for continued adoption.
Bitcoin: The Primary Use Case for the Currency Aspect of Bitcoin
While there are many use cases for the underlying blockchain technologies (NFTs are one we will discuss in Part 3 of this series), the primary use case for the currency aspect of bitcoin is generally for international payments or financial transactions for people who live in countries with oppressive governments. The decentralization aspect allows people to transact securely, at less cost, and with anonymity in ways that a centralized bank structure cannot and will not allow. So, will you buy your next Starbucks with bitcoin? Probably not. But if you needed to send money overseas or lived in an oppressive country, bitcoin holds promise in ways other currencies cannot.
Bitcoin: As an “Investment”
To the best of my knowledge, bitcoin has been the best returning asset class over the last ten years. That said, increases in the value of bitcoin is completely dependent on demand for the currency exceeding supply – this is the finiteness piece of the puzzle described above. It appears that bitcoin is going to continue to be adopted as its popularity grows. That said, buying bitcoin is still a bet on supply and demand. Unlike other investments that have income statements and balance sheets that allow you to analyze a potential investment from a cash flow perspective and estimate its fair market value, bitcoin is, by default, purely a speculation based on supply and demand – and by extension, human psychology.
Saying that investing in bitcoin is speculation is not the same as saying that it won’t continue to increase in value. It very well may and seems poised to do so. Instead, saying it is a speculation is simply a default position because it cannot be evaluated in any way similar to traditional cash flow-producing investments. Precious metal investing is the same way. These assets may very well continue to increase rapidly in value, but we can’t dismiss the fact that it is still a speculative investment.
We also can’t completely dismiss some of the headwinds that cause concern.
Bitcoin: The Primary Headwind
A few years ago, the primary headwind appeared to be pure skepticism around cryptocurrency in general. As adoption for bitcoin grows by the day, I think skepticism is just about in the rearview mirror. So, what may cause a shift in public sentiment toward this cryptocurrency?
Personally, I believe it’s the energy consumption required to process the transactions and maintain the public ledger. In a world where people are becoming more energy conscious, there are concerns about what is required to process bitcoin transactions. At current, according to BBC News, Bitcoin consumes ‘more electricity than Argentina’. As adoption grows, so does the energy required to process transactions. CNBC reported that one single bitcoin transaction has the same energy footprint as 453,000 payments on the Visa network. This is the cost of decentralization.
Will people end up shunning bitcoin due to its growing energy demand over time? We will see, but in a world where climate change is a growing concern, it seems like this is a legitimate issue.
Bitcoin: Final Thoughts
Personally, I believe the technology will continue to be adopted, but I have no idea what the future looks like. There are certainly some benefits that exist for its continued adoption, but personally, I cannot get past the inability to evaluate it as an investment. Call it what you like, but buying bitcoin (or any cryptocurrency or precious metal) is a speculative bet on whether future demand will exceed the current supply. Will that happen? It very well may, but I prefer to invest in income-producing businesses or invest in my own business ventures.
I hope this helps!
Thanks for reading,
Ashby “Paper Hands” Daniels
P.S. While stating the obvious, I reserve the right to change my mind at any time. 😉
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Full disclosure: I do not own any positions in any cryptocurrency and have no plans to initiate a position.
This post is not advice. Please disclaimers page. Additional disclaimers here: There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Bitcoin issuers are not registered with the SEC and the bitcoin marketplace is currently unregulated. Bitcoin and other cryptocurrencies are very speculative investments and involve a high degree of risk. Securities that have been classified as Bitcoin-related cannot be purchased or deposited in Raymond James client accounts.