Written in January 31, 2022 (Thumbnail image taken from Reuters)
Bitcoin Thesis
Bitcoin as an asset or as a digital currency? Satoshi Nakamoto, a presumed pseudonym, the creator of Bitcoin published the whitepaper on October 31, 2008, created the genesis block January 3, 2009, and released the source code on January 8, 2009. Begins the journey that led to a $780 billion market cap today.
Dubbed as the first digital asset, a new asset class, or equivalent to digital gold. Bitcoin is undoubtedly the first scarce digital object the world has ever seen, similar to silver and gold, and it can be transferred through the use of the internet.
The Bitcoin system presents an alternative to the traditional monetary system. Consisting of a collection of computers (node) running Bitcoin’s code, with the goal of maintaining the network and validating transactions. Currently, there are more than 13,000 nodes running the Bitcoin algorithm. Decentralized by nature, each transaction is recorded in the blockchain located in the internet; anyone running the code could verify and view each transaction in real-time ever since genesis – distributed ledger. Balances of Bitcoin tokens are kept using a public and private key pair, imitating that of traditional debit cards. These keys are generated through a SHA-256 mathematical algorithm, of which the private keys should be kept secret. Although Bitcoin is not backed by any government or institutions, its decentralized nature offers security and anonymity.
Being in the top 10 assets by market cap, surpassing several commodities and tech companies, many speculators thought that Bitcoin was too big to grow. This was refuted with the fact that Bitcoin has a Layer 2 (L2) network called Lightning Network. The L2 was created on top of the Bitcoin network solely as a payment protocol for the purpose of lightning speed transactions with lower fees; proposed as a solution to Bitcoin’s scalability issue.
Bitcoin as a digital currency tackles two underlying challenges associated with digital money – controlling its creation and preventing duplication, at once. Each created Bitcoin is in the form of rewards from Bitcoin mining (computer nodes running Bitcoin’s source code) and each Bitcoin down to the sats (unit of measurement equivalent to penny) has a public and private key that is unique.
From a supply/token economics perspective, Bitcoin is both inflationary and deflationary. The total amount of BTC tokens is 21 million fixed. Inflationary since each Bitcoin needs to be mined and not created, per se. Deflationary since within a certain time frame there will be halvings – an event where Bitcoin rewards to miners are halved from the period before. The following data are taken from http://bitcoinhalvingdates.com/. Initially, Bitcoin rewards 50 BTC per block, currently the rewards are 6.25 BTC from the latest halving in 2020. Nakamoto’s design presents an inflationary rate to the system – 1.5% inflation per year, lower than USD’s 6.81% per annum.
Bitcoin’s Halving (source: http://bitcoinhalvingdates.com/)
Bitcoin is designed to satisfy four of the economic assurances: as a value of exchange that could be transact globally and freely, wealth should be protected and self-owned wholly, rules should be enforced reliably and predictably, and system’s integrity should be verifiable.
Bitcoin allows anyone to enter and exit its network freely. It does not rely on a centralized authority figure to control the flow of transactions. The network promotes privacy by acknowledging users not by personal names or IP addresses but by cryptographic digital keys and addresses (public-private key pair). The public key is to receive BTC whereas the private key is to transfer. When sent over the internet and secured by a miner, transactions are irreversible with settlement guaranteed. Currently, Bitcoin appears to be more efficient at settling high value than small value transactions. Ever since genesis, Bitcoin has settled more than $2.5T in transactions with the average size being $2,000.
Source: https://ark-invest.com/
While legal structures and traditional local authorities enforce the ownership of conventional assets, cryptography enforces Bitcoin’s ownership. The possession of a private key equates to self-ownership and control is the main function of it. Bitcoin introduces a property system unlike other digital assets before its time that can operate well outside traditional systems. The network’s personal sovereignty is useful in jurisdictions with weak property rights as indicated by its higher usage in countries with unstable property right enforcement. Below is the view of ArkInvest for Bitcoin on the asset protection spectrum, recognizing Bitcoin as an asset that could only be moved with the private key owner’s intention.
Source: https://ark-invest.com/
Bitcoin’s software formulates its network rule. Humans are after all not the adjudicator of truth and cannot decide abruptly to change its rule. Instead, nodes that verify transactions are the enforcer. Each node follows the same set of rules and is allowed to participate if it follows those rules. If a node attempts to break the rules, all other nodes would reject its information. However, these nodes are only a part of the equation maintaining Bitcoin’s network integrity. Bitcoin holders have the right to engage in the Bitcoin Improvement Proposal (BIP) – a set of proposals designed to make Bitcoin relevant towards the ongoing economic situation.
Source: https://ark-invest.com/
The network not only protects participants from abrupt rule changes but also reinforces the assurances. Unlike in conventional financial institutions, individual or retail investors alike can verify every claim Bitcoin states. Each Bitcoin node provides native verification tools that can ensure enforcement of each rule. Furthermore, nodes contain Bitcoin’s history and could track the balances of all accounts. In simple terms, each node is equal to another in its capability to verify and audit. There is close to no barrier of entry associated with running a node.
Bitcoin is often associated as a Gold standard digitally, a commodity in a sense. However, untethered from traditional asset’s rules, Bitcoin is much volatile. Its volatility actually highlights the uniqueness, relying instead of exchange rate stability but on a quantity rule that limits the growth of token supply but allows free flow of capital. As idealistic as it may seem and generally uncorrelated to the behavior of other asset classes, Bitcoin could serve as a strategic allocation in well-diversified portfolios, despite its volatility nature.
Note: ± 1 is the highest correlation (Source: https://ark-invest.com/)
Continuing from free-flow capital, PlanB attempts to quantify scarcity through the stock-to-flow (SF) method; comparing the asset’s current stock to its production rate. In terms of SF ratios, Bitcoin is similar to Gold and are different from consumable commodities (i.e. Copper, Zinc, Nickel, Brass), since they have a high SF. The author uses a statistical method of scatter plot and logistic regression to plot the data.
Bitcoin Stock-to-Flow (source)
Do note that gold and silver are in line with Bitcoin model values for SF, which gives extra confidence in the model. Integrating halvings with the model would increase the slope of the regression line, meaning that the SF doubles and the market value would increase by 10x, this is a constant factor.
On the other hand, a paper published in 2017 by Timothy Peterson, CFA, covers the Bitcoin valuation through Metcalfe’s Law. Based on the underlying assumption describing connectivity amongst the number of users (n). With the formula that predicts as more people join a network, they would add value to the network nonlinearly – value of network is proportional to the square of number of users.
As a proven track record, Metcalfe’s law successfully fitted Facebook’s annual revenues over the period of 2004-2013 and concluded that “Facebook creates much more value than is captured and monetized by Facebook selling ads.” The model requires only three datasets: wallets, number of Bitcoins created, and Bitcoin price.
Bitcoin vs Metcalfe’s Value (source)
Bitcoin’s price in the medium to long-term appears to follow Metcalfe’s law, with R2 above 80%. The high degree of fit in both cases is attributed due to the fact that a principle assumption of network laws: uniformity of the transactions is met.
Looking forward, Bitcoin is not trying to mimic the traditional monetary system, however it is trying to migrate people from the usual paper-money to digital money. Transferring money through the internet is a crucial step that may bring the next form of payment, or better yet the next Industrial Revolution. Recently, El Salvador has taken the step of acknowledgement by allowing Bitcoin to be its legal tender.