Bitcoin is a decentralized, open source, peer-to-peer software protocol invented by an anonymous person or group named Satoshi Nakamoto that can store and transmit value. Bitcoin is a distributed public ledger, and owners of Bitcoin can access and transmit their Bitcoin from one digital address to another digital address, as long as they have their private key, which unlocks their encrypted address. Bitcoin’s protocol limits it to 21 million coins in total, which gives it scarcity, and therefore potentially gives it value… and given the demand that has emerged, makes for a compelling reason to buy bitcoin.
There is no central authority that can unilaterally change that limit; Satoshi Nakamoto himself couldn’t add more coins to the Bitcoin protocol if he wanted to at this point. These coins are divisible into 100 million units each, named satoshis, or sats after the creator of the protocol.
Because it is decentralized there is no singular authority that controls it. It uses encryption based on blockchain technology, calculated by thousands of nodes on the network, to verify transactions and maintain the protocol. Incentives are given by the protocol to those that contribute computing power to verify transactions in the form of bitcoins. In other words, by verifying and securing the blockchain, you earn some bitcoin. At the moment this is 6.25 bitcoin per block. Note that the protocol is names Bitcoin with an uppercase ‘B’ and ‘monetary’ unit is bitcoin with a lowercase ‘b’.
A private key can be stored as a seed phrase that can be remembered, and later reconstructed. You could commit your seed phrase to memory, destroy all devices that ever had your private key, go across an international border with nothing on your person, and then reconstruct your ability to access your Bitcoin with the memorized seed phrase later that week.
A Digital Scarce Commodity
Satoshi envisioned Bitcoin as basically a rare commodity that has one unique property that he outlined in 2009:
As a thought experiment, imagine there was a base metal as scarce as gold but with the following properties:
– boring grey in colour
– not a good conductor of electricity
– not particularly strong, but not ductile or easily malleable either
– not useful for any practical or ornamental purpose and one special, magical property:
– can be transported over a communications channel.
If it somehow acquired any value at all for whatever reason, then anyone wanting to transfer wealth over a long distance could buy some, transmit it, and have the recipient sell it.
Satoshi Nakamoto, August 2010
So, Bitcoin can be thought of as a rare digital commodity that has unique attributes. Although it has no industrial use, it is scarce, durable, portable, divisible, verifiable, storable, fungible, salable, and recognized more or less everywhere across the world, and therefore has the properties of money. Like all “potential” money, though, it needs sustained demand to have value.
At the time of writing, Bitcoin’s market capitalization is about $180 billion, or roughly the value of a large company. The total market capitalization of the entire cryptocurrency asset class is about $270 billion, including Bitcoin as the dominant share.
Bitcoin Market Capitalization
One of the concerns with Bitcoin back in 2017 was that anyone can now create a brand new cryptocurrency. Since Satoshi figured out the mathematical and software methods to create digital scarcity (based in part on previous work by others) and made that knowledge public, and thus solved the hard problems associated with it, any programmer and marketing team can now put together a new cryptocurrency.
There are thousands of them, now that the floodgate of knowledge has been opened. Some of them are optimized for speed. Some of them are optimized for efficiency. Some of them can be used for programmed contracts, and so forth.
So, instead of just one scarce “asset” that has the unique property of being able to be transported over a network, there are thousands of similar assets.
This risks the scarcity aspect of the asset, and thus risks its value by potentially diluting it and dividing the community among multiple protocols. Each cryptocurrency is scarce, but there is no scarcity to the number of cryptocurrencies that can exist.
This is unlike gold and silver. There is scarcity regarding how many elemental precious metals exist and they are all unique. Silver, gold, platinum, palladium, rhodium, a few other rare and valuable elements and Nature is not making more.
There is a ratio called “Bitcoin dominance” that measures what percentage of the total cryptocurrency market capitalization that Bitcoin has. When Bitcoin was created, it was the only cryptocurrency and thus had 100% market share. Following the rise of Bitcoin, now there are thousands of different cryptocurrencies. First there was a trickle of them, and then it became a flood.
By the end of 2017, during that peak enthusiasm period for cryptocurrencies, Bitcoin’s market share briefly fell below 40%, even though it still remained the largest individual protocol. It has since risen back above 60% market share. Out of thousands of cryptocurrencies, Bitcoin has nearly two thirds of all cryptocurrency market share.
So, what gives individual cryptocurrencies potential value, is their network effect, which in Bitcoin’s case is mainly derived from its first-mover advantage, which led to a security advantage.
Imagine that a cryptocurrency is like a social network like Facebook. Except instead of being about self-expression, it’s about storing and transmitting value. It’s not hard to set up a new social network website; the code to do it is well understood at this point. However, creating the next Facebook (FB) or other billion-user network is a nearly impossible challenge, because a functioning social network website without users, or trust, or uniqueness, is worthless. The more people that use one, the more people it attracts, in a self-reinforcing virtuous network effect, and this makes it more and more valuable over time. This is the Network Effect and it makes for a compelling reason to buy bitcoin.
Similarly, ever since Satoshi solved the hard parts of digital scarcity and published the method for the world to see, it’s easy to make a new cryptocurrency. The nearly impossible part is to make one that is trusted, secure, and with the sustained demand that Bitcoin has.
When many investors analyze the cryptocurrency market, they are concerned with market share dilution. Back in 2017 Bitcoin’s market share was near its low point, and still falling. What if thousands of cryptocurrencies are created and used, and therefore none of them individually retain much value?
Each one is scarce, but the total number of all of them is potentially infinite. If the total cryptocurrency market capitalization grows to $1 trillion, but is equally-divided among the top twenty protocols for example, then that would be just $50 billion in capitalization for each protocol.
In addition, there were some notable Bitcoin forks at the time, where Bitcoin Cash and subsequently Bitcoin Satoshi Vision were forked protocols of Bitcoin, that in theory could have split the community and market share. Ultimately, they have not caught on since then for a variety of reasons, including the centralization of their ‘creators’ and the lack of user support and miner support resulting in vastly weaker security levels relative to Bitcoin.
Gold vs Bitcoin
Gold also relies heavily on the network effect as well for its perception as a store of value, whereas industrial metals like copper don’t, since they are used almost exclusively for industrial purposes.
Unlike Bitcoin, gold does have non-monetary industrial use, but only about 10% of its demand is industrial. The other 90% is based on bullion and jewellery demand, for which buyers view gold as a store of wealth, or a display of beauty and wealth. If gold’s demand for jewellery, coinage, and bars were to ever decrease substantially, leaving its industrial usage as its primary demand, this would likely result in a much lower price.
In the West, interest in gold bullion has gradually declined somewhat over decades, while demand from the East for storing wealth has been strong. I suspect the 2020’s decade, due to monetary and fiscal policy, could renew western interest in gold, but we’ll see.
So, the argument that Bitcoin isn’t like gold because it can’t be used for anything other than money, doesn’t really hold up. Or more specifically, it’s about 10% true, referring to gold’s 10% industrial demand. With 90% of gold’s demand coming from jewellery and bullion usage, which are based on perception and sentiment and fashion (all for good reason, based on gold’s unique properties), gold would have similar problems to Bitcoin if there was ever a widespread loss of interest in it as a store of value and display of wealth.
Of course, gold’s advantage is that it has thousands of years of international history as money, in addition to its properties that make it suitable for money, so the risk of it losing that perception is low, making it historically an extremely reliable store of value with less upside and less downside risk, but not inherently all that different.
The difference is mainly that Bitcoin is newer and with a smaller market capitalization, with more explosive upside and downside potential. And as the next section explains, a cryptocurrency’s security is tied to its network effect, unlike precious metals.
Cryptocurrency Security is Tied to its Network Effect
A cryptocurrency’s security is tied to its network effect, and specifically tied to the market capitalization that the cryptocurrency has. If the network is weak, a group with enough computing power could potentially override all other participants on the network, and take control of the blockchain ledger. Cryptocurrencies with a small market capitalization have a small hash rate, meaning they have a small amount of computing power that is constantly operating to verify transactions and support the ledger.
However, Bitcoin has so many devices verifying the network that they collectively consume more electricity per year than a small country, like Greece or Ireland. The cost and computing power to try to attack the Bitcoin network is immense, and there are safeguards against it even if attempted at that scale by a nation state or other massive entity. This level of security makes for another compelling reason to buy bitcoin.
The Bitcoin protocol has never been hacked or had any bitcoin stolen from it. Instances of Bitcoin hacks and theft involve perpetrators breaking into systems like exchanges to steal the private keys that are held there. If a hacker gets someone’s private keys, they can access that person’s Bitcoin holdings. This risk can be avoided by using robust security practices, such as keeping private keys in cold storage.
The rise of quantum computers could eventually pose an actual security threat to Bitcoin’s encryption, where private keys could be determined from public keys, but there are already known methods that the Bitcoin protocol can adopt when necessary in order to become more quantum resilient, since the blockchain can be updated when there is broad consensus among participants.
Bitcoin’s programmed difficulty for verifying transactions is automatically updated every two weeks, and it seeks the optimal point of profitability and security. In other words, the difficulty of the puzzle to add new blocks to the blockchain is automatically tuned up or down depending on how efficiently miners as a whole are solving those puzzles.
If Bitcoin becomes too unprofitable to mine (meaning the price falls below the cost of hardware and electricity to verify transactions and mine it), then fewer companies will mine it, and the rate of new block creation will lag its intended speed as computational power gradually falls off the network. An automatic difficulty adjustment will occur, making it require less computational power to verify transactions and mine new coins, which reduces security but is necessary to make sure that miners don’t get priced out of maintaining the network.
On the other hand, if Bitcoin becomes extremely profitable to mine (meaning the price is above the cost of hardware and electricity to mine it), then more people will mine it, and the rate of new block creation will surpass its intended speed as more and more computational power is added to the network. An automatic difficulty adjustment will occur, making it require more computational power to verify transactions and mine new coins, which increases security of the network.
More often than not, the latter occurs, so Bitcoin’s difficulty has gone up exponentially over time, which makes its network more and more secure making for another compelling reason to buy bitcoin.
Even if a demonstrably superior cryptocurrency to Bitcoin came around (and some users argue that some of the existing protocols are already superior in many ways, based on speed or efficiency or extra features), that superior cryptocurrency would still find it nearly impossible to catch up with Bitcoin’s security lead in terms of hash rate.
Because they have a weaker security due to a weaker network effect, they have an in-built inferiority to Bitcoin on that particular metric, and for a store of value, security is the most important metric. The fact that Bitcoin came first, is something that can’t be replicated unless the community around it somehow stumbles very badly and allows other cryptocurrencies to catch up.
An investment or speculation in a cryptocurrency, especially Bitcoin, is an investment or speculation in that cryptocurrency’s network effect. Its network effect is its ability to retain and grow its user-base and market capitalization, and by extension its ability to secure its transactions against potential attacks.
Bitcoin Is Increasing Market Share and Security
Since my 2017 analysis when I was somewhat concerned with market share dilution, Bitcoin has stabilized and strengthened its market share.
The semi-popular forks did not harm it, and thousands of other coins did not continue to dilute it. It has by far the best security and leading adoption of all cryptocurrencies, cementing its role as the digital gold of the cryptocurrency market.
Compared to its 2017 low point of under 40% cryptocurrency market share, Bitcoin is back to over 60% market share in 2020.
There is a whole ecosystem built around Bitcoin, including specialist banks that borrow and lend it with interest. Many platforms allow users to trade or speculate in multiple cryptocurrencies, like Coinbase and Kraken, but there is an increasing number of platforms like Cash App and Swan Bitcoin that enable users to buy Bitcoin, but not other cryptocurrencies.
The ongoing stability of Bitcoin’s network effect is one of the reasons I became more optimistic about Bitcoin’s prospects going forward. Rather than quickly fall to upstart competitors like Myspace did to Facebook, Bitcoin has retained substantial market share, and especially hash rate, against thousands of cryptocurrency competitors for a decade now.
Currencies tend to have a winner-take-all persona and they live or die by their demand and network effects. Cryptocurrencies so far appear to be following the same path, with a handful of big winners taking most of the market share and most of the security, and this is especially true of Bitcoin. Some of them, of course, may have useful applications, but as a store of value Bitcoin sits as the undisputed king.
During strong Bitcoin bull markets, these other cryptocurrencies might increase their market cap, and briefly push Bitcoin down in market share, but Bitcoin has shown considerable resilience through multiple cycles now.
Through a combination of first-mover advantage and smart design, Bitcoin’s network effect of security and user adoption makes it very, very hard for any other cryptocurrency to catch up with it at this point which is perhaps the most compelling reason to buy bitcoin.