Tag Archives: We Trust Bitcoin

(NakamotoInstitute) No matter how many times Bitcoin grows by orders of magnitude,
holdouts still remain who argue that it is a bubble destined to fail. To
address this claim, I will describe a theory that describes how to
appraise Bitcoin according to the Austrian theory of money.

In Austrian economics, money is valuable because it is liquid. This
means that a given value of money is demanded everywhere and can easily
be traded for goods. For example, say I had enough bitcoins to buy a
100-oz gold bar. In late 2010, this would have been worth around one to
two million bitcoins and would have been impossible to sell on the open
market without drastically affecting the price. By contrast, in early
2014, 100 ounces of gold was worth about 100 bitcoins, and this amount
could easily have been traded quickly on one of the major exchanges
without affecting the price noticeably. Thus, in early 2014 Bitcoin was
more liquid than in late 2010, and was therefore a better currency.

Unfortunately, this insight about the value of money does not give us
a means of appraising it because the liquidity cannot be separated from
the price. This is kind of a problem—it sounds like a circular argument
because it says that Bitcoin’s value is caused by its price! This
allows for no way to detect whether Bitcoin is overvalued or
undervalued.

In order to prevent this model from being causally circular, a time
element is required. Our observations about money come from the past,
whereas our judgments about its value are about the immediate future.
This makes the value of money into a positive feedback loop. If the
network is growing, then it will tend to continue to grow, whereas if it
is shrinking, it will tend to continue to shrink.

This model of money has no independent quantity that estimates
anything like an underlying value. Any price is as good as any other—the
only thing that matters is the direction it is moving. This is not
really an appraisal after all—but it is still the right way to
understand Bitcoin’s price.

In the short term, there is money to be made by buying anything whose
price is showing an upward trend if one spots the trend early enough.
In other words, if one can predict that other people are likely to
appraise a good more highly in the future, regardless of whether that
appraisal is rational or irrational, then it makes sense to buy into the
change of sentiment. If lots of people begin to think this way, then
they can create a positive feedback among one another and bid up the
good beyond any rational appraisal of it. This is a bubble.

A bubble bursts because eventually people have to get around to using
a good for its ultimate purpose. Once it is understood that the people
who actually use the good are being bid out of the market, then the
price crashes because people stop predicting higher and higher
appraisals to the price.

Money, however, need not have any ultimate use. It may only ever
passed around from person to person, without ever being consumed. A
stock is valued by the sum of its interest-adjusted dividends. A bond is
valued by its redemption value adjusted by the interest rate and the
risk of default. A commodity is valued by the value of the goods it can
be used to produce. However, for money, there is no independent quantity
to provide a reality check. All money is like a bubble that never
bursts.

Some of the theory of money can be understood in terms of Metcalfe’s law
from computer networking. Metcalfe’s law says that the value of a
network is proportional to the square of the number of nodes. The
rationale is that the network should be valued according to the number
of connections it supports, which is approximately proportional to n2 (for large n).
Consequently, as the network grows, it presents a better and better
opportunity for new members. As new members enter, the network improves
for all its present members.

Metcalfe’s law must be adjusted slightly to apply to media of
exchange because some nodes in the trade network will be more valuable
than others. Those who have a lot of the medium are potentially able to
spend more than those who have little. Therefore, use the market cap of
the medium of exchange as n instead of the number of people.
Similarly, some transactions are also worth more than others, so it
makes sense to use the transaction volume rather than the number of
transactions.

A striking test of Metcalfe’s law in Bitcoin recently appeared on the Bitcointalk forums, created by Peter R. I have made my own chart here.

This chart plots the market cap in blue and the square of the
transaction volume excluding popular addresses in green. The axis on the
is the price in dollars. Exactly as Metcalfe’s law predicts, the
transaction volume increases very neatly as the square root of the size
of the network. The correspondence is beautiful. I wish I had thought to
make it first!

I would like, however, to criticize the interpretation of the
diagram. On the original Bitcoin Talk, thread, the green plot has been
labeled as the “Metcalfe Value”, as if it is an appraisal of the Bitcoin
that estimates what it could cost.

This interpretation is incompatible with the theory of the value of
money I presented above. In my theory, the value causes the
transactions, whereas in the diagram, the transactions cause the value.
However, it is only potential transactions that cause the value. Past
transactions are of no value to anybody. The present size of the
network and the consequent opportunities is likely to provide tomorrow
will motivate people to buy and sell today.

This may seem like hair-splitting, but a confusion of cause and
effect can have serious consequences. For example, many people believe
that it is necessary to spend bitcoins and increase the transaction
volume in order to make Bitcoin more valuable. Of course this is
nonsense; all this does is fill up the network with transactions for
things that nobody actually wanted. That does not present a good value
for a newcomer because he will want a network that presents him with real
opportunities, not just ways of artificially increasing transaction
volume. The more that the Bitcoin network is focused on artificially
increasing the transaction volume to make it look good, the more it
resembles a Ponzi scheme. Rather, to make the network more valuable, we should be hoarders. This is more likely to present newcomers with lots of potential uses for Bitcoin as a medium of exchange.

A real good, of course, can have value due to a network effect and some productive use. Gold, for example, can be money and used as components in electronics. If there were ever a time when gold were used only
for electronics, but were then to acquire use as money once a network
effect formed around their price, an investor might be excused to call
the price an unsustainable bubble. However, it would turn out to be a sustainable bubble that inflates until it fills the entire economy. At least until Bitcoin came along.

This brings us to Bitcoin. To what extent is Bitcoin’s price a
rational appraisal or an investment bubble? The answer is easy, much
easier than with a commodity like gold. Bitcoins have almost no use
other than as a medium of exchange. Thus, the fact Bitcoin has any
price at all is evidence that there is a real network effect. It is
much easier to prove that Bitcoin acts like money than that gold does,
in fact.

Each step in Bitcoin’s growth follows the same pattern. Any demand
for Bitcoin at all is enough to make it function as a medium of
exchange. If demand continues to grow, then it becomes a better medium
of exchange. There is no end to this process because the primary value
of Bitcoin is the network effect surrounding it, not any final
productive use.

Thus, Bitcoin is not a bubble. Its growth is like a self-fulfilling
prophesy: as more people believe in it as a medium of exchange and
become willing to buy it, they create the very conditions required of it
to make it more useful. There is nothing irrational, therefore, in
treating Bitcoin’s price as the cause of its value and no reason to
expect the momentum in its exponential upward trend to cease.1

Every time you buy Bitcoin, a fairy gets its wings. Now clap your
hands, click your heels together three times, and believe in Bitcoin! It
will only take faith the size of a mustard seed.

(HarvardBusinessReview) Digital currencies like Bitcoin have captured the attention of
the media, entrepreneurs, and regulators. The coverage has described
exchange meltdowns, price volatility, and government crackdowns.
However, the focus on Bitcoin as a currency may distract businesses and
governments from its disruptive impact: as a technology.
Bitcoin is more than just a new way to make purchases. It is a
protocol for exchanging value over the internet without an intermediary.
Bitcoin is based on a public ledger system, known as the blockchain,
which uses cryptography to validate transactions. Bitcoin users gain
access to their balance through a password known as a private key. As a
result, Bitcoin is peer-to-peer and open, yet secure and nearly
frictionless. Much has been written about the payment applications of
Bitcoin, including remittances, micropayments, and donations.
However, Bitcoin could disrupt other systems that rely on
intermediaries with a similarly open, peer-to-peer system, including
property, contracts, and identity management.
Anywhere a transaction between two parties has traditionally required
third party validation, Bitcoin may be applicable. Consider these three
common actions:

Transfer of property. The Bitcoin protocol could
simplify complex asset transfers, revolutionizing the services that
support this industry. Currently, the transfer of large assets requires
significant time and resources. For example, in order to purchase a car
from an individual seller, one has to engage a third party to transfer
the title. Additionally, one has to use services like Carfax to learn
about the car’s accident and inspection history. And who doesn’t like to
spend a Saturday at the DMV updating a car registration?
The blockchain could change all of this. Bitcoins can be qualified in
such a way that they represent real-world assets. Bitcoin entrepreneurs
at companies like Colored Coin
are already working on ways to use small portions of Bitcoin to denote
physical property. A fraction of a Bitcoin would publicly identify who
currently owns that property, and could include a record of both past
ownership and other history about the property. When purchasing the car,
one would be able to verify all accidents and inspections over the
blockchain and transfer the title on site. Similarly, real estate and
financial instrument transactions could all be executed over Bitcoin.
This could soon create efficiencies and reduce friction by allowing
individuals to directly transfer property without the use of a broker,
lawyer, or notary to sign-off on the transfer.

Execution of contracts. Bitcoin could similarly be
used to structure contracts, bringing new efficiency and transparency.
Contracts are typically developed by lawyers on a case-by-case basis
with significant time and resources devoted to negotiation, development,
and enforcement. Additionally, markets based on contracts, including
certain financial derivatives markets, lack transparency, which
complicates regulation.
Traditional contracts could be replaced by code, executing themselves
when a triggering event occurs. In a simple example, a financial
instrument, like an option, could be developed and executed over the
blockchain. In addition to reducing legal fees, this could bring new
transparency to financial markets, as regulators could use the public
ledger to understand the market without forcing individual actors to
reveal their specific positions. It is possible that new
crypto-currencies will emerge to serve these niche purposes.
New ventures, like Ethereum, are creating these capabilities today. Ethereum is developing a network to serve as both the registry and escrow to execute the conditions of a contract automatically through checkable rules.

Identity management. Bitcoin’s cryptography could also transform identity management. Much of identity management, including passports, still operates on a paper-based system.
These documents are frequently forged and stolen. Interpol’s database
currently lists 39 million stolen travel documents. Instead of carrying
paper documents, what if there was a way to create a unique, verifiable
key that was impossible to forge?
A cryptographic network similar to but separate from Bitcoin could be
used to verify individuals’ identities and monitor movement across
borders. When a person travels through a checkpoint at a border
crossing, instead of showing and scanning a paper passport, she could
present her private Bitcoin key. A network privately maintained by the
government could verify the key and register the entry into the ledger.
This system, based on cryptography instead of paper documents, would
simultaneously increase mobility and security. If Bitcoin can be used
for travel documents, it could also be used for other forms of identity
management like social security numbers, tax identification numbers, or
even driver’s licenses.
Property, contracts, and identity management are only a few examples
of how a peer-to-peer, open, and frictionless system could change how we
conduct business in the future. In order to achieve this wider
adoption, Bitcoin will need to address significant questions around
trust, ease of use, and operability. However, the Bitcoin community has
shown remarkable adaptability and is already working to mitigate these
problems. In the next decade, we can expect significant innovation
around the Bitcoin network. Much of that will revolve around payments,
particularly early on. The real value, though, lies beyond.