Bitcoin: Digital Scarcity — VegaX Holdings Research Report
The previous installment of the Bitcoin Educational Series, Bitcoin’s Lightning Network, endeavored to illuminate a prominent attempt to scale Bitcoin’s base layer protocol into a daily-use payment layer.
This installment will re-focus on the base layer and delve into the central thesis for many bitcoin investors: the intentionally programmed scarcity of Bitcoin.
Scarcity is a fundamental problem in economics — it represents the gap between limited resources and theoretically limitless wants of those resources. As it relates to money, the last two years have been wildly illustrative of what happens when civilizations are supported by non-scarce monetary gods (fiat currencies). If left unchecked, central banks and similar organizations create new money out of thin air (printed on paper), thus devaluing the units currently in circulation and effectively taxing constituents without their consent.
In the face of the previous global financial crisis of 2008, Bitcoin was born. Intentionally designed to have a predetermined supply of coins, there will never be more than 21 million Bitcoins in existence.
This piece will explore the following topics:
- What is “money,” and how has it changed over time?
- How does Bitcoin compare as a monetary good, and what aspects of its design support the claim that it is the world’s hardest money?
- What are the implications of bitcoin’s programmatic design? Can Bitcoin, as a protocol, be fundamentally changed?
What is Money?
Though it would appear as an innocuous subject that many in modern times believe to be settled, understanding the concept of money, and its iterations throughout time are crucial to understanding the value propositions of Bitcoin.
Prolific investor and macroeconomic thinker Lyn Alden highlights four key actions that one can take as it relates to their resources (money): consume, save, invest or share.
Consuming carries a connotation of immediacy — when we consume, we use our resources to satisfy our most basic needs like food, water, and shelter. Saving, on the other hand, involves storing those resources in a vehicle that is safe, liquid, and portable (money). Savings can be thought of as a low-risk battery of future resource consumption across time and space.
Investing resources is a step beyond Saving in potential risk and reward. Investments are, in general, riskier, less liquid, and less portable than money — but carry a possibility of multiplying resources originally invested in a particular project. Giving excess resources to those in our community we deem to be worthy, in need, or both constitute “Sharing.” This can also be thought of as investing in one’s local community.
In addition to actions, money has historically been evaluated on a series of characteristics; the Austrian School of economics identifies the ideal money as being a combination of the following:
- Divisible — can be subdivided into various sizes to make different sized purchases
- Portable — easy to move across distances (high value contained in small weight)
- Durable — easy to save time; cannot rust, break, rot or break easily
- Fungible — individual units of the money don’t differ significantly from each other which facilitates fast transactions
- Verifiable — seller of good/service can check to see if the money is valid or not
- The scarce — money supply doesn’t change quickly as a rapid increase would devalue existing units in circulation
- Intrinsic Utility — desirable in some way; either it can be consumed directly or has aesthetic value.
Given the scope of this piece, we will focus on the last two characteristics listed above, scarcity and intrinsic utility. Lyn Alden states that money is the good that is most universal: all people want it. She also makes a clear distinction between currency and money. Whereas currency is a liability of an institution that is used as a medium of exchange and unit of account, money is a liquid, fungible asset that is not also a liability.
Furthermore, scarcity of money is not solely related to how rare an asset is, but how hard it is to produce new units. Lyn suggests conceptualizing this idea in the form of a stock-to-flow model, where a monetary asset like gold is rare and is also quite difficult to produce more of.
Scarcity as stock-to-flow ultimately boils down to: does the demand for an asset outweigh the circulating supply and the marginal cost to produce newer units?
Money Changes Over Time
Throughout the history of mankind, there have been countless iterations of money, from massive stones carved into coins on the island of Yap to gold and silver coins, all the way up to modern promissory notes backed by good faith in a government — money continues to re-invent itself.
All the while, the central elements of scarcity and intrinsic value ultimately determine the staying power of each monetary incarnation.
The Rai stones on the Isle of Yap have intrinsic value — they are aesthetically appealing and were understandably difficult to create. But when European settlers with advanced technologies (ships) found the Yapese stones, they were able to “counterfeit” the money relatively easily — as these stones were not necessarily scarce.
Commodity monies that have been present throughout history are primarily centered around precious metals like gold and silver. They are intrinsically valuable, in that they are aesthetically pleasing and can be used as inputs to create other goods. They hold their value well across time, and especially now that most surface deposits have been depleted, new units are difficult to produce.
Precious metals have stood the test of time, and were instrumental in the construction of the modern monetary system via the transition from gold coins, to gold-backed notes, to the fiat currency system.
In its current incarnation, money is a promissory note from a governmental institution — it is not scarce, and its value is solely derived from institutional backing.
Fiat currency, which is not backed by a commodity (gold standard) nor a trade agreement (Petrodollar) is able to be manipulated by the centralized institution that controls its supply. When central banks print massive amounts of new fiat currency, they are necessarily devaluing existing units in circulation, thereby reducing the purchasing power of all assets denominated in that currency. The current precariousness of the global financial system can be attributed to the gross mismanagement of fiat monetary policy.
Is there perhaps another form of money that is better suited for our modern, digital age?
A Peer-to-Peer Electronic Cash System
Bitcoin was designed and created against the backdrop of global financial collapse, skyrocketing unemployment, and malaise about prospects. However, before bitcoin, other digital cash implementations had been developed — but none had yet been able to solve the double-spend problem.
Double-spending is an issue unique to digital monies where, without a clear, chronological ledger of events, a digital asset could be “spent twice,” or more nefariously, a transaction could be retroactively modified to return an already-spent coin to the spender.
Satoshi Nakamoto, a pseudonymous developer (or group of developers) sought to solve this problem by implementing a combination of digital signatures — required to authorize the spending of funds — and a Proof-of-Work consensus model, to validate new transactions. At its core, the Bitcoin blockchain is a series of groups of transactions (blocks) that are cryptographically attached (hashed) to the previous block of transactions. In this process, this hash-based proof-of-work forms a timestamped record of transactions that cannot be altered without re-doing the entire blockchain.
To briefly revisit a topic covered in the first installment of this series, Proof-of-Work mining is a process by which specialized hardware devices compress (via hashing) the newest block of transactions in order to meet an agreed-upon threshold. Once reached, the new block is added to the blockchain, with a sort of signature (called a block header) that directly references the block that immediately preceded it.
After the requisite amount of CPU, the effort has been expended to make it satisfy the Proof-of-Work, the block cannot be changed without redoing the work. As more blocks are subsequently chained to that block, the work to change any block would require the re-doing of all subsequent blocks.
As Lyn Alden reflects “Since work is inherently scarce, we tend to recognize Proof-of-Work as being evidence of value, but only if the finished good in question has properties of money.”
Let’s see if Bitcoin meets the characteristics of “ideal” money as outlined earlier; Bitcoin is divisible down to 1/1,000,000th of a Bitcoin, this smallest unit is called a “satoshi” or “sat.” Bitcoin is uniquely portable: a set of private keys — which determine ownership of specific bitcoin addresses — can be stored in one’s head, written down on a slip of paper, or even etched into a steel plate. If stored properly, etched into a steel plate, or memorized, Bitcoin is durable enough to withstand time and the elements.
Any unit of Bitcoin is identical to an equivalently sized unit; Bitcoin is fungible. As a natively digital asset, built upon and supported by a decentralized network, Bitcoin is instantly verifiable via the Proof-of-Work hashing process that ties each transaction to its immediate predecessor.
21 Million Coins
In the modern era of fiat currency, among the most important characteristics of a monetary good is its scarcity. Bitcoin was originally designed so that the maximum supply of Bitcoins in the world would only ever be 21 million. This facet of Bitcoin is widely publicized, and according to seasoned investors/firms like Paul Tudor Jones, Marc Andreessen, Fidelity, and BlackRock — the fixed, predictable supply is a major catalyst for its growth over the years.
New Bitcoins are created as a reward to miners expending CPU processing power via the Proof-of-Work consensus model; this is the only source of new units. In addition, the protocol is designed to systematically reduce its inflationary velocity by halving the block reward paid to miners at every 210,000 block mark (roughly every four years). As a result of this system, similar to gold, the supply of new Bitcoins is not dependent on demand for the asset, but rather on the rate at which new blocks are mined.
Bitcoin is not unique in its being digital money, and frankly, other iterations of digital assets offer more functionality and throughput (amount of transactions per second). However, as Fidelity explained in their paper Bitcoin First:
“No other digital asset is likely to improve upon Bitcoin as a monetary good because Bitcoin is the most (relative to other digital assets) secure, decentralized, sound digital money and any “improvement” will necessarily face tradeoffs.”
For those other digital assets to be faster and more functional, significant sacrifices needed to be made in the areas of decentralization and security.
Over the years there have been attempts to change the fundamental system by which bitcoin operates. In conjunction, critics have expressed concern that once the block reward subsidy is all but exhausted — sometime in 2140 — that miners will no longer be incentivized to mine new blocks.
Superficially, it might seem as though miners would benefit from an increase in total supply, as they are the party that receives the reward. However, a scenario where more than 21 million bitcoins are created is unlikely to occur for two distinct reasons.
First, an increase in total supply would completely erode confidence in the central investment thesis of Bitcoin: it would thenceforth not be a digitally scarce asset. This could send the price of Bitcoin into a free fall, thereby negating any financial gains made by miners.
Second, Bitcoin is a decentralized network of individual node operators each running their instance of the Bitcoin software. Note that there is not one version, but dozens if not hundreds of different versions. In order for the total supply to be increased past 21 million, the vast majority of node operators would have to be convinced to run that particular version of Bitcoin (> 21 million supply version). This update would necessarily be discussed and debated amongst a contentious group who have thus far been unwilling to fundamentally alter the protocol. Even if such a version of the software was available, the implementation would be optional — as every upgrade to the software is.
Sufficed to say, it is extremely unlikely that there will ever be any more than 21 million Bitcoins in existence.
Conclusions
It is rumored that since 2008, around 30% of the circulating supply of Bitcoins has been lost due to hard drive crashes, misplaced private keys, and other similar misfortunes. This means that the scarcest monetary good on the planet is even more scarce than it was originally designed to be.
The Bitcoin protocol was designed to maximize robustness, and censorship resistance through decentralization. Further, the security of the network benefits from the global distribution of miners working to lengthen the chain roughly every 10 minutes. Bitcoin draws its intrinsic value from this security and immutability.
When compared to other digital assets, Lyn notes that Bitcoin “[is] not the most efficient way to exchange value, but it’s the most unstoppable way to do so online.” Immutability matters, especially in a fiat monetary system where citizens’ purchasing power is stolen from them year-over-year by unelected bureaucrats turning on money printers whenever they so choose.
Hard money eats soft money, at the end of the day. Money that is backed by confidence in an institution is bound to fail when that institution falters — or when the public realizes the danger of a centrally controlled money supply.
Something that Bitcoiners and gold-bugs can both agree on is: that at some point, intrinsic value and legitimate scarcity matter more than what central bankers say.
At VegaX, we pride ourselves on creating investment products that offer our clients a way to opt out of soft money and opt into the hardest money humans have thus far created. Our Enhanced Bitcoin Exposure product not only provides exposure to Bitcoin — but also generates passive income, regardless of market conditions.
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