Functionality and Monetary Properties of Bitcoin
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What makes Bitcoin so special that makes everyone talk about it? What are the unique properties that Bitcoin poses?
Bitcoin was designed as a decentralised peer-to-peer payment system. In other words, the whole purpose of Bitcoin is to serve as a medium of exchange, somewhat similar to conventional monies, but as one could argue, as an alternative to these.
Problems of acceptance
The road to Bitcoin's broader acceptance as conventional currency, however, is not without obstacles.
Before we proceed any further, I need to remind myself and tell you about three main functions of fiat money that make any modern currency useful. Money needs to be accepted as a medium of exchange; it must serve as a store of value and be a unit of account.
Although it has become widely accepted as mediums of exchange, Bitcoin (and any other cryptocurrency to be fair) does not yet meet the other two main characteristics of “money”. Besides, there are even some barriers to becoming a competitive medium of exchange.
One difficulty of a wide adoption of Bitcoin for daily use is the complicated process of obtaining new coins. Unless you are a miner, you need to go to an exchange to get Bitcoin and then find a way to store them securely using digital wallets (not a smooth process in itself, but stay tuned for the discussion about crypto wallets). Once you've spent all the coins in your wallet, you need to repeat this process. And imagine how annoying it will be when you are just about to pay for your coffee, but your wallet balance is zero. A bitcoin credit card is not an option, at least yet. In other words, a buyer must have Bitcoin on hand for a merchant to accept the payment.
Even if the Bitcoin community manages to remove frictions and the adoption of Bitcoin payments systems continues, barriers of being a store of value and unit of account still remain.
The main current hurdle preventing Bitcoin from meeting these two functions is its extreme volatility. Bitcoin is 15 times more volatile than equity.
Unit of account means one US dollar or GB pound will deliver the same economic value both today and in the future.
Large weekly or even daily price swings mean that prices of goods and services in terms of Bitcoin will be constantly moving up and down, making life difficult for everyone.
On the other hand, US dollars or GB pounds in your bank account will not lose 50% of their purchasing power in one day, but at the same time this can’t be said about some other currencies. Compared to the USD, Bitcoin is not as good of a value store. But it should be compared to some other extreme examples such as that of Venezuela, Zimbabwe or Turkey.
Back to the volatility, however. The high volatility of Bitcoin also makes holding it even for a short period very costly, thereby infringing the idea of a store of value.
Besides, there is no uniform market price of a Bitcoin, which means that Bitcoin can be traded at different prices on two exchanges at the same point in time. If we compare it to GB pounds, one GBP in London is one GBP in Tokyo.
As a result, multiple studies and papers written over several years concluded that Bitcoin resembles a speculative asset rather than a digital medium of exchange. I will leave them here, here and here.
Where do we stand then?
So far, it does not sound very promising for Bitcoin. Imagine my discontent when I was doing the research for this post.
But I came to realise that we need to look beyond a simple "medium of exchange" concept and compare the Bitcoin system to the conventional monetary system.
In contrast to fiat monies, Bitcoin possesses a unique set of monetary properties that can't be replicated by politically dependent money and even physical commodity money, like gold.
Firstly Bitcoin is a decentralised payment system, which means that no one has full authority over it. Hence, it is resistant to any form of censorship.
Imposing economic and political sanctions on some countries is not an uncommon practice in the 21 century, even when this has nothing to do with the citizens.
Bitcoin allows people, regardless of their geo-location, religion or status, to use a monetary system and send value around the world without asking for anyone's permission. All they need is an internet connection.
Bitcoin democratises access to a true store of value and medium of exchange and allows absolute freedom of trade.
Secondly, the supply of Bitcoin is limited, identical to gold. Only 21 million coins can ever be created. We know the growth of Bitcoin supply - it will increase at a decreasing rate until 2040 and remain flat thereafter. In contrast, there is no real limit on the amount of fiat money each government or central bank can print. For instance, as of November 2020, the Bank of England spent just under £900 billion to purchase bonds as a part of its quantitative easing (QE) program. Meanwhile, the US Federal Reserve's balance sheet currently stands at over $8 trillion, the money funnelled into the economy since 2008. Whether the QE leads to higher inflation is still unclear, but the fixed supply of Bitcoin does alleviate some of the worries (you can check one of my earliest articles about QE, low inflation rate and inflation from last year here).
Limited supply or scarcity, according to Anthony Pompliano has a high correlation to value across all assets. It is the signal of value. Let’s take human life for example. When you remove the finiteness of life, everything loses its value. Bitcoin, therefore, allows acquiring an asset that not only holds its value (a store of value) but also appreciates over time.
Finally, the Bitcoin system is open-source, meaning that anyone can review the protocol, make changes and submit these changes for approval. Although I must admit, you need to have some experience of programming.
I hope at this point I've started to revive the Bitcoin image of technology of the future. Speaking of which, the final aspect of Bitcoin I would like to explore today (to start exploring to be precise) is the functionality of the blockchain itself.
Functionality
The Bitcoin blockchain is a decentralised ledger - a database that is held and updated independently by each member of the network. It represents an innovative way to register and distribute information without a need for a trusted party, which facilitates relationships.
For example, you don't have to rely on Facebook when sending texts via What'sApp or on your bank when making transactions.
The trust is substituted by the specifically designed set of rules (blockchain protocol) and private key cryptography to authorise and authenticate any type of transaction. A wide network of nodes or "validators" will review the transaction simultaneously, make a conclusion on its validity and then make an independent vote. The conclusion (transaction) with the majority of votes is added to the blockchain. It is exactly how Bitcoin democratises the money system - as long as you meet the transaction requirements and have coins.
But what does it mean beyond a simple payment system? Cryptocurrencies and exchanges are only the first types of platforms developed on blockchain. The community is now moving towards developing platforms with wider applications, one example being smart contracts. A smart contract requires a Bitcoin input to trigger a certain activity on the blockchain.
Combining the payment system with smart contracts provides a platform for financial institutions to create direct links to each other, which could facilitate cross-border transactions. Banks could create a shared ledger for transactions, contracts and documentation. They could use the database to keep track of all transactions without the need for any third parties or centralised entities.
Bitcoin has also created a digital code that can't be copied, opening an avenue for digital assets.
Final words
As it turns out, the use of Bitcoin could be ample, just like the arguments as to weather the whole system is worth our resources
Bitcoin is a very young technology, compared to the banking system - let alone the money system. As with any new technology we should allow it to unveil all of its capabilities before dismissing it.
I like Anthony Pompliano’s comment from one of his interviews where he stated that the most valuable technologies are not the ones that replace the old technologies, but those that expand their capabilities. Perhaps, Bitcoin can indeed improve our payment and financial systems.
Besides, who said that Bitcoin has to compete with the US dollar or Visa or Mastercard.