3 Reasons I’m Investing in Bitcoin
Blockchain-based cryptocurrencies have been around for over a decade, since the release of Bitcoin in early 2009.
While the asset class has grown considerably, it remains relatively small and highly volatile, so deciding whether to insert a small bit of Bitcoin or other cryptocurrency exposure into a portfolio allocation can be a controversial and confusing decision.
Maybe this article will assist some investors in the decision one way or the other. Bitcoin analysis online can be very polarizing; either written by hardcore bullish enthusiasts or dismissed as a worthless ponzi scheme. As a generalist investor with a value-slant and a global macro emphasis, I’ve sought to bridge the gap a bit by sharing my view of Bitcoin, which is currently bullish.
Although I was aware of Bitcoin as a speculative small asset since around 2011, and knew someone who mined it on her computer back when that was possible (now it requires application-specific integrated circuits, due to heavy competition), I wrote my first article on cryptocurrencies back in November 2017, when the price was in the $6500-$8000 range. During the week or two writing and editing period, the price rose substantially in that big range. My conclusion at the time was neutral-to-bearish, and I didn’t buy any.
Right now, there’s already a lot of optimism backed in; bitcoins and other major cryptocurrencies are extremely expensive compared to their estimated current usage. Investors are assuming that they will achieve widespread adoption and are paying up accordingly. That means investors should apply considerable caution.
-Lyn Alden, November 2017
Within the next month or so after the original article, Bitcoin briefly soared to reach $20,000, but then crashed down to below $3,500 a year later, and has since recovered to bounce around in a wide trading range with little or no durable returns.
I’ve updated the article from time to time to refresh data and keep it relevant as changes happen in the industry, but other than keeping an eye on the space from time to time, I mostly ignored it.
In early 2020, I revisited Bitcoin and became bullish. I recommended it as a small position in my premium research service on April 12th, and bought some bitcoins for myself on April 20th. The price was around $6,900 for that stretch of time. Since that period in April, Bitcoin quickly shot up to the $9,000+ range with 30%+ returns, but its price is highly volatile, so those gains may or may not be durable.
My base case is for Bitcoin to perform very well over the next 2 years, but we’ll see. I like it as a small position within a diversified portfolio, without much concern for periodic corrections, using capital I’m willing to risk.
As someone with an engineering and finance blended background, Bitcoin’s design has always interested me from a theoretical point of view, but it wasn’t until this period in early 2020 that I could put enough catalysts together to build a constructive case for its price action in the years ahead. As a new asset class, Bitcoin took time to build a price history and some sense of the cycles it goes through, and plenty of valuable research has been published over the years to synthesize the data.
So, I’m neither a perma-bull on Bitcoin at any price, or someone that dismisses it outright. As an investor in many asset classes, these are the three main reasons I switched from uninterested to quite bullish on Bitcoin early this year, and remain so today.
Reason 1) Scarcity + Network Effect
Bitcoin is an open source peer-to-peer software monetary system invented by an anonymous person or group named Satoshi Nakamoto that can store and transmit value.
It is decentralized; there is no singular authority that controls it, and instead it uses encryption based on blockchain technology, calculated by multiple parties 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 newly-“mined” coins, and/or transaction fees. In other words, by verifying and securing the blockchain, you earn some coins.
In the beginning, anyone with a decent computer could mine some coins. Now that many bitcoins have been mined and the market for mining coins has become very competitive, most people acquire coins simply by buying them from existing owners on exchanges and other platforms, while mining new coins is a specialized operation.
Bitcoin’s protocol limits it to 21 million coins in total, which gives it scarcity, and therefore potentially gives it value… if there is demand for it. 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, like fractions of an ounce of gold.
For context, these “coins” aren’t “stored” on any device. 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. Owners store their private keys on devices, or even on paper or engraved in metal.
In fact, a private key can be stored as a seed phrase that can be remembered, and later reconstructed. You could literally 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 Monetary Commodity
Satoshi envisioned Bitcoin as basically a rare commodity that has one unique property.
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 across borders, and therefore has the properties of money. Like all “potential” money, though, it needs sustained demand to have value.
As of this writing, Bitcoin’s market capitalization is about $170 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.
One of my concerns with Bitcoin back in 2017 was that, even if we grant that these digital commodity attributes are useful, and even if we acknowledge that the units of any cryptocurrency are scarce by design, 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, rather than just one scarce “commodity” that has the unique property of being able to be transported over a network, there are thousands of similar commodities that have that new property. This risks the scarcity aspect of the commodity, 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, say, gold and silver. There are only a handful of elemental precious metals, they each have scarcity within the metal (200,000 tons of estimated mined gold, for example), and 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… that’s it. 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.
An analogy is that a cryptocurrency is like a social network, 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. Anyone can make one. However, creating the next Facebook (FB) or other billion-user network is a nearly impossible challenge, and a multi-billion-dollar reward awaits any team that somehow pulls it off. This is 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.
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 sustained demand, which are all traits that Bitcoin has.
When I analyzed cryptocurrencies in 2017, I was concerned with cryptocurrency market share dilution. 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. Even if just ten protocols take off, that could pose a valuation problem. If the total cryptocurrency market capitalization grows to $1 trillion, but is equally-divided among the top ten protocols for example, then that would be just $100 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 didn’t catch on since then for a variety of reasons, including their weaker security levels relative to Bitcoin.
Gold vs Bitcoin
This reliance on the network effect is not unique to Bitcoin or other cryptocurrencies. 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 utilitarian purposes, basically to keep the lights on.
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 jewelry demand, for which buyers view gold as a store of wealth, or a display of beauty and wealth, because it happens to have very good properties for it in the sense that it looks nice, doesn’t rust, is very rare, holds a lot of value in a small space, is divisible, lasts forever, and so forth. If gold’s demand for jewelry, coinage, and bars were to ever decrease substantially and structurally, leaving its practical industrial usage as its primary demand, the existing supply/demand balance would be thrown out and 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 jewelry 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 Adoption
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.
Bitcoin, on the other hand, has so many devices verifying the network that they collectively consume more electricity per year than a small country, like Greece or Switzerland. 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.
Any news story you have ever heard about Bitcoin being hacked or stolen, was not about Bitcoin’s protocol itself, which has never been hacked. Instead, instances of Bitcoin hacks and theft involve perpetrators breaking into systems to steal the private keys that are held there, often with lackluster security systems. 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 way 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.
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. Simply by coming later and thus having 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. The gap, though, is quite wide.
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.
Looking to buy LTC on a budget? Don’t worry, Kraken offers a minimum order size of 0.1 LTC to help you gain exposure to a variety of assets.Researchers have pointed out at a 'trend towards centralization'. Although bitcoin can be sent directly from user to user, in practice intermediaries are widely used.:220–222 Bitcoin miners join large mining pools to minimize the variance of their income.:215, 219–222:3 Because transactions on the network are confirmed by miners, decentralization of the network requires that no single miner or mining pool obtains 51% of the hashing power, which would allow them to double-spend coins, prevent certain transactions from being verified and prevent other miners from earning income. As of 2013 just six mining pools controlled 75% of overall bitcoin hashing power. In 2014 mining pool Ghash.io obtained 51% hashing power which raised significant controversies about the safety of the network. The pool has voluntarily capped their hashing power at 39.99% and requested other pools to act responsibly for the benefit of the whole network. c. 2017 over 70% of the hashing power and 90% of transactions were operating from China.