Bitcoin, Why You Should Own a Bit

The crisis of 2008, which nearly crippled the financial world, was a loud and clear warning that our financial system had become a house of cards. Its integrity depended on the continued solvency of over-leveraged financial institutions.

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At the time, I was working as a Senior Data Architect in the trading room of one of Germany’s biggest banks. It was there that we witnessed up close the freezing of accounts, ATMs shutting down and credit cards deactivated. It became clear that owning physical gold and silver – not gold derivatives – was one of the few ways to reliably protect one’s wealth in such a crisis.

After the 2008 experience, I could never fully trust this financial system again as there was no guarantee that the system could be bailed out again by governments in the next crisis.

Satoshi Nakamoto, the alias used by the anonymous developer of bitcoin, must have had a similar experience, as it galvanized him/her to present a concept for a peer to peer payment model that could elegantly solve the too big to fail bank dilemma.

Satoshi’s original bitcoin white paper made it clear that Satoshi was a superb system architect who had a financial risk modelling background with an interest in complexity theory and a drive to make the world a better place.

Satoshi had embedded the text, “Chancellor on brink of second bailout for banks”, in his bitcoin genesis block (the block that started the bitcoin blockchain). It was the headline of The Times back in 3 January 2009. This was a strong indication that Satoshi’s blockchain was indeed a response to the fragility of our financial system. His decision to remain anonymous made sense in light of the enormous special interest that his design could threaten, if it ever were to be widely accepted.

Bitcoin could have easily been discarded and faded into obsurity. Yet almost nine years later, Satoshi’s theoretical alternative is published on all financial news channels and has surpassed 315 Billion USD in capitalization as of 18 December 2017. Needless to say, I feel a strong connection to Satoshi’s motives and I admire his work, the significance of which I will try to explain in this article.

Bitcoin – World’s First Trustless Ledger

In its essence, bitcoin is just a distributed ledger which allows bitcoin entries to be reliably sent from one address (akin to an account) to another without requiring a central bookkeeper. Satoshi’s key innovation was that he solved the “double spend problem” – essentially how to keep users from cheating by spending or copying the same bitcoins over and over in the absence of a central bookkeeper to prevent it.

Satoshi’s genius was inventing and combining the proof of work system, which requires the solving of mathematical riddles to make it expensive to cheat, the majority consensus rule to discard cheaters and the use of distributed computing encouraged via bitcoin mining to obtain the processing power to run it all.

When people refer to the “blockchain”, they refer to this trustless ledger implementation that was made possible by those three key innovations. Satoshi then used “bitcoin” or “BTC” as the unit of account of his trustless ledger and mathematically limited the number of bitcoins that will ever be created to 21 million, of which about 4 million have not yet been “mined”.

Because the code running bitcoin has been made public for everybody who can read code to check (open source), the system is transparent and therefore generates the trust needed for it to take off. In essence, bitcoin rules are very clear, trustworthy and remarkably simple. Open sourcing also meant that countless other entities were able to easily copy the bitcoin code and made their own version of it often hoping for quick overnight riches via, sometime questionable, ICOs.

Bitcoin can withstand systemic shocks that the financial system cannot

Bitcoin and other well designed distributed ledger systems such as Ethereum are inherently stable systems in that they can react well to systemic shocks. If a third of all processing (mining) nodes, for example, were to be wiped out due to an external event, transaction fees would increase to incentivize the creation of new nodes, which would bring the system back into balance. More importantly, wiping out these nodes would not cause any data to be lost or cause other nodes to fail as they are not directly dependent on each other to function.

Our financial system, on the other hand, has become increasingly unstable as each bank is dependent on other banks via their leveraged derivative exposures which can be hundreds of times higher than the bank’s reserves. Thus, it just takes a few banks to become insolvent for the whole banking system to be threatened via a financial contagion.

The system is like a seriously ill patient that needs to be rescued periodically with increasingly expensive bailouts and kept alive with cheap money. We can keep it going a while longer, but at some point, it is just not worth subsidizing this system anymore as bureaucracy, outdated legacy IT systems and special interests block the sweeping reforms necessary to truly change it.

On the other hand, as distributed ledgers mature they will gradually replace these old systems. PricewaterhouseCoopers (PwC), our auditor and one of the Big Four accounting companies, for example has started accepting Bitcoin as payment for their advisory services and there is growing consensus that blockchain queries could be used in place of bank statements in the future.

Satoshi’s bitcoin is indeed changing the world, making many people rich in the process and setting the stage for a shift of power away from centralized “too big to fail” banks towards distributed peer to peer systems such as bitcoin.

Physical Crypto Storage

Crypto storage has unique challenges – see how materializing Private Keys eliminates digital theft.

Bitcoin’s Monetary Characteristics

Bitcoin has become an increasingly popular method of exchange that is universally accessible, given an internet connection, and is extremely resilient and durable to disruption due to its distributed nature.

Bitcoin also has a pretty clearly defined price – 18,818 USD per BTC at the time of writing – and each bitcoin is divisible into one hundred million satoshis. So, for example, 0.02 Bitcoin is equivalent to 2,000,000 satoshis. These, along with trust, are key characteristics of money.

Furthermore, unlike most crypto currencies the issuance of new bitcoins is clearly defined in code and will be capped just short of 21,000,000 BTC by around 2140, therefore creating code enforced scarcity that makes it deflationary in nature.

This deflationary tendency means bitcoin is likely to appreciate over time, especially compared to FIAT currencies like the USD whose monetary base was increased by 450% over the last 9 years. Of note might be that bitcoin’s capitalization has now significantly surpassed the value of Australia’s M1 money supply of 357 Billion AUD – about 274 Billion USD.

Bitcoin vs. Gold and Silver

Bitcoin is similar to physical gold in that there is a limited amount, it can be held directly without intermediaries (possessing private key vs. holding a bar) and both are independent of the financial system. Both will do well when the next crisis occurs.

Of course, there are drastic differences. Gold and silver require physical storage and have a 5,000-year history of being a reliable store of value with nearly universal acceptance while bitcoin is literally just a ledger entry on a distributed network that has been invented nine years ago.

Sometimes being ethereal has advantages however, and we see bullion and bitcoin as complementary stores of value, each having their own strengths. This is why we have been making a market for converting bitcoin to gold or silver and vice versa for the last 2 years.

Over the long term it makes sense to own a bit of both crypto and bullion. Silver in particular is historically undervalued versus gold, as thesilver to gold ratio is near 80. So diversifying some of the massive crypto wealth gains into silver would be a prudent valuation move.

Bitcoin is here to stay

Bitcoin’s capitalization recently surpassed 315 Billion USD and the US, European and Asian media coverage has gone in overdrive these last few months as prices soared. However, the vast majority of people do not actually own any bitcoins and many of those who do are not intent on selling any of it.

Therefore, while bitcoin’s meteoric price increase definitely fulfills the price appreciation portion of being in a “bubble”, there seems to be plenty of hopeful buyers out there who have not bought any yet. Since a bubble will burst only once we run out of buyers there likely is still a long way to go.

Moreover, unlike the Tulip mania which the current bitcoin situation is sometimes mistakenly compared to, bitcoin is providing a truly resilient alternative to our fragile financial system and fulfills the requirements for a store of value, unlike tulips.

Bitcoin’s value will ultimately be determined by how popular it becomes as Metcalfe’s Law of Network Effects is likely to apply to bitcoin. Once bitcoin and other cryptocurrencies stop appreciating most people will not dump them the way tulips were dumped, instead they will regard them as a natural store of value.

I suspect that the transition in adopting bitcoin and other quality cryptocurrencies will accelerate further. Therefore, it is increasingly important to look beyond wallet user interfaces, understand how these currencies work and how to store them securely as over 25%* of bitcoins are believed to have been lost or stolen since it’s inception.

Consider buying a tiny bit of bitcoin and keep it for the long term, if you do not own any. If it fulfils its potential, your small investment can become quite substantial, if it crashes the loss will be small. If, on the other hand, most of your wealth is in crypto currencies, consider diversifying a bit into the stability of physical gold and silver.

For an analysis of crypto storage risks and how these can be addressed have a look at the Gregersen-Gono Standard whitepaper.