Why did I bet on bitcoin at the peak of the mania? — The network effect

Part 3: The network effect

I was well aware that we were in the final phase of a mania and the crash was near. Still, in December 2017 I made the bet that bitcoin would outperform gold on a five-year horizon. In this article series, I describe what I based my opinion on.

In Part 1, I presented the background of my bet. In Part 2, I argued that there is a need for digital gold. This part and the next will explore why bitcoin has the best chance to fulfill this purpose.

Consensus

Once upon a time, the world came to agree that the universal safe haven asset for savings will be gold, serving as a store of value during inflation or chaotic economic conditions. This was a spontaneous process without top-down control. Gold prevailed thanks to its special properties.

In a similar vein, the world now needs to come to a consensus on which cryptocurrency will be the modern safe haven asset, the digital gold. It is unlikely that we will have two. If a cryptocurrency starts to take the lead as digital gold, the network effect will take care of the rest. That is because if someone seeks shelter for their savings among cryptocurrencies, and sees that the majority is already using one for this purpose, then the smartest thing is to join the herd. There is no point in experimenting with something else, just like in the traditional world you would not buy clam shells instead of gold, hoping it may be a better safe haven. Thus it keeps snowballing until the role of digital gold becomes unquestionable.

In retrospect, it is not too surprising that gold became the global safe haven asset. Similarly, looking back from the future, the world’s choice in cryptocurrencies will not surprise us either. Maybe we can already find it out — or at least we can try.

My guess is that it is bitcoin. A critical factor for gold was its physical properties, while for bitcoin, it is its first-mover advantage. Thanks to that, it gained an unbeatable popularity over other cryptocurrencies. The network effect started long ago: those wanting to rescue their savings into digital gold today will arrive at bitcoin, since the majority is already using it for this purpose.

Limited supply

An extremely important feature of safe haven assets is their limited supply. It is often inflation that we seek protection against, so they need to be especially resistant to that.

The supply of gold is quite rigid, as mining adds about an annual 1.5% to the amount amassed by humanity. Although currently the amount of bitcoins grows by 3.7% annually, next May the rate of creating new units will halve, putting it close to that of gold. And later it will decrease further, because the maximum supply of bitcoins is set at 21 million (currently 18 million exist). We can rest assured that there will never be more, while gold does not have such an upper bound.

Gold also holds the danger that someday in the future we will be able to mine it in commercial quantities from asteroids, or synthesize it economically in particle accelerators. Technically, we have been capable of the latter for long: if we bombard mercury nuclei with neutrons, we can get gold. The alchemists’ dream has come true, with a little caveat — the procedure is far from economical.

Of course, these are weak arguments against gold and for bitcoin. At best, these will be achievable only in the unforeseeable future, if ever. But they are arguments, nevertheless. Bitcoin provides us with the safety that it does not exist physically, only in our collective imagination. So it is up to us how many we are willing to imagine. And we decided to imagine no more than 21 million. We also decide the rate at which new units are created. So, unlike with gold, the supply of bitcoin will keep on expanding at a predictable, predefined pace.

Sovereignty

However, bitcoin as a safe haven needs to excel not only over gold, but also over other cryptocurrencies. Plenty exist with a limited supply (for example, Litecoin), and we can create an unlimited number of them with similar features. What makes bitcoin stand out?

The network effect has another consequence. Cryptocurrency mining consumes enormous amounts of electricity, which seems unnecessary. Obviously, the biggest consumers are bitcoin miners, exactly because bitcoin is highly valuable and it is worth the energy expenditure. Currently, about 0.1% of the world’s electricity consumption comes only from this. That is a huge amount, and also comes with a huge electricity bill, so the Bitcoin network is not too green.

But burning that electricity does have some purpose. Namely, if someone wanted to take control of the Bitcoin blockchain, they would need to burn even more insane amounts of electricity. They alone could pay a bill that is greater than what every other bitcoin miner pays altogether. No one is capable of that. And this would not even mean they could spend others’ bitcoins. It would only let them decide which transactions are added to the blockchain and which are not.

The independence and sovereignty of bitcoin is protected by this massive amount of burned electricity. The more power a network consumes, the more certain we can be that no one can take control of it. And since bitcoin consumes more power than any other cryptocurrency, its sovereignty has the highest assurance.

Transfers

Among other reasons, gold could become a global safe haven asset because it is independent from any central authority. Unlike bank notes, central banks cannot print it, and confiscating it en masse is much more problematic than freezing every bank deposit by government decree. Central authorities can neither print cryptocurrency or freeze bitcoin wallets.

Transporting gold from one place to another can be more difficult though if it is centrally prohibited. In such countries, gold is usually confiscated from those who get caught. Everyone thinks twice before traveling with gold, so it rather remains stashed away. And state borders are often impossible to penetrate.

Bitcoin is in a much better position. To begin with, it is borderless. And, as we have shown earlier, administering the transfers (that is, the blockchain) requires a huge power generating capacity. The network is currently consuming as much as all of Austria. This astronomical electricity bill exceeds the resources of any state. Even if they committed enough resources, the most they could do is stopping transfers for the time being — but not confiscating them.

Cryptocurrencies of the future

In terms of sovereignty, bitcoin is a better choice than any other existing cryptocurrency. But what if a new cryptocurrency will be created that surpasses bitcoin’s technology by far in every aspect, and the world will settle on that as digital gold?

The dot-com bubble is often cited as an example. In the stock exchange mania of the late ’90s, the Nasdaq Composite index and the value of the component tech companies went through the roof, without any real merit. Many of them went bankrupt after the bursting of the bubble. But today’s Nasdaq has far surpassed its value at the peak of the mania. It is now composed of massively profitable companies, and their valuations do not seem extremely unrealistic. However, the composition of the Nasdaq has thoroughly changed in the meantime. It turned out who are the real winners of the internet revolution, and some of them are companies that did not even exist two decades ago. What stops a similar scenario from happening, where the real winners after the crypto mania would completely differ from those who were leading the boom?

Although new successful cryptocurrencies may indeed emerge, I find it unlikely that the digital gold status of bitcoin would be called into question. That is because bitcoin is not a company and works completely differently. On this note, it is important to understand that the technology or the rule set of a cryptocurrency is not set in stone. It may and does change. A decentralized system operated by a community works as the majority of that community sees fit, not as the CEO wishes. A change in the technology or the rule set of a blockchain is called a fork.

Flexibility

For example, the first version of the bitcoin mining software contained multiple critical bugs, which were found early on. In these cases, the code was fixed and, since miners had no incentive to operate a defective cryptocurrency, everyone (or at least the majority) quickly upgraded to the new version. The blockchain forked, but nobody was mining on the old version, so it died off and consensus was preserved.

Bugs are not necessarily critical though, and fixing them is not necessarily urgent for the miners. They can get stuck in the system for a long time. They may not even be bugs per se, just obsolete parameters that have no agreed-upon optimal values in the community (like the maximum block size or the time between two blocks). Without consensus, typically the current — although suboptimal — values stick and become the status quo.

Something similar happened to bitcoin a few years ago. The system reached its transactional capacity, blocks got full, and huge amounts of bitcoin transactions remained unprocessed. Clearly, something had to be done. But there was no consensus on what exactly. The community was struggling with the solution for years.

Ultimately, these events lead to the August 2017 fork of the Bitcoin blockchain. Since they failed to come to consensus on the correct solution, two camps modified the rules in two different ways. What we call bitcoin today is the modification to the earlier version that the majority preferred. The other camp birthed bitcoin cash. But the point is that no one is using the original, obsolete version of the mining software anymore. The technological development of bitcoin takes multiple paths and evolution will select the winner.

If a technology appeared that is radically superior to what we know today, the community would sooner or later come to agreement and integrate it into bitcoin. Or, absent consensus, a part of the community would do it anyway and fork the blockchain. If it has true merit, the new chain would live on, and even become the dominant one.

So it is unlikely that a cryptocurrency would take over the role of bitcoin if it had a superior technology, but less initial popularity or community commitment. You can upgrade technology, but gaining global popularity and adoption is orders of magnitude more difficult.

It could happen that by late 2022, when my bet will be over and we will announce the results, bitcoin will not be the same bitcoin it was in December 2017. It could even be that the same bitcoin will also exist, but the new, forked one will be worth much more. Which bitcoin’s value will decide the outcome of the bet?

A fork in the blockchain means that two worlds are created that share the same past. Thus, if I had a bitcoin before the fork, post-fork I will have one in each of the worlds. The bet is deliberately phrased such that it handles this situation fairly. So what counts is how much profit or loss I would incur on the whole if I had bought bitcoin for a given amount in December 2017 and held it for five years (compared to what my colleagues would achieve with gold). If I would have two or more kinds of bitcoins by then, their values should be added up.

Worthless?

At this point, I would like to clear up a misconception about bitcoin. Many people think it can be infinitely inflated through forks. They reason that, although only 21 million can exist on one blockchain, if the chain is doubled through repeated forks, one could create an infinite amount of coins. And the value of those is necessarily zero, as of anything that is infinitely available. But this reasoning is flawed.

In case of a fork, miners need to decide which chain they continue to mine. This means the computational capacity is split between the two forks. Each blockchain’s sovereignty is protected by different amounts of burned electricity. If only a few mine a chain, using little electricity, it will become vulnerable and even a single party could easily take control of it. This means that the coins on it are worthless. In theory, anyone can fork the Bitcoin blockchain anytime. It just makes no sense, because it would result in an easy-to-attack chain with worthless coins that no one uses. The value is in the coins of the robust chain.

If computational capacity is split at similar levels after the fork, such that both chains remain strong, then two individually viable coins can come into existence — as it happened in the case of bitcoin and bitcoin cash. But it is not possible to have an infinite number of such forks, because then the mining capacity would become too fragmented.

Alternative evolution

Many see platforms like Ethereum as the competition to bitcoin — or, more precisely, its native cryptocurrency, ether. Ethereum enables a much more diverse set of use cases through its smart contracts, but this very aim of diversity makes its development much more difficult. And that calls its future success into doubt. But let us assume that, over time, all technical difficulties will be solved and someday Ethereum will be able to serve its users reliably, cheaply and at scale.

Will then ether take over as digital gold? Unlikely, since it was designed to be some kind of digital oil to drive the big, shared virtual computer. I do not want to spend my precious digital gold on running my smart contracts.

But then what if a new token is created in Ethereum, with the explicit purpose of replacing bitcoin as the new digital gold? I find that unlikely either. Stranger things are possible in the crypto world and forks are not the only way bitcoin can evolve. We already have an Ethereum smart contract that can move bitcoins from their own blockchain to Ethereum. Under the hood, when a bitcoin is frozen (made unspendable) on its own blockchain, this smart contract mints a new token on the Ethereum blockchain. This newly created coin represents the frozen bitcoin, but it can be used on the Ethereum chain.

If someday it becomes obvious that Ethereum and its smart contracts are the future, the bitcoin community would begin to move over their coins en masse. There would not be a need to come up with a new kind of digital gold on Ethereum and make the world adopt it. Bitcoin could retain its role of digital gold, which would be consolidated by then, and continue its career in the new and unified crypto world. In this case, bitcoin’s own technology could become completely obsolete and no one would mine it after a while. Lacking interest, its blockchain could even cease to exist. Bitcoins would still live on, just like humanity would move from an uninhabitable Earth to a more livable planet.

Bitcoin’s position as the potential digital gold seems unquestionable. But its first-mover advantage, limited supply, sovereignty and infinitely flexible technology are not the only factors in this. There are many other strong reasons for bitcoin, which I will detail in the next article. We have yet to explore the most important one.

www.superposition.hu