The Big Long – Answer to Michelle Caruso-Cabrera’s Question – Why does Bitcoin Have Value? – 12/12/17

Michelle Caruso-Cabrera has been questioning the value of bitcoin and cryptocurrencies in general. In the following video she states at 1:40:

Here is the thing. There is Litecoin. There is going to be thousands of Cryptocurrencies. I’ve asked this question for viewers. They have heard me ask this question for a full week on straight to nearly every expert that we have on. If there are going to be so many cryptocurrencies and some are actually better than bitcoin at doing certain tasks, why does bitcoin, in and of itself, have any value.

Then she goes on to state:

I get that it is a fiat currency like the US dollar. I totally get that, but there is only one US dollar, and the supply of it is controlled by the federal reserve. Cryptocurrencies seem like there could be thousands of them created by countries all over the world, so I don’t understand how they retain value.

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BITCOIN IS NOT FIAT MONEY AND GOVERNMENTS CANNOT CREATE BLOCKCHAIN-BASED CRYPTOCURRENCIES

First, Maria makes two statements that are factually incorrect. She states that bitcoin "is a fiat currency like the US dollar." Bitcoin is not a fiat currency. It is a private currency much like gold or silver. By definition, fiat currencies are issued by ‘decree’ from a central authority. No central authority issued a ‘decree’ that bitcoin should be used as money. We don’t even know who created bitcoin.

Secondly, she states that "Cryptocurrencies seem like there could be thousands of them created by countries all over the world." This is also incorrect because countries cannot create their own blockchain-based cryptocurrencies. At best, countries can migrate their existing fiat currencies onto a digital format, but these currencies would still be controlled by a central bank, rendering them fiat currencies. These fiat currencies would not share the same security properties through decentralization as bitcoin, so they would not be comparable to cryptocurrencies as we know them. To be fair, I suppose the jury is still out on how exactly to define cryptocurrencies.

FUNGIBILILY

While countries cannot create their own cryptocurrencies, individuals and groups of people are free to create these currencies at will. However, these currencies are not fungible, meaning they cannot be traded on a 1:1 basis with other cryptocurrencies. In other words, one litecoin cannot be traded interchangeably for one bitcoin. They both have different exchange rates. When dollars are created, they have the direct effect of diluting other dollar-holders because they are fungible with other dollars. Non-fungibility limits the dilutive properties of newly-created cryptocurrencies.

HASH POWER IS A FINITE RESOURCE

For Proof-of-Work coins, hash power is directly tied to the security of the system. Higher rates of hash power equate directly to higher levels of security, as it would require more real-world expenditure of electricity and hardware resources to successfully attack the system. Currently, it would take roughly $4billion to attack, control, and sensor transactions on the bitcoin network.
A good comparison would be the relationship of market cap to hash rate for bitcoin and bitcoin cash. Bitcoin cash recently split from the bitcoin network in the form of a hard fork on August 1, 2017. Both coins use the same POW scheme to secure the system.

Coin	Hash Rate	Market Cap	Value per Giga-hash
Bitcoin	12.5 exa-hash/sec	$284 billion	$22.72
Bitcoin Cash	0.886 exa-hash/sec	$26 billion	$29.34

coinmarketcap

As you can see, bitcoin has roughly 10x the value of bitcoin cash and roughly 14x the hash power, while market cap per giga-hash are at least somewhat similar. In other words, bitcoin currently has roughly an order of magnitude more value and corresponding security than bitcoin cash. If bitcoin cash were to overtake bitcoin in terms of market cap, it would need to gain a bit over 10x in terms of market cap. This would most likely result in a corresponding increase in hash rate to secure the network, as miners would move to the more profitable coin. This hash power must either come in the form of brand new capital investment in electricity and hardware or by diverting existing investment from other similar POW currencies. Electricity, hardware, human resources, overhead, ect. cannot be created out of thin air to produce hash power. Hash power is a finite resource. New POW coins issued onto the market will most likely have to garner a finite resource (hash power) to gain value, limiting the dilutive power of issuing new POW coins.

CRYPTOCURRENCY HAS INTRINSIC VALUE

Contrary to popular belief, a decentralized, censorship-resistant cryptocurrency has intrinsic value outside of having the property of money. One use case is what I like to think of as a “written-in-stone” application for the internet. "Written-in-stone" infers that whatever is written cannon be changed. This is exactly how public blockchains work, unlike traditional forms of data storage that can be hacked, deleted, changed, lost, etc. Data recorded on a public blockchain is almost entirely permanent and immutable, with a select few exceptions in the case of forks. These forks are always heavily disputed and the data that is changed is well documented and can result in a spin-off chain such as ethereum classic that keeps a permanent and immutable record of the original data itself. So for all intents and purposes, popular public blockchains retain the properties of being a digital "written-in-stone."

Wide-ranging use cases for this will emerge such as Factom’s service to record the hash of legal documents on the blockchain, providing a way to genuinely verify the authenticity of documents. One problem this could solve is the robo-signing scandal during the 2008 financial crisis, where authentic mortgage documents could not be reproduced. New use cases will almost certainly emerge over time.

This service may ultimately have to move to another blockchain other than bitcoin that has higher throughput, but that is the subject for another day.

WEALTH IS A FINITE RESOURCE

The value proposition of Proof-of-Stake coins is more straightforward (and more sustainable in my opinion) as they will ultimately be valued similar to stocks. These systems are still primarily in the experimental phases, but their value will largely come from stakeholder subsidies minus inflation.

In Ethereum, for example, when users transact on the system, they pay transaction fees. Those transaction fees will be mined by people who put their coins in a bonded stake contract. This contract will be funded by coins purchased on the open market using dollars, bitcoin, gold, or any other form of wealth, which is a finite resource. Competing POS systems will also be secured by people using their finite wealth to buy the underlying native currency, with the expectation of future returns based on transaction fees. Transaction fees paid will be finite because there will be a limit to how many users can possibly use the system, even at mass adoption. These systems will compete over these users and ultimately most users will probably use one select system (similar to how most people use facebook over myspace because people find value and utility in using the same system everyone else uses, also called network effect), limiting the dilutive power of competing systems.

The chain that garners the most users, has the most activity, and has the highest volume will be the most valuable chain and investors are more likely to purchase the coins of that system to stake and gain interest on their investment, leading to an increase in value due to network effects.

POS systems, such as ethereum’s proposed Casper, will likely need to meet or exceed the level of security of POW systems, but that is a discussion for another day.

CONCLUSION

I have outlined 5 reasons why cryptocurrencies have value and why any issuance of new coins will not have a large dilutive effect. Because of network effects, I believe cryptocurrency values will ultimately follow a pareto-inspired path. One system will garner roughly 80% of market share while all other systems combined will garner roughly 20%. As an investor, the trick will be determining the dominant chain and buying into that native currency.