Anyone familiar with centralized currencies and monetary systems has to adopt a starkly different mindset to understand bitcoin.
Wait! It is possible to have a currency that isn't issued by the government?
Wait! Currency is minted by solving math problems?
Wait! The total supply of money is capped?
Wait! I can pay someone online without going through a bank or credit card company or any regulated entity with employees?
=> What is happening?
I believe bitcoin faces an overload of criticisms precisely because it challenges people's mental model of what money is. I attempt here to address some of the criticisms.
1. Bitcoin is too volatile to be a store of value.
2. Bitcoin facilitates criminal activity.
3. Bitcoin cannot be used as a medium of exchange.
4. Governments will ban bitcoin.
5. Bitcoin is bad for the environment.
6. Bitcoin has zero inherent value.
7. Bitcoin will be replaced by a more advanced competitor.
8. Bitcoin ownership is too concentrated.
1. Bitcoin is too Volatile to be a Store of Value
Allegation - An asset as volatile as bitcoin cannot be used as a store of value.
Matt Hogan in Bitcoin vs. Gold: Is Bitcoin really a new Safe Haven Asset? highlights the returns from gold over the decades:
1970s: +1,365%
1980s: -22%
1990s: -28%
2000s: +281%
2010s: +50%
Why did it give such high returns in the 1970s? Because the US went off the gold standard in the 1970s. People didn’t know what to make of gold. It wasn’t obvious that gold would succeed as a store of value. Its price could collapse because it wasn’t technically backing money anymore. This was also an extremely volatile decade. In 1973 the price of gold changed more than 3% in 1 out of 10 days.
The point Mr. Hogan makes is that if you want to grow your wealth, you don’t invest it in a store of value. You invest it in an emerging store of value. Precisely how you would describe bitcoin today.
Bitcoin is volatile. If you buy it today at $60,000, there is every chance that it could fall to $50,000 by next week. You need to accept that. So investing next month’s rent money in bitcoin is probably not smart. However, given increasing mainstream acceptance and new classes of investors yet to discover the asset, the 5-year/10-year/20-year returns look promising.
Compared to bitcoin, the value of the US$ next week is likely to be similar to what it is today. But given unlimited money printing, it is highly likely that what you can buy with your US$, 5 years/10 years/20 years down the line will be lesser than what you can today.
So which one is a better store of value? Short-term volatility with long-term upward trajectory i.e. bitcoin, or short-term stability with long-term downward trajectory i.e. fiat.
Having said that, the volatility of bitcoin is falling and it will continue to do so as the asset class matures, develops a thriving spot and derivatives market, and achieves mainstream adoption.
2. Bitcoin facilitates Criminal Activity
Allegation - Cryptocurrencies are used “mainly for illicit financing."- Janet Yellen
Let’s start with some numbers. According to Chainalysis, the leading blockchain analytics firm, 0.34% of crypto spending in 2020 was in illegal activities. This was down from 2.1% in 2019. Given the transparency of bitcoin, it is possible to arrive at a number like this. I haven’t seen similar studies on how much cash is used for illegal activities. I suspect it is higher than 0.34%. According to United Nations Drugs and Crime Office- For every $1 spent in bitcoin on the darknet, $800 is laundered in cash. Further, according to the International Consortium of Investigative Journalists Review- Some of the biggest global banks including HSBC, JP Morgan, and Standard Chartered, moved trillions of dollars identified as being potentially tied to money laundering or other crimes despite raising concerns about those transactions in filings with US regulators.
=> So I think it is fair to say that a very small share of bitcoin is used for illegal activities compared to cash and the banking system, and even that number is falling.
Further, let us remind ourselves that when the internet launched, among the first industries to use it was Pornography. We might find porn distasteful, but do we believe that the internet should have been banned because it facilitated the distribution of porn? In the 1990s few could have fathomed what the internet would eventually become. It's the same with bitcoin.
The permission-lessness of the network, where no central authority decides if a transaction is allowed, meant that governments couldn’t stop payments to the drug industry. This however does not mean that law enforcement cannot track payments to the drug industry. The transparency of the network is what enabled law enforcement to find the players behind Mt. Gox and Silk Road.
Bitcoin is a neutral technology that can be used by the criminal and law-abiding alike. Just like we don’t blame cash because it's used for illegal activities or cars because they’re using in kidnappings, bitcoin should not be blamed for global terrorism, especially given how little bitcoin is used for unscrupulous purposes.
3. Bitcoin cannot be used as a Medium of Exchange
Allegation - Bitcoin can process a maximum of 7 transactions per second while Visa can process 1,700 transactions per second. At this throughput, we will never be able to use bitcoin to pay for a latte at a cafe.
Tesla recently announced that it'll accept bitcoin as payment for its cars. Paypal will soon allow users to pay their merchants with bitcoin. Many others are working out infrastructure needs to accept crypto payments. So why does this criticism still exist? Because if all payments are processed using the Bitcoin blockchain then the network will get clogged and transaction fees will rise even higher than they are today.
I'd like you to take a minute to understand the following short statement - “Paying for coffee using the Bitcoin blockchain is kind of like paying for coffee with a wire transfer.”
You don’t pay for coffee with a wire transfer. You pay for coffee using MasterCard or Alipay or a Starbucks Loyalty card. Why? Because a wire transfer would be expensive, time-consuming, and simply not worth the hassle, despite being more secure.
A wire transfer is a secure, irreversible, final settlement. Mastercard payment on the other hand is a credit transaction that will hit the merchant’s bank account 2 days later. The customer will pay at the end of the billing cycle and the transaction can be reversed for up to 3 months.
The Bitcoin blockchain is likely to take on a role similar to Fedwire and be utilized for final settlements. For instance, if HSBC and Citibank customers have 10,000 transactions of varying amounts with each other today, HSBC and Citibank do not execute 10,000 individual transfers between themselves. They make 1 transfer for the net amount using the Central Bank payment system.
The Bitcoin ecosystem is working on a similar solution where a Layer 2 will execute micro-transactions while net settlements will take place on the Bitcoin blockchain. The most promising Layer 2 solution is called the Lightning Network. One can make payments nearly instantly and at near-zero cost using this solution. The Layer 2 is still not fully functional but this is the direction the protocol development is focused. Till Layer 2 is fully developed, bitcoin is likely to continue to function more as a Store of Value than a Medium of Exchange.
Having said that, why did Bitcoin settle for such a small block size? (Bitcoin has a block size of 1MB vs 32MB for Bitcoin Cash and 2GB for Bitcoin SV). If you increase bitcoin block size then the number of transactions that can be settled on the main blockchain per second would increase.
=> Any technology has to make trade-offs. Increasing the block size does not impact miners but makes validating blocks more expensive. This leads to fewer validators and hence lowers network security. The best example of the ill-effects of large block sizes is EOS where running a full archive node is nearly impossible.
4. Governments will ban bitcoin
Allegation - “Government’ outlawing bitcoin is a good probability” - Ray Dalio. If the US government could outlaw the possession of gold in the 1930s, there’s nothing stopping them from outlawing bitcoin.
Bitcoin threatens the power of governments and central banks. They are therefore unlikely to lay out the red carpet for it. Banning bitcoin however is easier said than done. To start with, one country banning bitcoin is not enough. That would only serve to exclude that country from crypto developments. At least all major countries will need to ban bitcoin for the ban to be truly effective. Every country would have to declare all crypto companies illegal, stop trading in bitcoin trusts, bitcoin ETFs and bitcoin futures, get their citizens to turn over the private keys to their coins to the authorities under threat of jail time, find and bulldoze mining farms (seizure of mining capacity is not enough as you don't want the governments to keep mining capacity for themselves), somehow stop hobbyists from mining from their homes, etc. How likely is that?
The discussion in India to ban bitcoin seems to be subsiding with the realization that if a ban was feasible at all, the impact would be to exclude Indians from crypto innovation which the government does not want. The discussion on the ban of cryptocurrencies in Nigeria appears to have subsided with the Central Bank of Nigeria (CBN) claiming that they never actually banned cryptocurrency activity in the country.
We already seem to have reached a point where billion-dollar asset management firms and the most conservative of insurance funds are investing in cryptocurrencies, institutional-grade support services including custody and tax reporting are available, ETFs have been approved, and jurisdictions like Wyoming and Miami are competing to be seen as crypto-friendly venues to attract crypto investments. The boat may have sailed on a full-fledged ban.
This is not to say that governments won't try to put roadblocks in the path to crypto adoption. They will. They can impose crippling KYC requirements, control the access to on-off ramps for their citizens, order their banks to refuse funding to crypto firms, etc. Bitcoin’s censorship resistance is being tested as we speak.
5. Bitcoin is bad for the Environment
Allegation - Bloomberg published an article earlier this year where it called Bitcoin an “Incredibly Dirty Business” and pointed out that 1 Bitcoin transaction generates the CO2 equivalent of 706,765 swipes of a Visa credit card.
First, let's accept it upfront - “Bitcoin consumes a lot of energy”. Energy consumption is the very basis for securing the network.
In that, it is similar to gold. Gold is among the most destructive of industries. Producing enough gold for 1 wedding ring generates 20 tons of toxic waste. Gold mining contaminates water and land with mercury and cyanide and destroys pristine landscapes. Since the more accessible gold deposits have already been mined, gold mining is now moving to ecologically more sensitive areas and displacing communities.
I’m not saying this to criticize gold, but to point out that gold is valuable precisely because it consumes a lot of energy and is expensive to produce. If it was cheap to produce, it would lose its function as a store of value. The good news is that bitcoin is far better than gold in terms of carbon footprint. Here is why:
1. 76% of miners use renewables as part of their energy mix and 39% of total mining energy consumption is renewables. Also, the share of renewables is rising as we speak.
2. An increasing part of energy utilized in bitcoin mining is stranded energy. Stranded gas is natural gas that is too expensive to transport and hence is currently flared to avoid explosion. Companies like Equinor, Crusoe Energy Systems, and Greenidge Generation are utilizing this stranded energy that would otherwise be burnt, for bitcoin mining.
3. It is important to understand that the global energy problem is not one of a shortage of energy but the inability to transport abundant energy to places where it is needed. Ross Stevens explains this perfectly in the Stoneridge Shareholder Letter. Cities like New York, Hong Kong, Tokyo, and Mumbai weren't built near power sources. They were built near ports. Electricity had to be transported to these cities. Industries then developed around these cities because these cities had roads, infrastructure, and human talent. Bitcoin mining is one industry that does not need to be located around a human settlement. It can be located anywhere. Including next to an inaccessible waterfall whose energy is currently not being harnessed because it cannot be transported profitably. This means that a bitcoin mining site can potentially attract human settlement around a renewable power source at a location that is currently impoverished.
=> This is the direction in which bitcoin mining is moving. The bitcoin protocol that relies on people looking out for their best interests is incentivizing users to develop and utilize renewable sources of energy, as mining using unsubsidized fossil fuels is already unprofitable.
Now let's go back to the specific allegation made by Bloomberg that 1 bitcoin transaction consumes the same energy as 706,765 Visa card swipes.
I think Nic Carter says it best when he calls it an “apples-to-koalas comparison”. Visa is a single layer of the payment system, while bitcoin is the entire payment system.
Visa as a non-final credit transaction is just a thin layer of the overall payment stack. For the Visa swipe to work, it needs well-functioning external settlement rails including the global correspondent banking system, clearinghouses, Fedwire, SWIFT messaging, Central Banks, and the US military and diplomatic strength ensuring the supremacy of the US$.
Therefore, while determining the energy consumption of that swipe, we must include the energy consumed by and waste created by all the buildings that house all the above-mentioned entities, travel necessitated by all those entities, the paperwork created by those entities, the carbon footprint of the employees of those entities, etc. And actually, there’s more. Visa payments work because of the status of the US$ as the global reserve currency, and that is maintained by the presence of the US military in every corner of the globe. That same US military is the single largest consumer of oil globally.
Bitcoin on the other hand is a full-stack, self-contained monetary system. Bitcoin transactions rely only on bitcoin. Because of its transparency, it is easy to calculate its carbon footprint, but let us not pretend that the current monetary system does not have polluting negative externalities.
Before ending the discussion on this topic, I’d want to make another point. Anything of value causes some pollution. Cars cause pollution but we accept them as they contribute to human development. Sanitary pads cause pollution but we accept them because they make it possible for women to participate equally in the world. Yes, we impose stricter emission standards for cars and encourage women to use eco-friendly menstrual cups but we don’t question the need for cars and feminine hygiene.
If people could see why bitcoin is useful, I suspect that the criticism regarding energy consumption would die down. We need people to see the value of a decentralized, censorship-resistant, seizure-resistant, immutable, rule-based monetary system that cannot be manipulated by the powerful. Unless they see that, any joule of energy consumed, will be a joule too much.
6. Bitcoin has Zero Inherent Value
Allegation - Bitcoin is not backed by anything
Bitcoin is backed by a global decentralized ledger and the energy consumed to maintain it.
Lions, cows, birds or fish don’t know money. They have no concept of paying dollars for meat or prime forest real estate. Money is a uniquely human invention. It has no inherent value. It works because we believe it has value. The US$ is backed by the US government. What that means is that if you go to the government with a dollar, the government is obliged to return to you a dollar. Yes, the US$ at one point was backed by gold, but believing that gold is money is also a shared human illusion.
So what makes money valuable? Vijay Boyapai in his article The Bullish Case for Bitcoin elaborates on what properties make something valuable as a store of value and gives a score to bitcoin, gold, and fiat on all those properties. As you will see below, bitcoin scores very well.
Durability - Gold wins. All the gold that has ever mined since the time of the pharaohs exists in some shape or form today. Bitcoin’s durability is unproven and will survive as long as the network of miners and nodes that secure it remains in place. The fact that it has survived this long despite nation states attempting to ban it is encouraging. Fiat survives as long as the issuing institutions survive.
Portability- Bitcoin wins. Bitcoin ownership is represented by a digital private key that can be transported in a pen drive, piece of paper, or simply memorized. Now try bringing a million dollars worth of gold to an international airport. Regarding fiat, regulation and capital controls limit portability.
Fungibility - Gold wins. Gold is the most fungible as an ounce of gold is always equal to another ounce of gold. Because of its transparency, it is possible to spot which bitcoin was used for illicit activity. Merchants can refuse to accept such tainted coins. Fiat is also fungible but with CBDCs, governments will have the power to issue programmable money with varying properties.
Verifiability - Bitcoin wins. Bitcoin is the most verifiable. Cryptographic signatures prove ownership in a transparent network. Counterfeiting is a real problem with cash and even gold can be counterfeited using gold plated tungsten.
Divisibility - Bitcoin wins. It is divisible to up to 100,000,000th of a bitcoin. Cash comes next as it is divisible to pocket change. Gold is physically difficult to subdivide beyond a certain level.
Scarcity - Bitcoin wins. Bitcoin supply is transparently scarce. There will at most only be 21 million bitcoin created and its supply cannot be adjusted based on demand. Gold is scarce but one cannot be certain about how much gold exists out there yet to be discovered. Fiat fails miserably in this test as unlimited amounts get printed by several central banks.
Censorship resistance - Bitcoin wins. Regulations like capital controls by nation-states do not apply to the peer-to-peer bitcoin network. Governments cannot stop you from taking your bitcoin with you when you move to a foreign country. They can stop you from taking your cash or your gold.
=> The combined impact of the above properties is what gives bitcoin value.
Before closing on the topic, I’d add that it sometimes takes time for the human mind to attribute value to intangible items. Earlier physical share certificates were issued to prove stock ownership. There was a certain discomfort when stock ownership became digital with Demat accounts. When we deposit money in a bank we have a mental image of the bank storing our money in its vaults. Of course, we know that is not how it works. The bank lends out multiples of the amount it receives as deposits and our deposit is simply an entry in a digital ledger. It took us some time to internalize the value of such digital assets. It is probably the same with bitcoin.
7. Bitcoin will be replaced by a more Advanced Competitor
Allegation - With all the technical challenges that bitcoin has, it can be replaced by a more advanced technology
Since bitcoin is open source, anyone can take the original code and improve upon it to launch a competitor. Many have tried. Today we have Bitcoin Cash, Bitcoin SV, Litecoin, and Dogecoin that are all hard forks of Bitcoin with some changes like larger block size and faster transaction speed. Despite that, none of them are anywhere close to bitcoin in terms of market cap, transactions processed, active addresses, or hash power.
Why is that? Network effects.
Yassine Elmandjra of Ark Invest, explains it well with an analogy- One cannot replace Facebook by copying its code or developing a superior backend. To replace Facebook, one would need to move most of their users and developers to the replacement. Something Telegram and Signal are both struggling with.
Similarly, it isn’t sufficient to copy the Bitcoin codebase, you need to convince the miners, nodes, users, and developers to move. Bitcoin mining is more profitable than mining other proof of work coins, therefore miners are unlikely to move. If miners don’t move, then the blockchain is less secure and more vulnerable to a 51% attack. If the blockchain is less secure then it is less likely to attract users.
8. Bitcoin Ownership is too Concentrated
Allegation - A Bloomberg report claimed that 95% of all bitcoin was owned by 2% of all accounts.
Glassnode does a thorough analysis of bitcoin holdings here and arrives at the conclusion that at max 71.5% of all bitcoin is held by 2% of network entities.
However, this number is also misleading. Network entities like Exchanges represent 130 million users but are factored as a handful of users in the above calculation. Grayscale Trust holds roughly 650,000BTC which are actually owned by multiple participants but again included as a single entity in the above calculation. 115,000 BTC that are wrapped in the WBTC ERC20 token are held by custodians in separate wallets in bundles of at least 1,000 BTC. This again is actually owned by a larger number of participants than the number of wallets indicate.
Moreover, the relative amount of BTC held by smaller entities has been increasing through the lifetime of Bitcoin. The smallest players (Shrimps & Crabs owning under 10BTC each) have increased 130% since 2017 and the second smallest participants (Octopuses & Fish owning between 10 and 100 BTC) have increased 14%. The holdings of the largest entities (Dolphins & Sharks owning between 100 & 1000 BTC, and Whales & Humpbacks owning over 1,000 BTC) has dropped 3% and 7% respectively.
Final words
Bitcoin is a revolutionary technology and it takes time to get our heads around it. However, the effort is worth it.