Archive for November, 2014

Why it is possible for cryptocurrencies to gain and sustain value

This text is in large part based on the arguments from the NPR article for why gold historically has become the standard currency, “A Chemist Explains Why Gold Beat Out Lithium, Osmium, Einsteinium”, and on my own comparison between the valuable properties of gold and the equivalent properties of Bitcoin and other cryptocurrencies.


So why DID gold win thousands of years ago over other forms of money and stay popular until now?

There’s a few basic properties which is necessary for something to useful as money: It is easy to store, easy to move, it is easy to accurately divide in parts, it doesn’t corrode and isn’t otherwise fragile or deteriorate over time and it isn’t dangerous to handle. Those are the basic physical properties, and without those nobody will want to use it.

And for the economic properties: It is scarce (unlike sand and practically all relevant metal alloys), it is hard to forge (or else you’ll get counterfeits everywhere) and supply is reasonably predictable and don’t increase too fast (something which is scarce on a global scale but doubles every month isn’t useful as money, and something you don’t know the supply of is too uncertain). Another important property is fungibility, that the majority of samples of it is similar enough to be interchangable – which gold fulfills since it is an atom that allows you to purify a sample of the metal by melting it and clearing out the unwanted elements, leaving you with pure gold which always will be the same (without fungibility every sample needs to be valued independently, which is a major PITA).

And since gold has fulfilled all those requirements better than the alternatives (as an example, it is more scarce and corrodes much less than silver), it has become highly valuable. You can with relative ease melt it into whatever shape and size you want, divide it in chunks of arbitary size and store it safely for centuries without it going bad. And you could fairly easily verify that the gold indeed is real gold. So when people wanted to make trades with each other for valuable items, gold was one of the simplest options because there’s always somebody willing to accept it. All the other options were lacking in one or more of these properties compared to gold.

So how does cryptocurrencies like Bitcoin compare?

The comparison is quite straightforward: Scarcity is guaranteed by the blockchain (ledger of transactions) and the accompanying rules which all miners and Bitcoin wallets obey (anybody breaking the rules will be detected and ignored!), the rules of Bitcoin guarantee a maximum of just below 21 million coins and there’s no way around it. You can trivially confirm if the “coins” somebody claims to have is real by looking at the blockchain to see if the referenced transaction is there or not, and if it has been moved away or not. And fungibility is provided as well since on the blockchain all “coins” are essentially equivalent, they are all a form of “statement” in the ledger/database which the blockchain is (“X coins belongs to address Y”). The divisibility goes down to 8 decimals, making for a total of 2,099,999,997,690,000 subunits (that’s two thousand trillion) and more decimals can be added if necessary.

To pay with gold you need to make sure it already is divided in parts with equal value to what you’re buying. No such need with Bitcoin, the software takes care of it automatically. Verifying that the gold is real is much harder than to verify Bitcoins. Bitcoins are far more lightweight – you just need to store the private keys that your addresses are connected to (using public key cryptography) and that can be done on paper, which means storage is far easier by a huge margin once you reach larger values. Like gold, Bitcoins which you hold don’t deteriorate over time. The supply for Bitcoin is highly predictable, scarcity is certain, similar to gold (it is actually far less certain for gold, with the potential for asteroid mining in the future).

Using a Bitcoin wallet is simple. Some of the most common ones are Electrum or Bitcoin Core on computers, Mycelium and Schildbach’s Bitcoin Wallet on Android, and Breadwallet on iOS. None of them need any registration of any kind to use and they can all verify that the “coins” sent to you is real with no extra work required on your part. To send a transaction all you need is an internet connection. Making transactions takes merely seconds, and you can send money globally without a problem. Receiving coins is equally simple, just install one of those wallets and start it, and give the sender the address which your wallet just automatically generated – you don’t even need to be online when recieving! That’s all you have to do, and the wallet tells you when the “coins” is yours to spend. The “coins” will stay there forever if you don’t touch them, and with the high divisibility of Bitcoin you can easily send exactly the sum you want (one thousandth of a dollar? no problem!). No third party needs to be involved, neither part needs to trust the other anymore than they normally would if it were a cash payment or if gold was used to pay.

So then we have established that Bitcoin can match the properties which enabled gold to gain and sustain value, but why would it gain value in the first place? Why do people want start to use it, where is the demand coming from?

I have already mentioned some of the first reasons above – it can be used globally without any need for shipping anything around, it is easier to verify and it is easier to store. But that’s not all, far from it. Thanks to the combination of the blockchain and proof-of-work mining, Bitcoin had the ability to introduce a bunch of new features which are unparalleled – Bitcoin has a scripting language, making it programmable money! It is the first truly decentralized cryptocurrency, all the predecessors relied on central servers and was under the control of a third party.

Can you imagine being able to program a piece of gold to teleport back into your vault if the seller didn’t fulfill the terms you agreed to? With Bitcoin you can do something with just that effect that using 2-of-2 multisignature escrow. Can you imagine being able to securely ensure that something like 3 of 5, or 7 of 10 (or any other combination of numbers you like), people on the board of a company MUST sign all transactions that spend money from the reserves of the company, as if a bar of gold would refuse to move unless enough board members agreed? With Bitcoin you can achieve just that using m-of-n multisignature transactions. Can you imagine being able to prevent a sum of money to be spent before a certain date, as if you could make a bar of gold refuse to move until a given day? With Bitcoin you can do that using timelock transactions. And that’s just the beginning!

So not only does Bitcoin match the properties of gold which enabled it to gain and sustain value, it also provides entirely new and unmatched incentives to use it. If you are involved in just about anything where you want to enforce a certain set of rules on how the money can be spent, Bitcoin can make your life much simpler. If Bitcoin is the best option available to achieve a goal, then there also exists demand for it. And when there’s both demand and a limited supply, it gains value and will have a market price.

What about altcoins (“alternative coins”, other blockchain based cryptocurrencies), why wouldn’t one of them replace Bitcoin? That answer could fill an entire book, but the short answer is that because of the network effect most people will want to use the most popular cryptocurrency, a spot that Bitcoin holds and has held since shortly after its release.

Cryptocurrencies become exponentially more useful the more people that accepts it. It’s the same reason for why there’s usually just a few social networks that’s big at a time, being considered the place to go for discussions and organizing events, and so on. It is the same reason for why the phone networks of most countries are compatible and interconnected. Bitcoin was both first out and good enough to make sure that any competitor needs to be substantially better to be able to beat it. Any competitor would need features that Bitcoin is unable to replicate, but since Bitcoin fundamentally is a computer protocol implemented in software it can also be updated to replicate any features of a competitor before that competitor would gain momentum. So the probability that an altcoin would overtake Bitcoin is very slim, and any software developer capable of creating a better altcoin likely would gain more from working on improving Bitcoin itself instead.

Then there’s the question of how valuable it will become. Since the demand on global markets is inherently unpredictable (you can never be certain that current trends continue), nobody can possibly know for certain. There’s no guarantee it will ever go up from here, because for all we know it might already have found its niche in the market. My personal opinion is that what it offers is so much better than the current options (mainly fiat currencies, also known as state issued paper money) and payment mechanisms (such as credit cards and paypal) that the demand should grow in the future when other people takes a closer look and decide that its features is desirable.

One thing we can know for certain is that it will be interesting to follow its progress in the future, no matter where it goes.

If you have any questions, feel free to ask below. I’ll try my best to answer most questions, anything from questions about the technology to the economic incentives and how to use it.

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