Is Bitcoin a Good Store of Value?

Date: September 2022

I am writing this to summarize what I’ve learned about bitcoin. I used to be skeptical of bitcoin, but recently I’ve come around to see its value.

This article tries to answer the questions that I consider to be most critical in examining bitcoin’s value. It uses as simple language as possible so that hopefully a person who is unfamiliar with this topic can understand it too.

This is a complex topic I am continuing to learn about, so I appreciate any feedback, challenges, and questions.

The base case for the value of Bitcoin

The base argument for the value of Bitcoin is that it is an emergent form of money that could replace some of the functions that existing money like gold and government currencies do for our society.

Money is strange if you think about it. Unlike a computer, or a loaf of bread, or a rental property with income, goods considered money like paper currency or gold bars have little usefulness on their own. Offer them to a pre-historic human, and you wouldn’t get anything back in exchange. But in today’s society, we value money for its important functions in our economy: storing value for the future, as a medium of exchange with others, and as a unit of account to measure other goods and services.

In the most abstract way to think about it, money is a technology that allows a society to divide up economic value and transfer value across time and space. It’s a pretty incredible invention.

To assess the value of bitcoin involves understanding: is it fulfilling the functions of money, and is it offering new benefits that existing forms of money are not able to?

We’ll start by comparing it to existing forms of money.

Gold

Precious metals like gold has been valued as money for thousands of years and across different cultures in human history. Gold has been particularly highly valued because it has been the hardest and most costly to produce. The mining difficulty has remained as true today as it was for thousands of years. Despite the high incentive to mine for more and with better technology, global production could only increase the total supply by approximately 1.5% every year. Gold also doesn’t erode. If you owned a bar of gold 100 years ago, it would be just as valuable if not more today. Gold is the monetary good with the best store of value that we know.

But gold makes a poor medium of exchange in today’s global economy. The physical weight makes it hard to transfer across large distances. The high value also makes it impractical for small purchases. This limitation of gold is why paper currencies became dominant.

Fiat Currencies

Paper currencies backed by governments are also called fiat currency. Fiat means by authoritative command or decree. They are issued by the government (often through the central bank, which is a bank that support all other banks) and are enforced to be the only money that is acceptable for paying taxes and debts (i.e. “legal tender”).

Fiat currencies, combined with the telecommunication network, are excellent mediums of exchange for a global economy. Countries around the world typically hold each other’s currencies in reserve (US dollar is what’s mostly held). They can record transactions across the wire and settle it in the bank accounts quickly. However, they are not great stores of value.

Fiat currencies cost almost nothing to produce. They are not tied to any real physical wealth. The only way they can retain their value is through legal enforcement and good management by the central banks. Central banks in general believe that expanding the money supply slightly every year is good for economic growth. They generally target an inflation rate of 2%, which means that the currency loses half its value in approximately 36 years. It is not a good long-term store of value.

Fiat currencies risk as an even worse store of value in cases where mismanagement by governments create hyperinflation. In hyperinflation, a currency can rapidly lose half of its value in weeks and months. Living in developed countries, this may seem rare. But globally, since 1918, hyperinflation has occurred 56 times. With a monopolized control on money supply and zero cost to produce more, it is naturally tempting for a government to print more money to solve its financial problems.

Bitcoin’s Promise

Gold is a good store of value but a poor medium of exchange. Fiat currency is a poor store of value but a good medium of exchange. If there is a new form of money that is both a good store of value and a good medium of exchange, it would have a higher value than gold and fiat currency. This is bitcoin’s basic promise.

Bitcoin tries to achieve this through issuing a digital money on a network that cannot be controlled by any centralized entity. It maintains a scarce money supply and supports peer-to-peer transactions that require no permission from any third party. No government or bank can intervene.

At first glance, it is not obvious why these features are useful (except perhaps for those engaged in illicit activities). For most of us living in developed countries, we are quite comfortable doing our financial activities through established institutions. Our currency is generally stable; we trust the banks with our money; we do online payments through credit cards or bank transfers. From this perspective, bitcoin is at best a speculative collectible.

However, if we expand the perspective globally, we would find bitcoin to be gaining practical adoption in countries that have bad currencies, poor banking services, and / or authoritarian governments. Ordinary citizens have been using bitcoin to protect their wealth against hyperinflation, access the global economy, and protect themselves against government infringement on property.

How much someone values bitcoin is typically correlated with how much they trust their government and institutions. In developed countries, there is a modern history of good governance that earns government trust. But it is also important to keep in mind that our system of fiat currency is only 50 years old, while the historical record of any government controlled money is not good. Looking across history, it is the tendency for governments to print money and assert authoritative control in times of crisis. Those who find alternative ways to store their wealth tend to weather the turbulence better. Bitcoin could be one such option.

Bitcoin’s ultimate promise, if it reaches there, is for it to become a global reserve currency that is not only held by individuals, corporations, but also nation states. As a currency that cannot be controlled by any government, it could become the trusted currency that all nations use to facilitate trades. This would be similar to the role that gold played in the late 1800s and early 1900s.

To fulfill its promise, bitcoin has some way to go. The path for something to become socially-accepted money goes through 4 stages: as a collectible, as a store of value, as a medium of exchange, and finally as the unit of account to measure all things. Bitcoin started as a fun collectible and is now establishing itself as a store of value. It still functions as a poor medium of exchange because of its slow speed and limited transaction volume, but that is about to change as new layers of technology like the Lightning network are being built on top of it.

Tens of thousands of other cryptocurrencies followed the emergence of bitcoin 12 years ago. But none of them have the same promise as bitcoin, because bitcoin focused on establishing itself a reliable store of value before scaling its capability as a medium of exchange. This is one of the reasons why bitcoin is still the top cryptocurrency today with a total market capitalization (i.e. the value of its total supply) around 400 billion (as of August 2022).

In the next section, we’ll examine whether we can trust the claim that bitcoin is a digital money that is scarce and non-reproducible.

Is it actually scarce?

A critical question to whether bitcoin has value is whether it is actually scarce and non-reproducible as a digital product? This was my critique for a long time, but I’ve come to see that bitcoin is achieving the scarcity effect. Theoretically, anything digital can be reproduced to the infinite. But bitcoin so far has proved to have guards against those risks.

The key mechanism that bitcoin enforces the scarcity and non-reproducibility of its money supply is having a public ledger of all transactions that is visible and verifiable by everyone on the network. This public ledger is what’s known as the “blockchain”, because it is a chain of blocks that records the sequence of all transactions from the beginning of bitcoin’s existence to now. The ownership of every bitcoin is transparent. No new bitcoin can come into existence except by pre-established rules. No one can modify the blockchain without the consensus of the whole network. There have been attempts by different parties to change the blockchain, but to-date they have all failed. An attacker that can control the majority of the mining power could disrupt new transactions, but it still could not erase old transactions (the vulnerability of this “51%” attack is further explored in later sections).

The other mechanism that bitcoin uses to create scarcity is to establish a maximum cap on the total money supply. This is capped at 21 million bitcoins. New bitcoins are still issued today at a fixed rate, which is inflationary. But this rate decreases by half every 4 years, until the limit of 21 million is reached. When entering the next halving cycle in 2024, bitcoin will have a production rate that is even harder than the hardest money known to date, which is gold.

Another reason that bitcoin has scarcity is that the blockchain, despite being a digital good, is actually tied to physical scarcity. The creation of each block requires immense amount of electricity for computing power. This mechanism is called “proof-of-work”. Just like gold is valuable because it is a proof that an immense amount of work and costs went into mining for it, bitcoin is a proof of the amount of computing and electricity costs that were invested. It cannot just be created out of thin air.

How does Bitcoin retain its value against competitor cryptocurrencies?

Another key question is: sure, bitcoin has scarcity within supply, but there is nothing to stop someone from copying bitcoin to create another digital money, which can be an infinite number. There can be a finite amount of bitcoins, but there can be infinite amount of new cryptocurrencies. So what makes bitcoin retain a value of scarcity?

That was also my biggest concern. There are tens of thousands of cryptocurrencies in the market now. What distinguishes bitcoin? Couldn’t one of the newer ones replace bitcoin in the worst case, or dilute its value in the nominal case?

Yet, the answer to this is that Bitcoin has achieved a dominant network effect. A clone can have the exact same technology but not have the same value because it doesn’t have the same base of users. You can clone the Facebook or Wikipedia technology, but you cannot clone its network.

For a new competitor to take up Bitcoin’s dominant position, it needs to be not only slightly better but 10x better. Many have tried, and many new ones are still trying. They are offering new or better features in smart contracts, decentralized finance, transaction speed and volume, privacy, security, etc. But they have all one fundamental problem. The Bitcoin network was designed to be decentralized, so that no one needs to trust anyone else except the public blockchain. All other cryptocurrencies added new features that created a trade-off against decentralization. None of them are as decentralized as they claim. Many of them, including the second biggest cryptocurrency on the market, Ethereum, have been able to modify the blockchain.

The reason that Bitcoin has retained its value against other cryptocurrencies is that it focused on being a good store of value first. Other cryptocurrencies were trying to scale to become a medium of exchange before it is a good store of value. In packing too many features, the network became only accessible by big computers, influenced and controlled by the few.

With bitcoin, even you with an average laptop can download and verify the entire blockchain. There was a time when a large percentage of bitcoin developers and miners wanted to change the blockchain size to allow for larger transaction speed and volume (look up “the blocksize war”). But they failed, because the majority of user nodes did not agree. This delicate balance of power exists in Bitcoin, but not to the same extent in the other cryptocurrencies.

Bitcoin is the only cryptocurrency that grew organically. The anonymous founder disappeared without making any profit. There is no developer committee or investor group that has the power to change Bitcoin. All other cryptocurrencies are backed by a group of developers and investors who have control and influence. Ethereum, for example, has a monetary currency that is continually changed and tweaked by the developer group. This is not much different from a money supply controlled by a central bank.

While bitcoin does not have the complex futures that other cryptocurrencies currently do, I think that will change. As someone with an engineering background, I know that good technology design is modular and layered. Internet protocol is a good example. Each layer is simple and focused on its own purpose. And you can create more complex behaviours by layering on top. Bitcoin has a good foundation in its base layer that is secure, decentralized, and a good store of value. New layers of technology are maturing now on top that can achieve fast and high volume transactions. The Lightning network in particular looks very promising.

Bitcoin’s network dominance cannot be ignored. In a market with free choices, people would pour their wealth into the best money available. There are rarely space for multiple winners. You can see this being played out in a developing country with high inflation, when people would hoard a more stable currency like US dollars. This was also played out in late 1800s when most of the nations in the world converged around the gold standard, and silver rapidly dropped in value.

Bitcoin is still new. Being a digital asset, there are still risks and hurdles. But it has proved itself now against multiple threats and still retained its value. Will it survive in 100 years? I don’t know. Can it become even more dominant in the next 5-10 years? I see that as a likely possibility.

What is the potential future value?

The potential future value of bitcoin depends on how much it can displace the total value currently invested in gold/silver and fiat currencies. Bitcoin is already 5-10% of the gold market capitalization. As it improves as a medium of exchange, it could also start to displace more of the fiat currencies.

Bitcoin’s current market cap is around $400 billion. Gold’s market cap is around $11 trillion. Bitcoin has been fluctuating between 5-10% of gold’s market cap.

The market cap of all the world’s fiat currencies is around 120 trillion. Bitcoin is approximately 0.3% of that. With the current high level of national and household debt, central banks around the world will have no choice but to print more money at some point to make the debt value smaller. With bitcoin holding its value with a limited supply, I would expect more people to allocate some of their wealth from fiat currencies into bitcoin this decade. Will bitcoin take over 1% of the total currency market? 5%? 10%? We’ll have to wait and see. There is certainly still room to grow from the current 0.3%. As a comparison, Chinese RMB has about 30% of the market, USD has about 20%, Euro about 15%.

Approximately 1-2% of the world population owns bitcoin right now. It’s being adopted not only by individual investors but also increasingly large institutional investors. This is still the early adoption phase. When a new technology adoption reaches 10%, it will be a significant tipping point into mainstream. Nothing is guaranteed, but the curve of adoption that Bitcoin is currently on is projecting well. Despite the volatility that comes from being an early technology, the fundamental technology and business value seems sound to me. It is hard to predict how government and central banks will respond yet if Bitcoin goes mainstream. They are also exploring CBDC (central bank digital currencies). But a decentralized currency like Bitcoin has enough unique appeal that it will be difficult to simply go away.

What could make Bitcoin Fail?

As a digital technology, bitcoin has many risks and unknowns. So one should be clear-eyed about what is one buying into. If one buys a bar of gold, it will most likely retain its value in 100 years. But the same cannot be said for bitcoin. Bitcoin has proved its security and reliability so far in its 12 years history. I think it will most likely to be around for the next 5-10 years, but I cannot say for sure about 100 years. Things change quickly in this space, and the risks need to be monitored.

Government Ban

Bitcoin is difficult to ban from the technical perspective. To enforce a full ban on bitcoin would require a country to cut off its entire internet network from the rest of the world. It’s possible to initiate a ban like China did, but as long as someone has internet access, there are ways to get around it.

It is difficult to ban entirely, but government regulation could still limit how widely bitcoin is adopted.

There are precedents. Between the 1930s and 70s, the US government banned ownership of gold to enforce the value of a depreciating fiat currency. The difference with bitcoin is that it is not physical like gold; it is just information, making it impossible to fully ban or confiscate. Any attempt to ban or limit bitcoin may also have the opposite effect of signalling its value proposition as a hedge against authority control.

With the increasing investment in bitcoin from institutional investors and wealth elite, there could also be increasing political influence to lobby against the banning of bitcoin.

Theft with the 51% attack

The 51% attack happens when a malicious actor accumulates enough computing mining power to control more than 50% of Bitcoin’s total computing power. Bitcoin transactions are confirmed through distributed computing power. If an attacker controls the majority of the computing power, it can create invalid transactions where it uses coins that it does not have for profit (i.e. double-spending coins that it already used).

So far, this has not happened on the bitcoin network and is now unlikely to happen as the network grows. The total computing power on the bitcoin network is now too large for any single attacker to take on. The 51% attack has occurred on cryptocurrencies with smaller networks, however.

It also hasn’t happened on bitcoin because it is not an economically viable move. The profit is limited. No previous bitcoin transaction can be erased or reversed. The attacker can only take advantage of new transactions. Finally, any attack would reduce the market trust and market value on the bitcoin network, which goes against the motivation of anyone who wants to collect bitcoins.

Hostile State Attack

It is not economically viable for an attacker to mount a 51% attack on bitcoin for profit. But what about a government who could attack it for non-economic motives?

This is still incredibly difficult. Revenue for all bitcoin miners in 2021 was $15 billion, which is also a rough estimate of the running cost for all the computing power. In addition, the cost for all the highly-specialized mining computers is in the range of $8 billion. So to mount the attack would require a government (or a group of governments) to spend in the range of $20 billion. This is beyond the budget of most small countries. It could be possible for countries with big defence budgets. For example, US has an annual military budget of $800 billion, China is close to $290 billion. This attack would still take time to prepare, with lots of give-away signals.

If this happens, it will be a huge test for the bitcoin network. It will be a battle between government force and the ability of the bitcoin network to adapt. The damage is limited, however. The attack can disrupt new transactions, but it cannot erase the history of transactions. It would be cheaper to just run denial-of-service attacks on the network.

Rival Cryptocurrencies

Tens of thousands of new cryptocurrencies came after Bitcoin, all claiming to have better features than Bitcoin. But Bitcoin persisted as the top crypto on the market, while many of the new ones got washed out.

Because monetary goods require network effects, there are only few winners. It is hard for any other crypto to displace bitcoin’s network effect at the moment.

There could be better technology that comes along. But bitcoin, with all the computing power and wealth attached to it now, can also adapt (as long as there is network consensus).

The development of CBDC (central bank digital currency) is something to monitor. As a currency that would be native to the digital space, CBDC could offer benefits that are similar to bitcoin’s and compete for the same market share. However, I fail to see how it can replace bitcoin. CBCD would give central banks even tighter control over the currency. For example, it would allow the central bank to set negative interest rates. The desire to escape from this type of control is what drove many people towards Bitcoin in the first place.

Collapse of Mining Revenue

This is a risk that is not mentioned enough. If Bitcoin fails to scale into a high-volume medium of exchange, it will collapse. It will either scale or collapse; there is not much middle ground for it to stay as a collectible and store of value.

This is because bitcoin’s network security depends on its total mining computing power. Today, miners are rewarded mostly with new bitcoins that come into existence. A small fraction of the mining revenue comes from transaction fees paid by the transaction parties. Over time, however, less and less new bitcoins are issued. And as the total number of bitcoins reaches 21 million, no more new bitcoins will be issued. The miners’ revenue will all need to come from transaction fees. If there is not a high enough transaction volume, the number of miners will significantly drop, making bitcoin vulnerable to attack.

Therefore, Bitcoin’s future success depends on its ability to scale as a high-volume medium of exchange. There is currently a growing network of services being built up around Bitcoin to make it more suitable as a high volume payment system. The Lightning network is one such example that looks promising.

This problem won’t fully present itself til decades into the future, so there is still time for Bitcoin to grow. I am cautiously optimistic here. The next several years could be a critical time to see if bitcoin gains wider adoption.