- Thoughts on Bitcoin: following up the article by Ray Dalio
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Ray Dalio recently published an article about his thoughts on Bitcoin and its prospects. I should say that for me, as a blockchain enthusiast, it’s inspiring to see how more and more people from the world of finance recognize the technology and its potential. From that article, I also see that, although being mostly correct, it lacks some important statements worth mentioning to make the picture more complete and clear. For this reason, I’d like to express my point of view on some matters that were covered in the aforementioned article.
In this post, I’ll point out some important features of Bitcoin and cryptocurrencies in general that maybe helpful for people who seek to understand crypto technology and that can unlikely be found in other sources.
To start with, it seems that the authors of the article perceive all blokchains as competitors of Bitcoin (although recognizing Bitcoin’s limited potential as a medium of exchange). That’s not something unusual, as such approach is quite standard in the crypto community. It is commonly believed that Bitcoin was the grandpa of all blockchains (cannot deny that), which is why Bitcoin, together with some early altcoins, is usually classified as “blockchain 1.0.” Then Ethereum came with all its bells and whistles, which caused its perception as an upgraded Bitcoin and hence “blockchain 2.0.” Later projects, which mostly offered technical improvements to the concept of Ethereum, are considered “blockchain 3.0.”
According to this approach, we can envision the development of the industry as a consequential introduction of more and more enhanced technical implementations of the ideas embedded by Satoshi in Bitcoin. We can assume that eventually there comes a version so advanced that it will finally surpass Bitcoin and become a number one cryptocurrency.
I, however, find the underlying premises of this classification incorrect. Decentralized ledger technology (DLT) allows to build ledgers of different purpose, which not only do not compete with each other, but can easily co-exist and be mutually benefitting. Moreover, I consider that Bitcoin has no actual potent competitors and won’t have any in future. I can propose the following general classification:
1 Digital gold: coins optimized to store value. This is where Bitcoin and it’s actual competitors (Litecoin, Monero, different forks, etc.) should be placed. The main distinguishing feature is the concept of a scarce supply (either fixed or slowly inflating/contracting), which secures that the value of each unit shouldn’t drop given the presence of a constant (at least non-dropping) demand.
2 Decentralized virtual machines: smart contract platforms used as an infrastructure for various tokens (Ethereum and most modern DLTs). The main distinguishing feature is the support of Turing-complete scripts.
3 Digital money: coins designed to serve as an actual medium of exchange. Ironically, despite the fact that we know a lot of cryptocurrencies, there is no actual currency among them, and this category is still empty. We can conditionally place so-called algorithmic stablecoins here, but this would be an exaggerated claim, for none of the existing platforms is actually capable of substituting the conventional fiat currency framework.
This classification instantly raises a question: why digital gold and digital money are separate categories if there’s no reason why an asset that can be a medium of exchange cannot be a value storage and vice versa? In addition, why can’t Ethereum and other platforms of its kind perform the stated functions? Well, that’s a tricky part that causes a lot of confusion.
Indeed, a monetary asset is commonly considered to perform three main functions: a medium of exchange, a unit of account, and a storage of value. The first function, however, is the main point from which the other two are derived. As long as the asset is accepted as a universal medium of exchange for various goods, it becomes convenient to measure the value of goods in its units. We can also store value in such units taking into account that the amount of the value stored is comparable to the value of goods ready to be sold for those units.
If we apply this logic to Bitcoin, however, it simply fails. Bitcoin’s market cap greatly exceeds the size of the real economy behind it, and there is nothing tangible that justifies its current value, which forces to perceive it as a kind of a financial bubble. In reality, the intrinsic value of Bitcoin has the same origin as that of gold. It derives from two premises:
a) due to Bitcoin’s properties, people find it a perfect store of value;
b) people expect others to think the same way.
As long as there is a demand for hedging assets that are engaged to store value when financial markets seem unreliable and uncertain (or simply to counter inflation), people will look for an asset that has the best properties to be used as such. The more people choose a particular asset, the more value it accumulates. This is exactly what is happening to Bitcoin, and this shows that it is here to stay at least until a better asset in invented. Since under the current conditions Bitcoin is much more convenient to use as a hedging asset (its digital nature perfectly fits the digital era we are living in), we can presume that it will slowly drain capital from gold and other conventional assets, as more and more people will acknowledge its benefits.
The statements above show that perception of Bitcoin as a gold-like value storage asset is absolutely correct. They, however, also show that Bitcoin grew not because it was promoted by someone (or the community in general), but rather dew to game-theoretical incentives embedded in its design. Simply put, when someone realizes its benefits, he is incentivized to invest ASAP, because he understands that once someone else realizes the same, he will be willing to join too. The more people join and the more capital is accumulated, the more the value grows. At this point, it really looks like a speculative bubble, a Ponzi scheme or whatever else of this kind. There is one important feature, though: there is no incentive to exit. Unlike common financial bubbles, although we can play a speculative game, the asset cannot be completely abandoned, because there is no better alternative to opt for. Even if someone cashes out in the expectations of a future price drop, he will inevitably join again, as the need of a hedging asset never depletes. That intrinsic utility function guarantees that Bitcoin is here to stay.
Now that we see that Bitcoin is a good asset for value storage, why cannot we use it for payments and why cannot we place it in the digital money category? We surely can, and to a certain extent Bitcoin can perform money functions, indeed, but so does any more or less liquid asset.
Satoshi was a bit naïve to endow it with the properties of gold and consider it appropriate for a digital cash. The main argument of Bitcoin proponents is that gold successfully performed the functions of money for centuries and that fiat money was an invention of evil bankers, which allowed them to print money at their discretion and enrich themselves at the expense of common citizens. I may agree with the last statement to a certain extent, but no matter how much I dislike the modern FRB system, I cannot argue that the adoption of the current monetary model was a necessity that helped stabilize the economy and secure a long-term economic growth.
Contrary to Satoshi’s belief, the concept of a scarce supply actually precludes the asset of becoming a universal medium of exchange. This is a long story, which is covered in this article.
For that reason, I divided digital money from digital gold in my classification: if you endow an asset with properties that make it a perfect money, it won’t be a good storage of value and vice versa. These two concepts are incompatible.
Now, speaking about Bitcoin’s prospects, I can’t fully agree with the assumption that Bitcoin can possibly be overthrown by competitors, which is derived from the blockchain 1.0–3.0 classification and is mentioned by the authors from Bridgewater. I acknowledge competition in other types of DLTs, but I do not believe that something can compete with Bitcoin for the status of digital gold. There are two reasons for that:
a) Bitcoin can be highly flexible and adaptive. The premise that the way Bitcoin works is fixed is incorrect. In fact, we can make any required amendments into the underlying protocol up to changing it completely. The current version of Bitcoin has undergone several forks and the original Bitcoin blockchain is long abandoned. If there comes a system so far superior to Bitcoin that it is capable of surpassing it, we can simply take its protocol, transfer Bitcoin’s current UTXOs into it, and call it Bitcoin from that point. Simply put, Bitcoin is anything we agreed to call such.
The reason why Bitcoin stays as it is lies in the lack of urgent necessity to seriously amend it and the resistance of certain interested parties with high authority. To better understand how this works, it is advisable to research the matter of forks and decentralization in general. It’s a long story, which I can’t cover in this post.
b) The game-theoretical fundamentals of Bitcoin, which force each player to predict the choice of the others. When you choose a value storage, you should not only take into the account your own preferences, but also try to predict the behavior of the others. This all is brought down to a game with a focal point, which is apparently a long-adopted Bitcoin with a tremendous baggage of credibility rather than some new system, even if it’s technically superior.
The only option for the new system to win is coming to a consensus and moving simultaneously, which requires players to be coordinated. It would be safe to assume that it could be done via a massive PR campaign, but that begets an inherent downside: such a campaign can be only held in a centralized manner with an obvious beneficiary, which unavoidably undermines credibility.
As for the potential problems with authorities, it’s obvious that regulators will involve more over time and that it can affect Bitcoin’s value and the industry in general, but I do not believe that it can come to harsh restrictive measures for the following reasons:
a) It is unwise to fight progress.
Bitcoin and DLTs in general are not just some new products, but implementations of a completely new paradigm of decentralization. It’s an evolutionary step in the development of digital assets, and we cannot simply throw it away and pretend that it never existed. It’s much more beneficial to jump on board now than to run after the train when you have already missed it. That’s why governments that will try to wage a war on DLTs will simply fight against their own economic and technological progress. Although it may be tempting for conservative politicians to simply ban any risky technology that is capable of shifting the settled paradigm, there are also many among them who are aware of the consequences. So, in the near future we will likely witness some tug-of-war about the subject among different political forces, but I see no way for conservatives to win it completely.
b) Bitcoin doesn’t threaten conventional financial infrastructure.
My point of view is a bit controversial and is not popular in the blockchain community, but I strongly believe that Bitcoin is perceived incorrectly and it cannot perform as a fully-fledged monetary asset (which I explained above). Therefore, being just another type of a hedging asset, it poses no threat to fiat financial infrastructure. Of course, to a certain extent we can use it for payments and it can perform functions of money as any more or less liquid asset can, but it can never become money overall.
c) Decentralization impedes enforcement.
Decentralized blockchains are designed to resist centralized regulation attempts, which renders many restrictive legal measures inefficient. We all know that Bitcoin had been long prohibited in China, yet over 60% of its hashing power is reported to be located in that country.
The SEC directly acknowledges the importance of decentralization. According to William Hinman, in the presence of a sufficient level of decentralization “the ability to identify an issuer or promoter to make the requisite disclosures becomes difficult, and less meaningful.”
This means that regulation will mostly target outputs to conventional finance (stock exchanges, institutionals, etc.) rather than blockchains themselves. To a certain extent, this may create a threat to the pace of proliferation of blockchains, but regulators unlikely possess enough power to pose an existential threat to truly decentralized platforms.
Overall, I consider risks coming from regulators exaggerated. There will likely be some restrictions put on the turnover of certain cryptocurrencies (those with an emphasis on privacy at least), and there may be some restrictions toward operations with cryptocurrencies for certain actors (institutional investors, state companies, etc.), but regulators will unlikely go for serious attempts to shut down the industry or, if they do so, their actions will have a very limited efficiency.
Decentralized Virtual Machines as Storage of Value or Money
What about Ethereum and other similar platforms? Can their native tokens be an equally good storage of value as Bitcoin? In fact, they can, but it completely distorts the entire concept, which is why they shouldn’t.
Storing and transacting native coins of such blockchains (say Ether in Ethereum) is not the main purpose around which the systems are build. The main idea is to create smart contracts and transact tokens generated by them. Native coins serve as a payment for block creators (or other participants of various roles) for processing smart contracts, which is why they are often presented as fuel for d-apps (payments for transactions in Ethereum are literally called gas).
We can compare Ether to oil: the latter is required for many production cycles, logistics, etc., which creates a strong and constant demand and defines its value. As oil is intrinsically valuable due to its utility function, we can theoretically use it as a value storage or medium of exchange. If we think of storing barrels of oil in a warehouse as savings, however, this doesn’t seem a brilliant idea.
Of course, we can state that currently Ether in many ways is accumulated for the same reasons as Bitcoin, and it won’t be far from truth, but we must take into account that blockchain tech is still in its infancy, and most of the value of various digital assets has the speculative origin. In such a primordial soup of the speculative market, the utility function of assets doesn’t matter much yet, but it will surely start playing its role when the industry matures. By that time, economic models of smart contract platforms should be adjusted to better fit the concept of fuel.
Despite being initially presented as a peer-to-peer electronic cash system, Bitcoin cannot substitute cash or at least become widely used as such. Moreover, I see no other currently available cryptocurrency that can coop with the task. To impose serious competition to conventional money, a blockchain system should provide solutions to the following problems:
a) Superior user experience.
Traditional financial tools can offer convenience superior to any existing blockchain. Since people got used to many benefits provided by popular financial products (credit cards, PayPal, Apple Pay, etc.), a blockchain should offer at least an equal level of user experience.
This is a non-trivial task, for decentralization applies many limitations that are very hard to circumvent. Developers usually concentrate on a single issue (scalability seems to be the most popular), but it requires solving all of them simultaneously to reach the stated goal.
b) Decentralized algorithmic central bank.
Modern economies are powered by central banks with flexible monetary policies, whereas currently available monetary models implemented in cryptocurrencies are far too primitive. We need a model with an adjustable supply that can consistently maintain a selected target (an inflation rate, r*, or whatever else we choose).
First significant steps toward the stated goal were made by the developers of so-called algorithmic stablecoins. Basis was the first described concept of such, which was unfortunately never implemented. Later projects upgraded the initial concept and introduced several working solutions, none of which, however, featured a sufficient level of decentralization, for each relied on centralized governance to a significant extent. Moreover, most models are pegged to a fiat currency (or other existing stable assets, such as gold or SDR), which mitigates independency and turns such assets into mere derivatives.
The only proper solution is creating a fully decentralized model of an independent economy that is capable of maintaining economic stability without human involvement and the necessity to be pegged to any off-chain assets; a solution that I’ve been working on during 2020 and that I will present shortly. Stay tuned!
- Date of publication:
- Tue, 02/23/2021 - 14:06
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