Note that this is a pure educational post. Opinions expressed in this post are mine and mine only! they are definitely not financial advice. Even though potential future investment was a motivation for me to look into bitcoin, I neither recommend nor oppose investing in bitcoin. Always do your own research and reach your own conclusion.

Throughout this post, I use “Bitcoin” (in capital) to represent the peer-to-peer network and “bitcoin” (lower case) or “BTC” to represent the network digital currency with monetary value.

 

The Birth of Bitcoin and Where It Is Now

It was October 31, 2008. Satoshi Nakomoto published a white paper describing a peer-to-peer digital currency, titled “Bitcoin: A Peer-to-Peer Electronic Cash System”. The first sentence of the paper’s abstract says the following:

“A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”

Let’s fast forward to July 24, 2022. As I am writing this post, I am looking at the two charts below (my own creation) with my eyes wide open.

With its price reaching an all time high of $69,044 in November 2021 and close to a billion daily trading volume in US dollars, bitcoin sure has come a long way in such a short period of time. If we asked someone in 2010, 2015, or even 2018, it would be very unlikely that they would have foreseen what bitcoin had accomplished as a digital currency. It is truly fascinating to see that something with zero value can grow at this exponential level in a little more than a decade’s time, creating a wealth that is equivalent to about 9% of total gold value in the world. In terms of the Bitcoin network, it has grown exponentially as well, including huge growth in total number of transactions, unique wallet addresses, etc. (https://www.blockchain.com/charts provides an excellent collection of statistics on the current status of the Bitcoin network.)

Source: https://en.wikipedia.org/wiki/File:BTC_vs_fiat_M1_and_gold.svg

As an outsider who did not pay attention to bitcoin until recently, I find the information available on the Internet about Bitcoin is filled more with noise than signal. Bitcoin is also one of those things that the majority of the public have strong opinions about. As such, we have bitcoin maximalist on one spectrum and bitcoin-zero-value-opinionist (if there is such a word) on the other side of the spectrum. Annoyed by all these noises on the Internet, I decided to take matters into my own hand and spend time to understand what Bitcoin/bitcoin is and what is going on under the hood. Another motivation for me to do my own research is that I have been thinking about investing in bitcoin for a long term. For this serious purpose (money is serious), I don’t think I can confidently rely on online information.

My Study List

I spent about 150 hours in the last two weeks studying Bitcoin. In this process, I have studied/read/listened to more than ten materials. I provide the list of materials below so that if anyone wants to do their own research, they can follow this list.

1. Books. I have read four books, cover-to-cover. The first two look at Bitcoin from a monetary value perspective. The last two focus on the technological aspect.

2. Lex Fridman podcast. The Lex Fridman podcast is one of my favorites for its exceptional quality and the variety of contents. I also knew that Lex covered some Bitcoin related topics last year so I decided to dig in the podcast list to see if I can find some. Surprisingly, I found multiple episodes on Bitcoin and its related topics. The episodes I watched are:

3. Technical implementation. Andrej Karpathy published an excellent blog post in June 2021, implementing Bitcoin from scratch using only Python’s native dependencies. My own exploration of Bitcoin on the technical side was to redo his implementation. I spent two whole days re-implementing his implementation line by line and adding more explanations on the things that I lack knowledge of. The result of this exercise is this GitHub repository: https://github.com/AysajanE/Bitcoin-from-scratch-in-python. This implementation process covers many technical details in the book “Mastering Bitcoin”.

What Did I Learn?

The goal of this study is to better understand Bitcoin/bitcoin, as a technology, as a potential future money, and as an investment opportunity (more on this in Part 2, yet to be posted). As such, I present my understanding and views on the first two aspects in this post. 

Technology

From a technology standpoint, Bitcoin is a peer-to-peer digital ledger system consisting of hundreds of thousands of computers - called “nodes” - distributed across the world. All those nodes together constitute a network. The special thing about this ledger is that it is decentralized, meaning no central authority has control over it. It is open, programmable, and publicly available. In this ledger, all bitcoin transactions are securely recorded. In order to be efficient, we can collect transactions into blocks and link those blocks together in a chain, thus the name “blockchain”; within each block, we can also link transactions together so that the correct order of the transactions is preserved.

Every node on the network has a copy of the entire blockchain. As mentioned above, the blockchain consists of blocks “chained” together. Once finalized, the order of blocks in this chain cannot be tempered with - altered, erased, or hidden. Each block includes thousands of transactions. For instance, if I send you 0.1 bitcoin through the Bitcoin blockchain, after its confirmation it will be included in one of the blocks. With a transaction hash, anyone can locate this transaction and see its details on the blockchain.

After reading Mastering Bitcoin and Bitcoin and Cryptocurrency technologies, and re-implementing Andrej’s Bitcoin implementation, I have no doubt that Bitcoin is based on sound principles. Its technology is deep, novel and revolutionary. First, the cryptography applied to Bitcoin has a strong theoretical foundation. It is not something that Satoshi created for fun (I am looking at you, Dogecoin). Cryptographic hashes and digital signatures are the two main primitives used in Bitcoin. As a matter of fact, these two primitives are useful in building cryptocurrencies in general. Strong security provided by those cryptographic technologies has enabled the Bitcoin network to operate without any hack since its launch in January 2009, while holding billions of dollars worth of bitcoin asset. 

Bitcoin is novel and revolutionary. Two important features stand up here: incentive mechanism and randomness by proof of work (POW). Incentive mechanism ensures that the Bitcoin network can achieve its decentralization and security. In Bitcoin’s case, its security relies on a high degree of decentralization so that no single entity can control the majority of the nodes in the network. Randomness is important for the efficient consensus mechanism. If randomness is not designed with extreme care, malicious actors can crack the “randomness” and take advantage of it, which of course will be destructive to the credibility of the network. 

Nodes in Bitcoin mainly work on two tasks: verify transactions and propose new blocks in about every 10 minutes to include those transactions (and “push” it to the chain). Let’s use an analogy to explain how it works. Imagine I am writing some stuff on a piece of paper; you are writing, probably, exactly the same stuff on another piece of paper; and Alice is also likely writing the same stuff on a third piece of paper. Every once in a while, the page is full. Since all three of us are writing about the same stuff, we just need to keep one of them and discard the other two eventually. For this purpose, we need to select, very carefully, someone who takes his/her paper and adds it - in order - to the piles of papers we have already stored in a box. This is an extremely important task. Why? Because if the person selected is dishonest, he might change the order of the papers, or the contents of the papers in the pile. The solution offered by Bitcoin (or, Satoshi Nakamoto to be precise) is proof of work. Proof of work in essence is a “horse race”. Whoever runs the fastest wins the race and gets a prize: the bitcoin ($BTC) reward. The race is designed in such a way that it is impossible to cheat. And of course, the owners of these horses need to feed them well in order to win the race. That is exactly what happens in proof of work. Miners invest capital on hardware and electricity to solve a very complex math puzzle. There is no shortcut and every one needs to solve it by brute force. Whoever solves this puzzle first will have the right to append a new block to the already finalized chains of blocks. Why are those miners willing to invest heavy capital to be the first in this race? Because of the prize - a fixed number of bitcoins. This prize will be halved in about every four years. Initially it was 50 bitcoin, and now it is 6.25. It will be halved again to 3.125 BTC in about two years. The difficulty of this race will be adjusted automatically such that only one horse can win the race in about every 10 minutes. We can make our horses stronger and faster by feeding them better and training them better, but the track also gets tougher and tougher along the way.

In summary, I am fascinated by the technological innovation behind Bitcoin. It is something built on top of existing technology with added nuances. In my view, Bitcoin design is part science and part art. Humans are complex and emotional. It is very hard to fit human actions into mathematical formulas. That’s why no developed theory, as far as I know, has fully explained why Bitcoin consensus works. It is one of the areas where practice is ahead of the theory.

Monetary value

This is where the largest disagreement exists. Let’s first look at some historical context on Bitcoin's creation. 

The very first sentence of the Bitcoin whitepaper envisioned bitcoin as a peer-to-peer electronic cash that can be transferred directly between parties without an intermediary financial institution. Satoshi Nakamoto also left a hidden message in the coinbase transaction (a special type of transaction where the miner writes to transfer the block reward to their address) of the first Bitcoin block, called Genesis Block. This message was the headline of the London Times on January 3rd, 2009

   

Source: https://medium.com/geekculture/decoding-bitcoins-first-block-coinbase-transaction-aeefe87ceec0

Because of the timing of the launch - whitepaper in October 2008 and first block mining in January 2009 - when the world was in the middle of a painful global financial crisis - it is widely believed that Bitcoin was created to provide an alternative solution to the traditional monetary system. In one of his quotes on trust, Satoshi wrote:

The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

From his/her words, it is obvious that Satoshi disdained the traditional financial system. Bitcoin as a permissionless digital currency could provide a new solution to the world monetary system. 

There are several other related concepts that we need to explain before looking at bitcoin’s monetary value aspect:

What is money?

After reading books and listening to podcasts listed earlier, here is my takeaway: 

  • Money is a medium of exchange that facilitates indirect exchanges between goods. Direct exchanges can only be possible when there is a coincidence of wants of goods: what I have is what you want and what I want is what you have. If there is a mismatch between I-have-what-you-want and I-want-what-you-have, the transaction will not happen. Vast majority of today’s transactions are indirect exchanges where money plays an intermediary role. We first exchange what we have with money then purchase what we want using this money since it is recognized and accepted by everyone. If a specific money/currency is widely accepted to settle international transactions, then it functions as a global reserve currency, a role that was played by the United Kingdom’s pound sterling for the most of the 19th century and first half of the 20th century, followed by the United States dollar since then. 
  • Money is a store of value/wealth. Money with a good store-of-value function will hold its value into the future. For instance, I cannot store my wealth in fruits, electronics, or animals. Apple will get rotten very fast and become worthless; my laptop will be worth a tiny fraction of what I initially spent after a few years; The sheep I have will die eventually. None of these things will preserve its value over a long period of time. One important feature of something to preserve its value for a long term is scarcity. If I can increase the supply very easily, that thing hardly holds its value. In this regard, we want money to be sound and hard. Soundness implies no counterparty risk and hardness implies the supply is difficult to increase.

Monetary standard

Historical monetary standards/systems play a central role in the argument of Bitcoin’s monetary value and its potential to serve as a digital reserve currency in the “global” economy. Two types of monetary standards are discussed the most:

  • Gold standard. A simple example can explain how the gold standard works. Let’s suppose I set the conversion rate between my currency - let’s call it “ding-dong” -  and gold to 50:1, meaning the value of one ding-dong would be 1/50th of an ounce of gold. If there is 50 ding-dong in circulation, an ounce of gold is stored in some vaults in a safe house. It has two important implications. One is to determine the value of a currency. Low exchange rate implies high currency value and vice versa. Two is to limit new issuance of the currency since the money in circulation is directly linked to the physical gold supply under gold standard. When arbitrarily printing money is constrained, inflation of the money can be effectively controlled.
  • Fiat standard. The meaning of the word “fiat” can explain this money standard relatively well. According to the dictionaryfiat means “an authoritative or arbitrary order”. Thus, fiat currency is a type of currency that is issued by the government, not backed by any physical asset, and used by the government’s order as a means of payment. For instance, the dollar is the fiat money in the US; yen is the fiat money in Japan, etc. To put it plainly, we are ordered/forced by the government to use fiat currency. In general, each country has its own fiat currency that they determine and control the supply. Inflation is closely associated with fiat currency because its issuance can easily be out of control, making it less and less worthy over time. In gold standard, as long as gold has value, the currency backed by gold will never be worthless. We can look at the chart below to get a sense of the fiat currency value depreciation denominated in gold since 1900.

      Source: voimagold.com

What does bitcoin offer?

Having covered some fundamental concepts in money, let’s go back and look at the monetary value of bitcoin digital currency. Let’s relate bitcoin’s design features to sound/hard money.

  • Scarcity. Bitcoin has a max supply of 21 million by design. Technically, it is possible that the max supply can be increased, either directly or indirectly, but there has not been any such plans. There might never be one. Current circulating supply of bitcoin is a little over 19 million, which means 2 million more bitcoins will ever be minted. 
  • No counterparty risk. Sound money means no counterparty risk. Whoever owns it, they have full control over it. In bitcoin’s case, if I own a bitcoin, I have full control over it (if I keep it in centralized exchanges, there still be counterparty risk since these exchanges control your fund.). 
  • Durability, easy portability and divisibility. As a digital asset that lives on the Internet, bitcoin is extremely durable. Anyone in the world with internet connection can send/receive bitcoin at a speed that is much faster than what our current financial system allows. The lowest denomination of bitcoin is satoshi and 1 BTC = 100,000,000 satoshi. Thus it is easily divisible. 
  • Backed by real assets. This feature might be up for a debate. But in my view, bitcoin is not created out of thin air. Satoshi designed bitcoin in such a way that a fixed number of bitcoins are created in 10 minutes on average. This creation requires a miner to win a mathematical competition, which is only possible with capital investment in the form of physical hardware and electricity. The miners are profitable enough so that they are willing to keep going in this race but not too profitable so that everyone wants to be part of it. 

Bitcoin reality

All these features of Bitcoin make it an attractive candidate for being a store of value and medium of exchange. But it has a long way to go before it achieves, if ever can, any one of these functionalities. Four main obstacles exist in the horizon.

  1. Volatility. In October 2009, a bitcoin trade happened on an online exchange named New Liberty Standard where bitcoin was priced at $0.000994. In May 2010, the first real-world transaction happened when a developer paid 10,000 bitcoins for a $25 pizza, putting the price of bitcoin at $0.0025. In November 2021, bitcoin price reached an all time high at $69,044. As of this writing, bitcoin price is sitting at $22,785, already losing two thirds (~ 67%) of its all time high. The degree of volatility we’ve seen in bitcoin is unprecedented, which offers a strong counter argument for bitcoin functioning as a store-of-value asset. Its price could potentially stabilize in the next decade or next century but nothing guarantees that.
  2. Scalability. At its current network settings bitcoin block size is limited to 1 megabyte, which is 1,048,576 bytes. The current average bitcoin transaction size is about 470 bytes. Accordingly, we can calculate the number of transaction Bitcoin network can handle in a second:

(1,048,576 / 470) / (10 * 60) = 3.7 transactions/second

(A new block is created in 10 minutes on average, and that’s why we have 10 * 60 in the denominator). Thus, Bitcoin currently handles mere 3.7 transactions per second. In contrast, Visa network claims to handle 6,500 transactions per second, or 206 billion transactions per year. Therefore, bitcoin has a very very long way to go before becoming an everyday medium of exchange. Do note that whether or not bitcoin wants to become a medium of exchange is a different question. Some positive progress has been made on improving scalability. For instance, layer 2 solutions like the lightning network built on top of the Bitcoin network provides a potential solution. Increasing block size to include more transactions in a block also provides an alternative, even though this topic has raised heated debate within the Bitcoin community.

  1. Uncertain government regulation. Everything bitcoin tries to achieve (or, bitcoin proponents want bitcoin to achieve) goes against the government’s agenda. Bitcoin promotes individual sovereignty, global free market and a monetary system that the government has no control over, whereas the government wants to control every one of these tightly. Thus, a regulation is inevitable. It is largely unknown what those regulations will be at what degree, which puts a big shadow on bitcoin’s future perspective.
  2. Environmental impact. It is well known that Bitcoin mining consumes huge amounts of energy. In order to operate mining hardware equipment 24/7 and prevent overheating, Bitcoin miners consume a significant amount of energy worldwide. The magnitude of the energy consumption is so large that it has become a main arguing point for Bitcoin rejectionists. We put the Bitcoin network energy consumption into context in the figure below:

Source: Cambridge Bitcoin Electricity Consumption Index (https://ccaf.io/cbeci/index/comparisons)

As we can see, if Bitcoin were a nation, its electricity consumption would be ranked 36th in the world, right behind the Philippines and ahead of Belgium. Bitcoin proponents claim that miners operate in places with excess energy and as a result they are actually “contributing” to the efficient allocation of resources. Whatever argument might be from both sides, one fact is clear: the Bitcoin network consumes a huge amount of energy to maintain the network.

Summary

Bitcoin is a technology with a solid theoretical foundation and innovative design features. In my opinion, it is wrong to dismiss it as worthless. About its potential economical, social, and philosophical impact, no consensus exists. I also fail to construct any strong opinion on those aspects after going through all these study materials. In fact, people have vastly different opinions on bitcoin’s value outside of a peer-to-peer decentralized ledger. There are bitcoin maximalists who are obsessed with bitcoin and believe that bitcoin will solve many of the world’s biggest problems, such as “broken” financial systems, widening wealth distribution discrepancy, and many others; they also dismiss any other cryptocurrencies, including Ethereum, as worthless (“shitcoin” is the name they use). There are also bitcoin zero-value-opinionists who believe bitcoin is worthless. In my view, both of these views are biased. The mountain of challenges bitcoin needs to overcome in order to become the thing that bitcoin maximalists want it to become is about the same as the conditions that need to be satisfied in order for bitcoin to have zero value. I believe Bitcoin/bitcoin is here to stay as a technological innovation with human aspects in it.

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The root problem with conventional currency is all the trust that's required to make it work.

And the root problem with cryptocurrencies is that they threw away all of the apparatus (convention, regulation, laws, and court precedents) that provides much of that trust, MUCH more cheaply than blockchains.

BTC and ETH are the best of them, and they're good for payments that are difficult in regular currency (due to regulation, cross-border issues, etc.), and wild enough to be worth investing small amounts in.  They're NOT good as a primary currency.

Too volatile as a store of value.  Worse than most currencies, but really any currency is a horrible store of value.  For long-term value preservation, you need your assets to be in the form of working capital, not in a static form.  And because it's a bad store of value, it's got more friction than most currencies for payment use - you have to convert to BTC before you can spend the BTC.

I won't bother to argue against the newer, much scammier, exchanges, stablecoins, and the like.  Basic crypto has a place, but it's not all that big a place.

Great point on trust. Here's a recent paper by Eric Budish reflecting on the issue, via Tyler Cowen.

Thanks for doing your own research and laying out clearly what you think Bitcoin offers.

All these features of Bitcoin make it an attractive candidate for being a store of value and medium of exchange.

I think you're mostly right on what features Bitcoin has, but I think you're mistaken that they make it a good currency.

  1. Bitcoin is scarce. No debate there.
  2. Bitcoin has no counterparty risk. In theory, sure, but in practice as you note in your parenthetical, it will remain intermediated, even if it could deliver some gains.  
  3. Bitcoin is durable, portable, and divisible. No debate there.
  4. Bitcoin is backed by real assets. It takes resources to create BTC, but that doesn't mean it is backed by real assets. Look no further than the US Mint - it takes resources to create and maintain fiat currency.

If BTC has 1, 2, and 3, do those make it a good currency?

BTC maximalists and goldbugs lament printing dollars (if the Fed is achieving its stated goal, the dollar should depreciate against a general basket of products at 2% per year, i.e., it only buys 98% of what it would the previous year). In a world where production is constant, stabilizing the supply of money should be sufficient to deliver a "sound currency" (one that buys the same general basket of products every year, i.e., 0% inflation). But we don't live in that world; production increases. Thus to deliver a "sound currency," the money supply needs to increase (albeit not as much as it needs to in order to achieve a 2% inflation target [aside: money demand is also important for these macroeconomic dynamics, but not critical to the discussion here]). A constant money supply (assuming BTC would be used as money) in the face of increasing production will lead to an appreciating currency (i.e., deflation [aside: there are also macroeconomic frictional reasons to prefer inflation to deflation but again, not relevant]). So much for storing value as a "sound currency," its value is moving! That said, people can plan pretty well under a transparent monetary regime, so we don't need 0% inflation, we just need a consistent inflation rate (hence the 2% target). If there are real production shocks, it would be nice to implement shocks to monetary policy as well to preserve the nominal economy; it needs to not just be a store of value but also a unit of account. A fiat currency is superior to BTC in this regard. Structural scarcity doesn't necessarily make for a wonderful store of value that can also be used as a unit of account in the currency context. I agree with Sam Bankman-Fried that BTC can store value in the same way other assets store value. Gold bars store value (we don't want to use them as currency). Company shares store value (we don't want to use them as currency). BTC stores value. But that doesn't stem particularly from its scarcity. The value comes from the beliefs about its scarcity and value; see GME stock in 2021. In this regard, BTC is just another asset in that its value derives from belief, albeit belief that must be cultivated rather than ordered out of the implicit barrel of a gun. But, the stability of its supply hampers its effectiveness as a unit of account in an economy susceptible to real shocks. And the fact that the perceived value of BTC is either as pure speculation (sell before everyone decides there's no there there) or as the promise of useful currency in the future, differentiates it from other assets that have value even though we don't think of them as currency. A gold bar can be used for physical things, a company share is a residual claim on the company's assets. A dollar is backed by fiat/guns. A BTC-that-will-never-be-a-currency may not be completely devoid of value (novelty, medium of exchange in small circles, etc.), but it's of very limited value or a game of musical chairs. The case for tremendous value and not being a game of musical chairs requires the existence of BTC-that-might-eventually-be-a-currency; because I believe that to be unlikely, you can surmise that I believe BTC to have little value (that doesn't mean you can't make -or lose- money trading it!).

Blockchain (and central bank digital currencies [CBDCs]) offer the potential to further reduce frictions and risks in the intermediation structure of money (assuming they get transactions/second to compete, which is a big assumption). BTC gets to ride this wave, so that is good for its prospects as a medium of exchange. But practically, a sovereign will not relinquish its monopoly over the currency; if BTC looks like it will replace the dollar, the sovereign can regulate a market structure into existence that neutralizes the benefits of BTC vs. the fiat currency (see CDBCs, or something to make BTC operate less usefully).

Yes, BTC is as durable as, more portable than, and more divisible than current digital dollars, so that is good for its prospects as a medium of exchange. But as above, I don't see these as truly unique selling propositions; these are advantages that can be eroded away by improvements to current payment networks.

So overall, BTC offers marginal benefits over digital dollars in intermediation, durability, portability, and divisibility that in the future can be competed or regulated away. It fails as a unit of account since its scarcity is ironically a problem, not a benefit. It stores value based on belief, but the collective belief is on shakier ground than many other assets that store value. It has features, but they're not enough. IMHO

"Divisibility" is meaningless. Your accounting ledger can use however many decimal places are desired. And unless price tags are denominated in a currency, it doesn't matter if I have 1,000,000 yen or .0000001 BTC. And if price tags are written in a currency, it helps to have common items cluster in a clean set of values, preferably near 1, but Xthousand or Xmillion or Xhundreths or Xthousandths etc. can also work.

Backed by real assets. This feature might be up for a debate. But in my view, bitcoin is not created out of thin air.

This sort of depends on your reference class. Proponents of Bitcoin tend to make a big deal about the cap on total Bitcoins and artificial scarcity, but once you include the cryptocurrencies in general in your reference class, then "created out of thin air" is the thing that happens all the time, there is no limit, and no scarcity.

The main argument here is that at its current state, you have to invest not-so-small capital in order to be part of the bitcoin production system. If no one puts capital, no bitcoin will be created. In this regard, bitcoin is different from all other cryptocurrencies, including Ethereum (Yes, Ethereum also uses POW but there new blocks can be created much faster with less capital intensity). This has nothing to do with 21 million cap or scarcity. 

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