When I first dove down the bitcoin rabbit hole in 2014, the accepted view was that bitcoin was a 3-legged stool:
- Leg 1 = Store Of Value
- Leg 2 = Currency for daily spending
- Leg 3 = Payment Rail
The idea that bitcoin could get to such a high value (over $6,000 as I write) on one leg alone was inconceivable in 2014. Yet that is where we are in 2018. Many argue that a one legged stool cannot be worth $6,000, so it must be a ponzi scheme heading to zero. This Chapter of The Blockchain Economy serialised book argues that bitcoin is surprisingly stable with only one leg. This matters because bitcoin is the first killer app for Blockchain and if bitcoin fails it will bring down the whole Blockchain Economy.
This is Part 1/Chapter 18 of The Blockchain Economy. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the the transition to an economy where value exchange is permissionless and disintermediated. For the index please go here.
This chapter covers:
- The original 3 Legged Stool Thesis
- Leg 1 KISS: bitcoin is a digital alternative to gold
- Leg 1 Fear Begone: Why bitcoin will not go to zero
- Leg 1 Greed is good: bitcoin is a speculative store of value, like early stage stock
- Leg 2 = Currency for daily spending
- Leg 3 = Payment Rail
- If bitcoin fails it will bring down the Blockchain Economy and we will return to Legacy Finance.
- Only got one leg? Don’t worry, be happy!
The original 3 Legged Stool Thesis
In the early days, discussion about the deficiency of one leg was accompanied by a retort from a bitcoin true believer along these lines:
“Yes, I understand your reservations about bitcoin as a store of value, but it is also a currency for daily spending and a payment rail.“
“Yes, I understand your reservations about bitcoin as a currency for daily spending, but it is also store of value and a payment rail.”
In 2018, bitcoin is increasingly accepted as a store of value, but the other two legs are totally broken. The three-legged stool thesis has been debunked. Yet bitcoin is surprisingly valuable and stable with only one leg.
Leg 1 KISS: bitcoin is a digital alternative to gold
This is a generational divide. For older people, something that has not been tested for thousands of years and that you cannot touch and sort into nice piles cannot possibly be a store of value. For younger people, bitcoin has a similar scarcity value as an alternative to Fiat currencies, but with the huge advantage over gold that it is easy to “chip off” a bit of your digital gold and send it to somebody remotely.
Saying bitcoin is a store of value is relatively uncontroversial in 2018, but one cannot describe bitcoin as a stable store of value. The price action alone makes that clear. You can argue a case for bitcoin losing 90% and an equally strong case for bitcoin increasing by 10x or 100x. So, bitcoin is a speculative store of value. This is confusing. There is no single/simple analogy that fits bitcoin. Bitcoin is not a currency or a commodity or a stock but has some characteristics of all three:
- currency. You can buy some stuff with bitcoin, so it is a currency today, albeit not a very good one, because there is not much you can buy directly.
- commodity. Bitcoin is sort of like gold except that gold supply can theoretically increase and the value of gold has been fairly stable for centuries. In practice the supply of commodities like gold do not increase much. But that is different from having a fixed hard limit like bitcoin.
- stock. Another asset with a fixed hard limit is stock. You can never have more than 100% of a stock. But, bitcoin has no earnings stream.
This makes bitcoin an “odd duck”. It is a bit like a currency and a bit like a commodity and a bit like a stock – yet different from all of them. It is easy to see why bitcoin is such a regulatory football – which regulatory entity should have jurisdiction over this odd duck? The reality is that bitcoin is not like anything we have ever seen before. If you want an analogy, bitcoin is like gold but a) before gold had a long history of value and b) with a fixed hard limit to how much could ever be mined. Imagine somebody pitching gold before gold had an established monetary value and you come close to understanding bitcoin by analogy.
Leg 1 Fear Begone: Why bitcoin will not go to zero
As bitcoin does not have a long established monetary value, it is easy to make the fear argument that bitcoin will fall to zero:
– there is no government backing
– it is not useful as a currency for daily spending
– it is worse than a tulip, at least a tulip has some value. The only value in Bitcoin is what the next greater fool will pay, which is the classic sign of a Ponzi scheme.
One argument used by bitcoin enthusiasts for a floor above zero is mining costs, but that makes no sense. It costs money to take out garbage, but that does not make garbage valuable.
However there are two reasons why it is safe to assume that bitcoin will have a price floor above zero:
- Bitcoin is NOT a ponzi scheme. Ponzi schemes are built by somebody who controls the currency. If anybody can find Mr. Ponzi behind bitcoin please tell me. Do bitcoin holders benefit from somebody paying a higher price? Yes, but show me an asset where that is not true.
- The strong hands of early bitcoin buyers. While bitcoin price could drop 90% it won’t go to zero. The reason is that those who bought in at $6 or $60 are quite sanguine about holding at $600. Ho hum, prices fluctuate so HODL. So these strong-hand holders provide a price floor.
Note: losing 90% is close to 100% in practical terms for most investors.If you bought in at $6,000 and it drops to $600, you need a 10x win just to get even; but you may need the $600 to pay rent. If you bought in at $20,000 a drop to $2,000 is a 90% loss. These are classic weak hands that are flushed out in a bear market.
Leg 1 Greed is good: bitcoin is a speculative store of value with some statistical probability favouring the upside.
All markets have fear and greed as opposing emotions, but in no market are these two emotions as starkly opposed as in Bitcoin.
Currently the wisdom of the market says BTC is worth about USD6,000. Will it be $600 or $60,000 in future? Will you lose 90% or get a 10x gain? All investing/trading/speculating is a game of statistical probability; certainty is impossible (despite what some Technical Analysts like to sell).
You simply calculate the odds of a 10X loss vs a 10x gain and make your bet accordingly. Although bitcoin’s trading history is just under 10 years, that decade does show that bear markets are followed by bull markets and the long term direction is up. Given that 100% loss is the maximum and 10x gain is far from the ceiling (it could be 100x or higher), many people calculate statistical odds that favour buying bitcoin.
That type of high risk/high reward investing/trading/speculating is like early stage stock. Although bitcoin is not equity, in the sense that that there is no earnings stream/dividend, the calculations made by bitcoin investors is similar. What is quite different is having an early stage stock with a price quoted 24/7. Imagine Facebook pre IPO having a price quoted 24/7.
(Whether you call it investing or trading or speculating is largely a function of time horizon and risk tolerance with some moral judgement thrown in. Investing is trading with a longer time horizon and “speculating” is bad but “trading” is OK).
Leg 2 = Currency for daily spending
The first Bitcoin civil war led to the creation of Bitcoin Cash (BCH). The primary argument used by proponents of BCH was that bitcoin BTC was no longer useful as a currency for daily spending because of the high cost and time to verify transactions. In short, they were saying “the second leg is broken”.
The original bitcoin fans, supporting BTC, do not dispute that bitcoin is too slow and too expensive (in mining costs) for low value transactions. They argue that new technology is coming in the form of off-chain processing networks such as Lightning Network. However that is as yet unproven. So there is technology risk.
Also even with Lightning Network, the price volatility problem for BTC will remain.
BCH does reduce verification costs, but it does not solve the volatility problem. The way that Altcoin promoters, such as BTC or BCH or LTC, make money is via trading speculation, which is fundamentally at odds with the requirements of a stable currency for use in the everyday economy. There was a reason that the Swiss National Bank (SNB) gave speculators a bloody nose when they decoupled CHF from its EUR peg on 15 January 2015. The SNB wanted speculators to go to gold or Bitcoin and not to CHF. Currencies need to be boringly stable, which is at odds with a cybercurrency designed to make speculators rich.
This is where the new breed of Stablecoins bring huge value. For more on Stablecoins, please see this chapter.
The other big problem with BTC as a currency for everyday spending is that the incentive today is to hoard not spend. So the velocity that a spending currency needs (people earn and spend regularly) does not happen. This may change as bitcoin gets closer to its 21 million hard limit and the market gets consensus of what % allocation should go to bitcoin.
Leg 3 = Payment Rail
Legs 2 and 3 are related. Until we get to the stage that it becomes mainstream to both earn money in bitcoin and spend money in bitcoin, we will need on-ramps and off-ramps for Fiat currency. That time may come, but it is certainly not here today.
You could argue that you don’t need Leg 3 because we won’t have Fiat currencies in future. That is magical thinking. There will be long periods of transition (possibly forever) where cybercurrency and Fiat currency co-exist.
Leg 3 needs to solve the cross-border payments problem.Within-border digital payments do NOT need cybercurrency. The P2P digital payment vendors that work within national borders do not have a problem. In America, Venmo (from Paypal) and Zelle (from some big banks) works well as does M-Pesa in Kenya; one could easily make a longer list in many countries. There are two reasons why these within-border payment systems work so well:
- There is no currency volatility. For example, you send USD or KES and the other party receives USD or KES.
- There is no KYC/AML problem. To send money within-a-border there is one regulator to get a license from and that regulator will require KYC/AML checks (which are not that hard as you use national government approved ID checks (eg Social Security Number in America or Aadhaar in India)
The problem comes when you go cross-border. Then the currency volatility becomes a problem. Then it becomes harder to agree on transnational KYC/AML checks.
If bitcoin fails it will bring down the Blockchain Economy and we will return to Legacy Finance.
There is a reason why I put a Chapter about bitcoin in the Infrastructure Part of the book. My thesis is that if bitcoin fails, Legacy Finance wins and all other Blockchain ventures will also fail. The reason is simple. A permissionless, stateless cryptocurrency is disruptive and will bring non-linear change like the Web and Social eras. DLT (Distributed Ledger Technology) that is permissioned and controlled by institutions is incremental change. Legacy Finance fears the former and promotes the latter. If bitcoin fails, Legacy Finance will cheer and roll out DLT solutions using enterprise tech platforms from companies such as Oracle and IBM. If bitcoin fails we will return to business as usual.
Only got one leg? Don’t worry, be happy!
Some stools are stable with one leg. Bitcoin can survive enough with a single leg until the other two legs get built out:
- Leg 2 = Currency for daily spending. This will happen through multi layer-and other blockchain scaling solutions. This is why long term bitcoin bulls watch the rollout of Lightning Network so avidly. If this fails, then bitcoin’s second leg maybe permanently broken, in which case people may question how long it can stand on one leg. However, the progress of Lightning Network is encouraging, so the long term bitcoin investors feel comfortable.
- Leg 3 = Payment Rail. This will happen when bitcoin reaches its 21 million limit and a baseline price is achieved. Then bitcoin price maybe stable enough to be used as a payment rail. By that time, Leg 2 should be in place.
Bitcoin investors with a long term horizon feel comfortable that Legs 2 and 3 will emerge. Of course there is some risk, but there is enough upside to compensate for that risk.
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).