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 and $3,800 as I update ) on one leg alone was inconceivable in 2014. Yet that is where we are in 2018/
9. Many argue that a one legged stool cannot be worth anything, 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!
- Leg 2 is under construction.
The path to mainstream adoption of Bitcoin is not through Institutions.
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 appears to have 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.
Venture investors, used to betting on younger people, find it natural to invest in bitcoin even if they are older themselves.
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.
Update in January 2019, the price is now around $3800.
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. There are currently 3 cryptocurrency solutions for Leg 3:
- Ripple XRP
- Facebook stablecoin based on a basket of currencies
- JPM stablecoin based on USD (and likely variants from other Big Bank
Bitcoin today is too volatile for Leg 3 – although XRP is also volatile. The main reason why Bitcoin is unlikely to be used for Leg 3 is that the Bitcoin community will be too busy building Leg 2.
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.
Leg 2 is under construction
Towards the end of 2018, there was data to indicate that Lightning Network was gaining traction in terms of number of nodes.
Technically, Lightning Network seems to work, but there are still many well-reasoned articles explaining why it won’t work.
Without going into the technical details, note two facts:
2. Ethereum, another major layer 1 chain, is working on a similar off-chain scaling solution called Raiden.
The path to mainstream adoption of Bitcoin is not through Institutions, it is through those who have been excluded by Legacy Finance.
This section describes:
- The conventional wisdom trajectory
- Bitcoin’s second leg will be built from the wreckage of exotic Fiat currencies
- When Bitcoin gets traction in developed markets, it will be via those who feel excluded by Legacy Finance
- Traders are from Venus, Investors are from Mars and Martians need to study Venezuela
- Profit comes from serving the excluded said Captain Obvious
- Investors who understand Bitcoin users will do best
- Serving the Bottom of the Pyramid is a lot easier when the marginal cost is zero and payment cost is close to zero
- Blue and Red Ocean strategies of Legacy Finance Institutions in the Blockchain Economy
- Watch what is happening in the Exotic Fiat Currency Countries.
The conventional wisdom trajectory
The conventional wisdom trajectory has 3 phases – from past, through present. to future.
- Phase 1. The past (still with us). Cypherpunks, Anarchists & Libertarians. This created the early traction that got Bitcoin from an obscure message board to the possibility of game-changing innovation.
- Phase 2. The present. Speculators. This classic speculative bubble that brings in new players and new capital (and excited the Legacy Finance Institutions) is the bull run of late 2017 and bear market of 2018 and early 2019.
- Phase 3. The future. Institutions & Governments. This is when bitcoin is supposed to grow up and put on a suit, to make it make it easy for the masses to user services offered by Legacy Finance. This is like a pivot from Phases 1 and 2. in this pivot scenario, the Cyperpunks, Anarchists & Libertarians are thrown into the dustbin of history and the speculators are told to stop being stupid and trust in the products sold by Legacy Finance.
This post argues a contrarian thesis that bitcoin’s path to mainstream is not a pivot but rather a continuation of Phases 1 & 2.
The conventional wisdom scenario plays well at Davos (World Economic Forum), the gathering place of those with wealth and power (Big Tech, Big Bank & Big Crypto). This post shows why that conventional wisdom is wrong.
Bitcoin needs a second leg to be stable. Bitcoin’s first leg – store of value – will eventually become unstable if it has to stand on its own. Bitcoin needs a second leg – a currency for everyday spending. That second leg will not be built by Institutions or Speculators, it will be built by entrepreneurs (maybe with Institutional partners) who know how to serve the needs of those who have been excluded by Legacy Finance (who need Bitcoin as a currency for everyday spending).
Bitcoin’s second leg will be built from the wreckage of Exotic Fiat currencies
We can witness this happening today in countries such as Venezuela that are suffering from hyperinflation (as described in this post). This has reached Act 4 inthe Creative Destruction 7 Act Play This is “when the going gets weird, the weird turn pro” (quote from Hunter S Thompson, who was certainly weird but also professional enough to write best-selling books).
it is likely that the Bitcoin habit, which we can witness in Venezuela, will spread to countries that are close, physically or culturally to countries with hyperinflation. These neighbours will witness the horror of hyperinflation and see how practical Bitcoin is as an alternative. For example, Argentina and Peru, while not yet suffering hyperinflation, may follow the example of Venezuela. This has reached Act 3 in the Creative Destruction 7 Act Play. Act 3 is Denial. A famous example of the Denial Act 3 was subprime mortgages that blew up in the Global Financial Crisis in 2008. For a long time the surface numbers looked good until a few nonconformists looked below the surface (watch The Big Short movie for an entertaining take on that story). A more recent example in Finance was the Wells Fargo fake accounts scandal (which was going on for a long time before it was uncovered).
If Bitcoin is limited to countries with hyperinflation, those of us working in developed markets with strong Fiat currencies can dismiss it as a phenomenon (like wheelbarrows full of cash) that have nothing to do with “normal” countries. The next bull market needs a use case story that more people can relate to.
If Bitcoin spreads from Venezuela to Argentina and Peru, the markets will have a story to relate to. There are 180 currencies listed as legal tender, of which about 36% make up 90% of global GDP. Contagion spreads rapidly. When we see that contagion spread to developed markets with Fiat currencies that are perceived to be strong today, then we will have reached mainstream adoption. Again we need to look at edge cases aka those who feel excluded by Legacy Finance.
When Bitcoin gets traction in developed markets, it will be via those who feel excluded by Legacy Finance
This is Act 2 in the Creative Destruction 7 Act play. Act 2 is the Straws in the Wind It takes guts to see a few straws blowing about and bet that this is caused by an invisible wind. The signs of change are far from obvious but “the answer my friend is blowing in the wind”.
The reason change comes from the excluded is obvious. Their needs are not being met by Legacy Finance. We see that happening today in Venezuela. When the issue is feeding your family, the clunky UI and risks of Bitcoin do not seem a big deal. Using Bitcoin gets onto your Must Do Today action list.
Are there markets like this in the developed world? Are there enough people excluded by Legacy Finance in the developed world to make sure that the Bitcoin contagion spreads to a person in the neigborhood or social circle of those investing in Bitcoin? I believe the answer is yes and that ew can see this answer blowing in the wind of three niche markets in developed world that have excluded by Legacy Finance:
– Legally excluded. For example, businesses operating in the Legal Cannabis market.Or cryptocurrency businesses who cannot get a normal bank to offer them an account, who go to a crypto friendly bank like Silvergate.
– Financially excluded. The Western underbanked, excluded from or ripped off by Legacy Finance market providers will see the appeal of Bitcoin. When told by Legacy Finance that “Bitcoin is bad for you” they may take the view that if Legacy Finance does not like it, then it must be good.
- Excluded by Banks because they are Small Business. Daily Fintech has dedicated on day a week (Wednesday) to Small Business finance because Small Business owners are a good example of the Excluded – banks did not want them because they were neither Corporate or Consumer. This is why Square is such a big player in Bitcoin. Small Business owners who want to avoid problems with credit card networks (see here for more) will be motivated to accept Bitcoin and spend in Bitcoin.
Traders are from Venus, Investors are from Mars and Martians need to study Venezuela
The difference between traders and investors looks small on the surface – it is simply how long is the holding period. In reality, the approach is fundamentally and completely different.
Bitcoin traders look at price charts. Bitcoin investors look at how people are using Bitcoin. Given that real Bitcoin usage today is quite limited, they look at what products are being built today that will enable new forms of usage in the future. To give an example from an earlier era, an investor would look at an early version of Hotmail and extrapolate that mass use of email via browsers was possible.
So Bitcoin investors need to understand how Bitcoin could serve the Excluded
Traders need a story. Bitcoin as a one-legged stool (digital gold store of value) is not enough to power the next bull market. To reach the mainstream investor, Legacy Finance Institutions will need more than the how (things like Custody), they will also need a story. They will need to show why Bitcoin will change the world and how that is already happening.
Traders will still trade and their liquidity is essential. Some of the traders who got into Bitcoin during the last bull/bear cycle will get back into active trading during the next bull/bear cycle. Many will do this via Institutions, others will use startups.
Profit comes from serving the excluded said Captain Obvious
Question: which market looks more attractive:
- Customers have many options and you will need to persuade them to switch from their current way of doing things and the advantages you offer are not really life-changing?
- Customers have few if any options, if you can deliver them a solution it will be life-changing for them and they will take whatever steps are needed to get your solution?
You probably answered B, yet most solutions target A. A big reason is that most developers today work in developed markets (where Customer A is located) and we find it easy to build solutions for people who are like us.
Investors who understand Bitcoin users will do best
That is another Captain Obvious statement and yet most investors work in developed markets and feel comfortable investing in solutions for those markets.
We can see this in some early Bitcoin entrepreneurs such as Wences Casares of Xapo who comes from Argentina.
Serving the Bottom of the Pyramid is a lot easier when the marginal cost is zero and payment cost is close to zero
The Bottom of the Pyramid (BOP) is a socio-economic concept that allows us to group that vast segment – in excess of about four billion – of the world’s poorest citizens constituting an invisible and unserved market blocked by challenging barriers that prevent them from realising their human potential for their own benefit, those of their families, and that of society’s at large.
Technically, a member of the BOP is part of the largest but poorest groups of the world’s population, who live with less than $2.50 a day and are excluded from the modernity of our globalised civilised societies, including consumption and choice as well as access to organised financial services. Some estimates based on the broadest segment of the BOP put its demand as consumers at about $5 trillion in Purchasing Power Parity terms, making it a desirable objective for creative and leading visionary businesses throughout the world. One of the undeniable successes in this process is the explosion of the Microfinance industry witnessed in many parts of the world.
The first person to really focus on BOP was C.K. Prahalad (1941-2010), who in the process has inspired influential leaders and countless ordinary citizens sharing his vision, to joint efforts for the unleashing of their creative and productive potential as part of an inclusive capitalist system, free of paternalism toward the poor.
The iconic use case was Unilever with their single serving soap packages in India. That took real innovation.
Serving the Bottom of the Pyramid is a lot easier when the marginal cost is zero for obvious reasons. You can deliver at the price point needed in the market without having a cost of goods sold margin problem.
The advent of fast, low cost micropayments via offchain technology such Lightning Network also make it much easier to profitably serve the Bottom of the Pyramid. Credit Cards obviously don’t work in that market and physical cash has hidden costs (theft, time, handling etc).
Blue and Red Ocean strategies of Legacy Finance Institutions in the Blockchain Economy
The Cypherpunks, Anarchists & Libertarians who kick-started the Bitcoin Blockchain engine tend to relegate Legacy Finance Institutions to the dustbin of history. Clearly Bitcoin is a big bang disruption for Legacy Finance and many will suffer a Blockbuster/Borders/HMV/Kodak type fate.
We see three fundamental strategies for dealing with this kind of big bang disruption:
- partnering with Entrepreneurs who know how to serve the excluded – blue ocean strategy. For more on this please read Getting to strategic value in partnerships between Fintech ventures and Banks.
- beat your current Legacy Finance competitors, even at risk of disrupting your current business, by aggressively offering Bitcoin related services – red ocean
Institutions need help from a range of service providers such as strategy to code to legal. Serving the Institutions will always be a profitable business.
Watch what is happening in the Exotic Fiat Currency Countries
The bridge from hyperinflation “broken Fiat” Currency Countries to developed markets will be via “exotic Fiat” Currency Countries.
The 8 most traded currencies are
U.S. Dollar (USD)
European Euro (EUR)
Japanese Yen (JPY)
British Pound (GBP)
Swiss Franc (CHF)
Canadian Dollar (CAD)
Australian Dollar (AUD)
South African Rand (ZAR)
There are 180 current currencies across the world, as recognized by the United Nations. That is a lot of what FX traders call the “exotic” currencies.
Watch the currencies/countries that are physically and or culturally close to “broken Fiat” currency countries. For example, If Bitcoin spreads from Venezuela to Argentina and Peru, the markets will have a story to relate to and other countries may copy this way to avoid the horrors of hyperinflation.
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