Bitcoin: the Egg or the Basket?

Part 3: Bitcoin Supremacy

There are countless stories of those who got into bitcoin in order to increase the size of their fiat holdings. Some made millions trading bitcoin but many lost everything. The amount of money people lose every day trading crypto on leverage is well over $1B. The moral of these illustrations is that bitcoin’s rewards are generally inversely proportional to the amount of time someone spends building crypto investment strategies. In fact, one of the greatest investors in bitcoin forgot that he even owned the currency for 8 or 9 years. We have all lived our entire lives under an inflationary standard and we are so accustomed to laborious and complicated financial management that our experience screams “It can’t be that easy to preserve wealth in only one asset!”

In contrast however, we will see that bitcoin serves those best who treat it not as a basket to store fiat value, but instead treat it like a daily egg collection which requires focus and attention to gather and guard. Bitcoin has inscribed its entire future monetary protocol into millions of computers and minds all around the globe. This history has eliminated the many long term uncertainties that plague the alternate networks listed in the previous section. Due to its unstoppable momentum, decentralized foundation, immutability, and unparalleled scarcity, bitcoins are the eggs worthy of minimal asset diversification for long-term savers.

At this stage of bitcoin’s development many people admit that it is great option for storing value, but again the modern portfolio culture recommends no more 5% allocation. The main argument for such a low allocation stems from understandable human fear of volatility. Fidelity published a report in October 2020 (BTC $9k) analyzing various small percentage allocations in bitcoin, but had to justify every recommendation with the perceived dangers of volatility. “Annualized volatility was slightly higher in portfolios with any allocation to bitcoin. While an allocation to bitcoin leads to an increase in a portfolio’s volatility, investors who can safely take on the marginal increase may be willing to accept it given the greater improvement in the portfolio’s risk-adjusted returns as measured by the Sharpe ratio.” The biggest question then is our current fear of volatility natural to humanity or are we more susceptible to it because of cultural conditioning?

Volatility is synonymous with vitality. If I go to the park with my 3 year old I can promise that I will experience much less volatility on the bench watching him play, but the undeniable probability states that his health prospects in 10–20 years are much better than mine. Looking at news headlines we can see that doomsday prognostications for the dominant network have only increased as the network has grown. Many of these recommendations have tremendous influence on the western population who have been conditioned to expect emergency bailouts with every 20% stock market correction. Knowing those bailouts will never come for bitcoin has many still believing that bitcoin has a reasonable chance of going to 0 overnight. The reality however is that bitcoin has reached a point of virtually unstoppable momentum and when compared with the other stores of value it is much more likely to continue to draw energy from them than it is to cede it.

Having topped $1 trillion in market capitalization in February 2021, bitcoin became the fastest asset in history to reach that mark. Even though many people admit cryptocurrency is here to stay many people think that bitcoin might be unseated as easily as Myspace or Netscape. The first error in this thinking is that bitcoin is a protocol not a company. Myspace, Facebook, and Instagram compete in the social network space but they all depend on the same TCP/IP protocol. The second mistake is giving no allowance for critical mass. At a maximum valuation of $12B Myspace was still a long way from Bitcoin or Amazon’s $1T valuations. Perhaps even more important than size is the age or duration of a protocol. Popularized by Taleb, the Lindy Effect states that the longer something has endured the longer it is expected to endure. With the longest history of any cryptocurrency, bitcoin maintains the longest expected lifespan and that continues to grow.

In analyzing bitcoin’s strength against other networks many people make the mistake of looking at total marketcap. If we reference the graphic to the left we might deduce that there is a 56% chance of bitcoin being overtaken by some other protocol.

The reality however is that marketcap is a poor measure of network dominance in an age where one NFT sale of Beeple’s digital artwork for $69 million might cause some to believe the marketcap for all of his art was north of $1B! I think that a more realistic measure of the reach and impact of a monetary network is to analyze internet searches. By comparing what people search for on the internet we can measure the impact of news broadcasts and conversations with friends and family on individuals around the world. When we look at these numbers we see that bitcoin network dominance is more than 80% in most countries.

Another important factor that details bitcoin’s unstoppable momentum is its code maintenance and development. As an open-source, consensus driven protocol, developers may have various reasons for contributing to a network’s development. The most obvious reason is to secure value invested in time and resources. Several large companies that have staked their entire business on the bitcoin ecosystem have made significant monetary contributions to source code development. The greater the percentage of value allocated to one network, the higher the incentive to contribute to its development. This self-reinforcing cycle means that more protocol security means more interest from new investors who may become stakeholders and realize their own need to contribute to code development. Another common mistake people often make is that bitcoin is old technology which can be quickly surpassed by some young kid with a breakthrough idea. Again because bitcoin is volatile and alive it is able to change when there is near total consensus. As evidenced by the impending taproot upgrade, we see that any truly great technological advance with overwhelming support will simply be absorbed by bitcoin. Since the large majority of code development happens on github we can analyze the health of the network by the contributions. The below chart indicates a very clear winner (look at the scales).

Further evidence of bitcoin’s unstoppable momentum can be seen in its financial sector reach. Bitcoin was the first crypto network to be traded on the CME and CBOE futures exchanges. Bitcoin is also leading the charge towards SEC approval of an ETF, as well as the first crypto asset to be listed on public treasury balance sheets. One of the largest, most respected advisory services (NYDIG) leading this wave of institutional adoption only works with bitcoin. They are also now working with banks to assist them in providing bitcoin custody services. With great momentum comes great displacement, and the firms and governments that see bitcoin as a threat rather than an opportunity will continue to oppose the leader most vigorously. As a former Goldman Sachs executive, former Treasury Secretary Mnuchin never hesitated to voice his disdain for bitcoin. Despite his power, he failed to in a twilight bid to handicap the cryptocurrency through backdoor regulation because the bitcoin lobby interest in Washington was already too powerful. In addition to this political momentum, bitcoin also has overwhelming educational momentum. Any quick search for podcasts or university courses is likely to return a bitcoin dominant result list. This momentum signals that bitcoin will be nearly impossible to beat by other crypto networks, but the reasons for this dominance also imply that its momentum is likely to subsume enormous value from even the more traditional baskets and networks.

Probably the most unique aspect of bitcoin among all the monetary networks in history is its decentralized foundation. Many people equate decentralization with cryptocurrency but that is far from the truth. Begun by an anonymous programmer in 2009, who left the project and over 1 million bitcoin only a year later, bitcoin has grown up as a leaderless phenomenon. This characteristic led to many acrimonious battles over the purpose and destiny of bitcoin over the past decade, but true to its design the community consensus carried the day even despite a closed door agreement of the most powerful bitcoin conglomerates in 2017. Bitcoin was able to grow up decentralized because it was the first cryptocurrency. Most people doubted it would ever gain the value that it did, and so the relative interest to control or attack the protocol was relatively small. Compare that history to Ethereum’s origin only 6 years later, where one man led a foundation to premine 70% of the coins that would go on sale and give that money to the founders and developers. Without a premine or the hype that crypto would takeover the financial world, bitcoin represents the most equitable distribution of a new monetary asset in history. The early buyers had much less certainty of success than those who purchase today and they were rewarded for their research and risk.

Decentralization takes time and bitcoin has an unfair headstart. Having operated for 12 years, bitcoin has penetrated the markets, news sites, and dinner tables of every country on the planet. The information required to propagate this success is only growing stronger by the day. This visualization of global bitcoin transactions is as insightful as it is entertaining. Now transactions aren’t nearly as important for decentralization as nodes. A bitcoin node validates the entire bitcoin blockchain against whatever trusted version of the bitcoin protocol the node owner decides to run. Due to bitcoin’s very restricted block size, the entire blockchain is less than 400GB which means most households in the developed world could run a bitcoin node with $200 of hardware and negligible electricity and internet costs. Having a wide node distribution is important for censorship and control resistance. If any country or entity wanted to change the bitcoin supply of 21M for example they would need to go to the home of every node operator and simultaneously convince them or force them to operate the new protocol. This map doesn’t even show the true extent of node distribution because many nodes (like mine) hide their IP addresses behind a VPN. Having begun only in 2018, the lightning network has accelerated the decentralization of the bitcoin network as individuals became incentivized by low fee transactions and routing income to run their own node. The reason for this accelerating decentralization, making bitcoin harder and more accessible, is its inimitable scarcity.

There are many objectives and monetary theories that filter into the protocol of monetary networks. Bitcoin’s unique history meant that as Satoshi worked on early protocol development in 2008, he/she/they witnessed a then unprecedented bailout of the global banking elite at the expense of every person with fiat savings and no access to the bailout money. Satoshi even coded the first genesis block mined in bitcoin with title from the Times newspaper “Chancellor on brink of second bailout for banks.” This frustration with the loss of value from inflation may have caused him to remain resolutely firm on the 21M maximum supply of bitcoin.

In all of history there has never been an asset with the scarcity of bitcoin. Many economists worried for years about peak oil. In 1909, some calculated we might run out of oil in 20 years! The miracle of price increases is that the opportunity for profit has driven miraculous innovation like fracking or electric cars which have placed downward pressure on oil prices. There are 2 revolutionary concepts that mean bitcoin’s scarcity will remain dissimilarly unaffected by market forces. First, since the genesis block, bitcoin’s code rewarded miners with 50 bitcoin every time they successfully mined a block. Every four years that reward has been cut in half, and today miners are rewarded with a little over 6 bitcoin per block. Remember when we looked at the sporadic and unpredictable issuance rates for USD and ETH in the previous article? Contrast that unpredictability with bitcoin’s known supply schedule.

Second, there is a protocol feature called the difficulty adjustment that assures savers that more bitcoin can not be brought to the market in times of elevated demand. Mining difficulty means that every two weeks the protocol measures the average time in between blocks and if blocks are created too fast then the difficulty adjust upwards thus requiring more hash power and lower probability that one miner with the same equipment will find a block in the next period. Similarly if bitcoin drops in value and mining at the current difficulty becomes unprofitable, then the difficulty will adjust down. This fact gives everyone the assurance that even the wealthiest individual or government couldn’t run out, mine all the remaining bitcoin, and begin a fire sale on the market. You can visualize how the difficulty will adjust at the next period on this site. By the end of 2021 over 90% of the total bitcoin supply will have been mined. It will be difficult to imagine an economy where the scarcest resource will be the money we once considered the least secure means for wealth preservation.

Scarcity by itself is meaningless if it is unaccompanied by immutability. Ethereum recently dropped their issuance to 0, but the foundation’s credibility is questionable because they have issued hard forks and sporadic issuance changes before. Since the Ethereum blockchain is so enormous that only massive datacenters can validate the protocol, it is much simpler to make code changes. Bitcoin’s immutability is guaranteed then by its small blocks, slow block chain, its leaderless and consensus driven governance, and the global reach that it gained in its 12 year history. As a digitally native currency the only requirement to possess bitcoin is a 12 or 24 word passphrase. Any violent attempts to change its scarcity or confiscate it would see thousands of people memorizing their passphrase, walking across a border, and starting a new life with all of their accumulated wealth. Due to this fact it will become increasingly important for countries and communities to attract bitcoin wealth to their borders by promising to honor the principles of immutability, scarcity, and decentralization.

Wealth will accumulate were it is best preserved. Due to far superior value preservation characteristics that are only reinforced with growth, we can expect that bitcoin will continue to extract value from many traditional baskets. Should this development continue, diversification and rebalancing will provide disastrous consequences towards a saver’s goal of wealth preservation. Some think that since central banks already maintain the most dominant networks that they will soon issue their own digital currencies which will wipe away demand for bitcoin. The mistake here is a misunderstanding of the incentives for the protocol. Central banks need inflation to finance government spending and thus, despite great networks and technological miracles, they will never be able to convince savers that their CBDC will preserve their wealth long-term. As more savers become convinced of bitcoin’s network dominance, scarcity, lack of counter-party risk, and asymmetric risk reward they will continue to divest their portfolios of less secure stores of value like stocks, bonds, gold, and alternate cryptocurrencies and buy bitcoin. Despite a recent 50% drop, bitcoin returns over the past 12 months still dominate virtually every stock in the S&P 500. Investors will only support these relatively poor returns for so long and as the migration accelerates the most diversified will pay the highest price.

Further reading

1. Bitcoin for beginners playlist.
2. Common criticisms of bitcoin address in a Fidelity report
3. Great visualization showing the massive amount of value traveling over the bitcoin network.
4. My favorite podcast on bitcoin’s global importance.
5. Free introductory course on bitcoin
6. My favorite “Why bitcoin?” video