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Mind Of Mav
Why Bitcoin Always Bounces Back; Where BTC’s Value Comes From?
At the time of writing, the market value of Bitcoin is slightly more than $800 billion. According to a January 2022 study report produced by G. Cipolaro and E. Kochav of NYDIG, Bitcoin’s annual payment transaction volume has surpassed that of American Express. To avoid misreporting such data, the report modifies and excludes transactions having limited economic value, such as eliminating intra-entity transactions (transactions between addresses within the same wallet or managed by the same firm).
Now that we’ve cleared it out, have a look at the diagram below.
Image source: NYDIG report (LinkedIn)
According to the research, Bitcoin processed $3.0T in payments in 2021, surpassing well-known card networks such as American Express ($1.3T) and Discover ($0.5T). Although this is still less than Visa’s $13.5T and Mastercard’s $7.7T, if we look at transaction volume growth of Bitcoin versus other payment networks, we can see that by the end of 2021, transaction volumes have grown by about 100% yearly over the last 5 years (G. Cipolaro, E. Kochav, NYDIG, Jan 2022). Please see the diagram below.
Image source: NYDIG report (LinkedIn)
This is an astounding growth for a payment network that has only been around for 13 years. To compare card network history, Visa was launched in 1958, with the introduction of debit cards in 1976 (‘History of Visa,’ visa.com, 2022), MasterCard was launched in 1966 (‘Brand History,’ mastercard.com, 2022), and Amex was launched in 1958 (‘Our History,’ americanexpress.com, 2022), and they are some of the most well-known brands in the payment space.
Furthermore, as of December 2021, Bitcoin’s daily active addresses averaged 970,000, according to Glassnode, a blockchain analytics and intelligence provider that develops novel on-chain measurements and solutions (‘Bitcoin: Number of Active Addresses’ Glassnode.com, 2022).
Based on the data presented above, we can factually establish that Bitcoin’s payment network is actively used, with approximately a million users per day settling more transactions per year than Amex at an astounding rate of adoption, given that there were only a few thousand active daily addresses ten years ago (‘Bitcoin: Number of Active Addresses,’ Glassnode.com, 2022).
Taking all of this into account, we can use Metcalfe’s Law to calculate the value of Bitcoin. Metcalfe’s law is founded on a mathematical tautology that describes connectivity among ’n’ users. As more individuals join a network, their contributions to the network’s value are non-linear: the network’s worth is equal to the square of the number of users. Metcalfe’s law has been empirically validated in its ability to value a variety of network effect technologies and businesses (Madureira, A., den Hartog, F., Bouwman, H., Baken, N. 2013).
Lets consider empirical evidence and calculate Bitcoin’s value using Metcalfe’s Law. See below:
Metcalfe’s Law: Bitcoin vs Internet Adoption
The internet, as shown in Exhibit 1 (T. Peterson, March 2019), is an excellent tutorial for network economics study. It’s a good analogy for Bitcoin because Bitcoin requires internet access to function. Both have received diverse degrees of acceptability in different nations, but both have grown in acceptance over time.
We can calculate the Metcalfe value of the internet by using the equation (Metcalfe value V is as follows: VV = AA nn(nn 1) / 2) to the number of internet users in Exhibit 1. This corresponds neatly with the Dow Jones Internet Composite Index over the same time period, despite the fact that it is an independent measure of value in Exhibit 2 (T. Peterson, March 2019):
Following that, we’ll take a look at a specific internet company: Facebook (Meta). Facebook is an excellent candidate for comparison with Bitcoin.
The duration of each data series are remarkably similar (10 years or more). Both were quite innovative, though not wholly unique (DigiCash preceded Bitcoin, MySpace preceded Facebook.)
Both were subjected to prohibitions in China and both garnered a lot of attention for their adoptions (T. Peterson, March 2019):
As per calculations in Exhibit 3, Bitcoin’s value looks to follow Metcalfe’s law in the medium to long run (similar to Facebook).
However, the next question to be answered is why. What is the secret behind Bitcoin’s success?
Bitcoin is the first immutable ledger created in the 7,000 year history of accounting. The first censorship resistant payment network that does not require a central authority and cannot be seized or confiscated in the 5,000 year history of money.
Economists and historians contend that the explanation to why some items are recognized as monetary goods while others are not may be found in a variety of criteria that define “good money.” The more features a good possesses, the better it can function as money or the more probable it will appear or be accepted as money (‘Origins Of Money’, Karl Menger, 1892).
Karl Menger investigates the mobility, scarcity, divisibility, and durability of money in human history in ‘Origins of Money’. Let us compare these characteristics to today’s exchange values (gold and fiat) and Bitcoin, as shown below (Fidelity Digital Assets Report, 2022):
Image source: Fidelity Digital Asset Report (2022)
Bitcoin plainly combines the scarcity and durability of gold with the convenience, storage, and improving on the ease of transport of fiat money.
Furthermore, fiat currencies have a dismal track record, with significant currency crises happening every nineteen months on average (Krugman, 1999, ‘Currency Crises’).
Furthermore, Krugman emphasizes government intervention in currency markets throughout history, one example being ‘competitive devaluation.’
“In the European crises of 1992–93, there was an element of competitive devaluation: depreciation of the pound adversely affected the trade and employment of France…”
Let us look at two main challenges in the history of money, as identified by Krugman in ‘Currency Crises’, and how Bitcoin addresses them: devaluation and control.
One of the most important aspects of Bitcoin’s qualities is its scarcity. There will never be more than 21 million Bitcoin. In comparison to sovereign currencies, Bitcoin’s monetary policy may be considered the most credible.
In contrast to the fiat world, where excessive inflation is a recurring occurrence that has resulted in catastrophic economic collapses throughout history (‘Currency Crises,’ Krugman, 1999), Bitcoin’s inflation rate is about 1.8% (Fidelity Digital Assets Report, 2022). Yes, Bitcoin experiences inflation as more of it is mined, but because the number of new Bitcoins are automatically cut in half every four years, Bitcoin’s inflation rate will also decrease over time. This is due to the fact that the rewards per block are halved every four years in order to reduce mining payouts, which means that producing new Bitcoins becomes an increasingly costly proposition. Each coin gets increasingly valuable over time. In contrast, currencies such as the US dollar inevitably lose buying value over time.
Unlike fiat, control of Bitcoin’s network by a central authority is almost impossible. Because Bitcoin is decentralized, no single person, institution, or state owns or controls the Bitcoin network or the rules that govern it. It must be stated unequivocally that no miner consortium or consortium of the largest Bitcoin owners can dictate the network’s course or modify its rules. This is due to the fact that each proposed change must be approved by the network participants, i.e. the node operators.
Simply put, nodes keep miners in check.
Node operator is any computer that runs a Bitcoin implementation and stores the entire blockchain. Anybody can be a node operator and setting up a Bitcoin node is simple, and can be done using a home computer. All nodes are run freely and are used to verify that the blockchain transactions are valid. Any change in the consensus rules requires the approval of 95% of the nodes, making it extremely difficult for a single organization to change the Bitcoin software. There are presently over 14,000 active complete nodes throughout the world, with the number of nodes increasing by about 30% in only the last year (Bitnodes, 2022).
Image source: bitnodes.io
Furthermore, Bitcoin has effectively solved the double spend problem and given a practical solution for a digital form of money, which had previously been attempted with DigiCash (D. Chaum, 1982) and E-Gold (H. White, 2014), but both failed owing to being impractical. Bitcoin created the world’s first decentralized blockchain and provided a practical solution to the Byzantine generals problem (Lamport & Shostak, 1982).
The next question is, how did it do all of the above?
Consider developing a trustless system in which you may make payments without having to trust anybody or worry about your funds being frozen or hacked, as well as an immutable public ledger that cannot be modified, edited, or controlled by any third party (Bitcoin Whitepaper, Satoshi Nakamoto, 2008).
But how can we put our faith in a public ledger like this? What’s to stop someone from entering a transaction? How can we be sure that all of these transactions are what the senders intended?
The concept here is that, similar to handwriting signatures, the user should be able to add something next to each transaction that confirms he/she has seen and authorized it, and it should be impossible for anyone else to forge that user’s digital signature.
But how can a digital signature ever be considered secure? The way this works is that each user generates a private key and a public key pair. Private key is something you keep to yourself, hence it being private. A digital signature looks like a string of 1’s and 0’s, commonly consisting of 256 bits of numbers.
For example, creating a digital signature (which varies for each message, i.e. transaction) requires a function that is dependent on both the message and your private key. The private key assures that only you can generate that signature, and the fact that it is message-dependent implies that no one can fake one of your signatures on another message.
The second function is to validate the signature, which is where the public key comes into play. It accomplishes so by returning ‘true’ or ‘false’ depending on whether the signature was created by the private key linked with the public key used for verification.
So, when you verify that a signature against a particular message is legitimate, you can be certain that the only way someone could have created it was if they had the secret key linked with the public key you used to verify it. Otherwise, finding a valid signature is entirely impossible. For example, in order to verify that a message is legitimate, the following applies:
Verify (Sender’s Message + 256 bit signature + public key) = TRUE.
To run every potential signature number combination would take a significant amount of time:
Image source: info.townsendsecurity.com
In addition, in order to avoid fraudulently replicating a proper message/signature combination, each transaction has a unique ID linked with that transaction on the ledger.
The Ledger is Decentralized
The primary distinction between the present system and Bitcoin is that the ledger on the Bitcoin network is decentralized. In essence, everyone has their own copy of the ledger, and when users perform transactions, they simply broadcast those transactions to the network for other users to hear and record/update new transactions on their own private ledgers.
But how can we get everyone to agree on which version of the ledger is correct? For example, if Bob receives a $100 transaction from Alice, how can Bob be certain that everyone else got and believes the same transaction, and that he will be able to go to Charlie and use those same $100 to perform a transaction later on?
How can we be sure that everyone is recording the same transactions in the same sequence if the ledger is decentralized? How can we achieve consensus? This is also known as the Byzantine General’s Problem (Lamport & Shostak, 1982).
The solution Bitcoin offers is to trust whichever ledger has the most computational work put into it. If we use computational ‘work’ as a basis for what to trust, then fraudulent transactions and conflicting ledgers will require infeasible amount of computation to bring about.
This leads us to Proof-of-Work, which is the method through which a Bitcoin network confirms and records transactions on its ledger. This is also referred to as ‘mining,’ and those who confirm and add the broadcast transactions are referred to as ‘miners.’
When transactions occur, they are grouped into a block to be mined.
Bitcoin’s proof-of-work algorithm, called SHA256 then generates a hash for that block.
Miners race to be the first to generate a target hash that’s below the block hash.
The victor receives the privilege of adding the most recent block of transactions to Bitcoin’s network. They are also rewarded with Bitcoin in the form of newly created coins and transaction fees.
See below a simplified example:
You have a block with the preceding block’s hash and a string of numbers on it called ‘nonce’. The block contains a list of transactions as well as a reward for a block validator, often known as a miner.
The miner would then hash the whole block, producing a new hash at the bottom. Because the hashing process is essentially the ‘work’ done by computers solving mathematical equations, which means that miners have to invest in mining machines, storage for those machines, and power to keep the machines operating. Many mining enterprises additionally pay for accurate temperature and humidity controls in order to maintain the machinery functioning at peak efficiency.
When a hash number is successfully mined, the block miner is compensated for validating that block, and the payment is paid in Bitcoin. The new hash is then placed in the following block, and mining begins on the hash and ‘nonce’ number of that new block.
Proof-of-work requires miners to find a unique number.
A miner’s purpose is to take the current block’s header, add a random number called the nonce to it, and compute the hash. The hash’s numeric value must be less than the target value.
To put it another way, we must take a list of all the transactions that people want added to the blockchain, add a random set of numbers and letters to that list, and then calculate a SHA256 of all of that until we obtain an output with a particular amount of zeros.
Lets use a practical example: to get awarded and mine a block, you must locate “hello” with two zeros at the end using SHA256 encryption algorithm.
To do so, begin by guessing and checking with 1 and working your way up from there.
Use this link to test it out:
So you begin with ‘hello1’ and work your way up until you locate it. When you get to ‘hello1140,’ you’ve completed the riddle since it shows you two zeros. You would have been compensated for your efforts, and a block would have been added to the chain.
Looking at the most recent Bitcoin block, we can observe that on February 8, 2022 at 12:00 PM GMT, a miner named ‘Poolin’ had to compute 19 zeros (blockchain.com/btc/blocks):
Mining difficulty increases as more miners join the network (more zeros) or decreases (fewer zeros) if miners leave the network with an average block confirmation time of 10 minutes.
Any alteration in any quantity in the previous block would render hash numbers absolutely invalid. See the example below to see what happens if “Bob pays Charlie” is modified to $101 instead of the original $100.
As you can see hash numbers are now invalid. Because a hash number must begin with a string of zeros in order to be legitimate, it would necessitate repeating all of the work, devising a new special number for each of these blocks that causes their hashes to begin with zeros, and convincing the network’s 95% to agree to such a modification.
The only way Bitcoin’s network can be manipulated for any future transactions, is only if someone managed to gain 51% of the mining power. However, such an attack is very unlikely.
A 51% attack, also known as a majority attack, happens when a single individual or group of people gets control of more than 50% of the hashing power on a blockchain. Successful attackers obtain the power to prevent new transactions from being completed and to reorder new transactions.
While this is technically possible, it would be extremely expensive for the attacker because the attacker would have to expend significant computing power (cost of electricity & equipment) to achieve a 51% hashrate, and the attacker’s Bitcoin mining equipment, known as ASICs, which cannot be repurposed and are expensive, would also be rendered useless. Even if a malevolent miner successfully carried out an attack, the price of Bitcoin would plummet, depreciating the Bitcoin they had just stolen.
In essence, because of the foundations of ‘game theory,’ (R. Myerson, 1991), which states that players in a game are rational and would attempt to maximize their payoffs, incurring a significant initial cost in order to attack the network with no economic benefit would make such an attack highly unlikely and practically impossible.
Prior to October 2008, there was no digital form of value that could be traded directly with another person via the internet.
Bitcoin solves the problem of double spending by blocking transaction replication, so when someone transfers you Bitcoin, it stays with you until you decide to pass it on.
And it’s completely peer-to-peer. To receive Bitcoin, all you require is the Bitcoin wallet and nothing else is necessary to do business digitally. There are no subscriptions, no sign-up fees, no permissions and most importantly, no third-party control.
Bitcoin does exactly what it says on the tin, and does it well. Ultimately, it is and always has been up to the people to decide whether or not to use it. As Satoshi Nakamoto said, “in 20 years there will either be very large transaction volume or no volume.” The latter is doubtful, based on current data.
That’s why we can always, predictably, count on Bitcoin to bounce back when so many try to write it off.
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