Doc's Daily Commentary
Mind Of Mav
Responding To Common Bitcoin Criticisms
In this piece, let’s review and respond to criticisms and misconceptions that continue to come up in our conversations as Bitcoin nears $20k. The criticisms outlined below have been addressed many times over, but I wanted to share an updated response given the increase in attention on Bitcoin.
- Bitcoin is too volatile to be a store of value.
- Bitcoin has failed as a means of payment.
- Bitcoin is wasteful.
- Bitcoin is used for illicit activity.
- Bitcoin is not backed by anything.
- Bitcoin will be replaced by a competitor.
Criticism #1: Bitcoin is too volatile to be a store of value.
Response: Bitcoin’s volatility is a trade-off it makes for perfect supply inelasticity and an intervention-free market. However, with greater adoption of bitcoin and the development of derivatives and investment products, bitcoin’s volatility may continue to decrease, as it has historically.
The trajectory of a new asset from negligible awareness and adoption to a global store of value is unlikely to be linear. At this moment, bitcoin is an emerging store of value – it is undergoing financialization and is in the process of cementing its status as a store of value. Relative to other stores of value assets (e.g., gold), bitcoin is narrowly held.
The day-to-day volatility should come down over time with increasing spot and derivative market liquidity and the development of products that allow investors to express interest in bitcoin in different ways, leading to greater ownership, participations, and heterogeneity of market participants. As bitcoin ownership becomes more widespread, the price of bitcoin should stabilize in tandem with net new participants having less of an ability to move the market. However, while the volatility of bitcoin should continue to decline relative to where it is today, in the following paragraphs, I’ll put bitcoin’s volatility into context.
One way to put the volatility of bitcoin into perspective is to compare it to gold in the 1970s. As Matt Hougan of Bitwise Investments highlights, the role of gold was unclear to investors when the U.S. abandoned the gold standard. This resulted in annual and even daily volatility that is similar to the volatility of bitcoin today. For example, in 1973, the price of gold changed by more than 3% in one out of ten days. However, as Paul Tudor Jones outlined in his widely read May 2020 Investor Letter:
“In the case of gold, it was a tremendous buying opportunity as gold went on to more than quadruple past the prior highs.”
Paul Tudor Jones, Tudor Investments
Another way to understand bitcoin’s volatility is that it is a consequence of the asset’s perfectly inelastic supply. A rise in demand cannot result in the increase in supply of bitcoin or increase the speed at which bitcoin is issued (thanks to the difficulty adjustment, which ensures that blocks are produced every ten minutes on average). Notably, this supply inelasticity is also what makes bitcoin scarce and valuable. Thus, bitcoin investors accept volatility as the cost or premium of getting access to a rising store of value asset that they believe has a significant untapped addressable market.
Bitcoin’s volatility could also be explained by the fact that bitcoin has an intervention resistant market –no central bank or government can step in to support or prop up markets and artificially subdue volatility. Bitcoin’s volatility is a trade-off for a distortion-free market. True price discovery accompanied by volatility might be preferable to artificial stability if it results in distorted markets that may break down without intervention.
“We are operating in highly distorted markets whose upward trajectory depends ever more on the persistence of investors’ collective faith in the power of an already-stretched monetary policy stance to compensate for a growing number of headwinds.”
Mohamed A. El-Erian, Bloomberg
Criticism #2: Bitcoin has failed as a means of payment.
Response: Bitcoin makes deliberate trade-offs, such as limited and expensive capacity, to offer core properties such as decentralization and immutability. Given its high settlement assurances, Bitcoin optimizes its limited capacity for settling transactions that aren’t well-served by traditional rails.
Many continue to believe that bitcoin’s core use case is as a means of payment for everyday low-value transactions.
Believing this, critics suggest bitcoin has failed because it does not (and cannot) offer the same transaction throughput as payment rails like Visa, MasterCard, or PayPal. Contrary to what some people think, data from Chainalysis highlights non-trivial transaction volume flowing through online payment processors at more than $500 million per quarter since 2017, presenting a lower bound for bitcoin’s use as a means of payment. However, while medium of exchange may be one of Bitcoin’s use cases in specific situations, it is not Bitcoin’s core or only function.
“As a means of payment, it can perform better than incumbent technologies in specific instances (think international payments), but Visa, Apple Pay, Google Pay, PayPal and fiat currency work well and better than cryptocurrency for most day-to-day payments
John Pfeffer, Pfeffer Capital
Bitcoin has properties that make it a viable payment tool – it is portable, fungible, and divisible. On the flip side, it also has limitations in that it is volatile and has limited throughput. These are deliberate consequences that Bitcoin accepts. As discussed above, volatility is the trade-off bitcoin makes for perfect scarcity. Limited throughput is the trade-off bitcoin makes for decentralization, which is a direct result of cheap and easy validation. By placing a cap on capacity (which limits the amount of data stored on the ledger), bitcoin makes it possible for people with basic computers to run validating nodes. Validating nodes are important because they verify the work performed by mining nodes and present checks and balances on miners in charge of creating blocks and processing transactions, so that no one group of stakeholders has outsized power and influence – and so that Bitcoin can be decentralized.
Accepting bitcoin’s limited throughput to achieve decentralization,n and implement appropriate checks and balances, the next questions worth asking are what transactions deserve to be written to the base layer of Bitcoin? And, what transactions demand Bitcoin’s global, immutable settlement? Arguably, the most valuable use of Bitcoin’s limited capacity is not to record transaction data related to day to day payments at the point of sale, like the popular example of paying for a cup of coffee, but rather for situations that have the most to gain from Bitcoin’s high level of assurances and are underserved by traditional rails – e.g., that are inefficient and/or costly using traditional rails.
This includes, though is not limited to global settlement between international businesses and eventually even central banks and governments. One such example is BitPesa, which helped clients (SMEs and multinationals) trade-in, out, and within African currencies via Bitcoin. BitPesa was one of the first companies to leverage Bitcoin for commercial settlement to reduce the cost and friction of doing business in frontier markets. In specific situations, Bitcoin may also offer a superior option in remittances that have been burdened by slow speeds and high fees, especially to and from countries that face capital controls or struggle with high levels of inflation. According to the World Bank, the global average cost of sending $200 in remittances was 6.8% in the first quarter of 2020.
Additionally, while on-chain capacity is limited, second layer solutions that settle to Bitcoin (e.g., the Lightning Network, bitcoin banks, or something else) may address demand for lower value bitcoin transactions (though without the same on-chain settlement assurances).
Tax treatment is another factor that complicates the use of bitcoin as a means of payment in countries like the United States. For example, the IRS classifies bitcoin as “property.” In the context of payments, this means that bitcoin users must calculate their gain or loss whenever they make a payment or purchase with bitcoin, reducing the attractiveness and seamlessness of bitcoin as a payment tool.
Criticism #3: Bitcoin is wasteful.
Response: A substantial portion of bitcoin mining is powered by renewable energy or energy that would otherwise be wasted. Additionally the energy the Bitcoin network does consume is a valid and important use of resources.
There are different estimates for the portion of bitcoin mining powered by renewable sources. For example, the 3rd Global Cryptoasset Benchmarking report by the Cambridge Center for Alternative Finance (CCAF) estimates 76% of miners use renewables, especially hydroelectric power, as a part of their energy mix. The aggregate share of renewables as a portion of total energy consumption by bitcoin miners is 39%, according to CCAF. CoinShares estimates that the renewables penetration of the energy mix powering bitcoin mining is 73% as of December 2019. Both estimates suggest a significant number of operations are powered by renewables (e.g., hydropower, wind, solar). Recent announcements also suggest that the portion of mining tied to renewables will continue to grow. For example, En+ Group formed a joint venture to leverage renewables energy assets that have low carbon footprint in mining bitcoin. CCAF also estimates that total carbon dioxide emissions from bitcoin mining would not exceed 58 million tons, or 0.17% of total global carbon dioxide emissions, even if bitcoin mining was exclusively powered by coal.
More recently, mining operations have been set up to power bitcoin mining with stranded gas, which leverages energy that may not be consumed for other purposes and reduces carbon and methane emissions in the process. Companies that use stranded gas byproducts to mine bitcoin also have the potential to generate more than fifteen times more revenue than if they could sell the gas at market prices. They may also set up bitcoin mining operations to comply with regulations that limit the amount of stranded gas that can be flared or vented and avoid regulatory fines or shutting down operations to prevent natural gas build-up.
Stranded gas is natural gas that has limited utility and is likely to be wasted. An oil or gas well that does not have the pipeline infrastructure needed to transport the gas is considered stranded. Stranded gas is flared (deliberately burned into the air to avoid the risk of explosions) or vented (allowed to escape into the air) if it cannot be used, if there is no pipeline capacity to transport it, or if prices are too low for it to be economical to transport. America’s two biggest oil fields flared and vented almost 500 billion cubic feet of gas in 2019, which would have had the climate impact of seven coal-fired plants if released directly into the air. In December 2019, Crusoe Energy Systems announced it had plans to set up 70 bitcoin mining units in this year, preventing the flaring of 10 million cubic feet of gas per day. Equinor, a publicly-traded petroleum multinational, also revealed plans to use stranded natural gas that would otherwise be flared and create carbon emissions to power bitcoin mining.
“My favorite way to think about it is as follows. Imagine a topographic map of the world, but with local electricity costs as the variable determining the peaks and troughs. Adding Bitcoin to the mix is like pouring a glass of water over the 3D map – it settles in the troughs, smoothing them out.”
Nic Carter, Castle Island Ventures
However, it is undeniable that bitcoin mining does consume energy. Thus, the question becomes, is it a worthwhile use of energy to secure the Bitcoin network and process transactions? Certainly, the answer will differ based on the person answering the question. Those who appreciate the importance of the first and only provably scarce, decentralized, censorship and seizure resistant digital asset that offers irreversible settlement would argue that it is. Bitcoin’s most valuable features – its perfect scarcity, its immutability (irreversibility of transactions), and its security (resistance to attack) – are tied directly to real-world resources used in mining. Bitcoin would not be able to fulfill its role as a secure, global value transfer and storage system without being costly to mine and maintain.
“In the long-game, there may be no greater, more important use of energy than that which is deployed to secure the integrity of a monetary network and constructively, in this case, the bitcoin network.”
Parker Lewis, Unchained Capital
Criticism #4: Bitcoin is used for illicit activity.
Response: Bitcoin, like cash or the internet, is neutral and has properties that may be valuable to good actors and bad actors. However, as a share of total transactions, Bitcoin transactions connected to illicit activity are very low.
Criticizing bitcoin for its use in criminal activity is akin to criticizing cash for its use in illicit activity or criticizing the internet for hosting the dark web and illegal marketplaces. Bitcoin (like cash or the internet) is neutral. Bitcoin offers novel characteristics that have a net positive impact on society; however, it may also be exploited by bad actors who take advantage of Bitcoin’s decentralized and censorship-resistant characteristics.
It is important not to consider Bitcoin’s use in illicit activity in a vacuum. According to data from blockchain analytics firm, Elliptic, bitcoin’s use in illicit activities (e.g., dark markets, ransomware, fraudulent activity) has been on a downward trajectory and transactions connected to illicit activity made up less than 1% of total bitcoin transactions in recent years. Bitcoin’s transparent nature allows us to establish a concrete estimate of bitcoin’s use for illicit activity in a way that we cannot for fiat currencies making it easier to point fingers at bitcoin for facilitating criminal activity, while ignoring the role that cash as well as the financial system play in criminal activity. For example, for every dollar spent in bitcoin on the darknet, at least $800 was laundered via cash, according to The United Nations Drugs and Crime Office and Chainalysis.
“Although virtual currencies are used for illicit transactions, the volume is small compared to the volume of illicit activity through traditional financial services”
Jennifer Fowler, US Department of the Treasury
The revelation that law enforcement can detect and punish criminal activity with the help of blockchain forensics may also present a barrier to the use of bitcoin by bad actors. Bitcoin is pseudonymous, not anonymous, and blockchain analytics firms have developed sophisticated techniques to trace criminal activity via Bitcoin to real-world identities. Additionally, the focus and scrutiny on Bitcoin from regulators and regulated institutions who have the duty to monitor for illicit transactions is only growing as Bitcoin becomes more financialized.
Criticism #5: Bitcoin is not backed by anything.
Response: Bitcoin is not backed by cash flows, industrial utility, or decree. It is backed by code and the consensus that exists among its key stakeholders.
In “What is an Asset Class, Anyway?” (Journal of Portfolio Management, 1997), Robert Greer defines three asset “superclasses” – capital assets, consumable/transformable (C/T) assets, and store of value (SOV) assets.
Greer places gold in the “SOV” superclass, which includes assets that “cannot be consumed nor can [they] generate income. Nevertheless, [they] have value.” However, gold also has characteristics of the “C/T” superclass given its use in jewelry and technology (e.g., electronics, dentistry), which drives the idea that gold is backed by its utility in jewelry and industrial applications. However, gold jewelry is arguably an alternate vehicle to store wealth and is used as a “private monetary reserve,” and only a very small portion is used in industrial applications (only 7% of 2019 gold demand was tied to applications such as electronics and dentistry).
Robert Greer also classifies fiat currencies as “SOV” assets. Fiat exists by decree. The argument for fiat currencies is that they (fiat) are backed by the full faith and credit of the government. However, in many situations, faith in the ability of governments and central banks to appropriately manage fiat currencies has been misplaced (see Venezuela and Lebanon for recent examples). Multiple central banks and governments have exhausted monetary and fiscal policies as a lever, leading to notable losses in the purchasing power of their currency over time.
Based on Greer’s definitions, Bitcoin best fits in the “SOV” superclass. Bitcoin is not backed by cash flows, nor is it backed by industrial utility or by decree. Distinctly, it is backed by code that is brought to life by the social contract that exists among its key stakeholders. These stakeholder groups exist in an equilibrium with no one group having outsized power:
—Users that choose to transact on the network and pay for transaction finality
—Miners that choose to incur costs to process transactions, providing finality
—Nodes that choose to run bitcoin software to validate transactions
—Developers that choose to maintain Bitcoin software
Bitcoin’s stakeholders make the explicit choice to use and support the network, realizing Bitcoin’s unique attributes – the perfect scarcity of bitcoin, transaction irreversibility, and seizure and censorship resistance. The addition of every new stakeholder – in other words, Bitcoin’s network effect makes it more reliable and further hardens its properties, attracting more stakeholders to the asset, and so on. Bitcoin code presents the rules but the execution of and agreement on the rules by stakeholders gives rise to the secure, open, and global value storage and transfer system that exists today.
Criticism #6: Bitcoin will be replaced by a competitor.
Response: While Bitcoin’s open-source software may be forked, its community and network effects cannot. Bitcoin makes trade-offs for core properties that the market deems valuable.
Many digital assets have emerged that claim to improve on Bitcoin’s deficiencies. However, to date, none have been able to achieve Bitcoin’s network effects. Bitcoin has qualities that make it valuable, and it makes explicit trade-offs to offer those qualities, as mentioned multiple times in this piece. While competitors have attempted to improve upon Bitcoin’s limitations (e.g., its limited transaction throughput or its volatility), it has been at the cost of the core properties that make Bitcoin valuable (e.g., perfect scarcity, decentralization, immutability).
This explains why Bitcoin continues to dominate in terms of market cap, investors and users, miners and validators, as well as retail and institutional infrastructure and products. As shown in the charts below, bitcoin’s market cap is orders of magnitude higher than the combined market cap of competitors (other proof-of-work digital assets).
While Bitcoin’s software is open-source and may be forked and “improved” upon, its network effects and community of stakeholders (users, miners, validators, developers, service providers) that understand and accept the trade-offs it makes cannot be so easily replicated away.
While this piece does not cover the exhaustive list of criticisms against bitcoin, I believe the responses outlined here may be adapted to address other common misconceptions.
Bitcoin is a unique digital asset for an increasingly digital world that requires digging deeper than the surface level to understand its core properties and trade-offs.
It pushes onlookers to question preconceived notions of what is right and widely accepted to begin to understand its full value proposition.
Onward and upward.
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