Bitcoin, the centralized & deflationary asset.

If you are already familier if Bitcoin, skip ‘Where it all began’ & ‘The Basics’. Start from ‘Digital Gold?’

Where it all began

In 2007–2008, the global financial system has experienced some unprecedented downfalls among its biggest financial veterans. With the biggest US investment banks and other financial institutions falling like dominos, US, along with the rest of the world needed a solution for the unstable, volatile financial system which was created. While the ‘Too big to fail’ institutions were looking for a lifeboat to jump on and begging for a bailout, a technological advancement was underway that arguably provided an alternative financial system and the solution to this mess. On October 31st, 2008 a technology called bitcoin has been created which fixated on providing an alternative financial system, if not a replacement all-together. October 31st, 2008 was indeed a revolutionary date because not only did bitcoin get created, but along with it came many more incredible technological advancements, including the blockchain, ethereum which enabled the creation of decentralized autonomous organizations (DAO), and countless other cryptocurrencies and tokens. But for the sake of this writing, we will focus only on bitcoin.

The Basics

As previously mentioned, Bitcoin emerged out of the ashes of the financial crisis in 2008. On October 31st, an anonymous individual (or group of individuals) named Satoshi Nakamoto released a white paper which would detail the technical details of bitcoin and explain how it functions. You can view it here: https://bitcoin.org/bitcoin.pdf. To start off with basic facts, Bitcoin is a digital currency. Which means it exists in the networks of computers and does not possess any physical form. Bitcoin’s network is open source, which means that any developer can add to the development of the infrastructure and code of bitcoin if they wish to contribute to it. A key feature which bitcoin enables is peer-to-peer transactions, which mean that no third-party has to be involved, enabling individuals to make financial transactions between each other only. Bitcoin also utilizes cryptography, meaning that it uses complex tools (such as the SHA-256 algorithm) in order to protect itself from being vulnerable to hackers. Bitcoin is very much privacy oriented, nobody knows that you are making that particular transaction, even the person receiving the payment. However it is not anonymous, there are other cryptos like Monero which has that anonymous perk to it, but Bitcoin is pseudonymous, meaning that the transactions that are being made are available for everybody to see, but nobody knows who makes those transactions because the account names of the senders and receivers are encoded with a combination of different numbers and letters.

In a nutshell, the basics of bitcoin, are that it is a digital currency that is run on an open source network which enables peer-to-peer transactions that are cryptographically secure, are pseudonymous making them highly privacy oriented. This is just the tip of the iceberg.

What’s beautiful about bitcoin is that it combines two different fields to it. Computer Science and Economics. We could dive into understanding the cryptography of how the mining and distribution of it works, different algorithms associated with it (and of course how the underlying technology works, the blockchain), how private and public key cryptography functions, but for the sake of time and not making the content too long we will look at bitcoin through the lenses of an economist.

Digital Gold?

In order to see if bitcoin has the same characteristics as money, we need to examine currency and more importantly gold. Currency, such as the Canadian Dollar, has a few key characteristics; it functions as a medium of exchange, a unit of account, it is portable, durable, and divisible, and fungible or interchangeable. When taking a look at gold, gold has all of those characteristics, plus one crucial one, and that is it has a store of value over a long period of time. Gold, unlike fiat currency does not devalue over time. Just like any asset, it has its ups and downs in the market, and is sometimes volatile, but never since 4,500 years ago in Lydia, when it was first used as currency, has gold been worth zero, (Maloney, 37) it has always prevailed in monetary history and came out on top, while all the previous fiat currencies that have existed are now worth zero. At the current moment, the existing supply of gold is at about 187 kilotons split evenly between financial and decorative uses (Gilder, 248).

Now going to bitcoin, Satoshi, the creator of bitcoin, has tried to design the cryptocurrency with the goal of mimicking gold. It is distributed through miners solving a mathematical problem using an algorithm. Miners get a rewarded in bitcoin. The current amount of bitcoin miners get as the reward for solving the ‘golden hash’ and extending the bitcoin blockchain is 12.5 BTC. (Bitcoin Wiki, Controlled Supply) At the beginning, in 2008, that amount was 50 BTC, not to mention that it was so easy to mine bitcoin that you could do it on your computer CPU. Now we need expensive, high energy consuming machines called ASICS. Furthermore, the distribution number will decrease to 6.25 by 2021, and will finally go to an end by 2140, that’s when the last bitcoin will be mined and 21,000 BTC will be in the financial system. Bitcoin, unlike fiat currency is not controlled by the government and banks. Therefore it is not prone to inflation. It could have a store of value over the long period of time, like gold. But what is wrong with that picture? Gold does not have a set cap for distribution. Bitcoin does.

Economic Flaws in Distribution

The BMI research forecasts for the “global gold production to increase from 105moz in 2018 to 125moz by 2026, averaging 2.3% annual growth.” (Mining.com, Gold Production will grow in the coming year.) If bitcoin mimicked that 2.5% rate of growth of gold production”, according to Mike Kendall, “the current number of bitcoins -16,651,130-… would reach 347,119,614 million units” by Satoshis closing date of 2140. (Gilder, 255). Therefore the two distribution models are very different.

Bitcoin, World’s Biggest Centralized Asset

However the distribution of this asset and the deflationary nature of it is not the only flaw in its design at the current moment. The protocol which was designed to be decentralized is becoming the opposite in nature. Out of the 10 biggest bitcoin mining companies worldwide, 7 are located in China. The three biggest bitcoin mining pools are all Chinese; BTC.com, Antpool, ViaBTC. China at the current moment owns about 81% of the hash rate of bitcoin. That does not really sound like a decentralized system. On our hands we might have a tool which could be used to secure financial stability in the future, but it is mostly produced in China. Could it be mostly owned by Chinese as well?

Since bitcoins network and the record of its transactions are pseudonymous, we cannot identify who the user of a particular wallet is. It’s really hard to answer this question, we can speculate at best. However looking at different wallet holders of bitcoin, we can clearly identify one fact. 1% of bitcoin wallets own more than 50% percent of bitcoins. A research unit, Diar, has determined that 1 percent of all bitcoin wallet addresses control $100 billion in Bitcoin. The report also indicates that “3.8% of the total bitcoin supply are currently sitting in the top 5 wallets that are known to be managed by major exchanges — approximately $4.2 Billion in value”. I encourage to check the research out for yourselves: https://diar.co/volume-2-issue-37/#1.

The Future

Bitcoin has the potential of being a great store of value, and enabling countless amounts of individuals that previously did not have access to the banking system, to finally participate in it. Even more than that, bitcoin can allow people, which live in countries with very unstable environments that have very high inflation rate on average, to have a better alternative to storing their wealth, and not have government steal it from them. Not to mention that there is no need for banks and similar institutions, making the processes of transferring money faster and cheaper.

However due to bitcoins deflationary nature, it is very vulnerable to people hoarding it and not actually using it for what it is meant for — a global, peer-to-peer currency. That itself, contradicts the whole nature and use for bitcoin. Furthermore, the asset which was designed to be decentralized in nature, is actually becoming centralized with the biggest mining firms originating from China and majority of bitcoin owned by only a few wallets.

At the current moment it is still fighting its way into mainstream adoption, and nobody truly knows what will happen to it. Solely predicting Bitcoins future price on economic factors has proven not to be very accurate, there is too much psychology involved with this asset. With more and more people getting exposed to it everyday, very strong support community, and major financial institutions on Wall Street potentially entering this market, who knows what will happen with this asset. Will it go to $1 million per coin, or not? Time will tell, your market to speculate.