The global financial system is in a state not seen before. We see governments everywhere are printing money, interest rates are hovering near zero, stock markets are at all-time highs, and everybody is searching for yield. Bitcoin, too, is currently near its all-time highest price. Tesla purchased bitcoin with $1.5 billion of $19 billion in cash reserves, and MicroStrategy has spent almost $2.2 billion on purchasing 90,531 bitcoins.
If you are tempted to buy bitcoin but have some lingering questions, this paper is for you. First, we discuss Bitcoin's intangible values and how Bitcoin is a store of value, then we go through the main criticisms of and challenges for Bitcoin. Please note that this paper is intended to be educational and should not be considered investment advice.
If you're unfamiliar with Bitcoin or blockchain or are reading this paper and want a refresher, please check our education page here.
Bitcoin's intangible values
The market value is what you pay right now to purchase bitcoin in an open market. It is a combination of innumerable forces acting on market participants, all aiming to gain value. The intrinsic value or fair value isn't knowable, and the various perceptions of the fair value, in and of themselves, act as forces on the market. Bitcoin is viewed as:
A cheap payments network
A censorship-resistant e-gold, or gold 2.0
An anonymous darknet currency
A programmable shared database
The reserve currency for cryptocurrencies
An uncorrelated financial asset
A Store of value
Many have attempted to find a target value for bitcoin by quantifying the available market. How much market share could Bitcoin take from each market that it is disrupting? For example, the sum of all gold ever mined is worth around $10 trillion US, and gold is 50 percent made into jewelry, and 50 percent held as a store of value. Let's say Bitcoin could take 25 percent of the store of value component; this would mean that the market share that Bitcoin is taking from gold as a store of value would be $1.25 trillion. This type of exercise is interesting because it can provide a general idea of an estimated fair value, but it is ultimately very dubious in estimating the market value. Estimating what markets would be disrupted, at what pace, and by what amount adds up to a lot of uncertainty.
Each value proposition's impact on bitcoin's price is practically impossible to distinguish from each other. Rather than quantifying Bitcoin's various values, if you look at Bitcoin's structure and security mechanisms, it may provide a clue as to why (so far) investments in Bitcoin with a four-year time horizon have always provided a positive return.
Bitcoin, at its core function, is pretty simplistic. It is just a public database or ledger where addresses exchange value. Because of the code, you can be sure that value is only sent when the sender has the private key. It is hard to grasp the full significance of Bitcoin without understanding how it drastically changes the roles and actors who participate in the payment network. Instead of a centralized network putting substantial security efforts to protect vast sums of data against an innumerable array of attackers (who can clearly see a high-value target), there is a decentralized network of individuals competing to earn mining rewards, each of which increases the security. As the value of bitcoin increases, so too does the mining reward and the number of miners. As mining efforts increase, so too does the security. About every four years, the mining reward is halved, decreasing the issuance rate.
Bitcoin has value, the root of which may not be easily quantified, but it is there. It currently costs more than $50,000 for one. Since Bitcoin represents an entirely new, uncorrelated financial asset class, it is hard to find an appropriate comparable growth curve to measure against. However, if you view bitcoin as a store of value alone, it has yet to disappoint with an investment horizon of at least four years.
Bitcoin is a store of value
The most easily demonstrable value of Bitcoin is as a store of value. A store of value retains purchasing power into the future, and every store of value comes with its risks:
Cash is devalued through inflation.
Bonds are safe but typically have a low yield, so you risk upside potential.
Stocks have more upside potential than bonds but more volatility and downside risk.
Debt isn't always repaid and typically isn't liquid.
Real estate is not very liquid and has large boom and bust cycles.
Precious metals such as gold, silver, platinum, and palladium have huge historical significance, but they are expensive to store and transport and getting harder to justify due to ESG factors.
Collectibles such as original art by a famous artist or antiques such as ancient artifacts or coins are not very liquid and can have high storage costs.
Gemstones have a small market, not very liquid and come with storage costs.
Since its creation, investors who held bitcoin for more than four years have vastly outperformed cash, bonds, most stocks and precious metals. Cash is not risk-free. In cash, with a two percent annual inflation, one-third of your wealth is lost every twenty years. Another way to view cash inflation is to price real estate in ounces of gold. Using a local example, the Real Estate Board of Greater Vancouver states that a detached home's benchmark price went from $343,980 to $1,576,800 between 2000 to 2021; over the same period, the same houses, priced in ounces of gold, went from 1185 oz to 651 oz.
Mature stores of value typically develop financial services to offer those who invest in it, such as futures markets, borrowing and lending facilities, custodial services and insurances. Bitcoin's role as a store of value used to be a matter of debate, but it isn't any longer. CME has a functioning Bitcoin futures market, the Toronto Stock Exchange offers Bitcoin ETFs, US banks are authorized to provide bitcoin custodial services, and the market cap of Bitcoin is over $1 Trillion.
To maintain your wealth, investors need to assess how much risk each store of value has then balance your risks.
Criticisms of and Challenges for Bitcoin
If bitcoin will be commonly used as a store of value by individuals, corporations, and governments, many problems still need to be addressed. Whether a problem is real or perceived doesn't change the fact that it is a challenge, and education will need to play a vital role moving forward. The following are what we consider to be some of the main criticisms of and challenges for Bitcoin.
Investors of all kinds are increasingly taking environmental, social and governance (ESG) factors into account when making their investment decisions.
On the environmental side, there is adequate reason for concern; bitcoin mining uses a lot of energy, more than some countries. But the comparison is quite difficult to make. What is most appropriate? Bitcoin versus gold, versus credit cards, versus debit card or cash. Gold mining has adverse environmental effects. How much energy does the payment processing component of the banking system use? How much energy is used to move all the cash around? What you are comparing to is hard to estimate, but so is bitcoin mining's actual environmental impact. The mining equipment and the electricity source used by miners have to be estimated. However, reports have concluded that due to the nature of bitcoin mining, miners are drawn to the lower cost, albeit less reliable renewable power sources. Additionally, as the mining space evolves, some miners are putting their 'waste heat' to productive uses such as heating greenhouses. The question is not whether bitcoin is good or not for the environment, but how it compares to the alternative. Further work on this may be the topic of another paper.
Socially, there are concerns that investing in Bitcoin would support bad actors who mine bitcoins. Whether it be a regular Joe, a multi-nation corporation, a repressive regime or a thief who steals electricity, the structure of Bitcoin allows anyone with an internet connection and a computer to mine. By investing in Bitcoin, you are buying an asset partially secured by nefarious actors (the distinction of which is obviously subjective); that fact is unavoidable. But does the participation of a nefarious actor within a free and open network diminish the network's value? Consider the UN general assembly. When the infamous General Muammar Gaddafi spoke at the UN general assembly in 2009, did that diminish the UN's value? Having some minor participation from bad actors is a necessary evil in having a freely accessible financial network with a security system that relies on open competition. If you're not convinced and still want bitcoin exposure, perhaps you should look into mining companies that operate within a jurisdiction you trust.
Governance factors of Bitcoin are likely to be viewed as positive from an ESG perspective. It is free and open-source. Anyone can participate as a minor, node or user, and anyone can propose changes to the code. As long as proposals follow the protocol, they will be considered and voted on by the miners.
Bitcoin price volatility is trending slightly downwards over the long term, but it is still nowhere near what foreign exchange investors typically associate with currencies. Major global trading currency pairs have daily average pip movement ranging from about 50 to 150, as reported by CurrenciesFX.com or about 0.5 to 1.5 percent. The average daily bitcoin volatility is around 2.75 percent, and the standard deviation is 3.1 percent. The most significant daily percentage drop in bitcoin's price occurred last March when it went from $7935 to $5142. People, businesses and governments all expect their currency's purchasing power to fluctuate by very little and slowly. It is hard to manage your finances, run a business or a government if your operating budget can fluctuate by 35 percent in a day.
That being said, volatility doesn't have to be a bad thing. If bitcoin is viewed as a store of value rather than a currency, its daily fluctuations are less concerning. Used as a long-term investment, it has so far proven to provide excellent returns. If you bought at the peak in 2013 or 2017, you would have had to wait just over three years to get a positive return. If you held for four years, the minimum return you would have is 775 percent.
For anyone who has been paying attention to bitcoin's price and the news over the past few years, you'd likely agree that the price does not appear to act rationally to the news. Days with multiple positive news stories can see double-digit price decreases, and the opposite is also true. Then, what is driving the price? Whales buying and selling to systematically pump the price? Or Tether printing its way to crypto dominance? Who benefits by trying to manipulate the price and why?
Whales are bitcoin holders with massive holdings. There are only 2374 wallets with balances over 1000 bitcoin, and they hold about 42.6 percent of all coins issued. Some of these wallets are known to be exchanges or large funds, but most are anonymous. With so few players holding such large quantities, it is fair to assume these whales can move the market. As long as bitcoin remains held in such a high concentration, the risk of whales moving the price remains. As more deep pockets, those coming after Micro Strategies and Tesla, buy bitcoin as a store of value, the concentration will continue to decrease.
Tether is a stable coin. It is pegged to the USD and maintains its value by printing Tethers via a reserve balancing mechanism and claims to keep a 1 to 1 ratio of their reserves. Currently in fifth place in terms of market capitalization and having launched in 2014, it is a significant player in the cryptocurrency space. It has gained much attention for a long-running legal dispute with the New York attorney general (NYAG). The parties have recently settled with Tether's parent company Bitfinex paying a fine of $18.5 million and not admitting any wrongdoing. Tether had maintained for some time that a USD backs each Tether with a reserve ratio of 1 to 1, while the NYAG argued that to be untrue and claimed Tether spent its reserves to cover losses in 2018. What is further worrying is that Tether has the largest average daily trading volume of all cryptocurrencies. If it turns out to be a complex scheme, it could prove quite damaging to the cryptocurrency industry. While Tether remains the dominant way for crypto traders to lock in and hold profits on an exchange, other stable coins have diminished Tether's dominance. It is suspected that if Tether is found to be acting in bad faith, other stable coins are ready and able to take the volume.
Lack of leadership
No one person or entity is in control, and that can be unnerving. If an unforeseen bug crashes the bitcoin network and you lose all your bitcoin, there is no one to pursue for recourse. There is no 1-800 number to call if you lose your secret key. And if you accidentally send your bitcoin to the wrong address, there is no way to reverse it. These 'features' of bitcoin have caused many to think twice about using it.
Development on the bitcoin network is slow, is not systematically coordinated and is done without direct funding. Proposed code changes are accepted on a case-by-case basis by users who choose to update their software or not. Disagreements on development paths have led to several software forks where a portion of the miners choose to adopt a change while another portion continues with the older version. Bitcoin has been forked multiple times, the most popular being Bitcoin Cash, which later had a fork that created Bitcoin SV. Having multiple versions of bitcoin is confusing to those unfamiliar with it.
Bitcoin's lack of leadership is not going to change; it's not a bug, it's a feature. It provides anyone with the opportunity to 'be your own bank', which comes at the cost of more responsibility. However, ever-increasing custody options are allowing for various user experiences based on comfort level. In time, we expect a large variety of insurance options as well.
Because the network is free and open-source, anyone can participate, and everyone can see all the information stored on the blockchain. Anyone can run a miner or a node on the Bitcoin network. It kind of puts the traditional view of network security on its head. As discussed above, instead of a centralized network putting substantial security efforts into protecting vast amounts of private data, there is a decentralized network of individuals competing to earn mining rewards, thereby increasing security.
The only way to change the Bitcoin blockchain is to add to it. Nodes are constantly checking to ensure the record is kept intact and history doesn't change. The only way to add transactions to the blockchain is to be the first miner to complete a block successfully. To be the first miner to complete the block, you must essentially win the race in a global 24 hr computing competition, starting a new race every 10 minutes.
The only way to update or change the protocol, the rules that the participants must follow, is by submitting a bitcoin improvement proposal (BIP) to the blockchain and then have 95 percent of the next 2,016 blocks (approximately 2 weeks) indicate acceptance. The primary attack method would be to include false transactions in a new block or by a nefarious protocol adjustment because of this structure.
One of the most discussed security threats to Bitcoin is the 51 percent attack. To execute a 51 percent attack, you would have to control at least 51 percent of the miners to enter fraudulent transactions into the blockchain. But is it possible to get that much control? A lot of infrastructure costs have gone into building the network; mining computers and the necessary electrical infrastructure are expensive, and the operation requires a lot of electricity. To illustrate the size of the network, consider the costs of the mining equipment alone.
A state-of-the-art mining computer costs $3767, mines at a hashrate (mining effort) of 110 Th/s and uses 3500W (Antminer S19 pro). The current estimated total hashrate of the entire bitcoin network is 148 Eh/s. This means that if the network were mined using state-of-the-art mining hardware, it would require over 1.3 million machines and cost about $5.1 billion. Operationally that would equate to 41 TWh per year. At an electricity rate of $0.05/kWh, the annual electricity bill would be $2.1 billion.
So, a would-be attacker would require control of machines valued at over $2.5 billion and have them connected to enough electricity to pull off a 51 percent attack. Possible ways to gain control could be through purchase, seizure by a nation, hacking a group of mining pools, a backdoor hidden in manufacturing or collusion between pool operators.
Let's consider the case of purchasing the equipment. $2.5 billion doesn't seem like too much to spend if you were a nation, large corporation or even a large family office that wanted to destroy Bitcoin, which has a market cap hovering near $1 trillion. It is, however, not possible as this volume of miners is not available on the open market; in fact, the miner discussed above is out of stock until August 2021.
The manufacturing of mining hardware is relatively centralized. There are only a handful of companies that supply the vast majority of hardware. Actual estimates vary, but there seems to be a consensus that Bitmain has manufactured the majority of bitcoin miners. So, they appear to have had the opportunity to sneak in a backdoor into most miners mining bitcoin. But at what cost? Having sold as many units as they have, many people are attempting to reverse engineer their hardware. A backdoor, should it exist, would eventually be found. If it were discovered that they used a backdoor to spy, steal bitcoin rewards or manipulate your miner, they would lose all their business. Bernstein Research estimates Bitmain's annual profits to be $3 billion per year. They have a good business going; putting in a backdoor would put that all at risk.
It makes us ask the question, to what end? It would be hard to make a profit from destroying Bitcoin. The way we see it, if Bitcoin were to be proven insecure, it would lose all of its value. We don't see how one would benefit from spending so much capital on machines and equipment that are useless in the end. Additionally, if you had the capacity to mine half the bitcoin minted each day, the revenue would be approximately $22.5 million per day; why not just be a miner?
Nefarious protocol adjustments
To make a change to the bitcoin protocol, you need consensus. A BIP has to be submitted, which includes the proposed changes, then it needs to have support by 95 percent of the miners for two weeks; this is why development is so slow. Changes require an overwhelming majority of miners to support the change.
Some question the ability to ensure that the supply of bitcoin will indeed remain capped at 21 million. Besides the fact that you would need 95 percent of miners to agree to dilute their holdings, a mechanism is in place that would not allow the BIP to be accepted. The limited supply of bitcoin is considered sacrosanct and cannot be altered and continue to be considered Bitcoin.
It is not a question of if but when quantum computing will arrive. Many speculate that bitcoin's proof-of-work security mechanisms will be breakable with quantum computing, which appears to be the case. It is a real threat. But it is not a threat that is isolated to Bitcoin. Most of our internet security will be at risk. This is a known problem, and cryptographers are creating quantum-resistant encryption that could be applied to Bitcoin.
Currently, investors worldwide are looking to diversify their portfolios while having an abundance of cash. Bitcoin has matured and evolved to become a store of value. Bitcoin is Gold 2.0. We have laid out the risks so investors can better consider the risks of their current stores of value vs Bitcoin. Risks and challenges exist for all stores of value, and we believe it is prudent to hold at least a small percentage of savings in Bitcoin. With the current state of the world, it almost seems too risky not to.