A realtime map of the Lightning Network, a transaction layer built on bitcoin. https://explorer.acinq.co/

This is a blog post that I've been putting off for years. Many people have written about the value of bitcoin. But I have been itching to write my own personal answer, something I can send to friends when they ask me: "Why is bitcoin worth anything at all?" Since I've never gotten around to writing it and I'm afraid I never will, I'm challenging myself to knock out a short version in an hour. Here we go. (Okay it took a day. But, whew, I got it done.)

What is Bitcoin?

If you're not already familiar with Bitcoin, I would recommend checking out an intro guide like this one. As that intro explains: "Bitcoin is the world’s first cryptocurrency. A cryptocurrency, otherwise known as a virtual currency, is simply an encrypted piece of data that can be used to buy goods and services. Bitcoins are not something that can be touched physically, instead they are bits of code that exist only in the digital realm."

They say a bitcoin has no value

I have heard many people say that bitcoin is doomed because a bitcoin has no underlying value. On the surface, they are right; unlike an asset like gold, a bitcoin has no value, or even meaning in the real world – after all, it's just a string of digits.

Image borrowed from https://tedideas.files.wordpress.com/2017/11/new_featured_art_monopoly_istock.jpg

But this doesn't mean that a bitcoin is worthless. After all, if you call bitcoin worthless, could you say the same about any fiat currency? If you called it meaningless, could you say the same about any logical system of meaning on which our world runs? But I digress..

Does a bitcoin have any value?

To understand whether a Bitcoin has any "real" value, I think we first need to consider whether the bitcoin network has any "real" value. If the network has value, then I think we can argue that a bitcoin has implicit value even if it is only derived from the network's utility.

Fiat Monies

Before we go further, it's important to acknowledge that it's actually quite normal for a currency to lack intrinsic value. The US Dollar and other government backed currencies are fiat monies, meaning that they only have value because a government decrees it to be so. Does this feel suspiciously like circular logic? Yes, because it is. In theory, it makes no sense that we believe the money has value because we believe it to be so. But in reality, we tolerate this faulty logic simply because it is useful to do so. Using fiat makes trade more efficient. And as long as we believe that everyone else will keep believing in the currency, it is safe to use a network which pretends that the currency has "real" value. Strange, but true.

Image borrowed from https://www.evolvingwealth.org/value-fiat-money-goes-to-zero/

To dig a little deeper, the reality of a fiat market is more complicated than value by decree. A fiat currency's value actually depends on a market's faith in that currency at any given time. This depends on supply and demand, which depends on market liquidity and predictions about future value.

So in reality, the value of fiat is not simply defined by a government, but is actually dictated by the users of that currency. This is important. Because it means that in practice, a government can only influence their fiat, not decree its practical value. A government can use economic levers like regulating supply, but this can only go so far and has its breaking point.

Bitcoin is fiat decreed by the masses.

With this understanding of a market's influence on a fiat money, it is easier to see how Bitcoin might be understood as a fiat decreed by the masses – by its own network of users. If we agree that it's really the market traders who decide the actual value of a currency, then does Bitcoin need a government? Well, maybe not, but it still needs governance.  Because it needs some way to enforce things like regulating supply and preventing counterfeit money. Well it turns out that Bitcoin is in fact able to achieve these things with just a careful design using math and code. No government needed. (This is admittedly oversimplified for the purposes of this essay.)

Image borrowed from https://cryptome.org/info/occupy-wall-st11/occupy-wall-st11.htm

It's important to understand that a fiat currency existing without governance is indeed a strange phenomenon. This had never existed before the world discovered Bitcoin. Bitcoin's ingenious design, published anonymously in 2009, leverages cryptography, economics, and network consensus protocols to manifest a trustless distributed ledger. This invention makes it possible for the first time to have a self-governing fiat.

Transaction networks are inherently valuable

A network that tracks financial transactions is an immensely valuable thing. The remittance market alone is worth billions. So what if we forget for a moment about the value of a bitcoin, and instead we consider the value of the bitcoin network? If we assume for a moment that Bitcoin does work and will always work, then it's not hard to understand why Bitcoin's network would yield the same value as any secure transaction network. For example, bitcoin has already demonstrated practical utility in the global remittance market.

If we build it, they will spend. If they spend, it has value.

The crux of this essay is to untangle the confusion around the perceived value of a bitcoin versus the perceived value of the bitcoin network. As we already acknowledged above, a bitcoin has no direct value, because it's a fiat currency. So when someone argues that a bitcoin has no value, they may be conflating bitcoin with its network and they may be misunderstanding some critical details about how the network actually works. While the price of a bitcoin may seem arbitrary, it is in fact regulated by Bitcoin's design.

Bitcoin uses a process called mining to both secure the network and to self-regulate the network's supply and demand. Through this process, mining rewards and transaction fees are automatically paid to network facilitators. And of course, these rewards are paid in bitcoin! Thus, the value of a bitcoin is intrinsically tied to the process of facilitating secure transactions. And so, the value of a bitcoin is intrinsically tied to the value of the bitcoin network.

Think of it this way: At any given time, a user decides how valuable they believe the network to be. (Maybe they realize that it's cheaper to send money overseas using bitcoin than using a bank, and that's why it is valuable to them.) But, in order to use the network, they need some bitcoin. To get bitcoin, they have two options.

A: They can trade bitcoin for something else, like another fiat. Or,

B: They can "mine" bitcoin, which is to say, they can help to secure the network, which will earn them bitcoin.

If you understand how Bitcoin's design connects the token's value to its network potential, you can understand this ecosystem which perpetuates both the network and its co-dependent fiat token.

The network exists, therefore it has value.

Above, we have defined the value of a network token as being codependent with the value of the network. This helps elucidate why a bitcoin might have any value at all, but it still does not rigorously explain why the network should exist in the first place, or why it continues to exist in a stable state.

Let's revisit an assumption we allowed ourselves above: We agreed that the bitcoin network (and therefore the bitcoin currency) is valuable if we assume that it will continue to work securely. But how do we know the market won't collapse tomorrow? If we can't trust that the market will remain stable, all of the network's value and therefore all of a bitcoin's value collapses. In other words, what if the whole thing is just a bubble?

The life of a bitcoin bubble is nasty, brutish, (but short)

When a market bubble bursts, it bursts hard. Often 90% of value is destroyed in the blink of a market cycle. Many bubbles burst and then die forever. But some bubbles are just temporary. A market crashes, but it's later buoyed back up even higher, and then it might explode into a new, bigger bubble cycle. And repeat. Such is the history of bitcoin, which has already survived many bubble cycles in it's short life.

So why does bitcoin repeatedly survive bubbles? After all, each bitcoin bubble is a grave threat to its users' assumption that the network will continue to work securely. So why haven't people lost faith in the network? Why hasn't the network fallen apart?

It seems that bitcoin continues to survive because there are always enough people who do hold their faith in the network, and are willing to bet on its future. This argument can also explain how the network was able to get started in the first place. From its inception ten years ago, just the idea of bitcoin alone was enough to inspire investment in the future network.

The chicken and the egg of network value

How did bitcoin overcome the chicken-and-the-egg problem and build its network in the first place? Why did bitcoin have any value at all before it had a network?

Props to http://www.friedegglove.com/

It's easier to understand this problem if we consider the power of network effects. Simply put, a network's value is often proportional to the square of its user base. This makes it rational to take a bigger bet on the network while it is small because you believe it will grow quadratically in the future. It explains why the value of a bitcoin could have grown exponentially since its birth. And it explains why people continue to have faith in the future value of the bitcoin network and therefore the future value of bitcoin itself. After all, the potential market of bitcoin is nearly the entire world's money. That's a lot of potential value.

Image borrowed from https://www.investopedia.com/tech/how-much-worlds-money-bitcoin/

Who will kill Bitcoin?

Another reason why so many people believe in the future of bitcoin, is that bitcoin is truly decentralized. There is no central power controlling who gets to use bitcoin or who doesn't. This also means that no one can shut down bitcoin. Admittedly, this is oversimplified. Bitcoin could be killed by a competitor, or by an unexpected flaw in its code. But this seems increasingly unlikely the longer that bitcoin lives on unhacked and unchallenged as cryptocurrency's strong leader.

A matter of faith

It's ultimately a matter of faith whether or not we believe that bitcoin will survive. I personally believe that even if bitcoin does not survive, it will be because the cryptocurrency market will evolve into something new. I believe that the invention of bitcoin is a pandora's box which will forever change our fiat markets. New cryptocurrency network designs will make markets more efficient and this will drive down prices of transaction networks. This will improve our banking systems and it will create new kinds of ecosystems that we haven't even thought of yet.

Image borrowed from https://www.robcottingham.ca/2014/11/leap-of-faithaaaaaaahhhhhhhggghhh/

Something emerging from nothing: resolving a paradox

To conclude this essay I want to revisit our chicken and egg metaphor - how is something complex bootstrapped into existence from nothing.  And I want to introduce a new metaphor – that of a whirlpool in a river.  (Strange I know, bear with me a moment.)

I find a whirlpool to be an interesting metaphor for a market, and I think this metaphor helps explain how a market like bitcoin can emerge and create value, seemingly from nothing.

https://en.wikipedia.org/wiki/Whirlpool#/media/File:Naruto_Whirlpools_taken_4-21-2008.jpg

A whirlpool is an example of what physicists call a semi-stable, emergent structure. This means that the structure is not a "real" thing in the world, but rather a pattern, a perceived phenomenon, which can emerge from some energetic medium in an environment. While you might say that the whirlpool is made of water, the reality is more complicated than that; in reality, it's comprised of different particles of water from one moment to the next, it is never the same water. This is also how markets work. Just like a whirlpool, the value of a financial market asset is really an emergent pattern. The price is dictated by a constant flux of supply and demand. It emerges from the pattern of money flowing through the market's psychological environment. As one trade follows another, the price appears stable, but the money is never the same money from one moment to the next.

Example of a market depth chart showing buy pressure and sell pressure

Whether we're talking about a whirlpool or a market, we can predict the stability of the emergent structure by examining the stability of the environment and the stability of the energy or value fluxing through that environment.  

A whirlpool is stable so long as the water keeps flowing and its riverbed does not wash away. A market price is stable so long as the supply remains predictable and the demand creates liquidity.

I think this metaphor helps to resolve Bitcoin's chicken and egg paradox. Bitcoin's original blueprint was like a dry river bed. It held no value when it was first designed. But the idea alone carved out the future possibility of value. It gave us the the opportunity to build a network and participate in it. And by doing so, we create value where there was none before, because the network itself holds value.

Like the ideal of democracy, the ideal of bitcoin itself compels the masses to participate. It offers the promise of a free and open currency. All we have to do is buy in. This idea has a kind of gravity which compels early adopters to dip a toe in the water. And just like any free market, the more people who participate, the more efficient the system becomes and the faster the value rushes through it as the network grows its influence.

So, is bitcoin valuable? Will it hold its value?

I believe that bitcoin and similar cryptocurrencies will continue to grow their influence for quite a while. Maybe they will last another five or ten years. Maybe they will last longer than any other fiat currency to ever exist. No one can know. But I believe bitcoin or something like it will survive because people will always want to trade as freely as possible, and I don't believe that any authority in the world can stop people from using it. What single government could succeed in policing the entire world? What government alliance could succeed in agreeing on a single monetary solution to rival bitcoin?

So yes, for better or worse, I think this technology could last a very long time indeed.

Image borrowed from https://www.worldfinance.com/strategy/government-policy/once-the-champion-of-free-trade-the-us-is-now-taking-a-protectionist-stance

Disclaimer: This is not  investment advice.