Does Bitcoin have what it takes to be a strong currency
Bitcoin has been around for about 12 years. Some countries especially in Latin America such as Argentina, Panama etc are considering adopting it as legal tender while others such as El Salvador have already made it as legal tender. Getting accepted as legal tender means it can be used for regular daily transactions. I ignore the intricate distinction between legal tender and currency in this article. In addition, in this article I also gloss over the precise difference between money and currency. Hence, I use those terms interchangeably.
So the question arises. Does Bitcoin have what it takes to be a currency or will it wither away? I plan to address this and two related questions in this article based on my own understanding.
To be precise, my focus in this article is on the following 3 questions.
Does Bitcoin have what it takes to be a currency?
Is it natural for a wannabe currency in this stage of its life to exhibit the volatility that we see from Bitcoin.
Do I think it is a good time to buy Bitcoin?
But before addressing these questions, I plan to set the background by explaining the three phases that a commodity goes through before it can be widely accepted as a currency.
Commodity -> Currency: Phases
A commodity or a collectible goes through three distinct phases before it becomes a strong currency. These phases are
Phase 1: Store of Value
Phase 2: Medium of Exchange
Phase 3: Unit of Account
A brief summary of each of these phases is given below. For details please check out this excellent article.
Store of Value
A commodity or collectible becomes a store of value if people believe that there is an element of scarcity associated with the commodity. And that such a commodity might increase in value over time. In such cases, people might start to buy and store the commodity.
In this phase, very few people will be buying and storing the commodity since there is a big risk that the expectations about the increase in value of the commodity might not happen. But the number of people who believe in this keeps increasing over time as more and more people see the commodity increasing in value.
Medium of Exchange
During this phase, the commodity would have been in existence for several years. And the value of the commodity would have been seen to increase since it’s existence thereby leading to increasing confidence in the ability of the commodity to act as money.
Given this, people might now become comfortable with exchanging other goods in return for this “commodity turned currency”. I believe that the commodity is not a full currency yet. This is because while several people are comfortable using this “currency” in exchange for other goods, there is a vast majority that is still not comfortable with this. As a result, not every item is priced in terms of this “currency”.
Unit of Account
When every good is priced in terms of the commodity turned currency, then we can say that the commodity is now a unit of account and is a full fledged currency. In this stage everyone is fine using this commodity as currency.
Is Bitcoin going to be the best currency
In a previous article, I proposed a Currency Evaluation Framework to evaluate the ability of any commodity to be a currency. This framework consists of 7 features - 4 of these are necessary features and 3 of these are desirable features.
The necessary features are
Value over time
Cost of transporting
Network Effects
Divisibility
The desirable features are
Privacy
Money Supply Transparency
Dependency on a central entity
I next evaluate Bitcoin in terms of these seven features.
Value over time
A commodity or a collectible does not become a currency overnight. Rather it goes through various stages of adoption before it is widely accepted as a currency as explained earlier. And it is vital that the value of the commodity keeps increasing over time while it is going through these phases. If not, the commodity cannot make the leap to become a currency.
In this section, I want to focus on the value of Bitcoin over time. It is vital that the value of Bitcoin increase over time as shown in Figure 1 below.
So then the question is, how do we determine the value of Bitcoin over time. Of course, we can look at the price of Bitcoin in terms of fiat currency over the last 12 years. But how about the future behavior of Bitcoin? Will it continue to go up in value.
Economists have looked at other commodities (such as gold, silver, copper etc) in history that took the leap into becoming a currency and have proposed a quantitative metric called the Stock to Flow (S2F) ratio (Bitcoin Standard, Plan B). This represents the ratio of the amount of the commodity that exists today to the amount of the commodity that can be created in a year. S2F ratio can also be considered as the number of years it takes to double the quantity of the commodity available. The higher the value of the S2F ratio the better the commodity is suited to be a currency.
For example Gold currently has a S2F ratio of around 55 as shown in Figure 2. This is based on the current expectations of Gold production. Of course, if we find an approach to produce lot of gold every year then this ratio will collapse. And gold will certainly lose its position as a currency.
Given this, I will use the S2F ratio to understand the value of Bitcoin over time. I show this in Figure 3 (Figure is from this site). You can see from this figure that the S2F value of Bitcoin keeps increasing over time. Note that unlike Gold, we know the schedule at which new Bitcoins are going to be created since the protocol creates new Bitcoins every 10 min on the average. And the number of new Bitcoins also reduces by half every 4 years. Further, we will not have any new Bitcoins created after 2140 AD.
Hence, it can be argued using both past prices and the S2F ratio that Bitcoin is well positioned to cross the chasm and become a strong currency over time.
GRADE: A+
Cost of Transporting
Another necessary feature that should be present in any commodity that seeks to become a currency is the ability for a person to carry the commodity along as the person travels. This would make it possible to transact with people who might be geographically separated. This was vital in the past since they had no concept of electronic money.
In today’s digital world, though physical transportation of currency is not important. What is important though is for any two people anywhere in the world to be able to transact with each other.
Bitcoin is very well suited for this since anyone in the world only needs a connection to the internet along with a device that can run the Bitcoin software (just the wallet to be precise). These people do not need the permission from their governments. These people do not need any paperwork typically. These people do not need to visit a branch of a bank which is typically an issue in many developing countries. And finally, the parties to the transaction can verify the success of the transaction without having to wait for days.
GRADE: A+
Network Effects
The fourth important property that a commodity needs to have is for more and more people to start using it. This is the Network Effect. A nice overview of the trajectory of the number of people using Bitcoin is shown in Figure 4. It also shows a part of the trajectory of the number of people using Internet when that was exploding.
We see from this figure that the number of users of Bitcoin is growing faster than the number of people who were using the Internet. While it took 7.5 years to go from 130M Internet users to 1B Internet users, we expect to take 4 years to go from 130M users of Bitcoin to 1B users of Bitcoin.
Hence, Bitcoin is exhibiting the right growth that can be expected from a commodity that is on its way to become a currency. In addition, given the number of people using the Bitcoin blockchain, it would be very difficult for someone to start another blockchain similar to the Bitcoin blockchain and expect to attract people to that.
However, there are risks associated with future growth. Risks such as issues with the underlying technology, issuance of central bank digital currency which would be based on principles of sound money etc. I expect to write about these risks in a future article. Hence I grade Bitcoin as an A here and not an A+.
GRADE: A
Divisibility
A currency is also expected to have the ability to be divided into smaller units. This will allow lot more people to own it and use it especially when it becomes the unit of account.
Bitcoin does have this capability. A Bitcoin is divisible into smaller units called the Satoshi. A Bitcoin equals 100 million Satoshis.
GRADE: A+
Privacy
Privacy would allow the owner of the currency to spend it without anyone being aware of where it is being spent. Privacy is a desirable feature especially in countries where the governments are considered to be repressive.
Bitcoin does provide for partial privacy since the Bitcoin addresses used in the transactions are partially anonymous. A determined party (whether belonging to the government or being a private party) can try to connect the Bitcoin addresses to real life identities and can sometimes succeed in doing so.
GRADE: B
Money Supply Transparency
The supply of Bitcoins in the past and in the future is completely transparent. We know how many Bitcoins were created and when and we also know how many Bitcoins will be created in the future and approximately when.
So there is no question about the money supply.
GRADE: A+
Dependency on central entity
As is well known, creation of Bitcoin does not depend on any central entity.
GRADE: A+
Based on all the above characteristics I conclude that Bitcoin is very well suited to be the best currency in the next several years.
What about the volatility
Given the above a question comes up about the volatility exhibited by Bitcoin when priced in US dollars.
Figure 5 (from buybitcoinworldwide ) shows the volatility of Bitcoin considering the price of Bitcoin over a 30 day window. The volatility of US dollar vs the Euro is also shown in this figure. Volatility here is measured as the standard deviation of daily returns for the preceding 30 day window.
There are two important observations from Figure 5. They are:
Bitcoin is definitely much more volatile compared to the well known fiat currencies.
Volatility in Bitcoin was highest in the early years of Bitcoin and it has reduced over time.
Volatility increased in early 2020 to correspond with the onset of Covid and the corresponding uncertainty. Ignoring this, we can see that the volatility of Bitcoin has been generally coming down over time.
Several people point to the volatility exhibited by Bitcoin as proof of the fact that it cannot be a currency. But this is the expected behavior from a commodity that is on its way to becoming a currency. To understand this better, consider the three phases given earlier, that a commodity goes through before becoming a currency
Phase 1: Store of value
Phase 2: Medium of exchange
Phase 3: Unit of account
During phase 1, the commodity is being used as a store of value since the value is expected to rise over time. Very few people are expected to be storing the commodity in this phase since only few people believe that the value will increase over time. The number of people who are convinced of the commodity being a store of value increases slowly. Hence we expect to see a lot of volatility in the value of the commodity during this phase since the opinions of the people about the value of the commodity can change drastically based on other factors.
The volatility should decrease slowly with an increase in the number of people who believe in the commodity being a store of value. This is indeed what we see when we look at Figure 5 above.
This is similar to the case when you pick random people off the street and ask them their opinion about the price of a particular house. Initially, you might see a lot of variability in the house prices predicted by the people, but the volatility starts dying down when you involve more and more people.
In addition, during this phase, the commodity has to be purchased using the unit of account at that time. For example, in the US, Bitcoin has to be purchased using US dollar which is the unit of account in USA at this time.
In my opinion Bitcoin is currently at the end of phase 1. A vast majority of people believe that Bitcoin is a good store of value. The next jump for Bitcoin is to become a medium of exchange. This will happen when it is accepted as legal tender in multiple countries. El Salvador has started on this journey by making Bitcoin as legal tender and several other countries are considering this.
Hence I believe that the volatility exhibited by Bitcoin when priced in US Dollar is normal for it at this stage in the life of Bitcoin. For a more detailed explanation of this including comparison with life cycle of Gold see Bullish case for Bitcoin by V. Boyapati.
Given this, the next question that comes up is whether it is a good time to be purchasing Bitcoin.
Is it a good time to buy Bitcoin
I would like to start this section by pointing out that you should not consider this as investment advice. Rather, this is my opinion based on the data that I see. Your decision should be based on considering this data and combining this with your own constraints. But based on the historical data and based on a model that I describe below I believe that the next six months might be a good time for me to add more Bitcoin to my portfolio.
Historical Data
Let’s consider the historical data shown below in Figure 6 and Figure 7. Figure 6 from @DocumentingBTC shows the lowest price of Bitcoin every year. As you can see from this Figure, the lowest price of Bitcoin in a given year is always greater than the lowest price of Bitcoin during the previous year with only one exception in 2015. Currently the price of Bitcoin is hovering around $31,000 which is still much higher than the lowest price from 2020.
So I would start adding Bitcoin if the price of Bitcoin keeps dropping.
Figure 7 is from @cryptopou. The author here points out that the yearly lows are typically in the Dec-Jan timeframe. The lowest value for 2021 so far happened in Jan 2021. So it’s a question of whether you believe we will have another opportunity to reach a minimum for 2021 in December of this year.
Model based Predictions
Plan B has modeled the price of Bitcoin using the concept of S2F. This is shown in Figure 8. From this model, we can see that the price of Bitcoin has followed this model since the time of its inception. This is another reason why I am bullish about purchasing Bitcoin at this point in time.
Conclusions
From this article, I hope I have been able to convince you that Bitcoin is currently on its way to becoming the best currency we have seen so far. Yes there are risks involved and yes some design decisions such as related to privacy could have been made better.
In addition, I also hope I have been able to shed some light on the reason for volatility that we see with respect to Bitcoin prices. Finally, I have also provided my opinion about a good price to get in on your Bitcoin journey.