Is Bitcoin a Ponzi Scheme?

Has a Bitcoin newsflash ever caught your eye???

Maybe it was during the bull run and media frenzy of 2017.?Or you saw reports of a ransomware hack in which criminals demand payment in Bitcoin. Maybe it was a headline about a Bitcoin exchange being hacked. Or you saw the story about Silk Road, a dark web marketplace for illicit activity shut down by the government in 2013.??

It flashes through your mind.?You wonder what these people are doing experimenting with crypto currencies.?“What is this, The Jetsons?”?You move on.?Bitcoin becomes dead to you for another few years.?But then you wake up a few years later and it's in the news again.?You ask a friend about it and they tell you it makes no sense.?Again, you move on.??

The media have portrayed Bitcoin to be everything from a ponzi scheme to the currency of the dark web. The list of Bitcoin skeptics is long and distinguished.?Everyone seems to have strong opinions about it.?

But if Bitcoin is truly the repugnant asset it’s portrayed as, why does it seem to persist? How come society hasn't banned it? Is it possible there is something under the hood we are missing??

This article will explore the things people say about Bitcoin from a first principles perspective.

Our brains tend to move in one direction if we are not careful.?We process the world by drawing on past experiences.?So when we see something new or counter intuitive, we sometimes inadvertently dismiss it.??Let's try to avoid that form of thinking here. Instead, let's stay open minded, humble, and free of confirmation bias.

When you finish reading this, mention Bitcoin to your friends and family.?These are the things they will say to you.?

“Bitcoin has no intrinsic value”

Bitcoin is a digital asset that does not produce anything.?This can immediately put one's brain in a pretzel when trying to analyze the asset.?We’ve never seen anything like this before.?Most investable assets are tangible, and produce things.?For example, commercial real estate produces rent revenue.?Stocks produce earnings per share.?Credit instruments produce fixed payments.?Investors can estimate future cash flows of these assets, discount them to present value, and analyze the risk premium.?

We cannot analyze Bitcoin this way because, well, it doesn’t produce anything. Bitcoin is similar to Gold in this regard.?

Furthermore, Bitcoin operates on open source computer code.?It is a manmade product that anyone can generate using algorithms and a computer. So how could this thing have value??

Bitcoin’s utility is that it allows people to store value digitally, outside of any sovereign currency, with provably scarce units. And we can transport this value all over the world. We can do this in a decentralized format, without a banking middle man siphoning fees and slowing down transactions.?

Imagine traveling with $500,000 worth of gold through an international airport vs bringing $500,000 worth of Bitcoin with you instead. With Bitcoin, you would have it on an app on your phone, a small digital wallet, or simply by remembering a 12 word seed phrase. Bitcoin is frictionless to transfer when compared to Gold, and it has a hard capped supply.???There are 3.5 billion smart phones on the planet today. All of these could carry Bitcoin on them. None could carry gold.

Let’s not forget that Bitcoin’s utility as a store of value is derived from its scarcity.?Compare this to the dollar, which has been debased by a 20% increase in M2 during 2020 alone.??

Source: Federal Reserve of St. Louis

I covered the topic of Bitcoin’s value prop and how it could be valued using stock to flow modeling in my last article. You can check that out here if interested.?

Let’s get back to the idea that Bitcoin could easily be disrupted by another digital currency.?This is the “Myspace vs Facebook” argument.

If you’ve been following the crypto space, you know that there are thousands of “altcoins” on the market today.?Many were created via ICO’s during the 2017 bull market in crypto.?This was a period in time for crypto that looked quite similar to the Dot-com bubble of the late 90s.?Most of these projects failed, while some are still around today.?Without getting too technical, I’ll note that most altcoins on the market are not designed as monetary assets like Bitcoin.?However, one such coin was developed to solve perceived weakness in Bitcoin’s scalability and transaction speed.??

Bitcoin Cash forked the Bitcoin protocol in 2017 after an internal dispute amongst Bitcoin engineers over block size which impacts security of the network and transaction speed. Bitcoin Cash was attempting to disrupt Bitcoin by forking the code, increasing the block size, and speeding up transaction throughput.

The attempt was successful. In 2017, Bitcoin Cash forked the Bitcoin protocol.?

However, there was one fatal miscalculation for the developers behind Bitcoin Cash - you can fork the code and the protocol, but you cannot fork Bitcoin’s community.?You cannot fork Bitcoin’s network effect.?Bitcoin has tens of thousands of miners and nodes all over the world running the protocol.?You have a developer community, brand recognition, security solutions, exchanges providing on/off ramps, and now custody services and other financial and lending products.?This is a worldwide network effect. Bitcoin Cash failed for this reason.

So yes, anyone can copy the open source software that Bitcoin runs on.?But you still have to get users on the platform.?You have to solve actual problems for the world and gain adoption.?This is a process that takes years.?Anyone can create a new Craigslist or Wikipedia.?Anyone can create a new Facebook or Instagram.?But you cannot easily recreate the community or network effect.?This is where the value lies.?We can think of this in terms of the dollar as well. Fiat currency is not backed by anything. It does not produce anything. But the dollar has a massive network effect due to its use in trade throughout the world. Furthermore, the might of the US military defending this network effect makes it nearly impossible for a sovereign nation to disrupt the dollar as the reserve currency.

Quick aside on the Myspace vs Facebook argument: Facebook was able to disrupt Myspace because they created a better product. However, Myspace's network effect was ripe for disruption because of the rise of mobile phones when Facebook was becoming a major force in social media. Facebook capitalized on this. They quickly scaled their network effect into everyone's pockets. Their growth happened to coincide perfectly with the massive adoption of mobile phones throughout the world. Additionally, it is worth noting that a one sided network effect is much easier to disrupt then a multi-sided network effect. Facebook only had to create a better consumer app - they had to build a better mouse trap. There is one side to the network effect here. So when Facebook introduced a superior value prop to one set of customers, they were able to disrupt Myspace. A two sided network effect can be seen with services like Craigslist and Ebay. In this case, their first mover advantage is insulated because a competitors value prop would have to be better for both buyers and sellers. Craigslist looks the same way it did 20 years ago. Yet their network effect stays in tact. Bitcoin has a 4 sided network effect: buyers, sellers, merchants (Paypal rolling it out with 28 million vendors in 2021), and the worldwide mining network.

Another angle people like to take with intrinsic value is they will point to gold and say that gold has value as a physical commodity.?This is true. Gold has industrial value because it can be melted down and used in jewelry.?Gold has a market cap of approximately $9 trillion.?It derives less than $1 trillion of the market cap from gold's industrial value and its use in jewelry products.?So, where does the rest of the $8 + trillion in market cap come from? It comes from gold's value as a monetary asset, store of value, and the network effect created around that - similar to Bitcoin.

One final thought on intrinsic value: value is subjective.?All market participants are attempting to satisfy their wants or the wants of others in any marketplace. These wants are subjective. Therefore, your wants are subjective. My wants are subjective.?This means value is subjective.?Nobody would show up to your neighbors yard sale if this weren't true.

What's next?

“Bitcoin is a Ponzi Scheme”

If you believe Bitcoin has no “intrinsic value,” then you have to say it’s a ponzi scheme or a bubble.?I get it.?If X, then Y.?We make similar statements about other assets or the stock market as a whole.?When we think the market value of an asset or asset class becomes detached from reality, we say it's “a bubble.” We could look at the fundamentals of the overall stock market today and say that it’s in a bubble right now.?Of course, there is no way to prove whether that is true or not. The market could continue to defy gravity and run higher. And it may be true that today's market values cannot be sustained.?At the end of the day, we don’t know. Could we also entertain the idea that the dollar is a bubble? Certainly.?We seem to think it’s ok that we’ve printed $5 trillion dollars (and counting) since March, yet we have no precedent for what the unintended consequences of these actions could be.?What if nobody wants to buy US debt anymore???Well, the bubble would burst.

So is it possible that Bitcoin could go to zero? Yes.?It is also possible that the Dollar could see its demise.??Yes.

Let's explore what a ponzi scheme is.

Ponzi (or pyramid) schemes are built on the premise of preying on investor ignorance. They are inherently centralized. Bitcoin is decentralized. ?For this reason, I actually consider Bitcoin to be the inverse to a ponzi scheme.?Furthermore, to understand Bitcoin, there is so much that you need to understand: history of money, monetary systems, macroeconomics, international trade, technology, human behavior, revolutionary innovations, and so much more.?There is a reason that people talk about Bitcoin as a “rabbit hole.” There is just so much to explore. So much to learn.?The more you learn, the more conviction an investor typically has about it.?I believe the opposite to be true of a ponzi scheme.?

A few additional notes: Bitcoins parabolic increase in price in 2017 and subsequent 80% correction gives rise to the theory that it’s a bubble or ponzi scheme.?Below is a linear chart of Bitcoin in 2017.?

Source: Stockcharts.com via Lyn Alden Investment Strategy

This looks like a bubble.?But if we zoom out and look at Bitcoin’s price action over a longer timeframe, it’s actually following a very rhythmic pattern since its inception.?It tends to have one of these blow off tops approximately every 4 years, which also follows its “halving” schedule in which the amount of new supply added to the market is reduced by half.?

Below is a view of the price action in a logarithmic chart where we can see the full picture.?

Source: PlanB @100trillionUSD via Lyn Alden Investment Strategy

A few more thoughts regarding ponzi schemes: have you ever seen a ponzi scheme that spawned an entire industry that solves real problems??A quick LinkedIn search for companies in blockchain returns 40,000 companies.?Meanwhile, Bitcoin is currently the only proven use case for blockchain technology. Finally, for Bitcoin to be a ponzi scheme, it would have to be the largest insider secret in the world's history. Bitcoin is a worldwide phenomenon.?Do we really think that millions of people bought Bitcoin and then colluded with each other to secretly pump the price and bring in additional market participants? Wouldn’t the early investors be out by now? Why are they still out here educating the masses??

If Bitcoin is a ponzi scheme, do we think that Fidelity would be in the space? This is an $85 billion dollar brand built off of the definition of fidelity: the quality or state of being faithful.

Do we think that the insurance giant, MassMutual, would invest $100 million into a ponzi scheme?

How about legendary macro investors Paul Tudor Jones and Stanley Druckenmiller? If Bitcoin is a ponzi scheme, I'll follow these guys into it.

Let's move on.

“Bitcoin Lacks Security. Hackers love it.”

Many have seen the headlines of the now defunct Mt. Gox exchange hack from 2014.?It was a massive breach of security and a big news story. Hackers confiscated millions of dollars of Bitcoin. We all saw the reports and thought, “yep, I knew crypto currencies were sketchy.” We moved on.?

You may be privy to the Twitter hack over the summer in which politicians and celebrities tweeted that they were matching donations to a specific Bitcoin address.??

And then we have email ransomware attacks in which a criminal demands Bitcoin for relinquishing control of a computer network or releasing personal information.??

These are all real things that have happened and could happen again.?

But do they represent a security concern for anyone interested in investing in Bitcoin? Do they represent a threat to the Bitcoin and blockchain protocol?

Let’s get under the hood.?

Mt. Gox was a hack of a crypto exchange that was unregulated. The #1 rule in Bitcoin is “not your keys, not your coin.” Bitcoin is a decentralized protocol. You are the bank with Bitcoin.?We should understand this before thinking about acquiring it.?To properly store Bitcoin, you need to move it off the exchange and into private custody. When Bitcoin is on an exchange, it is vulnerable to a hack.?It is not in your wallet.?If you have a wallet with a private key, you have nothing to worry about.?

The more logical way to look at the Mt. Gox hack would be to view it as the equivalent of a bank being robbed. The criminal in this case took advantage of users who did not follow private custody best practices. The exchange in this case is also at fault for lack of proper security.?Now, who do we typically blame when a criminal robs a bank? Do we blame the asset they seek (the dollar)? Or do we blame the criminal??

Key takeaway: An exchange hack does not represent a security concern for the Bitcoin blockchain itself. This is the key distinction - Mt. Gox was a private company that was hacked.?This differs from a hack of the Bitcoin blockchain or protocol, which has never been hacked. Responsible Bitcoin custody means you store your Bitcoin in a private wallet with a private key (preferably in cold storage). Your Bitcoin stays on the blockchain and you access it with your private key.?It’s that simple.?

With that said, as time goes on, the exchanges are becoming more secure themselves. Coinbase, Gemini, and Kraken are licensed exchanges based out of the US that follow KYC (Know Your Customer) regulation, and have partnered with former regulators at the major US stock exchanges (NASDAQ and NYSE) to enhance surveillance and anti-money laundering efforts.?

Regarding email and twitter hacks that demand Bitcoin - there will always be bad actors in society.?Bitcoin attracts criminals because it stores value.?If these criminals had demanded dollars instead of Bitcoin, would we call their actions “dollar scams?” Or would we just call them criminals? There is also a belief that Bitcoin is anonymous and therefore attracts criminals. Blockchain is an open source, transparent ledger in which transactions can be traced by law enforcement.?Users must identify themselves with the exchanges because of KYC regulation.?For this reason, law enforcement finds it much easier to track crimes committed with Bitcoin then with cash.?If you were wondering, there is over $2 trillion of illicit activity in dollars per year. This is the government’s primary focus, not Bitcoin. If you are a criminal and using Bitcoin for your illicit activity, you are making it easier on law enforcement.?

Criminals exist in society.?Bitcoin does not solve this, though it makes it easier for law enforcement to find them.??

Summarizing Security: Exchanges have been hacked. People have lost Bitcoin. Criminals like Bitcoin because it has value.?We’re not here to argue any of these points. It’s important to understand that while these things happened, they are not indicators of some inherent flaw with Bitcoin or blockchain technology.?The security of the Bitcoin blockchain itself has never been breached. The vast majority of users have no issues with Bitcoin custody or transacting with it. Do your homework before acquiring Bitcoin and you will be fine.?

Next.

“Bitcoin’s Price is Manipulated”

Before addressing price manipulation, I will just say that just about every asset on Wall Street is subject to price manipulation.?This just comes with the territory. For example, earlier this year JP Morgan settled with US authorities for $920 million over allegations of “spoofing” the price of gold. Spoofing refers to large market movers placing a buy or sell order with no intention of executing the trade. They then profit on the market move that they created with their “head fake” trade. JP Morgan was willing to settle for $920 million. I wonder how much they made on this scam to willingly pay $920 million? The bottom line is that smart money just has a level of greed and sophistication that retail investors do not. And they have the resources (AI, high frequency data, asymmetry of information, etc) and the volume to put retail investors offside in a trade for their profit. This is just the way it is.?They are typically ahead of the regulators on this stuff.?Retail investors in any asset class should understand this. We are all on the same field, but we are not all playing the same game.

The perception of manipulation of the price of Bitcoin is one of the reasons that the SEC is yet to approve a Bitcoin ETF, a development that would bring significant interest from the institutional space. SEC Commissioner Hester Peirce has called out the hypocrisy of the SEC in this area, citing a double standard for Bitcoin and crypto assets that has not been applied to traditional assets.

With that said, there is one area of focus that I will address here relating to price manipulation in Bitcoin.?This relates to Tether - a stablecoin pegged to the US dollar. A study was conducted a few years back that alleged that Tether played a role in artificially driving up the price of Bitcoin during the bull run of 2017.??It all stems from the idea that there was a correlation between the amount of Tether coming onto market at the Bitfinex exchange based out of Hong Kong, and the value of Bitcoin.

Several media outlets, including Bloomberg have reported on the story.?The accusation is that the exchange was “printing” Tether and using it to buy Bitcoin, while there was no dollar reserve backing the Tether.?If this action was true, it would artificially inflate the price of Bitcoin, allowing the perpetrators of the scheme to take profit before the price drop.?

First, I'd like to point out here that these accusations of “printing” Tether and artificially inflating the price of Bitcoin are exactly what is currently happening with the Federal Reserve and the US stock market. The government is “printing” money out of thin air and inflating asset prices.?Where are the white knights' leveling accusations at the Federal Reserve? Wall Street seems to be ok with this.

Apologies for that little aside. Back to Tether - the claims here are that a correlation was found between the amount of Tether coming online and Bitcoin’s price during the 2017 bull run.?That's really the gist of the study. Someone saw this correlation and assumed there had to be manipulation going on with no actual proof. The media ran with it, lawsuits were filed against Bitfinex, and skeptics had a story to point at.?

But there is actually a pretty good explanation for what happened here. It’s just not the juicy story the media was looking for.?

Back in 2017, many of the exchanges in the crypto space were reporting slightly different spot prices for Bitcoin. This opened the door for traders to find arbitrage by simply buying Bitcoin on one exchange and flipping it on another exchange quoting higher spot prices, taking the spread on the trade.?Pretty straight forward.??

At the time, Coinbase was the most popular exchange.?Coinbase was seeing massive volume during the run up in price and media frenzy around the bull market. As such, they were reporting a higher spot price than Bitfinex, based in Hong Kong.?Traders saw this, and so they were wiring into Bitfinex, purchasing Tether (because it was at a discount to the dollar peg), swapping the Tether for Bitcoin, and then sending the Bitcoin to Coinbase where they could sell it, pocketing the spread in spot prices at the exchanges on the trade.?At high volume, these trades produce significant returns.

Here is a link to an interview with Dan Matuszewski, former head of trading at Circle, a Stablecoin and Blockchain company based out of Waltham, MA. Dan executed many of these legal trades, and explains exactly what was happening in a discussion with Nic Carter via On the Brink podcast. The Tether discussion starts at the 50:30 minute mark.

I don’t have a lot to add to the Tether price manipulation story.?Is it possible that something like the accusations could happen? I would say yes.?And I think it’s possible that there are large traders (Whales in the Bitcoin world) that can move markets for their profit. I will also say that there is most certainly manipulation in the altcoin market - especially at unregulated exchanges operating out of the BVI, Seychelles, or Malta. This is where “pump and dump” altcoin schemes are propagated. This has nothing to do with Bitcoin, but if you are interested in learning about the subject, check out Nic Carters piece on Medium .

If you believe in Bitcoin long term, you don’t worry about price manipulation. You simply store your Bitcoin in a hardware wallet with a private key and wait for the market to come to you.

What else?

“Bitcoin is for Criminals and Scammers”

Criminals primarily used bitcoin?in its early days. This is absolutely true. The Silk Road was a real thing.?Anyone making the argument that Bitcoin is used for illicit activity is likely referencing the early days.?

However, it is rather shortsighted to be making this statement today.?Ironically, the dollar (cash) is a better vehicle for criminals and illicit activity.?Cash transactions are difficult to trace.?Bitcoin transactions can be traced because it operates on blockchain, which is a public ledger. The FBI and other agencies have become increasingly sophisticated in tracking on chain transactions. When you combine this with Know Your Customer regulations (KYC) at the exchanges, the government can follow the entry points into Bitcoin via these on/off ramps.?Therefore, they can trace transactions on the blockchain.?So, if you are a criminal and are using Bitcoin, you are making it easier for law enforcement to find you.?

If you’re interested, you can learn about how law enforcement tracked the criminals involved with the twitter hack/bitcoin donation scam over the summer here.

Finally, Bitcoin’s early use in illicit activity should not be too surprising.?This follows a similar adoption cycle for cell phones, beepers, pagers, and other technologies that were first discovered by criminals and later became mainstream.?

Next.

“Governments will Ban Bitcoin”

This is a legitimate risk.

Let’s investigate.?

It is reasonable to think that governments will ban Bitcoin.?After all, Bitcoin is a decentralized monetary system.?The government cannot control it. And if the government cannot control the money, they lose power.?So if we understand the government's incentives, we can see that Bitcoin could be something they may not be too keen on.?

There is plenty of precedent for governments implementing capital controls during a currency crisis. It has happened all over the world and even happened in the United States when FDR banned Gold in America in 1934.??

With that said, there are a few items we need to think about to understand how things could play out in the future for Bitcoin. When we peel back the onion, we may see that the government is more incentivized to regulate and tax Bitcoin than to try to prohibit it.

1. Bitcoin is protected by the 1st Amendment in America.?Bitcoin operates on an open source computer code. Open source computer code is free speech, established via legal precedent set during the so-called crypto wars of the early 90s. The two court cases that set this precedent are Bernstein vs the United States and Zimmermann vs the United States
2. The government is incentivized to regulate Bitcoin, not ban it.?Bitcoin is a decentralized worldwide network of computers operating on the internet.?No single entity owns or operates Bitcoin.?Therefore, if the United States government tried to ban Bitcoin, the exchanges would just move offshore (the majority currently are).?The network of computers running the protocol would still be intact.?The miners operating all over the world would still be intact.?This would essentially turn into a game of whack a mole for the government. They wouldn’t be able to stop it. We’ve already seen this playing out in China, which has banned crypto mining and any bank involvement with crypto.?This hasn’t stopped users of crypto or miners in China.??

If we look at incentives, we should expect the United States to regulate Bitcoin, tax it, and maybe buy some themselves.?Why? Because it is much easier for the government to track digital currency than it is to track cash.?Governments can regulate the on/off ramps for crypto with KYC (Know Your Customer) and AML (Anti Money Laundering) regulation.?We are already seeing this play out - exchanges in the US are working with regulators. Coinbase, the largest exchange in the US, recently lost their Chief Legal Officer to the United States Office of the Comptroller, which he now runs.?Does that sound like a government looking to ban crypto or understand & regulate it??

3. Game Theory suggests that governments will ultimately look to regulate, tax, and own Bitcoin.?Why? Again, because they cannot stop it. As the old saying goes, if you can’t beat em, join em.?Think about it - we are already seeing game theory play out at the individual level. We started with Bitcoin being used on the fringes of society, to some mainstream adoption in 2017, and now we see large and well known institutional investors getting into the space. We are also seeing this play out at the corporate level with publicly traded companies now buying Bitcoin with cash reserves on their balance sheets. MassMutual was the latest to join the party.?We see this with Paypal getting into the space, challenging their payment processing competitor, Square, who was a first mover in Bitcoin. What will happen if a Central Bank buys Bitcoin? Do you think other Central Banks will be incentivized to do the same? If you’re a Central Bank and you understand you cannot stop this, the smart thing to do is to buy some early.?A small country could invest $10 billion into Bitcoin today and in 5 years they may no longer be a small country.?Communist countries like China will ban Bitcoin. Does America want to be more like China? I think we all know the answer to that question.

The bigger Bitcoin gets, the more difficult it is to prohibit.?It becomes harder to ban once you have Paypal, Fidelity, MassMutual, and institutional money in the asset.?Once the political donor class owns it, which they increasingly do, the game is basically over for banning it. Banning it at that point would be an attack on the balance sheets of American corporations, funds, banks, and investors. You also have an industry being spawned around the asset.?A quick LinkedIn search for blockchain returns 40,000 start-up companies.???

As Charlie Munger says, "show me the incentives and I'll show you the outcome."

What else we got?

“Bitcoin lacks Regulation”

Bitcoin is still only 12 years old. Regulation is coming into the space, but it is still far from where it needs to be. We should expect this.?In this section I will break regulation down between the exchanges, custody services, and taxes.

Exchanges: some exchanges are better regulated than others.?I recommend Gemini, Coinbase, or Kraken, though there are others that are well regulated.?These exchanges are both licensed and based out of the United States. Each follows KYC (Know Your Customer) regulation that ensures their customers identify themselves with the exchange as a prerequisite to creating an account.?They also have Anti Money Laundering surveillance programs that were built out by former regulators at the NYSE and Nasdaq.?These exchanges voluntarily comply with regulators and see it as a positive for the industry.

However, not all exchanges are created equally.?Exchanges like Binance, which operate out of Malta, act more like crypto casinos.?They do not provide fiat currency on/off ramps and do not have banking partner relationships.?For this reason, they have no interest in working with regulators. These are the exchanges that partner with altcoin developers and coin ranking websites to propagate “pump and dump” schemes.??

Key Takeaway: stay away from any exchange based out of an exotic place like BVI, Malta, or Seychelles. Also steer clear of any exchange that does not offer on/off ramps for fiat currency. This is a sign that they are not seeking regulation of any kind.?

Custody: With Bitcoin, you are at the bank. There is no FDIC insurance if you lose your Bitcoin.

The United States Office of the Comptroller (OCC) recently issued a statement that federally chartered banks can now provide custody services for Bitcoin.?This is another step toward more regulation in the industry. You can check that out here. Brian Brooks, former Chief Legal Officer at Coinbase currently heads the OCC. For this reason, the OCC, a bureau within the United States Treasury, can be seen as a friend of Bitcoin and crypto. With that said, there have been recent rumors that Treasury Secretary Mnuchin is looking at possible regulation around private custody of Bitcoin. This is currently speculation, but if passed, it sounds like exchanges based in the US would be required to administer KYC rules for anyone looking to move their assets into personal custody. This would give the government further ability to trace transactions on the blockchain.

Taxes: Per the IRS, Bitcoin is treated as property for taxes.?This means that miners must pay taxes when they mine the coin.?Anyone transacting with Bitcoin must pay taxes each time they sell their Bitcoin, as long as it achieves a gain at the time of the sale when compared to the time they purchased it.?

This is a problem for Bitcoin as a medium of exchange. It makes it almost impossible to keep track of the taxes. For example, if people are buying or receiving Bitcoin, they must have records of the price paid for each transaction.?And if they are buying goods and services with Bitcoin, they must have a record of the amount of gain achieved at sale compared to the fair value paid to acquire the Bitcoin.?This is quite messy - imagine having to calculate capital gains tax when you purchase a loaf of bread???

Paypal will roll out Bitcoin as a payment option for their 28 million vendors in 2021.?If vendors adopt Bitcoin as a means of payment, we should expect governments to look into adjusting the tax laws.?This would allow governments to tax it in a less onerous way for the holder of Bitcoin - a win/win for users of Bitcoin and governments.

Final note on regulation: all signs are pointing toward increased regulation in 2021. For the most part, Washington has shown a curiosity and an interest in understanding the space. While the OCC and CFTC have been generally friendly toward crytpo, the SEC, despite calls from Commissioner Hester Peirce, have yet to provide guidance on a Bitcoin ETF, a significant step toward attracting more institutional investment into the space.

On the other hand, a step in the right direction can be seen with the recent news that FinHub, the SEC's strategic hub for innovation and financial technology, will report directly to the SEC Chairman moving forward.

At the end of the day, regulation will be a tricky area for Bitcoin to navigate. On one hand, regulation is needed to protect consumers and build trust. On the other hand, careless regulation runs the risk of distorting the market while preventing access to Bitcoin for 1.7 billion unbanked adults in the world.

What else?

“Bitcoin is Too Volatile”

We hear this one all the time. “Bitcoin is too volatile.?It must be manipulated.” Investors are more familiar with stocks, bonds, real estate and other assets that are less volatile than Bitcoin.?Again, our brains are looking backwards for a sister asset to make sense of Bitcoin.?We don’t find one, and so we assume the worst.?

Let’s lift the hood again.?

Many will focus on volatility as an argument against Bitcoin’s utility as a store of value. However, if an asset is volatile, it does not mean that it will be an ineffective store of value. The opposite is also true; if an asset is not volatile, it will not necessarily be an effective store of value. The dollar is a prime example - it is not volatile (today at least), but it is a bad store of value.?

Below is a visual of the dollar’s ability to store value over time:

Source: Federal Reserve of St. Louis

To better understand the volatility, let’s revisit the Bitcoin value prop.?Bitcoin is valuable because of its scarcity (fixed supply).?This also creates volatility when we layer on the adoption curve via Bitcoin’s expanded network effect.??

As Bitcoin attracts more miners, the security of the network has increased.?This drives more confidence, which drives more users to the asset.?More users lead to higher price and media attention, which attracts new market entrants.

Bitcoin jumped 44% in November of this year. This was because of the flywheel effect we see above; positive news from institutional investors, Paypal, and publicly traded companies entering the space creates more trust and adoption from additional market participants. This drives up price, which drives additional awareness and adoption.

Meanwhile, supply is restricted.?So, when we understand these dynamics, it is quite reasonable to see large price swings for Bitcoin.?As prices rise, early entrants see large paper gains. Long-term holders may sell, leading to a quick and violent drop in price. And then the cycle starts anew.?

Below is a visual of the supply curve for Bitcoin.

Source: Parker Lewis via Unchained Capital

When we contemplate the supply curve in correlation to adoption waves, the volatility makes sense. Bitcoin’s volatility will only decline when the holder base reaches maturity and as the rate of new adoption stabilizes.?

Below is a view of stages of technology adoption curves.?

Source: Parker Lewis via Unchained Capital

Summarizing Volatility:?What happens between adoption waves is the natural function of price discovery as the market converges on a new equilibrium, which is never static. While establishment economists deride Bitcoin’s volatility, I can't imagine how an asset that didn’t exist 12 years ago can become a stable form of money overnight.?Therefore, it would be shortsighted to view volatility today as a non-starter when thinking about the future of Bitcoin as a medium of exchange.?

At the end of the day, if we average out Bitcoin's price since inception, its value has increased 10x approximately every 2 years since its establishment in 2008:

2008:.01

2010:.10

2012: 1.00

2014: 10.00

2016: 100.00

2018: 1,000.00

2020: 10,000.00

I’d say the volatility is worth it. Hat tip to Dan Held.??

Anything else?

“Bitcoin uses too much Energy”

This is another argument that people will make against Bitcoin. Because Bitcoin operates on a decentralized network of computers, it uses a lot of electricity. Some estimates conclude that the total electricity consumption today is on par with a small country.?We aren’t here to argue about the use of electricity. We know Bitcoin is a large consumer.?

However, context matters when we talk about energy consumption.?My guess is that these folks assume the volume of energy consumption is a problem because if Bitcoin is consuming lots of energy, it must drive up energy prices, and potentially deprive someone, somewhere of the electricity they need.?Additionally, this excessive use of energy must leave a carbon footprint via CO2 emissions.?

This is the angle I'm going to take as we explore energy consumption. This would be the only reason to think that Bitcoin mining is really a problem for society.?

First, we need to understand where most Bitcoin is being mined. New data sourced from the Cambridge Center for Alternative Finance confirms what many in the Bitcoin world already knew - China is at the epicenter of Bitcoin mining. Specifically, mining density is greatest in the Xinjiang and Sichuan regions.??

This data is quite revealing when we investigate further.?Sichuan is a province characterized by massive overbuild of hydroelectric power in the last decade. Sichuan’s installed hydroelectric capacity is double what its power grid can support. This means that Bitcoin miners in the region are resourcefully using excess energy that would otherwise be wasted because of poor central planning in China.?With their local energy cost effectively zero, and with no buyer for the excess supply, the existence of a global buyer for their energy is a gift from the heavens.

We are seeing a similar trend ?play out in North America in what appears to be a beautiful marriage of supply and demand. Stranded gas - an industry term for the natural gas by-product that oil drilling produces but which cannot be used - accounts for 40-60% of the world's proven gas reserves. They do not waste the reserves; rather, there is simply a lack of utility for it and solutions to harness its energy. Producers are forced to either set it on fire or pay for its removal from their operation.?Because of the remote nature of many drilling sites, hauling it away is not economically viable. Regulations place limits on the amount of product that can be burned off or “flared.” When their cap is reached, producers may be forced to shut down oil wells to avoid the buildup of natural gas.?

This is where Bitcoin mining comes in.?Instead of exhausting the excess natural gas on site, or dealing with the sunk cost of moving it offsite, producers can convert the natural gas to electricity and use it for Bitcoin mining.

Bitcoin miners are incentivized to seek these areas of excess supply of renewable energy to keep their operating costs as low as possible.?This creates a win/win for regions producing an excess supply of renewable energy. Paraguay, home to Itaipu, the second largest dam in the world, is another area we could see miners flock to.?Most of the energy consumed in Paraguay comes from renewable sources.?With domestic demand relatively low, they regularly sell excess supply to Brazil and other neighboring countries.?

The bottom line is that Bitcoin uses a lot of energy.?The production of gold also uses a ton of energy. Data centers scattered throughout the world use massive amounts of energy.?Bitcoin gets called out mostly because it is an easy target and because energy consumption data for mining operations is rather straightforward to identify and measure. But if we understand that a large portion of Bitcoins energy use is coming from sources with excess supply, the narrative transforms.?Bitcoin mining operations are dynamic and mobile.?They are incentivized to find renewable energy sources to keep their costs low. We expect this trend to continue into the future; therefore pointing to energy consumption as an inherent flaw for Bitcoin is fundamentally misguided.

What's next?

“Bitcoin would cause Deflation”

Let’s talk about deflation. This one is true.?It’s a good argument - if the government cannot print more money, we would not be running an inflationary economy.?Prices would not rise. In fact, they would actually fall.?So why are we so scared of deflation? Because the government has brainwashed us to believe it's bad.?

What exactly is deflation? Deflation means that the prices of goods and services in an economy are dropping.?It is actually a sign of a vibrant and healthy economy.?Deflation is the natural byproduct of increased productivity, innovation, and progress in societies.?Think about it - we get smarter over time. We develop technologies that make our lives easier and more efficient.?We create abundance.?We free up time.?We do all of this so we can work less.?

When prices drop, purchasing power increases.?Consumers can buy more goods and services. Deflation rewards the fiscally conservative because their savings buy more goods and services in the future. Borrowers and those living beyond their means lose in deflation because their debt is locked in with the bank. Meanwhile, their earnings decrease in deflation, so purchasing power is lost.?

The opposite is true with inflation. Borrowers are rewarded by living beyond their means because they are able to lock in their debt.?Meanwhile, wages rise in inflation. Therefore, purchasing power rises for the debtor, and decreases for the creditor (the bank).?Your grandmother, living off of the cash balance in her bank account loses in this scenario.

So why do we think deflation is bad? Because we have a house of cards of debt in America and around the world.?The debt is the direct result of money printing and the inability for us to live within our means.?Simply put, debt is a trade in the timing of consumption — we are over consuming today in exchange for under consumption in the future. If every loan creates businesses that grow to create more income, jobs, and growth, then this would not be the case. But we know that is not true.?Eventually the chickens come home to roost. Therefore, when we enter a recession, the Federal Reserve immediately starts “printing” money.?Instead of taking the pain pill, i.e. under consuming because of prior over consumption, they “print” more money and create more debt with zero regard for how it will be paid back in the future.?

Deflation is not the problem.?The inflationary period that leads to rapid debt accumulation is the problem. Because to unwind that, we have to go into debt deflation.?This is where the pain pill is swallowed. Where we pay the price for prior periods of over consumption.?

Technology and innovation are naturally deflationary. Here is a quick example - the trucking industry is rapidly accelerating toward autonomous driving.?Most projections estimate 2-3 million jobs will be lost over the next decade. This will save the industry close to $200 billion/year, the vast majority coming from labor and wages.?Lower operating expenses means lower prices - a beautiful illustration of how technology is deflationary.??

Now, think about this on the grand scale of our economy.?This isn’t happening only in trucking. It is happening in almost every industry.?Technology is a deflationary force - it is creating abundance and trying to push prices down.?But our Central Bank refuses to let this happen.?Instead, we continue to print money, create debt, and force an inflationary economy.?Square peg, round circle. These competing forces simply cannot go on forever, and it appears we are nearing the breaking point. Rising and unsustainable wealth gaps are the clear indicator that the system is not working anymore.?

Bitcoin as a monetary system would be a perfect marriage for an economy with the deflationary force of technology within it.?Bitcoin keeps the money supply fixed. This means that as society advances through technological innovation, abundance is created, and prices drop.?We all benefit from productivity.?Again, this is the natural direction prices are supposed to move. You likely paid significantly less for the last TV you bought than the one you purchased 10 years ago. This is the deflationary impact of tech. Imagine if the average family could simply live within their means, save money, and watch it grow in purchasing power??Not everyone would need to have an MBA in finance to retire in that economy.?Imagine if the chart below showed rising purchasing power instead of decreasing?

Source: Federal Reserve of St. Louis

A final note on the deflationary force of technology.?People often point to the Industrial Revolution and other periods where we experienced technological innovation.?They will use these periods as proxies for arguing that technology is not deflationary.?That it creates jobs.?They are correct that this was the case during the period from 1870 to 1970.?However, this is not an apples to apples comparison to technological advances today. Why? Because the major advancements back then created an additional demand for natural resources and labor.?The combustion engine created demand for oil, assembly lines, and enhancements to highways, roads, and bridges.?The invention of electricity required the construction of the electric grid.?Modern sanitation, communication, and pharmaceuticals all enhanced demand for other elements of the production equation: how tech interacts with land, labor, and capital.??

Technology today does not create a demand for other natural resources or labor.?Technology today is smarter than humans - it is eliminating us from the equation.?This is the exponential growth factor of technology that we so often overlook.

Last one.

“Bitcon isn’t Scalable”

Another common criticism of Bitcoin is that the number of transactions the protocol can handle is very low compared to Visa or any other large payment provider. If true, this would limit Bitcoin’s utility as a medium of exchange for everyday transactions.?

To understand how this works, let’s review how a payment provider like Visa currently operates. Visa optimizes for speed, and somewhat for security depending on how you look at it. They do this by sacrificing decentralization; it's a centralized payment system, designed by Visa.?And it runs on top of the underlying currency, which is itself a centralized government fiat currency.??

Our global banking system has extremely poor scaling when you get down to the base layers.?Wire transfers, for example, generally take days to settle.?International transactions often must work their way through various intermediaries, further slowing an already inefficient system. Therefore, we don’t pay for everyday items with wires. That said, the banking and payment system builds multiple layers of scalability onto the base settlement layer, which occurs between banks. These additional layers include checks, online banking/e-checks, credit cards, PayPal, Venmo, etc. The additional layers allow for high volumes of smaller transactions, with the banks settling with each other at the more secure base layer via larger, batched transactions.??

Bitcoin works similarly.?Currently, transactions on Bitcoin’s blockchain settle approximately every 10 minutes.?This is the most secure, base layer of the blockchain. However, 10 minutes is too long to wait for a transaction to clear at Starbucks.?This is the scalability issue.?

Similar to our legacy banking system, the Bitcoin blockchain is building additional settlement layers and other smart contract concepts to solve the scalability problem for small transactions.?

The Lightning Network is one such layer.

The Bitcoin Lightning Network will allow for instant payments, micro-payments, and scalability. The Lightning Network will ultimately become the payment rails on which Bitcoin can scale into not just a store of value, but a unit of account, and a medium of exchange.?

Conclusion

Similar to any asset or asset class on the market, there are real risks for Bitcoin. However, it is important to be able to parse out the real risks vs the perceived risks that are actually misconceptions. Bitcoin is not intuitive. It is a very deep subject to explore because it covers money, finance, and technology - complex topics. Therefore, to really understand Bitcoin, we must leave our bias's behind. We must approach it with an open mind.

I hope this article serves as a foundation to think about the real risks for Bitcoin as it continues to mature into a global store of value.

The analysis provided here is for discussion and informational use only, and does not constitute investment advice.

Thanks for reading. Have a question, thought, bone to pick, or topic you'd like me to explore? Leave it in the comments. ??